In response to my post on Tuesday about a proposed financial transaction tax that would tax the purchase and sell of securities, Adam Rosenzweig sent along a link to his paper on the subject.  Imperfect Financial Markets and the Hidden Costs of a Modern Income Tax argues that the existing regime of taxing investing profits subsidizes speculation and suggests a derivatives transaction tax instead.  So, more issues to think about in this hot topic.  Here is the abstract:

The news has been filled with stories of meltdowns in the financial world, with the government, independent agencies, and politicians all devoting significant time and energy to coping with the consequences. As investment banks, hedge funds, and mortgage lenders continue to suffer massive losses, the government and its agents are left to try to pick up the pieces. Among other options being discussed, the government has proposed buying up illiquid assets of such investors, in effect betting on the price of illiquid mortgage securities. But what if, in addition to these more transparent problems, additional hidden costs from the financial crisis were being borne by the government in some other way? Even worse, what if the government had implicitly underwritten some of them in the first place? Building on insights from recent finance literature, this article contends that the government could in fact bear such hidden costs, through the interaction of a unique and underappreciated aspect of publicly traded financial derivatives - the ability to "decouple" the economic return of a risky asset from direct ownership of the underlying asset itself - and an income tax on risky investments. Under relatively conservative assumptions, such an analytical approach can produce a surprising result: the imposition of a facially neutral income tax can actually serve to subsidize speculators in financial derivatives, both in the model and as extrapolated to the real world. More specifically, an income tax in a world with imperfect financial markets can result in incentives to speculators to impose excessive amounts of liquidity risk on the markets, and the economy as a whole, with the government ultimately bearing the cost. These conclusions demonstrate the urgent need for a more comprehensive approach to financial derivative markets than has traditionally been undertaken, expanding the analysis beyond particular transactions to incorporate markets, traders, speculators, and investors more broadly. This article does so by proposing the adoption of a derivatives trading tax, not as a supplement to or replacement for, but rather as an integral part of, the income tax regime. Such a tax would not only offset the costs of imperfect financial markets borne by the government through the income tax, but could also ameliorate the suboptimal excess risk in the financial markets in the first place. Addressing such problems in this manner falls distinctly to the legal community, precisely because crafting the institutions and mechanisms necessary to equitably and efficiently allocate the costs and benefits of society is itself an inherently legal undertaking. Doing so may prove challenging, but it is a challenge to which the legal academy must rise for a comprehensive solution to be achieved.

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David Brooks writes today in the NYT about economist and co-director of the Center for Economic and Policy Research Dean Baker's proposal to create a "financial transactions tax."  This tax (the writer suggests .25%) would be assessed on any sale or transfer of stocks, bonds or other financial asset.  The columnist does not specify whether the seller or the buyer would pay the tax, but in a Coasian world it does not matter.  (Part of the article seems to suggest it would be both -- by hypothesizing that someone would "pay a quarter-percent fee to purchase the asset in the first place and then another quarter percent to sell it."  I'm not sure if this was intended or not.  If so, then there is a total of a .5% fee every time a security changes hands.)  This fee is projected to raise perhaps $100 billion a year.

Of course, a lot of different new taxes would raise a lot of money -- that's what taxes do -- but we should try to anticipate how a tax (or a deduction) would skew behavior, and try to determine whether that is how behavior should be skewed.  The unintended consequences of varying tax policies may in fact add to economic troubles or just create new ones.  Many have argued that the mortgage tax deduction may have been an accomplice in the housing bubble, so let's be a little careful before we start imposing taxes or subsidizing behavior with deductions.

My first reaction at reading the first part of the article was that if we want the capital markets to be efficient, taxes lead us away from efficiencies.  (Remember one of the (false) assumptions of the efficient capital market hypothesis is that there are no transaction costs.  When taxes are present, studies show that markets move away from efficiency, and this is why we see "January effects" for certain types of investments and "November effects" for others.  Adding a new tax to buying and selling securities seems like it has the tendency to move the market away from efficiency.  At this point in time, we want trading, right?  The tax would have to be fairly nominal if it is not going to skew behavior.  Is .25% nominal enough?  Maybe.

