The Yale Law Journal Pocket Part has published Part I of its Sovereign Wealth Fund Symposium, including a brief but valuable contribution by Mihir Desai and Dhammika Dharmapala. Desai and Dharmapala's essay responds to my paper, A Theory of Taxing Sovereign Wealth, in which I argue that current law subsidizes investment by sovereign wealth funds, and that we should change existing law to eliminate this subsidy.
Desai and Dharmapala argue that the subsidy I identify is illusory. Similar to the work of Bittker, Knoll, and others on the tax exemption for non-profits, Desai and Dharmapala argue that because sovereign wealth funds are tax-exempt on all of their investments, they must employ a higher (after-tax) hurdle rate in evaluating investments than do taxable investors. As such, they argue that imposing a tax on dividends at the same rate as taxable investors would drive sovereign wealth funds out of the equity sector and to other countries where such investments would not be taxed. Exempting sovereign wealth funds from tax, they conclude, does not give them a competitive advantage over private investors, but merely allows them to make the sound financial investments that they would otherwise make.
I disagree with Desai and Dharmapala for three reasons. The first is factual. Sovereign wealth funds are not, as they assume, exempt from tax everywhere. In Germany and much of Europe, they are taxed as private investors.
Second, as Michael Knoll has suggested, the difference in tax rates between interest and dividends for foreign private investors (zero vs. 30%, or 15% if a treaty applies) and SWFs (zero for both) may lead SWFs to allocate more investment into equities than private investors do. In other words, the relevant comparison is not limited to how SWFs are taxed abroad, but also how equity is taxed relative to debt.
Third -- and this is not so much a disagreement as an observation -- Desai and Dharmapala are engaged in a somewhat different inquiry than I am. They assume that SWFs are investing purely for financial reasons, while I assume that some SWFs have mixed financial and geopolitical motives.
This debate raises an empirical question that is difficult to answer -- if the US were to impose a tax on dividends received by SWFs, where would they shift their investments, assuming they would shift at all? Because their investments are typically structured as convertible debt/equity hybrids, and because SWFs are sensitive to geopolitical concerns, I suspect that the closest substitute would be a subordinated debt investment in the US, not an equity investment abroad. If that's right, then the difference between tax rates on debt and equity for private and sovereign investors is more important than the difference in tax rates on equity investments here and abroad.
Mihir Desai & Dhammika Dharmapala, Taxing the Bandit Kings (Yale Law Journal Pocket Part)
Michael Knoll, Taxation and the Competitiveness of Sovereign Wealth Funds (SSRN draft)
Victor Fleischer, A Theory of Taxing Sovereign Wealth (NYU L Rev, forthcoming)
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