The Interest Equalization Tax Act closed U.S. capital markets to foreign borrowing in response to a balance-of-payments deficit. It also taxed foreign stocks sold in the United States, in an attempt to encourage American investors to fund domestic rather than foreign or multinational corporations.
President Lyndon B. Johnson signed the Interest Equalization Tax Act into law on September 2, 1964. This legislation was a response to a continuous deficit in the Official Reserve Transactions Account
The Senate Committee on Finance
The Interest Equalization Tax was characterized as temporary for two reasons. First, policy makers did not appreciate the fundamental, significant structural changes that were taking place in the world economy.
During the 1950-1959 period, the deficit in the Official Reserve Transactions Account of the United States’ balance of payments averaged $0.9 billion. That average figure increased to $1.7 billion in the 1958-1968 period. By 1962, when the balance of payments deficit problem was beginning to be recognized and acknowledged, the United States still held the largest supply of monetary gold in the world, even though its gold reserves had been shrinking since 1959 at a compound annual rate of 6.5 percent per year. United States monetary gold reserves stood at $16.4 billion, of which only $4.6 billion were “free reserves,” the rest required by law to be held to back Federal Reserve notes and reserve deposits from members of the Federal Reserve System. In 1962, U.S. gold reserves stood at their lowest level since 1939.
To put the situation into perspective, the United States accumulated balance of payments deficits totaling approximately $24 billion between 1950 and 1961. Gold conversions (redemptions of dollars in exchange for gold) had accounted for almost one-third of this total and represented a loss of about one-third of the United States’ monetary gold reserves. In June of 1967, foreign U.S. dollar claims against the United States stood at 226 percent of the total U.S. holdings of gold reserves.
The deficits in the Official Reserve Transactions Account of the U.S. balance of payments were met by an outflow of U.S. monetary gold reserves and an increase in short-term liabilities to foreign holders of U.S. dollars. These short-term liabilities could be used to finance a run on the dollar whenever confidence in the dollar waned.
Under the Bretton Woods system,
The value of the U.S. dollar under the Bretton Woods system was defined in terms of gold. One ounce of monetary gold was equal to $35.00. All other nations defined the par value of their currency in terms of the U.S. dollar, and thus in terms of gold. The Bretton Woods system required that the United States run a continuous balance of payments deficit in order to supply the world with liquidity and monetary reserves. At some point, however, the U.S. balance of payments deficit became a problem, both in perception and in reality. In reality, the United States was beginning to spend large sums of money overseas to fight an unpopular war in Vietnam, while at the same time beginning to engage in deficit spending at home to cover the expenses of President Johnson’s Great Society program. European nations and Japan, which were once in need of U.S. aid, were now competing with the United States in the trade sector. All of this, coupled with a perception of the weakening of the U.S. economy, weakened global confidence in that economy.
The U.S. government looked to the U.S. capital markets, used to finance the international activities of foreign corporations and the foreign subsidiaries of U.S. multinational corporations, as one place to begin to stem the outflow of dollars. That outflow caused or at least allowed the balance of payments deficit. Dollars sent abroad eventually found their way back as a claim on the U.S. gold stock. Government officials feared that those claims would be realized. The U.S. stock of gold was insufficient to meet all the claims.
The Interest Equalization Tax Act was enacted to increase the interest rate in U.S. capital markets. At the time, interest rates in most foreign capital markets were at least 1 percent higher than the prevailing rate on comparable securities in the U.S. capital markets. Higher interest rates would increase the cost of borrowing and make U.S. capital markets less attractive. Foreigners would therefore borrow less and take fewer dollars out of the United States.
The Interest Equalization Tax effectively closed U.S. capital markets to foreign corporations and the foreign subsidiaries of U.S. multinational corporations. The legislation exempted international agencies, such as the World Bank and the Inter-American Development Bank, and foreign governments in developing nations. Foreign stocks sold in the United States would be taxed at a rate of 15 percent of their purchase price, while foreign bonds would be taxed at a rate ranging from 2.75 percent of their purchase price, for securities maturing in less than three years, up to 15 percent of their purchase price, for securities maturing in twenty-eight and a half years or more.
On its very first test, the Interest Equalization Tax Act worked perfectly. In September of 1963, the city of Oslo, Norway, offered $15 million in bonds paying an interest rate of 5.6 percent. The Interest Equalization Tax effectively reduced this rate to 4.9 percent for U.S. citizens. This relatively low rate proved unattractive to U.S. investors, and most of these securities were purchased by Europeans.
President Lyndon B. Johnson.
Because the Interest Equalization Tax was expected to be retroactive if the law passed, uncertainty over whether the tax would be passed created an atmosphere that acted to reduce dramatically the volume of foreign securities issued in U.S. capital markets. The total volume of foreign issues sold in U.S. markets in all of 1962 was $1.2 billion. In the first half of 1963, before the Interest Equalization Tax was proposed, the total volume was $1.3 billion. In the second half of 1963, the volume of foreign securities sold in U.S. capital markets fell to $315 million.