Except that Professor Baker and David Brooks want the tax to skew behavior -- speculative behavior.  You see, it's the really bad people known as speculators who are ruining our markets, who "bring a manic quality to the markets, who treat it like a casino."  Bad speculators trade multiple times a day, so the small fee would add up and possibly make them just calm down and trade slowly, like the rest of us prudent investors.  The "beauty" of the tax is that it is a "progressive" tax "that discourages nonproductive activity."  Hopefully some tax people will jump in here, but I think of progressive taxes as those that affect people more as income increases.  Do we know that day traders or speculators have more income than "buy-and-hold investors"?  We like to say that the "buy-and-hold" people come out on top, so then isn't the tax regressive -- taxing the silly speculators who don't understand investing, just like lotteries are regressive taxes on poor people who are bad at math?  I guess the speculators we really, really hate are the ones that make money.  Bad speculators.

So, the second question is whether speculation really has no utility or even negative utility to the market.  Studies are just appearing telling us what happened when short-selling was banned last Fall, so maybe we'll have the answers soon.  But regardless of whether you are a speculator, prudent investors need speculators for liquidity, and issuers need the presence of liquidity to be able to sell publicly-traded shares in the first place.  If we tax speculators away, then our financial models that assume the ability to sell a particular security at some price may have to be tweaked once the buyers are gone.

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Details over at TaxProf, where I am guest-blogging this week.

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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. 

References

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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Gregg Polsky (Florida State) has posted a new paper, Private Equity Management Fee Conversions.  Here's the abstract:

Because of the uproar over "carried interests," it seems that almost everyone knows that the tax law currently allows private equity managers to pay capital gains taxes on a substantial part of the (often substantial) income generated by their services. While this result raises significant tax policy concerns, the basic tax law governing carried interests is well-settled, and legislative action therefore would be necessary to address these concerns.

In contrast, a little-known technique utilized by private equity managers to convert the character of their remaining compensation income is extremely aggressive and subject to serious challenge by the IRS. Private equity managers regularly attempt to convert their fixed annual two percent management fees into additional carried interest through so-called "management fee conversions." The tax result, if this technique is successful, is the conversion of current ordinary income into deferred capital gains.

Despite the recent spotlight on the taxation of private equity management compensation, surprisingly little attention has been paid to this particular tax minimization strategy. This article attempts to fill that void. Its purpose is twofold. First, it will describe the mechanics of management fee conversions, which are pervasive within the private equity community but not widely appreciated or understood outside of it. Second, it will discuss the tax issues stemming from management fee conversions, focusing on the IRS arguments that could be made to disallow their intended tax results.

Gregg's contribution is an important one to the carried interest debate.  While my Two and Twenty paper focused on the "in plain sight" conversion of service income into capital gain through the straightforward use of carried interest, Polsky focuses on the more subtle gamesmanship of converting management fees into additional shares of carried interest. 

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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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It's been a year since the peak of the uproar about taxing carried interest.  In the year since, the conventional wisdom about what happened has been established.  It fits pretty tightly with what some public choice theory suggests:  legislators engage in rent-seeking behavior.  In other words, it's not just the interest groups and their lobbyists who play hardball.  Kimberley Strassel writes in the WSJ:

The corporate world got an early taste of this last year, when New York Sen. Chuck Schumer used his majority status to take advantage of his home-state financial industry. It works like this: Mr. Schumer steps up to protect hedge funds and private equity from his own party's threats of taxation. In return, a grateful industry writes enormous campaign checks that Mr. Schumer, as head of the Democratic Senatorial Campaign Committee, is now using to increase his party's majority. Somewhere, Mr. DeLay is whistling in appreciation.

