Wall Street strategists are voicing growing alarm over a provision in the ongoing U.S. budget bill that would impose a progressive tax of up to 20 percent on certain types of passive income earned by foreign investors. Introduced under Section 899 of the legislation, the levy targets dividends, royalties, and other passive receipts for entities—such as sovereign wealth funds, multinational corporations, and individuals—residing in jurisdictions that impose what the U.S. deems “unfair” digital service taxes or similar levies. While proponents argue the new tax could yield more than $100 billion over the next decade, detractors warn it risks deterring international capital flows and, in turn, weakening demand for U.S. Treasuries and the dollar itself.

Shifting Sentiment on U.S. Exceptionalism

For decades, global investors have gravitated toward U.S. government bonds and equities under the assumption of “U.S. exceptionalism”: the belief that America’s deep capital markets, reliable legal framework, and relatively stable economic growth would always outperform alternatives. However, rising fiscal deficits—now well in excess of $1.5 trillion annually—and a more protectionist trade policy have prompted institutional investors to reassess. A fresh foreign-tax levy, critics say, could cement the perception that U.S. policymakers are willing to use taxation as a tool to gain leverage in broader geopolitical disputes.

Several large asset managers note that if Washington begins to tax nonresident investors on passive income far more aggressively than most peer countries, it could amount to a de facto “capital war.” For instance, sovereign wealth funds from Europe, the Middle East, and Asia routinely invest in U.S. Treasuries as a safe-haven asset. If yields must be further boosted to compensate for a 20 percent tax drag on dividends or interest, many institutions may reallocate money toward European and Asian bond markets, despite those benchmarks typically trading at lower absolute yields.

The most immediate area of focus is the Treasury market itself. U.S. government debt sales—both in the form of Treasury bills, notes, and bonds—have historically relied on broad participation from overseas central banks, commercial banks, pension funds, and private wealth managers. In 2024, foreign holders accounted for nearly one-third of all outstanding U.S. Treasuries. If these buyers anticipate an effective tax bite on yields—or if they suspect Washington may expand the net of taxable income to include capital gains or agency mortgage-backed securities—they could demand to be paid a premium over market-clearing levels. That, in turn, would push yields higher and financing costs for the U.S. Treasury upward.

Private-sector strategists estimate that, to offset a 20 percent passive-income levy, non-U.S. investors would require at least 25 to 30 basis points of additional yield compensations on benchmark 10-year notes. As of late May, U.S. 10-year Treasuries were trading near 4.4 percent; in order to neutralize the impact of a new withholding tax on coupon income, that yield might need to climb above 4.7 percent—potentially spooking domestic borrowers as well. For corporations and municipalities issuing debt, higher Treasury yields translate into more expensive borrowing in all corners of the economy.

Dollar’s Vulnerability

Parallel to concerns about bond demand is the risk to the dollar. Historically, a sustained budget deficit financed by foreign capital has maintained upward pressure on the greenback. If a significant portion of those inflows were rerouted, perhaps toward euro-denominated bunds or Japanese government debt, the dollar could relinquish value. A weaker dollar would not only affect importers—raising the price of energy and raw materials—but also accelerate inflationary pressures, potentially forcing the Federal Reserve to reconsider its policy stance.

Analysts at several major banks caution that even before any legislation is finalized, speculative positioning in foreign-exchange markets has begun to reflect doubts. The U.S. dollar index, which measures the currency against six major trading partners, is down nearly 8 percent year to date. Although part of this slide owes to relative monetary policy divergence between the Federal Reserve and the European Central Bank, a new tax perceived as unfriendly to foreign investors could further exacerbate dollar weakness. This can create a feedback loop: a lower currency invites capital outflows, which depresses the dollar further, and so on.

Balancing Revenue Goals with Financial Stability

Advocates for the tax provision underscore the need to protect American firms from what they view as discriminatory digital-service levies imposed by select European countries and others. Under current law, foreign digital giants often dodge U.S. tax liabilities by routing earnings through low-tax jurisdictions. Section 899’s scope would extend a “mirror” tax on taxable entities located in countries that target U.S. technology companies. In theory, the proposal is designed to level the playing field and generate incremental revenue for Washington—estimated by the Congressional Budget Office and Joint Tax Committee to approach $116 billion over ten years.

Nonetheless, critics on Wall Street argue that any short-term revenue gain could be offset by higher borrowing costs and reduced economic growth. In particular, pushing foreign pension funds or sovereign wealth vehicles into alternative assets would undermine U.S. creditworthiness in global capital markets. One note from an equities research team at a leading New York bank suggested that “if foreign demand for Treasuries softens materially, both yields and spreads on U.S. corporate bonds will widen, squeezing corporate profits and equity valuations.” The ripple effects, they caution, could extend beyond government debt to consumer loans, mortgages, and commercial lending.

Should the tax be enacted as proposed, various sectors of the economy would feel the direct or indirect repercussions. Real estate investment trusts (REITs), which often distribute hefty dividends, might need to offer larger yields to signal attractiveness to foreign buyers; otherwise, capital may pivot to European property funds or Australian Real Estate Investment Trusts (A-REITs) with more favorable tax treatment. Likewise, utility companies issuing debt to finance infrastructure improvements could face steeper borrowing costs if municipal bond investors demand higher spreads.

