By Raymond Richman, Howard Richman and Jesse Richman

The United States tax system has a tax break that encourages giving to charity, a tax break that encourages people to buy their own homes – and a tax break that encourages foreign governments to take over U.S. corporations. Most people know about the first two, but few, outside of the IRS, are aware of the third. It exempts foreign governments from paying any U.S. taxes on dividends, interest or any other income earned from their U.S. investments. Other governments have the same policy. It’s a sort of gentleman’s agreement among governments: We won’t tax you if you won’t tax us.

The problem with this “gentleman’s agreement” is that it is one-sided. The U.S. government has virtually no investments abroad, while other governments are putting together huge bankrolls to invest in the United States. Morgan Stanley estimates that Sovereign Wealth Funds, the funds set up by foreign governments to invest in foreign equities, currently have $2.5 trillion in assets and will have $12 trillion by 2015. As a result of the giant U.S. trade deficits ($713 billion in 2007), foreign governments have huge surpluses of dollars with which to buy American businesses – and they’re doing so.

In May 2007, the Chinese government spent $3 billion to acquire a 10 percent interest in the Blackstone Group, a specialist in private equity takeovers. In December 2007, they paid $5 billion to Morgan Stanley, one of the most influential U.S. banks, for an eventual 9.9 percent of its common stock. The Chinese government still has about $1.2 trillion in dollar reserves, an amount that is growing by several hundred billion dollars each year.

China put together this massive fund from its trade surplus with the U.S. Instead of using the dollars earned from its huge trade surplus with the U.S. to buy American goods, they “sterilized” the dollars earned from trade so that the dollars would not be exchanged for yuans in currency markets. That would have caused the yuan to rise against the dollar, making Chinese goods more expensive to Americans and American goods less expensive to the Chinese. The change in relative exchange rates would have reduced their trade surpluses with the United States by increasing U.S. exports to China and reducing U.S. imports from China. This would have benefited both countries, which is what trade is supposed to do. Instead, the trade deficits cost the U.S. 4 million jobs, caused wages to stagnate and worsened the distribution of income.

In past years, the Chinese and many other governments have loaned surplus dollars earned from trade directly to the American government by buying U.S. Treasury bonds and indirectly to the American consumer by making borrowing less expensive. Now they are beginning to use those earnings to turn U.S. businesses into partially socialist enterprises owned by foreign governments.

This trend led Patrick A. Mulloy, a former member of the United States-China Economic Security Review Commission, to argue in November 2007 testimony before the Senate Banking Committee that the United States should address the “mercantilist trade practices” of China and other Asian countries before we become a “sharecropper society” (a term coined by Warren Buffett when describing the eventual result of our runaway trade deficits).

China is not the only government practicing the new mercantilism; it is just the most aggressive. The Japanese government has successfully out-competed the U.S. in industry after industry since Word War II while building up about $1 trillion in dollar reserves. Many of the other Pacific Rim countries are doing the same, including Taiwan and South Korea, and more recently India.

The new mercantilism violates Article IV of the International Monetary Fund agreement, which requires that countries “avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.” It can only succeed if the United States decides not to respond. In our forthcoming book, “Trading Away Our Future,” we lay out effective responses for the United States. Among those steps, we advocate that the United States start taxing the U.S. earnings of foreign governments. This step is long overdue.

The United States should not give tax breaks to foreign governments that it denies its own citizens, especially since the practice worsens the trade deficits and costs American jobs and factories. The debate is just beginning over whether such investments should be permitted at all. This much is clear: The Sovereign Wealth Funds deserve no special encouragement and no tax exemption.

Related special offer:

“China: The Gathering Threat”

Dr. Raymond Richman is the president of Ideal Taxes Association. He is professor emeritus of public and international affairs at the University of Pittsburgh with a Ph.D. in economics from the University of Chicago. Dr. Howard Richman is executive director of a nonprofit (Pennsylvania Homeschoolers Accreditation Agency) and an Internet economics teacher. Dr. Jesse Richman is assistant professor of Political Science at Old Dominion University. They are the authors of Ideal Tax Association’s forthcoming book, due out March 1: “Trading Away Our Future: How to Fix Our Government-Driven Trade Deficits and Faulty Tax System Before it’s Too Late.”

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