This article appeared in Cayman Financial Review on January 30, 2015.
Last November Americans went to the polls and voted a new Congress into office. Capitalizing on President Obama’s unpopularity, Republicans dominated the mid-term contest at the federal, state and local levels.
Surpassing even the boldest of predictions, the Republican Party cemented its largest House majority in half a century, captured the Senate handily, and flipped the governorships of several die-hard Democratic states.
A decent Republican showing was largely expected. The party of a sitting president generally does not do well during mid-term elections – i.e., when the president is not on the ballot – and that’s particularly true during a president’s second term when public fatigue has typically taken hold.
But the size of the victory surprised nearly all the pundits and could be a critical factor in how the next two years unfold.
The election results potentially factor into a number of ongoing issues relevant to international financial centers, and may have introduced new items of interest. Issues like the Foreign Account Tax Compliance Act (FATCA) and the OECD’s push for automatic exchange of taxpayer information are likely to be at least somewhat impacted by America’s electoral rejection of Obama’s agenda. There’s also potential for comprehensive U.S. tax reform and a general adjustment in the nation’s posture toward international finance.
FATCA under scrutiny
The FATCA implementation process is largely complete. The IRS has signed intergovernmental agreements (IGAs) with the vast majority of relevant nations to collect and report information on U.S. account holders that will allow them to implement FATCA, despite the obstacles posed by local privacy laws. Yet the IGAs also introduced a critical vulnerability that might force reconsideration of the law in the next few years.
Some governments were enticed to sign the agreements with promises for reciprocal information sharing. That means implementing FATCA-style reporting requirements on U.S. banks, a costly prospect not authorized by FATCA and thus requiring new action by Congress to implement. But adding expensive new obligations on domestic banks and discouraging foreign investment in the American economy are not popular ideas among U.S. politicians, particularly Republicans. For this reason, reciprocation will be a non-starter with the new Congress.
The administration might try to accomplish the same goal through regulatory action. There are legal and legislative tools available to Congress to override executive regulations, but they are rarely used. But with both chambers of Congress now in Republican hands, concerted opposition through use of conventional political tools such as oversight hearings may prove sufficient to prevent potential regulatory overreach via pursuit of domestic FATCA information collection and dissemination. Of course, obstacles to reciprocation will only matter if foreign governments bother to object to unfilled American promises.
Opposition to OECD agenda on the horizon?
Through the G20 and the OECD, the world’s wealthiest nations are pushing ahead with implicit tax harmonization in the sense that taxpayers will be subject to the tax policies of their home country regardless of where they save and invest. The current effort toward implementing automatic tax information exchange is the boldest attack yet on tax competition from the OECD, an organization that has increasingly focused on little else.
History suggests that the U.S. has the power to at least slow the OECD’s advance. After the release of its 1998 report on “Harmful Tax Competition,” the United States, and particularly after the OECD produced a blacklist of so-called tax havens in 2000, there was grumbling from Republicans in Congress who displayed strong ideological opposition to the idea of limiting tax competition.
This opposition became more powerful with the election of a GOP president in 2000, particularly after the Treasury Secretary also indicated disapproval of the OECD’s efforts. And congressional Republicans threatened to reduce U.S. subsidies to the Paris-based bureaucracy. Faced with these threats, the OECD backtracked and regrouped, though ultimately high-tax nations pursued the same goals after the 2008 elections using the G-20 process.
Some of these fights may now materialize again. Though even if Congress takes a critical stance toward international efforts, the Obama administration remains the primary representative of the U.S. government on the international stage and will continue to run cover for global tax bureaucrats and their endless war on tax competition. Significant U.S. opposition to the OECD, in other words, is at least two years away, when President Obama’s second term expires.
The road to reform
With so many of their members elected or re-elected by running against the excesses of government under President Obama, Republicans will presumably look for opportunities to restrain spending. Even modest reductions in the growth of government will reduce the fiscal pressure that has led to such frantic searches for revenue as FATCA, and successful spending restraint would provide breathing room for the fundamental reform that has been on the minds of U.S. politicians and pundits for the last several years.
The American tax code has grown out of control, and is largely understood both in and out of Washington to be a destructive and counterproductive mess. Unfortunately, the reform effort has thus far amounted to very little, and is unlikely to reach its conclusion in the next two years.
Retiring Ways and Means Committee Chairman Dave Camp’s long, drawn out tax reform effort bore no significant fruit during the previous Congress. The next Congress will likely pick up where he left off, though perhaps in a less centralized fashion, and continue trying to move the ball forward.
While Republicans are unlikely to pass the major pieces of reform under an ideologically hostile president, the groundwork for comprehensive plan will be laid in the next two years. Between FATCA, inversions, and a political class hopefully more focused on restraining government growth than fueling it, the eventual reform package may finally include abandonment of the uniquely American, and exceptionally destructive, worldwide tax system.
More limited reforms might be adopted to address the issue of business taxes. There’s significant momentum currently for corporate tax reform, thanks in part to the recent spat of inversions by corporations seeking refuge from an increasingly anti-competitive U.S. tax code.
While President Obama would prefer to treat the symptom rather than the disease by cracking down on inversions, Republicans recognize that excessive tax rates are at the root of the problem. They also acknowledge the role of the United States’ worldwide tax system in undermining competitiveness, though there will likely be debate among Republicans whether or not it would be worthwhile to find common ground with Obama and pass a smaller package addressing corporate taxes, or hold out for a more favorable White House occupant.
The uproar generated by the FATCA overreach also put a spotlight on the fundamental unfairness behind a system that taxes global earnings. And while unwinding FATCA poses a number of political challenges, adopting a territorial tax system is a more straightforward solution. There is fairly widespread agreement in Republican circles that a territorial system is preferable, and thanks to FATCA, there is for perhaps the first time strong outside pressure calling for it on both the corporate and individual sides of the code.
But in order for such policies to be practical, Republicans also would need to address the systematic double-taxation of income that is saved and invested. After all, it’s not feasible to adopt a system where Americans aren’t double-taxed on overseas saving and investment, but are double-taxed on funds inside national borders.
Conclusion
The Republican strategy for the next Congress will consist of laying the legislative groundwork and coalescing around a set of concrete reforms in time to hit the ground running should they capture the White House in 2016. Prognosticating on a presidential election this far out is generally a fool’s errand, but the field is likely to somewhat favor the Republicans. Whoever ends up winning the Democratic nomination will struggle to separate themselves from their unpopular predecessor, a task the most likely nominee – Hillary Clinton – will find particularly difficult given her time as Secretary of State under Obama.
Should the United States finally adopt pro-growth tax reforms – including eliminating double taxation of capital, and adopting a territorial system – the effects will ripple throughout the international community.
Not only would FATCA be rendered largely pointless, but the U.S. would lose any remaining incentive to cooperate with the OECD and participate in the war against low-tax jurisdictions.
