August 19, 2008
A Theory of Taxing Sovereign Wealth
Posted by Victor Fleischer

I've posted my Sovereign Wealth paper on SSRN.  The paper will be published in the NYU Law Review in 2009. 

You can download the paper here.

Here's the abstract:

Sovereign wealth funds enjoy an exemption from tax under section 892 of the tax code. This anachronistic provision offers an unconditional tax exemption when a foreign sovereign earns income from non-commercial activities in the United States. The provision, which was first enacted in 1917, reflects an expansive view of the international law doctrine of sovereign immunity that the United States (and other countries) discarded fifty years ago in other contexts. The Treasury regulations accompanying section 892 define non-commercial activity broadly, encompassing both traditional portfolio investing and more aggressive, strategic equity investments. Because section 892 was not written with sovereign wealth funds in mind, the policy rationale for this generous tax treatment has not been closely examined before.

This Article provides a framework for analyzing the taxation of sovereign wealth. I start from a baseline norm of “sovereign tax neutrality,” which would treat the investment income of foreign sovereigns no better and no worse than private investors’ income. Nor would it favor any specific nation over another. Whether we should depart from this norm depends on several factors, including the external costs and benefits created by sovereign wealth investment, whether tax or other regulatory instruments are superior methods of attracting investment or addressing harms, and which domestic political institutions are best suited to implement foreign policy. I then consider whether we should impose an excise tax that would discourage sovereign wealth fund investments in the equity of U.S. companies. If desired, the tax could be designed to complement nontax economic and foreign policy goals by discouraging investments by funds that fail to comply with best practices for transparency and accountability.

The case for repealing the existing tax subsidy is strong. We should tax sovereign wealth funds as if they were private foreign corporations; there is no compelling reason to subsidize sovereign wealth. My analysis also shows that imposing a special excise tax may not be the optimal regulatory instrument for managing the special risks posed by sovereign wealth funds, although a carefully-designed tax would be more effective than the status quo.

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Comments (4)

1. Posted by Ekonomix on August 19, 2008 @ 12:52 | Permalink

Considering that inflation runs at 5.6% and bond yields are below 4%, we are already taxing them significantly!!


2. Posted by Jake on August 19, 2008 @ 20:42 | Permalink

Nifty piece, Vic. Agree with taxing SWFs as foreign private corporations. Less enthused about the excise tax you propose. And what of income tax conventions? Were your proposed reforms to become law, SWFs surely would argue for tax treaty relief.

3. Posted by Vic on August 20, 2008 @ 6:24 | Permalink

Jake, I agree, SWFs could seek treaty relief. But many countries with SWFs don't yet have treaties with us, and at least the treaty process would offer an opportunity to make favorable tax treatment conditional on appropriate investment structure and behavior by the funds.

4. Posted by Jake on August 20, 2008 @ 20:19 | Permalink

Absolutely agree, Vic. Were Congress to repeal or modify section 892 as you suggest, the Treasury Department would get a valuable hammer to wield in tax treaty negotiations. Should you get the chance (and I hope you do), please explain this to Baucus and Grassley!

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