Taxing International Portfolio Income

Abstract

The importance of international portfolio investment to the world economy has grown exponentially in recent years. Yet most analyses of international tax policy have either lumped direct and portfolio investment together or ignored foreign portfolio income altogether. The economic differences between foreign direct investment and foreign portfolio investment ("FPI") suggest that the principal normative criteria used to evaluate international tax policy generally capital export neutrality and capital import neutrality ("CEN") have little or no relevance with respect to international portfolio investment. Furthermore, empirical analysis illustrates that to achieve CEN for FPI would require the U.S. government to make politically infeasible and fundamentally undesirable tax policy changes. Principles of international equity and interpersonal fairness, as well as U.S. national interest, all suggest that income from FPI should be taxed by the country where the investor resides, and that taxation of income from FPI at source should be eliminated. Thus, a strong case can be made that, for FPI, the U.S. should replace its foreign tax credit with a deduction for foreign withholding taxes. Multilateral cooperation and coordination would be essential to ensure that such a regime would not worsen the widespread underreporting and evasion of taxes on income from FPI.