Paying the Price for Investing in China

The federal government collects less tax from wealthy Americans for a dollar earned in the stock market than from middle-class workers for a dollar earned by the sweat of their brows. The highest marginal tax rate for the vast majority of long-term capital gains and qualified dividends is 20%, with a 3.8% surtax for high-income households. Add income and payroll taxes together, and most workers are paying a higher rate on their labor income well before their household earnings reach $100,000.

The policy is intended as a subsidy for investment. It’s a regressive tax break, mostly benefiting the wealthiest Americans amongst whom capital is concentrated, but it reflects the importance of long-term investment for economic growth and productivity, and of making the United States an attractive place for investors to operate. While some investment—particularly long-term fixed capital investment—is the motor of growth, investment is not all created equal. 

One might fairly question the relationship between, on the one hand, generating income by passively holding assets, and on the other, productive investment in the real economy. The saver who buys stock in Google and sells it ten years later at an enormous profit has not in fact caused a dollar to be deployed productively anywhere—indeed, the activity is no different than buying and holding Bitcoin or, for that matter, a painting. Such passive investing hardly has the same effect on the American economy as building a new factory, power plant, or apartment complex.

Of course, one might further question the tax code’s equal treatment of all returns to capital. Should investors pay the same tax rate on income generated by funding critical industries like semiconductor manufacturing as they pay on income generated by building a dominant sports betting platform? Here the argument is more likely that government is in no position to assess the worthiness of individual investments, and so a tax rate applied to one must be applied to all. Fair enough.

But there is a third distinction—a geographic one—where line-drawing is entirely natural. Should investors receive the same preferential tax treatment for building factories in the United States as for building them in China? Should we be as eager to subsidize venture capitalists taking risks in the Chinese AI market as in the American one?

Allowing investment in an adversary’s military-industrial base and technological prowess is bad enough. Subsidizing it is madness. So long as an outright ban on such “outbound investment” remains stalled, Congress should use the tax code to achieve a similar outcome. Specifically, Congress should raise taxes on capital gains and dividends from investment in China to at least the highest rate paid on ordinary income.

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The ill-fated economic integration between the United States and China—promoted over decades by elites of both parties convinced that China would liberalize and democratize, and if not we should want their cheap stuff anyway—has produced a dense thicket of policy challenges. One major challenge is the approximately $1 trillion of U.S. capital invested in Chinese companies.

A recent report from the House Select Committee on the Chinese Communist Party identified billions of dollars in U.S. venture capital investments flowing into Chinese companies that are at the cutting edge of China’s techno-industrial strategy and military modernization. American investors are thus directly aiding—through not only capital, which is widely available, but also unique expertise and political legitimacy—our greatest economic, geopolitical, and military adversary. The active investment provided by private-market investors assists with talent acquisition, research expertise, and entrance into international markets. It creates a powerful lobby within the United States pounding the table for the success of these firms.

The Biden Administration, through an executive order and Treasury Department Notice of Proposed Rulemaking, has focused specifically on these active investments, but even then its proposal imposes only the most modest of limits and primarily requires only notification of investments made in the most sensitive sectors. As American Compass’s Oren Cass noted in the Financial Times:

officials briefing reporters on President Joe Biden’s long-awaited executive order restricting American investment in China used the words “narrow” and “narrowly” no fewer than 10 times in half an hour. They emphasized that new rules would reach just three “national security sensitive technologies”: advanced semiconductors, quantum computing and artificial intelligence.

The rules will apply only to the “subset” of technologies in those three categories that are “specifically designed for military or intelligence end-uses” and only to particular categories of private investment such as venture capital, private equity and joint ventures. 

The approach reflects “our longstanding commitment to open investment,” the officials insisted. The action is “not an economic one” and the goal is “not decoupling our economies.” To illustrate the point, “investments in entities engaged in the development of less-advanced semiconductors or AI systems designed for certain dual-use capabilities that pose national security risks” can, subject to certain conditions, proceed.

That approach is wholly inadequate even where applied, and for the most part it will not be applied. The vast majority of outbound U.S. investment in Chinese entities takes passive forms in public markets. Much of it comes from pension funds and large financial asset managers, such as Vanguard and Blackrock, that control Americans’ retirement accounts and investments, as well as the governance decisions of American corporations. This type of investment lowers the cost of capital for Chinese companies, provides global legitimacy, and ties American financial interests to the goals of the Chinese Communist Party. Moreover, capital deployed to China is capital not deployed to the United States or even American allies.

The financial entanglement also creates rampant conflicts-of-interest between American firms and American ideals and interests. To succeed in China, business leaders must appeal to the Chinese Communist Party (CCP)—a party committed to a totalitarian ideology, that is engaging in genocide, bent on displacing and destroying the American-led world and the capitalist West, subsidizing an opioid epidemic that has killed hundreds of thousands of Americans, and a party that the Biden administration acknowledges is preparing for war against the United States. As a result of investment in China, wealthy Americans, large financial institutions, and multinational corporations all have a $1 trillion interest in appeasing the CCP and indeed ensuring its prosperity. Beyond threatening American national security, the result is to corrupt the American market and American democracy.

