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[9] The interest equalization tax has moderated the outflow of private capital abroad, by raising the cost to foreigners of obtaining capital in U.S. markets. While such outflows, in time, result in a return flow of earnings to this country, initially they are deficit items in the balance of payments and, if permitted to flow unchecked at a critical time, such as the present, could cause a serious weakness in the balance of payments.

The tax was introduced after a sharp increase occurred in the outflow of private long-term capital. Private long-term capital outflow (shown in table 3) increased from $2,881 million in 1962 to $3,673 million in 1963, an increase of 27 percent. In the first 6 months of 1963, such outflows accelerated to a level which, if sustained throughout the year, would have resulted in an outflow of $4.6 billion, or about 60 percent more than the 1962 figure.

Issues of new foreign securities accounted for much of the increased

Source: Department of Commerce, Survey of Current Business

outflow. U.S. persons increased their purchases of foreign securities from $523 million in 1961 to $1,076 million in 1962 and accelerated their rate of purchases in the first half of 1963 to an annual rate of $2 billion.

The interest equalization tax became effective on July 19, 1963 (August 17, 1963, for listed securities). The tax originally was imposed on U.S. purchasers of foreign stocks and on U.S. purchasers of foreign debt obligations having a maturity of 3 years or more. The rate of tax was intended, as nearly as possible, to aline the rate of interest foreigners would have to pay to obtain capital from U.S. markets with the rates of interest prevailing in other industrial countries. To achieve this

objective, the scale of tax rates imposed, 15 percent in the case of stocks and long-term debt obligations and lesser percentages in the case of debt obligations with maturities of less than 2812 years, designed to raise the cost that foreigners would have to pay to obtain

capital here by the equivalent of ap proximately 1 percent per annum. A rate of 15 percent on an obligation with a maturity of 2812 years is approximately equal to the present value of a 1 percent per year interest charge on the obligation. The lower tax rates for the obligations with shorter lives achieve substantially the same effect. The tax, which is imposed on the buyer or lender but ordinarily is passed on to the seller or borrower, therefore was about the equivalent of an increase in the interest rate paid by the borrower of 1 percent.

This tax was applied to outstanding issues, as well as new issues. A purpose of this was to forestall tax avoidance through the substitution, directly or indirectly, of new issues for outstanding issues held by for eigners and the subsequent sale of the outstanding issues to Americans. This provision also served to strengthen the balance of payments by moderating purchases of outstanding securities. In the Act, dis

retion was given the President to pply the tax to bank loans, includng those with a maturity of 1 of 3 ears. Subsequently, on February 10, 965, the President exercised this uthority and applied the tax to ank loans with a maturity of 1 ear or more. In 1965, the tax was xtended until July 31, 1967 [P.L. 19-243, C.B. 1965-2,6271, and was lso extended to cover other debt obligations with a period remaining to maturity of 1 to 3 years.

In 1967, the tax was extended to July 31, 1969 [P.L. 90-59, C.B. 1967-2,482], and the tax rates were increased to a 12 percent per annum interest equivalent (a 2212[10] percent tax rate in the case of stock and long-term debt obligations) for the period January 26, 1967, to August 29, 1967.

In addition, the President was provided discretionary authority to decrease the tax rate to zero or to increase it up to 150 percent of the

basic 15-percent rate provided by the law if he determined that an adjustment of the tax rates was necessary to limit acquisitions of foreign securities to an amount consistent with our balance-of-payments objectives. On August 28, 1967, the President provided that the rate of tax applicable to acquisitions after August 29, 1967, of stock and debt obligations with maturities of 281/2 years or more would be 18.75 percent, the equivalent of an annual interest cost of 14 percent [E.O. 11368, C.B. 1967-2,386]. On April 4, 1969, the President issued an Executive order [E.O. 11464, C.B. 19691,292] reducing the rate on stock and long-term debt obligations to 11.25 percent. This was the equiva

lent of a reduction in the annual interest rate from 114 percent to three-quarters of 1 percent.

