International Tax Competition Outlook
By: Daniel Mitchell

Supporters of tax competition, financial privacy, and fiscal sovereignty had a pretty good year in 2002. The hard work of many people inside and outside the Administration helped convince the White House to reject the European Union's (EU) proposed Savings Tax Directive. This decision – combined with Switzerland's emphatic opposition – caused the EU to propose a watered-down (but still misguided) alternative. The "harmful tax competition" scheme of the Organization for Economic Cooperation and Development (OECD) remains moribund, largely thanks to leaders in many low-tax jurisdictions and free-market groups in the United States. Supporters of tax competition even overcame immense odds and blocked a proposed IRS regulation that would force U.S. banks to put foreign tax law above American tax law.

But this does not mean that the news is all good, or that the battles have all been won. Indeed, every single victory should be viewed as a temporary respite. The EU, for instance, has announced a new Savings Tax Directive. The OECD is still trying to bully low-tax jurisdictions. The IRS regulation could be finalized any day, which would give a big boost to Europe pro-tax harmonization movement.

Unfortunately, there will never be a permanent (or at least long-term) victory in the battle for tax competition, financial privacy, and fiscal sovereignty until there is fundamental tax reform in the United States. Simply stated, IRS and Treasury bureaucrats will continue to agitate for tax harmonization policies such as "information-exchange" as long as America has a "worldwide" tax system. But if the internal revenue code is replaced by a simple and fair system like the flat tax, the United States government no longer will have any reason to care about income earned in other nations. And if this happened, Europe's welfare states would have almost no chance of convincing the United States to oppose tax competition. This would be the death knell of tax harmonization. The United States is the 800-pound gorilla in the world economy, and any effort to create a global tax cartel is bound to fail without American support.

Fortunately, there is growing evidence that the Bush Administration wants to reform the tax code. Proposals to reduce the double-taxation of corporate income are a sign that the White House understands the need to make America's tax code more competitive. President Bush's new Treasury Secretary, John Snow, should be a major ally in this regard. Mr. Snow is an economist who received his Ph.D. studying under Nobel Laureate (and avid tax competition supporter) James Buchanan. Snow also served on the National Commission for Economic Growth and Tax Reform in 1995-1996, displaying a solid understanding of tax policy. The President also named a new National Economic Council Chairman, Stephen Friedman, whose views on tax competition issues are a mystery. The optimistic view is that Friedman's Wall Street experience will make him very sensitive to the need to attract and retain financial capital, but only time will tell whether he is a strong ally.

So what happens next? There is every reason to believe that victories will outnumber defeats in 2003. Thanks to the Center for Freedom and Prosperity, the coalition supporting tax competition gets stronger every day, and the Center's work will be even more effective now that Republicans control the Senate. Most important of all, time is an ally. International competition is forcing governments to lower tax rates and reform tax codes – continuing a process that began when Margaret Thatcher and Ronald Reagan slashed tax rates 20 years ago. The politicians usually do not like having to respond to this competitive pressure, which is why they want the OECD and EU to create tax cartels, but they will be forced to make additional pro-growth reforms if the battle to protect tax competition is successful. This is why the following battles are so important (for more information visit CFP's web page at http://www.freedomandprosperity.org/)

EU Savings Tax Directive

The EU failed to achieve its primary tax harmonization goal. The Brussels-based bureaucracy has been forced to give up on the Savings Tax Directive, a scheme that would have required low-tax jurisdictions to inform high-tax nations about the private financial affairs of selected non-resident investors. That is the good news. The bad news is that the EU has proposed an alternative that is almost as bad. Under the new proposal, low-tax nations are supposed to either "share" information about nonresident investment (the original EU scheme) or impose a withholding tax on nonresident investors (and turn over the bulk of the revenue to the investors’ home countries).

Needless to say, this is bad policy. Income that is saved and invested should not be subject to an extra layer of tax – regardless of which nation imposes the double-tax. Moreover, nations should not seek to tax economic activity outside their borders – yet that is the chief goal of Europe’s tax harmonization advocates.

Fortunately, the new EU Directive faces huge obstacles. Most importantly, the bureaucrats are going to have a very difficult time gaining necessary approval from so-called third countries. Switzerland has nominally acquiesced to the scheme, but five other jurisdictions (Liechtenstein, Monaco, Andorra, San Marino, and the United States) still need to approve the cartel in order for it to take effect. Needless to say, this is quite unlikely. The United States, for instance, already rejected the original EU scheme. And since the U.S. is not going to impose a withholding tax on interest and capital gains (and certainly would not share any revenue with other countries), that should be the death-knell for the Directive.

The EU is pretending this issue does not exist, claiming that U.S. policies already are compatible with the Directive. This is a rather fanciful assertion, and it remains to be seen whether low-tax jurisdictions are sufficiently naïve to accept this inaccurate declaration. What is clear, however, is that Europe will lose immense amounts of capital is the new Directive is implemented. The U.S. will be a net beneficiary, but Panama, Hong Kong, Singapore, and many other jurisdictions also will reap the benefits of Europe’s self-inflicted wounds.

