The U.S. government has long had two minds on tax competition. Politicians routinely complain about so-called tax havens and support the bullying of smaller, low-tax jurisdictions. It seems that enforcement-über-alles is the rallying cry, with no thought for international comity, cost-benefit analysis, or pro-growth tax policy.

At the same time, the U.S. is the biggest tax haven in the world and is very dependent on a steady stream of foreign investment. As a general rule, non-resident foreigners are not taxed on interest or capital gains, and there is no reporting regime, thus making it rather difficult for foreign governments to tax the income. Moreover, American states such as Delaware and Nevada have very friendly corporation laws that protect the privacy of non-resident foreigners.

This approach, needless to say, is completely inconsistent. How can a nation be a tax haven while simultaneously browbeating other jurisdictions that have similar policies? But politicians are not exactly known for their intellectual honesty and rigor, so this disjointed approach should not be too surprising.

Nor should it be surprising that American lawmakers are getting even more aggressive in their attacks on the fiscal sovereignty of low-tax jurisdictions. President Bush and President Obama both dramatically increased the burden of government spending. Combined with a weak economy, this has resulted in a flood of red ink and politicians are salivating at the prospect of more revenue.

This helps explain the passage of legislation - the Foreign Account Tax Compliance Act – designed to compel foreign financial institutions to become deputy tax collectors for the Internal Revenue Service. This article will explain, however, that the «FATCA» law may backfire by driving capital from the American economy. For all intents and purposes, the U.S. government picked up a gun in a fit of misplaced fiscal rage, aimed it at its own head and declared, «Nobody move or the idiot gets it!» 

FATCA as a Haphazard Occurrence
Like so many decisions in Washington, the adoption of FATCA was a haphazard occurrence. In early 2010, it was increasingly apparent that President Obama’s so-called stimulus legislation was not working. Instead of falling unemployment, as the White House claimed would happen, the jobless rate was rising. And taxpayers were increasingly upset about stories exposing the waste and corruption in the $800 billion legislation.

So the politicians in Washington decided to adopt another «stimulus» package of bigger government. But some of the special-interest tax provisions in the «HIRE Act» reduced the overall tax burden and politicians needed a source of revenue as an «offset.» So they incorporated separate FATCA legislation introduced by a left-wing zealot from Michigan, Senator Carl Levin.

In other words, faced with a grim economic and fiscal situation, lawmakers decided to address the problem backwards. Rather than restraining federal spending, they expanded the burden of government and fooled themselves into believing that a bigger budget could be financed by significant revenues to be extracted from the global economy. So they pulled out their crayons, drew a rainbow, predicted they would find a pot of gold when they reached its end, and passed legislation to hunt for it.

Accidental Side-Effects
Today, reality is setting in. The fantasy has failed to come to fruition.

The rationale behind FATCA is simple in its destructiveness. Even though the United States has a very high compliance rate for tax laws compared to the rest of the world, U.S. politicians decided that more enforcement was needed to get more money to fund more spending and bigger budgets in Washington. Throwing aside any semblance of cost-benefit analysis, they then decided to spare no expense to capture every last dollar of potential tax revenue. Unfortunately, FATCA was not a wise approach. Ordinary Americans will suffer from the ensuing damage to the economy. Foreign financial institutions (FFIs) will endure higher regulatory burdens. And the FATCA law creates a powerful disincentive for foreign investment in the United States. FATCA thus has the net impact of potentially reducing both economic prosperity and government tax revenues.

The Act looks to accomplish its goals through heavy use of new reporting requirements and excessive penalties for noncompliance. Institutions that do not comply with the reporting requirements on U.S. persons – the costs of implementing the necessary changes to comply with the law have been estimated in media reports at 150 million Swiss francs for some global Swiss banking groups – have already begun dropping U.S. clients and divesting in U.S. assets. The alternative to compliance is either a new 30 percent withholding tax on payments to FFIs that do not comply with the disclosure requirements, or avoiding any U.S. business altogether. The results should have been predictable.

The legislation also has resulted in collateral damage. Many Americans living overseas have reported cases where they can no longer find banks to accept their business. Under the shadow of the FATCA regime, Americans themselves have become a toxic asset. The legislation also is leading some foreign banks to cancel accounts for foreigners who are legally residing in the United States. Furthermore, legal firms report that they are overloaded with requests from US citizens and green-card holders living abroad who want to turn in their U.S. passports and green cards. They have to wait between 18 to 24 months before receiving an appointment at the U.S. embassy to renounce U.S. citizenship. To put it bluntly, the FATCA law is a costly barrier to cross-border economic activity. Indeed, it is a form of fiscal protectionism, thwarting the efficient global allocation of resources.

Needless Damage
The worst part is the utter pointlessness of the entire endeavor. FATCA imposes a mountain of economic damage in exchange for a molehill of tax revenue.

