Exempting domestic currency government bonds from withholding tax is long overdue in much of South and East Asia as the move would have a significant and beneficial economic impact.
The mature economies in Europe and North America (and also Japan, Hong Kong and Singapore) no longer withhold tax on government bonds. This is the case for about 40 countries representing 90% of internationally held government bonds. However, across swathes of South and East Asia – notably India, Indonesia, South Korea, the Philippines and Taiwan – the withholding of tax is still prevalent.
Taxing government bonds increases the cost of borrowing for governments in three ways:
- price-setting investors require a higher (grossed-up) yield to obtain the same after-tax return;
- the government pays an illiquidity premium because the tax severely inhibits the demand, trading and liquidity of the bonds;
- the tax has an administration cost for both the government and the investor that is directly and indirectly paid by the government.
Eliminating the tax can reduce the cost of government debt by 1%-3%.
In practise the withholding tax is a net drain on government finances. The government does not collect tax at the full rate on all the bonds issued as many domestic investors pay a concessionary rate of tax and foreign investors use treaty countries to reduce the tax rate, often to zero.
Others “wash the coupon” by selling the bond to an investor that pays less (or no) tax on the coupon, just before coupon date; or they find other ways to minimise the amount of tax paid. On the other hand the government pays the grossed-up interest on the whole bond issue. As a result it receives less tax than the extra interest it pays out.
The tax also has a significant impact on investor demand.
The different investor tax rates, in addition to being inequitable, fragment the market and negatively affect trading as investments and transactions are driven (or inhibited) as much by tax considerations as by economics.
A number of foreign investors will not buy bonds that are subject to withholding tax (for policy or tax reasons). These distorted markets might be attractive to opportunistic arbitrageurs but not to long-term investors, and they discourage new investors.
The tax also precludes the bonds from being included in some bond indices (e.g. Citibank’s WGBI) that are tracked by more than two trillion dollars in funds.
Except in the simplest of cases, the tax and the tax-reporting obligation make it uneconomical or inefficient for the bonds to be held in accounts at the international central securities depositories (i.e. Clearstream and Euroclear Bank). Many investors will not buy bonds that cannot be held in these ICSDs.
(Note: when Russia enabled their rouble government bonds to be held at the ICSDs, demand increased so much that cross-border holdings grew from 3% to nearly 30%, yields dropped by 1.5% per year and trading turnover tripled in a few months).
For all of the above reasons, withholding tax has an adverse impact on demand, trading and liquidity that results in the government paying an illiquidity premium.
If capital gains are included the computation of the tax can be quite complex, with all the supporting documentation kept current and archived; so compliance and collection are expensive too. The issuer indirectly pays these additional costs.
Few sound reasons are put forward for the status quo. Some argue that foreign investors need to pay tax on income from the issuer’s country but this ignores the now-common convention (covering about 90% of international bond holdings) that results in holders of government bonds being taxed only by their host governments.
So the tax isn’t needed to level the playing field as it is already level.
Others see it as a tool to discourage inward flows of volatile offshore funds. In fact, cross-border investments in government bonds are relatively stable, even in stressful times. Being in domestic currency they should be seen as low risk by the issuer.
The way forward
The best way forward would be for governments in South and East Asia to stop issuing bonds subject to withholding tax and to issue two new types of bonds:
- New wholesale bonds, not subject to any withholding of tax that are restricted to domestic incorporated investors and cross-border investors (i.e. not available to domestic retail investors).
- New savings bonds, restricted to domestic tax-resident individuals. Any withholding of tax applied would simply be a deduction by the issuer from the coupon at a flat rate.
Existing bonds should continue to be subject to the current tax regime (so no windfall profits for current holders). The most illiquid series should be retired (or switched) as soon as possible and the others over time.
If these measures are applied more generally across South and East Asia, we will see the cost of government debt fall, boosting government finances so that more government funds can be made available for productive developments. Also cross-border bond investments will be more stable because more long-term investors purchase more bonds.
As corporate bonds are priced off the government bond yield curve the lower cost of government debt lowers the cost and improves the competitiveness of domestic corporate debt capital. Better liquidity along the government bond yield curve, in turn, will also support swap markets. Together this will boost economic activity.
Bringing regional government bond markets in line with global best practise will also encourage more Asian savings to stay in Asia. Everyone stands to gain.
The author is an Independent consultant focused on the development of domestic currency bond markets in Asia.