Sounds right to me.  For a more complete discussion, see Darryl Jones, The Taxation of Profits Interests and the Reverse Mancur Olson Phenomenon.  Darryll testified to Ways and Means last September.   On legislators as rent-seekers, see generally Ed McCaffery & Linda Cohen's Shakedown at Gucci Gulch and McChesney & Doernberg, On the Accelerating Rate and Decreasing Durability of Tax Reform, 71 Minn. L. Rev. 913 (1987) (available here).

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I decided to see how often the Internal Revenue Code and Immigration and Nationality Act have been amended of late.  And, as you probably expected, nothing beats the IRC for congressional tinkering.  Here's the number of sections of the code amended since 2001:

For a little comparison, here's the number of sections of the INA over the past few years:

Both huge statutes, both big issues - but man, Ways and Means stays involved in our tax affairs.  The DHS oversight people and Tom Tancredo have nothing on those guys.

Of course, the methodology employed here might be suspect.  Here's what I did, and I'd welcome your comments about what I did wrong.  I downloaded the credits for each section of each act from Westlaw.  That gave me a massive text file.  Then I used Concordance to give me a frequency count for each time a year was cited in the credit sections.  And voila, a hit for each year that the GPO recorded an amendment for each section.  Of course, I'm sorta depending on the GPO or whoever to accurately record amendments, but I'm not really sure how else I could do it.  Thoughts?

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The WSJ reports that some high profile horse trainers are sponsoring an investment fund that will buy promising thoroughbreds, complete with a 2&20 carried interest management structure. 

The carried interest portion of the structure will presumably qualify for long-term capital gains treatment for the trainers under current law.  But I have trouble imagining the argument that they, or the racing industry, deserves a subsidy.  I like horse racing as much as the next guy, probably more.  But why would want to use the tax code to subsidize investment in horses?  I'm having trouble seeing the positive externalities generated by the sport. 

This will provide a nice talking point the next time Congress holds hearings on carried interest. 

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Have you filed your taxes, yet?

Normally, I wait until April 15, but I decided to get on it early this year. I filed electronically yesterday. Today I received emails indicating that my filings had been accepted.

Thank you, Turbo Tax!

I was just reflecting on whether there is another product for which I have such warm feelings today as Turbo Tax.

Canaria Cheese, perhaps. We had some of this wonderful cheese, from Carr Valley Cheese in LaValle, Wisconsin. this afternoon.

Or Les Schwab Tire Centers. I have written about Les Schwab before, and I was absolutely thrilled last summer to find a Les Schwab outlet a mile from my house. We replaced the tires on one of our cars almost immediately after arriving in Utah, then did another car this past Friday. Impeccable service. One of our neighbors noted that we could have saved money at Costco, but Les Schwab is well worth the premium.

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The Senate Finance Committee is interested in taxing sovereign wealth funds.  Or at least they want to learn more:  Baucus and Grassley have asked the Joint Committee on Taxation to write a report. 

Meanwhile, on the non-tax front, Gilson & Milhaupt have posted Sovereign Wealth Funds and Corporate Governance: A Minimalist Response to New Mercantilism.  They suggest suspending the voting rights of SWF equity investments (the voting rights would return when sold to a private investor).  Seems very sensible, and a good start, although I'm not sure that it's sufficient to fully address the concern.  If you are a 10% owner of a publicly traded corporation, I'm not sure you need voting rights or a board seat to have influence over corporate policy.  Still, Gilson & Milhaupt's proposal seems like a sensible place to start the corporate governance discussion.  See also Paul Rose, Sovereigns as Shareholders.  Paul prefers the best practices / code of conduct approach.

I hope to post my own tax-focused paper in a couple of weeks.  Stay tuned ...