Led by the Center for Freedom and Prosperity, the EU Savings Tax Directive was defeated in 2002, and CFP already has announced that the opposition will be just as vigorous in 2003. Supporters of market liberalization will maintain pressure on the Bush Administration and work with others around the world to ensure this dangerous cartel is never implemented.

2003 Prognosis: The original EU Directive is dead. But the new proposal remains a threat to economic liberalization and global commerce. Fortunately, the revised Directive faces enormous obstacles, including the fact that the United States and other key jurisdictions will not participate in the proposed cartel.

OECD Anti-Tax Competition Initiative

Early last year, the OECD was able to get a large number of low-tax jurisdictions to send so-called commitment letters to the Paris-based bureaucracy. These letters, which promise changes to tax and privacy laws that will make it easier for high-tax nations to tax income earned outside their borders, were sent because the OECD was threatening these jurisdictions with financial protectionism. But these letters contained a "virus" – the jurisdictions promised to implement bad tax and privacy laws only if all OECD member nations agreed to the same misguided policies. This put the bureaucrats in a difficult situation since several member nations (including the United States, the United Kingdom, Switzerland, and Luxembourg) are "tax havens" according to OECD criteria. This explains why it was so important to defeat the earlier version EU Savings Tax Directive. Had the original Directive been approved, it would have created an information-sharing tax cartel among 21 of the world's most powerful nations - and also obligated more than 30 blacklisted low-tax jurisdictions to implement the policies contained in the commitment letters.

Even though the original EU Savings Tax Directive collapsed, the OECD is still trying to pressure low-tax jurisdictions. This comes as no surprise to those who have observed the OECD's dishonest tactics over the last two-three years. Fortunately, the low-tax jurisdictions have performed admirably. They have refused to implement the OECD wish-list, and two nations – Panama and Antigua – have sent letters to Paris explaining that they no longer are bound by the earlier commitment letters. Hopefully, this will be the start of a trend.

Last but not least, the seven nations (Andorra, Liechtenstein, Liberia, Monaco, The Marshall Islands, Nauru and Vanuatu) that refused to capitulate to the OECD deserve special praise. Their defense of national sovereignty was seen as risky. Yet none of these jurisdictions has been subjected to financial protectionism.

2003 Prognosis: The OECD "harmful tax competition" campaign will remain stalled. More low-tax jurisdictions will disavow their commitment letters. The OECD may even face budget cuts because many U.S. lawmakers now see it as a counter-productive bureaucracy.

IRS Interest Reporting Regulation

In the waning days of the Clinton Administration, the IRS proposed a regulation to force American banks to report the interest paid to all nonresident aliens. This proposal was bad policy for a number of reasons. It would drive capital from U.S. banks. It would undermine tax reform. And it represented a flagrant abuse of the regulatory process. This proposal drew heated opposition from both industry and the public policy community. More than 99 percent of the submissions during the public comment period were hostile, and 100 percent of the testimony at the public hearing was negative. Numerous members of Congress weighed in against the proposed regulation, and CFP mounted a strong lobbying campaign against the IRS scheme. About 18 months after the regulation was first proposed, this effort bore fruit. The IRS was forced to withdraw the regulation.

But in a duplicitous move, the IRS almost immediately re-issued the regulation after some cosmetic changes. Even worse, it appeared that certain segments of the financial services industry were tricked by the IRS bait-and-switch routine and planned to remain neutral, weakening the pro-tax competition coalition. Notwithstanding the odds, the Center for Freedom and Prosperity re-launched its battle against the regulation. Once again, the proposal attracted overwhelming opposition. In a mirror-image of the first fight, more than 99 percent of the public comments were against the regulation and the public testimony was unanimously negative to the IRS scheme as well. Many members of Congress also announced opposition to the new proposal.

There was considerable fear that the IRS would try to finalize the regulation before the end of the year (in part to give back-door support to the EU since the regulation could be misinterpreted as an "equivalent measure" and thus a sign of U.S. support for the Savings Tax Directive). Fortunately, this did not happen. But this may only be a short-term victory. The Treasury Department is actively pushing the proposal – even though it puts the interests of foreign tax collectors above U.S. law and before the interests of the American economy. The Coalition for Tax Competition will continue to fight hard to block the regulation, and opponents also believe that a legal challenge will be successful if the proposal is finalized.

2003 Prognosis: The President's new economic team probably will decide this issue. If the decision goes the wrong way, expect a legal challenge since the regulation contravenes existing law and the IRS also failed to obey regulatory procedures such as preparation of a cost-benefit analysis.

Conclusion

Supporters of tax competition, financial privacy, and fiscal sovereignty should be proud of their efforts. Fighting uphill battles, they have emasculated the OECD and forced the EU to retreat. The Coalition for Tax Competition has become an important force in international economic policy. This bodes well for the future.

Last but not least, we note with a mixture of sorrow and appreciation the retirement of House Majority Leader Dick Armey. Congressman Armey was the first member of Congress to join the fight against tax harmonization. His initial letter to the Clinton Administration (September7, 2000 - http://www.freedomandprosperity.org/armey.pdf) triggered a series of events that changed the course of history and made the world a better – and freer – place. Thank you, Mr. Armey.

By: Daniel Mitchell
Center for Freedom and Prosperity
Senior Fellow Heritage Foundation
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