The tax aimed at foreign investors

A new legislative draft on Capitol Hill proposes a withholding tax surcharge of up to 20 per cent on the dividends and interest paid to foreign holders of US corporate equity and debt. Markets took fright. The authors pitch it as a way to penalize capital flight and pay for domestic infrastructure. It also takes aim at the way America pays its bills abroad.

An old idea returns

The proposal did not come from nowhere. Stephen Miran, now chairman of the president's Council of Economic Advisers, wrote a paper last November that floated charging foreign holders of Treasuries a fee for the privilege, as part of a wider plan to weaken the dollar. In April, after the tariff announcements, American shares, Treasuries and the dollar fell together, and foreign investors began asking openly whether they were overexposed to American assets. A tax on their income gives that question a sharper edge.

Where the surcharge bites

The version that has attracted most attention sits in the tax bill the House passed in May, as a new section 899 of the tax code. It is aimed at residents of countries whose taxes Washington regards as discriminatory against American companies, a list that could include countries with digital services taxes and those applying the global minimum tax agreed through the OECD. The extra charge would rise by 5 percentage points a year until it reached its cap.

That drafting turns a tax provision into a trade weapon. Much of Europe has either a digital services tax or the minimum-tax rules, so pension funds and insurers in some of America's largest sources of portfolio capital could be caught. The provision would also reach the sovereign wealth funds of affected countries, which currently enjoy an exemption for many of their American investment returns.

Who funds the deficit

The United States runs a structural current account deficit of more than three per cent of GDP. To finance federal borrowing and private corporate investment it needs billions of dollars of net foreign inflows every day. Sovereign funds, pension trusts and private investors have long assumed that cross-border capital would be taxed neutrally. A punitive withholding levy breaks that assumption. If foreigners lose 20 per cent of the cash flow from US assets, they will want a gross yield higher by a similar margin.

The mechanism works through prices before it works through flows. A foreign pension fund that must now receive less after tax from an American corporate bond will pay less for it, which pushes up the yield American companies pay to borrow. For shares the effect is a lower valuation for any company with a large foreign shareholder base. Tax treaties that cut the standard 30 per cent withholding rate on dividends for residents of friendly countries would be undermined, and the countries concerned could retaliate against American investors abroad.

Treaties typically cut the rate on portfolio dividends to 15 per cent, and investors from treaty countries have built their allocations around that figure. A surcharge that layers extra percentage points on top changes the after-tax return on every American share they own. For an equity with a modest dividend yield the hit to total return is small in any one year. The larger effect is on the discount rate foreign investors apply, because they must now price the chance that the charge rises again.

Lessons from the 1960s

America has used tax to steer capital before, with instructive results. In 1963 the Kennedy administration announced the Interest Equalization Tax on Americans buying foreign securities, to stem the outflow of dollars. Borrowers simply moved their business to London, and the tax helped the young Eurobond market grow into a centre of finance beyond the reach of American rules. In 1984 Congress went the other way and scrapped withholding tax on portfolio interest paid to foreigners, precisely to draw their money into American debt. The lesson of both episodes is that capital is mobile and follows the tax treatment.

Treasuries spared, for now

The first draft appears to exempt Treasury debt. Global asset allocators are not much comforted. They see a precedent. Congress has shown it will use withholding taxes as a weapon, and foreign capital parked in American markets can no longer count on neutral treatment.

The strongest argument against alarm is that foreign investors have few alternatives. No other market offers the depth of American equities or the liquidity of American debt, and a surcharge might be bargained away in trade talks before anyone pays it. Both points are fair. Neither removes the damage already done by the proposal, because investors must now price the chance that such a tax passes, or returns in a later bill.

Winners, losers and the dollar

The losers would be American companies that rely on foreign shareholders or lenders, and American subsidiaries of foreign groups, which could face higher taxes on payments to their parents. Foreign governments whose taxes triggered the surcharge would come under pressure to drop them, which is the point of the design, and some may do so. That would count as a win for Washington's negotiators and for American technology companies that pay digital services taxes abroad.

The currency is the wider exposure. The dollar has fallen sharply against the euro and other reserve currencies this year, and foreign investors who kept their American holdings have increasingly hedged their dollar exposure rather than sell. Hedging lets them stay invested while selling dollars forward, which weakens the currency without any visible outflow. A tax on their returns gives them another reason to hedge more, or to shift new money to Europe and Japan at the margin.

What investors will watch

The first test is the Senate, which can narrow, delay or drop the provision. After that come the Treasury's monthly figures on foreign purchases of American securities, the dollar's performance against other reserve currencies, and the spread that American corporate bonds pay over Treasuries. A country running twin trillion-dollar deficits can ill afford to tax the foreigners who fund them. If the surcharge passes, American borrowers, the Treasury included, should expect to pay a lasting premium to keep that money coming. The likeliest near-term outcome is a Senate version that delays or softens the charge, but the proposal has already taught foreign investors to demand a little more for holding American assets, and that lesson will outlast the bill.