Prior posts: 

Current Law on Taxing Sovereign Wealth Funds: Why It's Good to Be the King (March 5, 2008)
Taxing Sovereign Wealth Funds (March 4, 2008)

Related Research:

Two and Twenty (forthcoming NYU L Rev)
Taxing Blackstone (forthcoming Tax L Rev)

Press Coverage:

AP / SF Chronicle (March 7, 2008)
Financial Week (March 5, 2008)
NYT Deal Book (March 5, 2008)
Dealbreaker (March 4, 2008)

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For those interested in non-tax issues, The House Financial Services Committee is currently holding a hearing on Sovereign Wealth Funds.   

For the tax nerds out there, I thought I might offer a short overview of how SWFs are currently taxed.  In future posts, I will propose some reform alternatives for Congress to consider.

The big picture is that Sovereign Wealth Fund investments in the United States are generally exempt from tax under Section 892 of the Code.  The idea is that when a foreign sovereign makes a portfolio investment in the United States, the sovereign is acting as a sovereign and is entitled to sovereign immunity. 

There is an exception for commercial activity.  So, for example, if the government of Italy were to operate a cycling touring company in the United States, the profits from that active business activity would be taxed as business income.  (Similarly, if a customer of that touring company fell off the bicycle and got hurt, Italy would not be immune from tort liability.)  The key for Sovereign Wealth Funds is that portfolio investing is *not* treated as a commercial activity under current law.  So the returns from their investments -- interest, dividends, capital gains -- are categorically exempt from tax.

The detail start to get a little complex, so I'll continue below the fold.

General Rule.  The general provision is Section 892(a)(1).  That section says that a foreign government's income from investments in the United States in (1) stocks, bonds, and other domestic securities, (2) financial instruments held in the execution of governmental fiscal or monetary policy, and (3) interest on deposits in US banks isn't includible in gross income and is therefore exempt from US tax. 

Section 892(a)(2) then carves an exception for income derived from a commercial activity, a controlled commercial entity, or the disposition of an interest in a controlled commercial entity.  These are all terms of art, which I'll explain in a minute. 

If any income isn't exempt, then Section 892(a)(3) says that the foreign government will be taxed as a corporate resident of its own country.

Foreign Investors.  What would it mean to tax a SWF as a corporate resident of its own country?  If the income is effectively connected with a US trade or business (ECI), then the income would be taxed on terms similar to a US business.  For non-ECI investments, however, the rules are a little different for foreign investors than US investors.  For non-ECI investments, a foreign corporation would be subject to tax on its FDAP income.  FDAP stands for fixed or determinable, annual or periodic income -- which means things like dividends, interest, rents and royalties.  What makes these streams of income special is that they can be withheld at the U.S. source of that income.

So the tax Code imposes a 30% tax on FDAP income to foreign investors, withheld at the U.S. source, such as a US company paying a dividend.  This tax rate is often reduced by treaty agreement.  Also, certain portfolio interest is also exempt, allowing US companies to borrow more freely abroad.

Capital gains are not FDAP income.  Portfolio capital gains are not taxed in the US -- they are instead treated as foreign source income and therefore not taxed here.

Lastly, direct U.S. real estate holdings and certain indirect real estate holdings are subject to FIRPTA, which imposes a withholding tax on gains from the sale of US real property. 

Why It's Good To Be the King.   There are thus a limited but significant number of ways in which it's better to be treated as a foreign sovereign than a foreign private investor--most notably, dividends, certain types of interest payments, and real estate holdings.  Under the applicable 892 regulations, the exemption for sovereigns is extended to "integral parts" or a foreign sovereign (such as an agency) or a "controlled entity" of a foreign sovereign, i.e., a separate juridical entity (such as a corporation).  Foreign-controlled pension trusts for employees of the foreign government also qualify under the regulations. Under the regs, then, SWFs qualify as controlled entities of a foreign sovereign. 