The tax was temporarily extended for 1-month periods (in H.R. 13079 [P.L. 91-50, page 11, this

Bulletin] and H.R. 10107 [P.L. 91-65, page 4, this Bulletin], or through September 30, 1969, to provide Congress with additional time to complete its consideration of this bill.

Effectiveness of the tax

The introduction of the interest

equalization tax was followed by a substantial decline in the volume of sales of securities and debt obligations subject to tax. Sales of new foreign securities to U.S. residents,

shown in table 4, fell from a total of $1 billion in the first half of 1963 to $250 million in the second half of that year. Moreover, all the issues sold in the second half of 1963 were exempt from the tax, either because purchase commitments had been made prior to the date the tax went into effect or because the issues originated in countries designated as exempt from the tax.

[10] TABLE 4.-NEw Issues of Foreign Securities PURCHASED BY U.S. RESIDENTS, BY AREA, 1962-68, 1969 1st Quarter,

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[11] Since 1963, 1963, purchases by U.S. residents of new foreign securities from countries subject to the interest equalization tax have steadily declined to less than $10 million last year and in the first half of this year. In fact, since 1966, virtually all the new foreign securities purchased by U.S. residents from these countries have been a small amount of securities which were exempt from the tax to facilitate U.S. exports and maintain stability of the international monetary system. Although it is impossible to measure precisely the effect of the interest equalization tax on purchases of new securities by U.S. residents, it is clear that purchases from countries subject to the tax would not have declined from $356 million in 1962 to a current level of less than $10 million in the absence of the tax. If purchases from these countries had increased above the 1962 level in the absence of the tax, by the same percentage since 1962 as did purchases from countries not subject to the tax (229 percent), the 1968 level would have been $815 million, nearly a 50-percent increase over the total amount of new foreign securities purchased by U.S. residents in 1968.

The tax has also moderated purchases by U.S. persons of outstanding foreign issues held by foreigners. In the 311⁄2 years which preceded the announcement of the tax, U.S. residents were, on balance, net purchasers of outstanding foreign stocks and bonds as shown in table 5. Their net purchases averaged $269 million per year.

Since mid-1963, U.S. residents have, on balance, sold more of these securities than they have purchased, thus contributing to the improvement in our balance of payments. Their net sales have averaged $70 million a year. In 1968 and the first half of 1969 on an annual rate basis, however, U.S. residents were net purchasers to the extent of $102 million and $414 million, respective

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ly. This continued net purchase of outstanding securities (although the amount is less than it was prior to the tax and than it would have been in the absence of the tax) in contrast to the cessation of purchases of new securities is one reason why it is appropriate (as provided by this bill) to modify the President's discretionary authority so he may lower the rate of tax on new issues without lowering it for outstanding issues.

[12] While commercial bank loans were not initially subjected to the interest equalization tax, it became increasingly apparent that that such loans were being substituted, directly or indirectly, for the sale of securities in the U.S. capital market. As indicated in table 3, the increase in long-term bank claims against foreigners rose from $126 million in 1962 to $755 million in 1963 and to $941 million in 1964. Short-term bank claims increased from $324 million in 1962 to $781 million in 1963 and to $1,524 million in 1964. Following a sharp increase in bank

loans to foreigners in the final months of 1964, the President, on February 10, 1965, exercised authority granted him under the Interest Equalization Tax Act and applied the tax to commercial bank loans made to foreigners provided the had a maturity of 1 year or more As a result of the interest equaliza tion tax, the voluntary program. and conditions of monetary strin gency, the increase in long-term commercial bank claims against for eigners was reduced to $232 million in 1965.

