Foreign Tax-Credit Limit Threatens Banks--and U.S.

Much has been written and said about the “Baker Initiative”--the proposal by Treasury Secretary James A. Baker III for the international commercial-banking community to make new loans to lesser-developed countries of up to $20 billion, with $7 billion expected to come from U.S. banks.

Since the secretary unveiled his plan last October at the International Monetary Fund meeting in Seoul, worldwide support for the proposal has been growing. It is a timely and direct approach to a restructuring of the Third World debt problem looming over the international financial system.

It will take the willing, if not enthusiastic, participation of more than 100 American banks to raise their $7-billion share of new private bank loans called for under the initiative.

But a little-understood provision in the tax-reform bill winding its way through Congress is being reshaped in a way that would seriously undermine U.S. participation. The provision, which would impose a new special limit on the credit that banks could claim for taxes paid to foreign governments, was not proposed by the Treasury Department as part of its tax-reform package. Federal Reserve Chairman Paul A. Volcker has noted that the proposal “would significantly complicate the task of arranging for bank support of the Baker Initiative.” Already there are indications that many regional banks will not participate on the risk that it may become law.

The provision in question would apply only to financial institutions and would limit only taxes paid to foreign countries on interest earned from “cross-border” loans (dollar loans made from the United States to countries in which the American bank generally has no branch, as is true in the case of most lesser-developed countries).

Most U.S. corporations are allowed to compute a credit for taxes paid to foreign governments through a system of global averaging. But, under the tax-bill provision, banks would be prohibited from using this computation for the taxes paid on interest income with respect to cross-border loans. As a result, American banks would pay higher taxes in this country on income from cross-border loans, with no corresponding reduction in foreign taxes paid on the same income. Because of ever-growing competition by foreign banks whose favorable tax laws allow them to keep their interest rates low, the increased tax burden on U.S. banks could not be recouped by charging higher interest rates to foreign borrowers. Thus, dollar-based cross-border loans from U.S. banks to countries that impose high taxes on such transactions will become unprofitable and will not be made.

Given the critical need to build broad support for the Baker Initiative, I am at a loss to understand how one hand of our government that is strongly supporting extension of new money loans for lesser-developed countries could fail to have a strong response to what the other hand of government is doing through tax-law changes to restrict such loans.

In addition to its adverse effect on the Baker Initiative, the tax-bill provision--while producing a relatively small amount of tax revenue--would have very negative implications for the U.S. economy as a whole and the competitiveness of American exports in the international marketplace in particular.

Numerous authorities on international trade and banking have recently testified that these provisions would reduce the ability of American banks to finance U.S. exports, causing reductions in exports and employment and increasing the trade deficit. Banks in Great Britain, West Germany, Japan and most of the developed countries would gain a strong competitive advantage and use their cross-border loans to finance their own countries’ goods and services.

The tax-credit-limitation proposal is an attempt by some members of Congress to address the fact that foreign taxes imposed on cross-border loans are too high. Indeed, they are too high, and our government should do everything possible to persuade lesser-developed countries to reduce taxes on cross-border transactions. But a special limit on the foreign tax credit, affecting only financial institutions, would not work. Instead, it would force U.S. banks out of this market, thwart the Baker Initiative and hurt the U.S. economy by reducing our exports to Third World markets.

The Administration has already tacitly rejected the proposed tax-credit limit by failing to include such a proposal in any of its comprehensive tax-reform packages. But a strong statement from the Treasury Department, following the lead of Federal Reserve Chairman Volcker, is needed to guide Congress through the mind-numbing complexities of international taxation and persuade our lawmakers of the significant policy errors inherent in this proposal.