The U.S. dollar had a unique role and responsibility under the Bretton Woods system. To the extent that other nations were willing to hold additional U.S. dollars as monetary reserves and that their citizens were willing to hold additional U.S. dollar assets as investments, the United States could continue to run a deficit in its balance of payments with impunity and collect a seigniorage, consuming and investing more than it produced. This consumption and investment would be financed by the creation of additional U.S. dollars. At some point, the U.S. balance of payments deficits became chronic and persistent. These deficits developed very rapidly after the de facto convertibility of the major European currencies was achieved. When the deficits began, policy makers and those concerned with the international monetary system were still focusing on the U.S. dollar shortage, the idea that there was a long-term, fundamental imbalance in the international payments system in favor of the United States. Very suddenly and to the surprise of many, a dollar glut developed. The U.S. balance of payments deficits developed because the outflow of U.S. dollars was too large for the rest of the world to absorb as additional monetary reserves and increased dollar asset holdings.
These deficits were caused by several factors: rapid growth in the United States’ overseas military expenditures, an increased flow of private overseas investment, extensive use of the U.S. capital markets to raise financing for projects undertaken by foreign subsidiaries of domestic international corporations as well as by foreign corporations, and an increase in official foreign aid grants. Surpluses on the balance of trade account, a measure of the balance between imports and exports of goods, did not grow fast enough to offset the increased overseas military expenditures, the flow of private investment, the use of the U.S. capital markets as a source of international finance, and official foreign aid grants.
A critical factor in the development of the U.S. balance of payments deficit was the failure of the U.S. trade surplus to grow. Had this surplus grown more rapidly than it did, the deficit problem might never have developed. The growth of the trade surplus would have absorbed some of the redundant dollars that were finding their way back to the United States to claim U.S. monetary gold reserves. Solving the dollar shortage would have required larger and larger U.S. balance of payments deficits. A permanent dollar shortage would have meant, had it actually existed, much slower economic growth, a worse allocation of world resources, and a slowing of the trend toward international economic and financial integration in the post-World War II period. A dollar glut, on the other hand, would prove to be much more dangerous. It would ultimately result in the collapse of the fixed exchange rate system established by the Bretton Woods Agreement, under which currencies were traded for each other at known, fixed rates of exchange. A dollar glut would make the fixed price of dollars appear too high, and other countries would become unwilling to hold them, trading them for gold.
The ability of foreign holders of U.S. dollars to convert their dollar holdings into gold was a central element of the Bretton Woods system and essential to support the claim that the U.S. dollar was “as good as gold.” The U.S. Treasury’s ability to convert U.S. dollars into gold became more and more problematic as the nation’s balance of payments deficits grew. Monetary crises followed, confidence in the dollar waned, and eventually the Bretton Woods system collapsed.
The U.S. dollar played a unique role in the Bretton Woods system. When the U.S. dollar became overvalued relative to other major currencies of the world, the United States government could not unilaterally devalue the U.S. dollar. Because the dollar acted as a reserve currency, it could not be devalued. This was the price the United States paid for the special role of the U.S. dollar and the seigniorage collected when nations would freely accept dollars.
The Interest Equalization Tax Act did not solve the U.S. balance of payments problem, essentially because the world economy was undergoing significant structural changes and the balance of payments problem faced by the United States was misperceived as temporary in nature. By the late 1950’s, the huge trade surpluses that the United States had enjoyed in the early postwar period were shrinking, both absolutely and relatively. The Interest Equalization Tax, moreover, only focused on one element of the problem, the use of U.S. capital markets as a source of international finance. The closing of the U.S. capital markets to foreign borrowers was not a full solution to the United States’ balance of payments problem. The Interest Equalization Tax Act was the first in a series of unsuccessful actions undertaken by the U.S. government to attempt to solve problems that would ultimately result in the collapse of the Bretton Woods system of fixed exchange rates.
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Cohen, Benjamin J., ed. International Monetary Relations in the New Global Economy. 2 vols. Northhampton, Mass.: Edward Elgar, 2004. Extremely comprehensive account of the theory and practice of international finance. Places the Interest Equalization Tax in context, both historically and in terms of theoretical policy-making principles. -
Kindleberger, Charles P. International Economics. 6th ed. Homewood, Ill.: Richard D. Irwin, 1978. This book is very well written and easy to understand, with an interesting discussion of U.S. capital markets and the Interest Equalization Tax. -
Scammell, W. M. International Monetary Policy. 2d ed. New York: St. Martin’s Press, 1965. An excellent, well-written book with much useful information on the Bretton Woods system. Explains the development of the Bretton Woods system and the role the International Monetary Fund played up to the early 1960’s. -
_______. International Monetary Policy: Bretton Woods and After. New York: John Wiley & Sons, 1975. Another excellent book, well written and easy to understand. Examines the development of the system, changes in the international environment, and the role the International Monetary Fund played up to 1973. Contains a good discussion of the merits and shortcomings of both the Bretton Woods system and the International Monetary Fund. -
Solomon, Robert. The International Monetary System 1945-1981. New York: Harper & Row, 1982. Solomon spent many years working in the Federal Reserve System. His perspective, as a participant and an objective observer analyzing and appraising developments in the international monetary system, is unique. -
Yeager, Leland B. International Monetary Relations: Theory, History, and Policy. 2d ed. New York: Harper & Row, 1976. Contains a wealth of historical, institutional, and analytical material relating to international finance.
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