Jeff Yass, an American venture capitalist, provides a prominent example. Yass personally owns a 7% stake in ByteDance, TikTok’s China-controlled parent company, which is estimated to be worth more than $20 billion. Despite an overwhelming bipartisan consensus among American lawmakers that TikTok poses substantial national security threats, as well as public support for banning the app or forcing ByteDance to divest the U.S. business, Yass has used his considerable financial resources as a leading political donor to pressure members of Congress to oppose a ban or forced sale.

Warren Buffett opposes “stupid” U.S.-China economic tensions, which makes sense given his stake in BYD, China’s leading electric-vehicle producer. Ray Dalio, founder of Bridgewater, a hedge fund invested heavily in China (including military companies), has urged America to adopt CCP General Secretary Xi Jinping’s “common prosperity” vision. CEOs of BlackRock, Blackstone, and KKR have all given Xi standing ovations. JP Morgan CEO Jamie Dimon had to apologize for making a joke that his century-old bank would outlast the CCP.

What’s needed is action from Congress. The Senate has made modest progress, led by Senators Bob Casey (D-PA) and John Cornyn (R-TX). In 2021, they introduced the National Defense Critical Capabilities Act, which would have created an interagency screening committee to monitor, regulate and prohibit a broad swath of outbound investment in foreign adversaries, roughly akin to the Committee on Foreign Investment in the United States (CFIUS) that screens inbound investment. A weaker version of this bill (the Outbound Investment Transparency Act), which required only notifying the government of investments, was added to the 2024 National Defense Authorization Act by an amendment that passed 91 to 6.

But even a modest notification requirement with overwhelming bipartisan support in the Senate was too much for the House of Representatives. House Financial Services Committee Chairman Patrick McHenry used his gavel and his market fundamentalism to single-handedly block any progress on outbound investment, despite efforts by the chairs of other national security committees.

McHenry has been a staunch opponent even of the Biden administration’s weak efforts. He wrote to Treasury Secretary Janet Yellen, expressing his concern when the executive order was still a rumor. American venture capital investments—far from aiding China’s military modernization—actually “represent potential national security risks to the target country—in this case, China,” he argued, because Americans could acquire controlling rights in Chinese companies. He found it “inexplicable that the Administration hopes to rescue China from these risks before Beijing can.” In a letter criticizing the final Executive Order, and urging Yellen to narrow it, McHenry explained more fully:

If we oppose China’s state-run economy, we want more private investment—not less. Of those private investors, we want more of them to be Americans—not fewer. And if we are truly concerned by China’s technology companies, we want as many Americans as possible steering them, spreading Western standards, and complying with U.S. laws.

Despite Speaker Mike Johnson and Majority Leader Steve Scalise directing House committee chairs to find a compromise, McHenry has managed to prevent any legislation on outbound from proceeding. He is also the reason House Republicans have not taken action against Chinese purchases of agricultural land, despite a bipartisan proposal to do so. He has worker to prevent any expansion of CFIUS authority to block new forms of Chinese investment in the U.S., such as greenfield investment that embeds Chinese supply chains and forced labor practices into the American electric vehicle sector. He has even used his influence to block bills outside of the Financial Services Committee’s jurisdiction, such as one from Congressman Jim Banks (R-IN) to prohibit ERISA plans from investing in Chinese companies.

To be clear, an outright ban on outbound investment remains preferable. But with the upcoming expiration of many Tax Cuts and Jobs Act (TCJA) provisions next year, Congress is likely to move forward a massive tax package. Increasing the tax rate on capital gains realized in China offers an opportunity to raise needed revenue. Moreover, it will discourage investment in China, and make clear that favorable treatment on investment should be contingent on that investment favoring America.

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The idea of taxing investments in China at a higher rate already has substantial support in the Capitol. Late last year, under the leadership of Chairman Mike Gallagher, the House Select Committee on China issued a near-unanimous, bipartisan series of economic, financial, and technology policy recommendations. The highest-profile proposals included ending China’s Permanent Normal Trade Relations status, requiring the Federal Reserve to stress test U.S. banks for their China exposure in the event of a war with Taiwan, and banning Chinese technology products from the U.S. market. Also on the list was to:

Enact legislation to ensure capital gains and dividends made from investing in the [People’s Republic of China] are not taxed at a lower rate than American workers’ salaries. Congress should give investors a one-year period to divest from PRC entities then tax investment in the PRC at the same rate as ordinary income.

In other words, the investment subsidy for long-term capital gains should not apply to investments in China. Following this recommendation, a bipartisan group led by Congressman Brad Sherman (D-CA) introduced a short bill to do implement the proposal.

As part of any 2025 tax legislation, Congress should include a provision along these lines, with the following features.

First, the law should define both the “investment” and “China” elements of “investment in China” broadly. Any investment that generates capital gains or dividends should qualify, including from active private-market investments through to passive index fund holdings. Ideally, an asset that has any China connection should be treated as wholly an investment in China. But at a minimum, a fund’s gains and dividends should be allocated as disfavored in proportion to the share of underlying assets in China. If 10% of a mutual fund’s assets are in China, at least 10% of the income from that mutual fund should be taxed at the higher rate.