The regs also require that to qualify as a controlled entity, the earnings must not inure to a private person.  For some government funds, like those controlled by Norway or Canada, this doesn't seem too difficult to show.  Singapore also seems pretty transparent on this point.  For others, like UAE, Saudi Arabia, and China, it's harder to know what happens to the earnings. 

How the rules work in practice.  SWFs are usually organized as separate juridical entities, funded and controlled by a foreign sovereign, and therefore qualify under the regulations as "controlled entities" of a sovereign.  The usual investments by SWFs in stocks, bonds, bank deposits, and government obligations are exempt from tax.  When these passive investment activities are mixed with commercial activities in the same investment vehicle, the tax rules get complicated.  There may also be circumstances where the SWF may blur the line between passive investing and operating a financing business.  But for present purposes, the analysis of current law is pretty straightforward.

To my knowledge -- and I welcome any comments from practitioners out there -- the Service has not looked into whether the earnings from SWF inure to a private person rather than the sovereign.  This inquiry is difficult, of course, in the case of royalty -- is a Prince a private person or a sovereign? 

That's enough current law for now.  In the next post, I'll talk a bit more about why all of this matters.

For more, check out the Tax Management Portfolio (913), U.S. Income Taxation of Foreign Governments, International Organizations and Their Employees.  Brett Dick (Heller Ehrman) is the author, and it's a great companion to the code and regs.

Prior posts: 

Taxing Sovereign Wealth Funds (March 4, 2008)

Related Research:

Two and Twenty (forthcoming NYU L Rev)
Taxing Blackstone (forthcoming Tax L Rev)

Press Coverage:

Financial Week (March 5, 2008)
NYT Deal Book (March 5, 2008)
Dealbreaker (March 4, 2008)

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My newest research project looks at the taxation of sovereign wealth funds.  The paper is still a work-in-progress, but here is where I think I am headed:  Under current law, Sovereign Wealth Funds are exempt from U.S. tax.  Congress should consider amending Section 892 of the code to tax these state-owned investments under certain conditions, and the Code should not favor state-owned investors over private foreign investors.  As with Two and Twenty, I think this is an example where the investment world has changed since Congress wrote the rules, and it is time for an update.

Overview. Under current law, based on the principle of sovereign immunity, investments by foreign state-owned funds and controlled entities are generally exempt from tax.  Commercial activities in the US may be taxed, but portfolio investing is not considered a commercial activity. 

By contrast, investment returns by private foreign individuals and corporations are taxed at rates as high as 30%, although this rate is often reduced by treaty agreement, or, in the case of most capital gains, treated as foreign source income and therefore exempt from U.S. tax.  Encouraging foreign investment in the United States generally increases overall welfare.  But there is no sound policy reason to unconditionally exempt state-owned investment funds from U.S. taxation, and it is not at all clear that we should give state-owned funds a competitive advantage that crowds out private investment.  At the same time, policymakers should proceed with caution, as raising tax rates on Sovereign Wealth Funds could be perceived as a protectionist signal that could discourage both state-owned and private foreign investment.

Regulatory arbitrage between investment regulation and tax.  One policy concern is how the funds want to have it both ways.  On the one hand, they present themselves to the SEC and other regulators as if they are just like any other institutional investor, investing for purely commercial purposes.  And thus, they argue, they should not be subject to any additional regulatory burden of disclosure, transparency, or anything else.  On the other hand, for tax purposes they are treated as sovereign states and thus entitled to sovereign immunity from taxes.  The net result of our regulatory scheme, then, is to give state-owned funds a competitive edge over private investment.

Continued below the fold.