The compliance costs for the entire banking system over the next ten years have been estimated at $190 to $220 billion. For these bureaucratic burdens, U.S. politicians expect to raise less than $1 billion per year from FATCA. Because it is likely that the new rules result in flight of capital of both foreigners in the U.S. and U.S. citizens living abroad, these expectations are very optimistic. They ignore that the taxable basis might shrink more than by what is hoped to be gained under FATCA. And even if the expectations of one billion per year turns out to be accurate, this amounts to an infinitesimally tiny share of the U.S. federal government's expected budget deficit for 2011. It is simply a fundamentally wrong-headed approach to tax policy. Rather than looking at how to make the U.S. tax system more hospitable to foreign investors, more conducive to economic growth, and easier for everyone involved to understand, the U.S. Congress decided to engage in the fools errand of trying to track down and collect every last dollar of possible unpaid tax, even though the U.S. has relatively high compliance rates compared to the rest of the world.

But as it turns out, tax compliance has less to do with vigorous enforcement and much to do with the tax rates themselves. Excessive tax rates trigger noncompliance. Citizens are only willing to support so much corruption and waste before they say enough is enough. Trying to garner one hundred percent compliance with excessive tax enforcement is impossible, but politicians find it an easier sell then going back to the public and admitting they've built a fiscal house of cards.

Greater enforcement of already high tax rates on savings and investment has a particularly destructive impact on long-run economic performance – an argument which the Florida delegation underlined in their letter to President Obama in March 2011. A harsh tax treatment of capital means a reduction in saving and investment, which leads to slower growth and a smaller tax base. Thus, even from the perspective of money-hungry politicians, FATCA will likely do more harm than good. A better approach in terms of tax policy would be to move away from a tax system that is biased against savings and investment, and toward a more pro-growth policy such as a simple and fair flat tax.

Threat of Contagion
As if the economic damage is not enough, FATCA has also placed particularly difficult burdens on nations which respect fundamental human rights such as financial privacy. More specifically, the FATCA law's requirements make demands of foreign financial institutions that almost surely violate privacy and confidentiality laws in some countries with strong protections of individual data. These laws are worth respecting, as they are an important safeguard for the many people throughout the world that live in countries afflicted by regular discrimination against ethnic, religious, racial, sexual or political minorities. Such vulnerable populations rely on financial institutions in nations that respect financial privacy. They need a refuge against persecution in their home countries, and the ability to protect assets can be a matter of life and death. Unfortunately, other nations now want to mimic America’s imperialistic approach, so FATCA-type laws may arise all over the globe.

But financial privacy laws are needed for other reasons beyond state-sanctioned persecution. In many nations, there are high rates of crime, extortion, political corruption, and economic mismanagement. Mexican families must worry that corrupt bureaucrats in the tax office will sell their information to criminal gangs, creating the risk of kidnapping. Business owners in Argentina must worry about devaluation wiping out the value of bank accounts. People all over the world suffer because of corrupt judicial systems. The human toll caused by the failure of governments to maintain and uphold the basic tenets of a civilized society should be reason enough to dump FATCA.

Conclusion
Thankfully, it's not too late for the U.S. to chart a new course. Originally, the new regulations demanded by FATCA were to be crafted and implemented by January 1st, 2013. But faced with a significant backlash over the excessive costs and expensive burdens of the rule from financial institutions throughout the world, the Treasury Department has pushed back the implementation date to the middle of 2014. Financial institutions should use this additional time to continue making the case for repeal. Countries that benefit from tax competition, in particular, would do well to make clear to U.S. politicians the likely repercussions of FATCA, such as significant loses of foreign investment in the U.S. economy.

Ultimately, lawmakers should consider better policies that would simultaneously boost compliance and improve prosperity. Fundamental tax reform, for instance, would eliminate the double taxation of saving and investment, thus making the entire FATCA issue moot. With a Hong Kong-style flat tax, there would be no second layer of tax on interest, dividends, and capital gains. As such, the IRS no longer would care whether Americans were investing in New York or Zurich.  

But if they foolishly want to maintain double taxation, at least they should examine approaches that are more reasonable. A simple Swiss-style withholding tax, for instance, would be much less onerous. And it hopefully would not cause too much capital flight if the IRS had a simple method of refunding the tax for nations with tax agreements with the United States. Such a regime would probably generate more revenue than the FATCA at significant lower cost.

Daniel J. Mitchell is a Senior Fellow at the Washington-based Cato Institute. He has a Ph.D. in economics from George Mason University and is the author of «Global Tax Revolution: The Rise of Tax Competition and the Battle to Defend It» (2008). Brian Garst is the Director of Government Affairs at the Center for Freedom and Prosperity. He has an M.A. in Political Science from the University of West Florida.