Several industrialized countries, including Australia, Italy, Japan, Spain, and Switzerland, levy withholding taxes on interest paid on the public debt to nonresidents. This paper examines to what extent nonresident withholding taxes on public interest affect the cost of government borrowing. Arbitrage is assumed to ensure that investors receive equal after-tax risk-adjusted returns whether they invest in public debt or Eurocurrency deposits in the same currency. An unknown parameter in the arbitrage condition is the extent to which investors receive a foreign tax credit for the nonresident withholding taxes paid abroad. Commercial banks are the primary investors in the Eurocurrency deposit market. Generally, banks are subject to corporate income tax and thus can obtain foreign tax credits. Other international investors such as pension funds and insurance companies, however, are tax exempt in some countries.
The empirical analysis shows that pretax public interest rates are increased by about half of the tax withheld. A fractional grossing-up of withholding taxes into higher pretax interest rates suggests that offsetting foreign tax credits from their home country tax authorities partly compensate international investors for nonresident withholding taxes. Investors that evade their home country income taxes on foreign source interest income clearly cannot obtain credits. The partial gross-up, therefore, suggests that the marginal arbitrageur between public debt and Eurocurrency assets does not evade his home country income taxes.
The paper estimates the gross-up of nonresident withholding taxes into higher government debt yields separately on the assumption that the investor is a resident of Germany, Japan, and the United States, respectively. Pretax interest rates appear to be most sensitive to withholding taxes imposed on investors resident in Japan. This finding reflects that either (i) Japanese holdings of international public debt are sizable enough to affect yields, or that (ii) Japanese investors receive relatively sparse offsetting income tax credits. The size of the gross-up changes over time and was more pronounced in 1991-93 than in 1989-90. This suggests that, as the state of the economy generally worsened from the late 1980s to the early 1990s, investors have anticipated relatively small offsetting foreign tax credits. The main role of international interest withholding taxes applied to government debt appears to be redistributive. Nonresident withholding taxes enable borrowing countries to capture part of the tax revenue associated with the interest income, at the expense of the lending country’s tax authority. Coordination of nonresident withholding taxes thus appears desirable for reasons of international equity.