What Are SWFs?  Sovereign Wealth Funds are investment vehicles funded and controlled by foreign governments.  The largest funds are controlled by Abu Dhabi (UAE), Saudi Arabia, Norway, Singapore and China.  These funds have grown rapidly in recent years.  Together these funds control perhaps $2-$3 trillion in capital, an amount which exceeds the size of the US private equity industry.  Fueled by oil profits and/or trade surplus, SWFs are expected to grow to as much as $10 trillion or more over the next ten years.  Historically, foreign governments would often recycle trade surplus back into the United States by buying Treasury bonds.  More recently, these governments are taking a more active investment role, seeking a higher yield than what Treasury bonds offer.  SWFs are the investment vehicles they use to do that.  Their portfolio investments include a mix of corporate debt, governmental obligations, and corporate equity stakes. 

Sovereign Wealth Funds have a complex relationship with the private equity industry.  For the last 20 years or so, SWFs have often been limited partners in private equity funds.  At times, SWFs make direct investments in target companies, competing with PE funds for deal flow.  Most recently, SWFs have purchased direct equity stakes in private equity sponsors and other US financial institutions such as Blackstone, Citigroup, and Merrill Lynch.  One way to think about SWFs is as a low-cost (and tax-subsidized) provider of capital to the PE industry. 

Why This Matters.  The big worry is that these sovereign wealth funds are Trojan horses which will allow foreign governments to shape and influence American enterprise in a manner inconsistent with our economic and national security interests.  Even if funds are currently acting in a manner consistent with other, non-governmental institutional investors--and by most accounts they are--there's no guarantee that they will continue to do so in the future in circumstances where the financial interests of the fund and the political interests of the government that controls the fund diverge.  Giving foreign governments partial ownership of companies like Citigroup and Merrill Lynch gives those countries new leverage in foreign policy discussions; sudden withdrawal of foreign state-owned investment could harm the financial services sector of the U.S. economy.  Of course, one can also view these investments in a more positive light; China's investment in Blackstone might help it learn to modernize its own financial infrastructure, a development which would benefit the U.S. and China alike. 

How They Are Taxed Currently.  Section 892 of the Internal Revenue Code exempts foreign sovereigns from income tax on their passive investment activities.  Foreign individuals and corporations, by contrast, pay taxes on most passive investment activities at rates ranging from 0% to 30%, depending on treaty agreements and the nature of the investment.  With the exception of certain real estate investments, foreign investors generally don't pay tax on capital gains from portfolio investments.   The tax code thus has the unintended effect of subsidizing state-owned capital over private capital, particularly on debt investments.

What To Do About It.  The policy objective is to tax Sovereign Wealth Funds as we tax private foreign  investors, and perhaps only on the condition that they are investing in a manner consistent with commercial portfolio investment. 

The most far-reaching option would be to raise the baseline tax rate on all returns from sovereign wealth portfolio investments, including capital gains, at a 30% rate.  Like the flat 30% rate on passive "FDAP" income to foreign individuals and corporations, this tax rate would be reduced by treaty agreement.  This approach would raise significant amounts of tax revenue, and it would give the U.S. a new policy lever to achieve nontax objectives, such as encouraging SWFs to comply with best practices of transparency, disclosure, and accountability.  Because capital gains cannot be withheld at a US source, however, this approach would be very difficult to administer.

An intermediate option would simply put SWFs on equal footing with other foreign investors.  As such, most capital gains would be exempt from tax, but passive FDAP income (interest, dividends, etc.) would be taxed at a 30% rate (withheld at the source), unless a lower rate were negotiated by treaty.  This option would be easier to administer and enforce, and it would still help achieve some of the nontax policy objectives noted above.

I'll discuss other reform alternatives--and the many complexities of the proposals--in future postings. 

Prior Related Research:

Two and Twenty (forthcoming NYU L Rev)

Taxing Blackstone (forthcoming Tax L Rev)

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This was the opening line of Mike Huckabee's speech yesterday, who, of course, is running on the idea of abolishing the IRS and all federal income tax. To be replaced with the "fair tax," a national consumption tax. To be sure, people disagree about whether the tax will be fair, or if it would hit low-income households harder than others because they sometimes pay more for the items that they consume. Nevertheless, it was an opening that received lots of cheers.

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