Likewise, an asset should be classified as “in China” not only if it is physically located in China, but also if it is owned, controlled, or directed through any chain of ownership by an entity incorporated or based in China. Holdings of Variable Interest Entities and other investment structures that do not involve direct ownership in China, but are designed to track the performance of assets in China, should be regarded as investment in China as well.

Second, the tax rate for any income earned from investments in China should be raised to at least the highest marginal tax rate on ordinary income (currently 37%, but rising to 39.6% upon TCJA’s expiration). A higher rate, perhaps 50% or more, should be on the table. The goal, after all, is not merely to stop subsidizing investment in China, but in fact to discourage it.

Third, investments in China should not be eligible for the “stepped-up basis” treatment afforded other investments upon death. Typically, the “basis” for an asset received via inheritance is reset, so that the recipient will only ever have to pay taxes on any gains occurring after the inheritance. Thus, an asset bought by John for $1, inherited by John Jr. at a time when its value is $10, and then sold by John Jr. for $11 would only incur tax on $1 of capital gains. Instead, if the asset is in China, as defined above, John Jr. should be assessed tax on the full $10 of gain from the time of John’s purchase.

Fourth, tax-exempt non-profit entities, such as universities, should have to pay the full capital gains tax on investments in China. The non-profit tax exemption, even for multi-billion-dollar endowments, exists on the theory that these organizations are public goods. Even granting this (increasingly dubious) premise, investments they make in America’s adversary obviously are not in the public interest.

Finally, in the interest of predictability, and not wanting to frustrate reasonable plans and expectations, Congress should afford investors with pre-existing holdings in China a grace period to divest from China and pay the pre-existing tax rates on any gains, before the new rates take effect.

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Eliminating the tax subsidy for investment in China would have many of the same advantages as an outright investment ban: limiting the support that the United States provides to China’s “Military-Civil Fusion” strategy for leveraging its economic development into military modernization; reducing the financial stakes that Americans have in the Chinese market, which create incentives for them to act as de facto agents of the CCP; making productive investment in the United States relatively more attractive.

Insofar as investment in China continues, the revised tax treatment would have the benefit of raising revenue. The opacity of investment in China makes the exact amount difficult to estimate; certainly, it would not solve the federal government’s long-term fiscal problems. But with ballooning fiscal deficits, and many in Congress eager to extend TCJA provisions wherever possible, any new revenue will be a valuable resource—especially from sources that already have a bipartisan committee endorsement. While Republicans have historically been reluctant to embrace tax increases, especially on capital, recent indications suggest that some may be open to tax hikes. Prominent GOP legislators have signaled that tax increases are under consideration for next year, from House Appropriations Committee Chair Tom Cole to House Budget Committee Chair Jodey Arrington to Freedom Caucus Policy Chair Chip Roy.

Furthermore, American Compass polling has found that a substantial majority of the public at all points on the political spectrum would support higher taxes as part of an overall fiscal settlement. No public polling has focused directly on higher capital gains taxes on investments in China. But it is hard to imagine a tax increase more popular than requiring American investors in China to at least pay the highest marginal tax rate for ordinary income. Republicans in Congress should consider tax hikes on China investments an easy win.

The need for a tax package next year coincides with another fortuitous event on the political calendar: the retirement of Chairman McHenry. With McHenry gone, power in the House’s GOP caucus will move to the China hawks on the Select, Armed Services, Foreign Affairs, and Intelligence Committees. This signal will be amplified if Congressman Andy Barr or Blaine Luetkemeyer, members of the China Select Committee, takes the gavel at Financial Services.

Regardless, any tax bill’s initial skirmishes will play out on the House Ways and Means Committee and the Senate Finance Committee—the chokepoints for any tax policy. Chair Jason Smith has been a breath of fresh air atop Ways and Means, building strong bipartisan support for a bill that would have substantially expanded the Child Tax Credit and provided more favorable tax treatment to research and development expenditures. His record on China has been mixed, for instance taking a relatively soft approach to the issue of de minimis tax treatment for imports from China—under which hundreds of billions of dollars of packages, each worth less than $800, are allowed to enter the country tariff-free.

Senator Mike Crapo (R-ID), ranking member on the Finance Committee, has had little opportunity to engage on China-related issues. Representing an agricultural state, he has traditionally been a free trader, even on China. He previously called for a rollback of the Trump administration’s tariffs on China (or, in his words, a more “thoughtful application”), though he has more recently sounded a more supportive note. Moreover, he voted for the Casey-Cornyn amendment to the NDAA and has sponsored numerous bills to restrict Chinese land purchases in the United States. Perhaps he can be won over. Democrats will have to decide between their enthusiasm for raising taxes on capital gains and their instinct to label anything that singles out China as xenophobic.

For any conservative eager to get into the coming tax fight by taking on China, fiscal responsibility, and unproductive investment all at once, this issue is ripe for the picking.