Since 1965, the amount of long term bank claims has fallen and this, therefore, has become a plus factor in our balance of payments Short-term bank claims, on the oth er hand, have increased, although at a lower rate than that prior to 1965

While the tax has succeeded in moderating the outflow of private capital from the United States, it has not eliminated it. Such investment has continued at a relatively steady level. Furthermore, direct investment by U.S. firms has also con tinued, although it has moderated in recent years (direct investments are not covered by the tax but are subject to the direct investment reg ulations). The income from direct investments abroad by U.S. corpora tions, on the other hand, rose to nearly $5 billion in 1968.3 This is more than twice the 1960 level. The tax, in conjunction with the other programs, has succeeded in moderat ing the rate of overseas investment, a result which is beneficial to the balance-of-payments position of the United States.

Extension of the tax is required

While progress has been made toward the elimination of the persistent deficit in the balance of pay ments of the United States, further progress is necessary. Furthermore. much of the gain that has been made would be lost if, at this time,

3 See table 2.

xisting programs were discontined. In the absence of the interest qualization tax, U.S. capital marets would again become highly atactive to foreign borrowers. Such orrowers would prefer the U.S. arkets to their own domestic marets because of the lower interest ites that generally prevail here and ecause the U.S. market is more fectively organized to supply the pidly expanding needs of foreign orrowers than the capital markets

their own countries. Moreover, nderwriters and securities buyers the United States have become miliar with foreign securities. Therefore, the relatively high interst rates such securities carry would, 1 the absence of the tax, result in a ubstantial increase in sales of forign portfolio securities thereby fur

TABLE 6.-COMPARISON OF YIELDS ON UNITED STATES AND SELECTED FOREIGN
GOVERNMENT LONG-TERM BONDS 1

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New Zealand..

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Netherlands..
Sweden....

her jeopardizing our balance-of-pay- U.S. Treasury bonds. ents position.

It is particularly necessary to void a large-scale increase in capial outflows at the present time beause we no longer have a trade surlus to offset deficits in our capital ccounts. Any increase in capital utflows [13] would therefore diectly add to our balance-of-payents deficit. The inflation in reent years in the United States has ontributed to the decline in our alance-of-trade surplus by making The price of imports more attractive

nd discouraging foreigners from Duying our higher priced exports. Extension of the interest equalizaon tax is necessary, even though nterest rates are currently high in he United States and the differenial between United States and forign interest rates is less than in prior

years, for several reasons. First, as long as foreign interest ates are higher than U.S. rates, here is still an incentive to borrow n the U.S. market. This differential 5 still significant for long-term govrnment bonds of many countries as hown in table 6.

For corporate bonds, the differenial is also still substantial. Table 7

1 Monthly average yields to maturity on issues with at least 12 years' life.

2 Recent low in U.S. average yields on Treasury bonds.

3 June is latest available month.

Comparable rates for Japan are not available.

Before January 1969 theoretical yield to maturity on issues with rebate of taxes on yield; 21/2-year bonds having no rebate of taxes on yield is 5.41. the January 1969 figure of this series is 5.04. Beginning January 1969 average yield on

Source: IMF, "International Financial Statistics."

TABLE 7-YIELDS ON CORPORATE BONDS IN DOMESTIC MARKET AND ON INTER-
NATIONAL STRAIGHT DEBT ISSUES

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U.S. corporate bonds 5.69 5.73 5.82 6.21 7.03 7.21 7.23 7.27

Dollar issues abroad

by

U.S. companies.. 6.46 6.23 6.31 6.94 7.29 7.63 7.49
Foreign

7.55

companies..... 6.75 6.66 6.72 7.19 7.47 7.62 7.65 Margin by which

7.70

foreign yield exceeds
U.S. yield:

U.S. companies..
Foreign

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companies..... 1.06

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Note: Rates and differentials do not take into account differences in issue costs or in possible bearer-bond and other tax advantages on Euro-issues.

