A taxing Treasury proposal

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If Treasury Department officials get their way, a new IRS regulation could be in place soon that would likely drive away tens of billions -- and maybe hundreds of billions -- of dollars worth of foreign investment capital from U.S. banks.

Treasury is pushing to finalize a regulation that would require American banks to report interest paid to foreigners in order to allow foreign governments to tax interest income earned by their citizens. With over $1 trillion of foreign capital directly invested in the U.S. banking system -- approximately $200 billion of which could be covered by the proposed regulation -- banks would likely suffer an exodus of investors who wish to remain free of the taxman in their home countries. The banking industry opposes the regulation, as does the Federal Deposit Insurance Corp. (FDIC). But Treasury is pushing ahead anyway.

The greatest irony, though, may not be that such a move would be made as the economy is struggling to regain its footing, but that it is the Bush Treasury Department that is going forward with a Clinton-era proposal in spite of significant opposition from conservatives.

Three days before Bill Clinton left office, his Treasury Department issued a regulation on which it had dragged its feet for well over a year: requiring banks to report interest income earned by "nonresident aliens" -- government-speak for foreigners who don't live in the United States. The Clinton administration likely waited until the last minute because it viewed the idea as controversial given how much money is at stake. Estimates vary, but it seems clear that foreign individuals and corporations have at least $1 trillion deposited in U.S. banks.

It's not just the banking industry, though, that believes the reporting requirement could drive away billions in investment dollars. In a letter to Treasury earlier this year, FDIC Chairman Donald Powell wrote that the proposed regulation could harm the banking industry, "particularly smaller institutions whose survival is dependent on stable sources of deposits." Mr. Powell's letter also expressed the concern that the extra red tape could be an onerous burden for banks.

Conservatives are also up in arms. Letters opposing the proposed regulation have been signed by 58 members of the House and 18 Senators. And more than 30 think tanks and associations -- such as the Heritage Foundation, Americans for Tax Reform, the Center for Freedom and Prosperity -- have registered opposition to the reporting requirement. Conservatives also flooded Treasury with complaints during the 90-day public comment period (something whereby a government agency solicits opinion from the general public about all proposed regulations). Out of 217 public comments submitted to Treasury, only one supported the proposal.

Ironically, Congress exempted interest on foreigners' bank deposits from U.S. taxation and reporting to foreign governments because it wanted the United States to be a "tax haven" in order to attract foreign capital. It worked. The United States now lays claim to more deposits by foreigners than any other place on earth. That's why Congress, on two separate occasions in 1976 and 1986, reaffirmed the policy goal of sheltering interest income earned by foreigners in U.S. banks.

Aside from the direct impact of the Clinton-era proposal, there could be a major side-effect that might also cause the banking industry to lose additional billions in investment dollars. Final implementation of the regulation would provide a dramatic boost to the European Union's worldwide campaign to wipeoutso-calledtax havens,"whereby European nations have been twisting the arms of low-tax countries like the Cayman Islands and Luxembourg to either raise taxes or allow the EU to tax more easily Europeans investing there.

The EU's tax collection efforts, though, have stalled in recent months. But a victory in the United States -- from a conservative, pro-tax cut administration, no less--would give the EU momentum in going after small, low-tax nations. Trouble is, if they succeed, the United States would suffer. An awful lot of the money invested in the Caribbean banking centers -- almost $800 billion by Treasury's own estimates -- winds up invested in the United States. So, if those low-tax countries cave to EU pressure -- and money gets pulled out of the Caribbean as a result -- the U.S. banking system would suffer further. And if the banking system loses tens of billions of dollars -- or more -- there will be a lot less money available for loans to car buyers, homeowners and small businesses.

The reporting requirement has been sitting in limbo for more than two-and-a-half years, and there is a chance that new Secretary of the Treasury John Snow won't sign off on the proposal. If he does, however, only time -- and disappearing bank deposits -- will tell how much the regulation will harm the economy.

Joel Mowbray is a syndicated columnist.