By Ashby Monk
This blog is a source of open discussion and engagement on the topic of SWFs. As such, we welcome and indeed seek out all views and opinions on the subject. Today, we offer the sixth instalment of our routine segment: “Q&A with a SWF expert, stakeholder or policymaker”. We are pleased to welcome Victor Fleischer of the University of Illinois College of Law. While Prof. Fleischer’s views are his own, his perspective helps to further debate and facilitate understanding.
Ashby Monk: Thanks for joining us today, Victor. Can you begin by briefly explaining your interest in SWFs?
Victor Fleischer: My research over the last five years has focused on how tax policy affects institutional investment, especially in venture capital and private equity. And so I first became interested in SWFs as investors in private equity, both as limited partners in private equity funds and as direct investors in private equity sponsors. As a tax person, I was curious about how SWFs are taxed, and at that point I started to research section 892, which grants SWFs a unilateral, categorical exemption from tax. My paper on this topic, A Theory of Taxing Sovereign Wealth, will be published next year in the NYU Law Review. You can download it here.
Ashby Monk: You note in your recent paper an interesting contradiction: On the one hand, SWFs want to be treated like any other private investor. On the other hand, the U.S. treats them (for tax purposes) as “sovereigns acting to further political, diplomatic or humanitarian agendas…” Can you give a brief explanation of the benefits afforded sovereigns under the U.S. tax code, and how this affects SWFs?
Victor Fleischer: Historically, foreign governments were exempt from tax in the United States according to the international law principle of sovereign immunity. Over time, the international law doctrine narrowed to exclude commercial transactions. But the relevant tax provision, section 892, has never been revised appropriately, and sovereign wealth funds continue to enjoy a unilateral, categorical exemption for tax for non-controlling investments. Private foreign investors, by contrast, face withholding taxes as high as 30% on dividends and other forms of periodic income.
This actually isn’t quite a big deal as it seems, as a lot of a foreign investor’s portfolio income, like interest and capital gains, is exempt from U.S. tax. The big difference is for dividends. One concern is that by allowing SWFs to avoid the withholding tax on dividends, the tax code could create a “clientele effect” that crowds out private investment in dividend-paying stocks.
Ashby Monk: The Joint Committee on Taxation recently published a report on this issue. They argued that, “it is difficult to conceive of any reasonable justification for modifying the existing rules to treat SWFs, or foreign governments more generally, less favorably than foreign corporations.” Do you agree with this conclusion?
Victor Fleischer: I disagree. I think, at a minimum, Congress should repeal section 892 and treat SWFs like private investors. Under current law, the tax code subsidizes state-controlled investment to the detriment of private investors. Allowing private investors to compete on a level playing field would dampen any potential clientele effect.
There are also reasonable arguments for imposing a higher rate of tax on SWFs. In my paper, I talk about the range of negative externalities that follow from SWF investment, including encroaching on the autonomy of U.S. enterprise, limiting our foreign policy options, and encouraging U.S. companies to partner with autocratic regimes. I don’t think that SWF investment should be prohibited, but there is a pretty good case for imposing an excise tax on SWF investment in U.S. equities. The tax could have a conditional exemption for funds that meet best practices of transparency, accountability, and professionalization.
Ashby Monk: If I’m not mistaken, you are of the opinion that SWFs are investing to achieve political goals. Where do you see evidence for this?
Victor Fleischer: SWFs invest out of mixed motives – they seek financial returns, but fund managers are subject to the influence and oversight of political leaders. So it’s not that most SWF managers have a political axe to grind, but rather that, when push comes to shove, foreign governments are more likely to influence fund managers to pursue non-financial motives than regular market investors.
The big concern isn’t that most current investment is politically motivated. Rather, it’s that China or Russia or Abu Dhabi or some other state that we are currently friendly with will accumulate strategic positions in U.S. companies … and in 10 or 20 years we find ourselves enemies with that country. Obviously that may compromise our foreign policy options.
Ashby Monk: What should Congress do?
Victor Fleischer: The most important step is to support the efforts of the IMF to establish best practices of transparency, accountability, and professionalization of the funds. Tax policy is of secondary importance, but it’s also worth pursuing. Congress should repeal section 892, and it may want to consider backstopping the IMF efforts with an excise tax on funds that do not comply.
Ashby Monk: Thanks, Victor, for taking time out of your busy schedule to chat with us today.
Victor Fleischer: My pleasure, and keep up the good work here – I have found this blog to be a wonderful resource.