Source: U.S. Treasury Department.

shows that the average rate for U.S. domestic corporate issues in August was 7.27 percent while the rate abroad was about 7.55 and 7.70 percent for U.S. and foreign companies respectively, a difference of 28 and 43 basis points respectively. Thus, there is still large potential borrowing which would take place in the absence of the tax. The fact that there has been substantial borrowing by countries and institutions that are exempt from the tax also lends support to the view that there would be substantial borrowing from countries that are not exempt if the tax were allowed to expire.

Second, as our inflation is brought under control as a result of the actions that have been taken, we can expect our interest rates to decline from their present levels without a corresponding decrease in foreign interest rates. This, of course, I will widen the differential and increase the pressure to sell securities in the United States.

[14] Third, in the absence of the tax, there would be an incentive to buy back from foreigners some of the securities that American companies have issued abroad to finance direct investment. These issues, some of which are convertible into stock, totaled $2.1 billion in 1968 alone.

Failure to extend the tax would also jeopardize other measures in the balance-of-payments program that have been undertaken to narrow the balance-of-payments deficit. The tax has a particularly important bearing, for example, on the program of voluntary cooperation by banks to reduce foreign lending that was inaugurated in 1965. In the absence of the tax, more foreign borrowers would seek to raise funds by borrowing from U.S. banks. Such a development would increase the pressure of foreign demand that the voluntary program must face.

In the case of the foreign direct investment program, the tax guards against the resale to Americans of

bonds issued abroad by U.S. companies to finance their foreign direct investments.

Thus, the tax assures participants in these programs that they are not being asked to assume a disproportionately large share of the burden of eliminating the payments deficit by reaching investors who are not under these programs.

Foreign reaction to our failure to extend the tax could also jeopardize our attempts to improve other aspects of the international trade and monetary system and place in creased pressure on the dollar. The cooperation we obtain from other countries depends, in many instances, on what they believe our attitude and intentions are toward our balance of payments. In addition, the role of the dollar as a reserve currency and the willingness of foreigners to hold dollars are also affected by their confidence in our willingness and ability to cope with our balance-of-payments deficit.

At a time when our balance of payments is in a precarious position and we are moving forward on implementing the Special Drawing Rights of the International Monetary Fund and in other areas, we must consider the possible international consequences of failure to extend the interest equalization tax.

[15] Temporary extension provided

In view of these considerations, the bill provides for a temporary extension of the interest equalization tax from September 30, 1969, to March 31, 1971. The committee views this tax as a transitional device to permit orderly progress to a satisfactory long-run solution to the balance-of-payments problem faced by the United States. An improvement in our trade account coupled with reductions in Government expenditures abroad and the continued growth in foreign investment income are necessary ingredients to any long-term solution to this prob

lem.

Authority to reduce the tax rate on new issues

The bill modifies the President's

existing authority to vary the rate of tax by permitting him to apply a lower rate to new issues than to outstanding issues. The Treasury Department indicated that it requested this provision to provide a means of permitting our reliance on the interest equalization tax to be reduced.

The committee agrees that ending reliance on the interest equalization tax as soon as possible is desirable. Reducing the rate of tax is a step in that direction but the large volume of outstanding securities could make it dangerous to reduce further the rate on both new and outstand

ing issues. Moreover, as was pointed out above, the purchase of new issues from countries subject to the tax is currently zero whereas U.S. citizens are still net purchasers of outstanding securities. If the rate of tax is to be reduced as a step toward its eventual elimination, a lower rate for new issues than for outstanding securities seems appropriate because of the large volume of outstanding securities and the indicated willingness of U.S. citizens to purchase them even at the present rate of tax.

International monetary stability exclusion

During public hearings on September 3, 1969, the committee questioned Treasury Department of ficials concerning the exemptions from tax which have been made in the interest of international monetary stability. In this connection the committee notes that the Japanese Minister of Finance announced on September 16, 1969, that it has been trying not to use the exclusion for Japanese securities which was granted under the international monetary stability exclusion (section 4917) and that there is no need for it to be continued. The committee has been informed that the Secretary of the Treasury is requesting

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