Multinational corporations headquartered in the U.S. that rely on foreign parent firms or international private-equity backers could also see a higher after-tax cost of capital. For example, a European energy company with significant U.S. holdings may reconsider acquisitions of refining or pipeline assets if the tax on dividends is too onerous. Similarly, technology startups seeking follow-on funding from foreign venture funds could face valuation discounts, as private investors externally evaluate returns net of the new levy.

Potential Exemptions and Negotiations

Anticipating some of these pitfalls, a growing number of financial institutions and trade associations are lobbying Congress to carve out explicit exemptions for U.S. Treasuries and other sovereign debt instruments. Separately, multinational banking groups that underwrite global bond issuance have signaled a willingness to press for a narrower definition of “passive income” to limit the tax’s reach. Industry insiders believe that negotiations could yield amendments exempting agency mortgage-backed securities, corporate bonds issued by U.S. companies, and possibly even dividends from large, publicly traded firms.

There is also talk of creating safe-harbor provisions for foreign pension funds or sovereign wealth entities that commit to a minimum investment threshold in U.S. assets. Lawmakers and aides on the Senate Finance Committee are said to be exploring a tiered approach—imposing a 10 percent tax on smaller portfolios, while capping or waiving the rate entirely for ultra-large institutional investors who agree to maintain certain exposure levels to Treasuries. Whether these carve-outs will survive the inevitable horse-trading in committee markup sessions remains uncertain.

Even before any final vote, signs of investor unease are emerging. Late May trading data shows that foreign buying of U.S. Treasuries has cooled relative to prior months; net purchases from Asia-based central banks were roughly 60 percent below their ten-year average. Anecdotal reports from bond traders in London and Tokyo indicate that orders for long-dated U.S. government debt have become more conditional—clients are requesting confirmation that new assets will be exempted from Section 899 if it becomes law. That hesitation, while not yet translating into outright selling, suggests a heightened level of caution that could crystallize once legislative paths become clearer.

Some hedge-fund managers are even positioning for a sustained selloff in U.S. Treasuries. One prominent macro fund reportedly increased short exposure to 10-year notes in late May, arguing that “the market is mispricing the risk that foreign appetite for U.S. duration will dwindle.” Similarly, certain global fixed-income mutual funds have adjusted their duration targets downward by about half a year, reallocating proceeds to Canadian and Australian government bonds—markets deemed less likely to impose a punitive tax on nonresidents.

Impact on Dollar-Denominated Equities

Beyond fixed income, equities denominated in U.S. dollars could also face headwinds if the tax proposal spooks global investors. Although the S&P 500 remains near record highs, its valuation multiples—particularly in high-dividend sectors such as utilities, real estate, and telecommunication services—could contract. Consider that a 20 percent tax on dividends for a European pension fund effectively shrinks net yield by 3 to 4 percentage points; to offset that shortfall, U.S. dividend-paying stocks would need to trade at lower price-to-earnings or price-to-dividend ratios. In turn, a broad-based equity allocation shift could weigh on U.S.-dominated global equity ETFs.

Alternatively, multi-asset funds might respond by increasing allocations to non-U.S. equities, including developed markets such as Japan or Germany, or even frontier markets offering higher net dividends. For instance, several large Asia-focused index funds currently yield between 4 and 5 percent on average—with lower or no withholding taxes on outbound dividends—making them more attractive on an after-tax basis compared to some U.S. counterparts.

Critics argue that the foreign-tax measure risks igniting broader capital-market blowback. Should other countries view Section 899 as a hostile act, they could retaliate by tightening their policies toward U.S. multinationals operating abroad—imposing higher tariffs, stricter data localization rules, or additional levies on American tech exports. Already, several European finance ministries are examining whether mirror taxes on U.S. royalties or digital revenues might be on the table, creating the potential for a spiral of reciprocal measures that could erode the competitiveness of U.S. firms overseas.

Moreover, the move comes at a time when China’s bond market has begun offering higher real yields to foreign investors—an outcome of Beijing’s efforts to internationalize its currency and attract nonresident flows. Between 2023 and early 2025, international holdings of Chinese sovereign debt grew by more than 30 percent. In contrast, U.S. Treasuries have seen flat or slightly negative foreign net purchases over the same period. If that trend accelerates due to new U.S. tax obstacles, Washington might find its borrowing costs climbing, not because of runaway inflation but due to structural shifts in global capital allocation.

Political Dynamics and Legislative Outlook

Within Congress, the fate of Section 899 remains highly contested. Fiscal hawks in the House argue that global digital companies have exploited loopholes for years, and now it is America’s turn to recoup lost revenue streams. Meanwhile, moderate Republicans and some Democrats, worried about the potential damage to domestic capital markets, are exploring amendments. Senate committee aides suggest that bipartisan interest may materialize around trimming the rate to 10 percent or applying it only to countries that refuse to engage in tax negotiations with the U.S. Even these scaled-back proposals, however, could be perceived as a signal that U.S. fiscal policy is becoming more inward-looking.

Political analysts note that timing is critical: if the Senate waits until summer recess to address the issue, foreign investors could interpret the delay as tacit approval of the tax, prompting them to begin shifting portfolios prior to the final vote. Conversely, an expedited amendment process could calm markets but would reduce Congress’s leverage to extract concessions from foreign governments on digital-service taxation. The intricate dance of legislative priorities—balancing deficit reduction, international diplomacy, and financial market stability—remains fraught with competing pressures.

While much of the focus has been on Europe and Asia, the proposed tax would also touch investors in Latin America and Africa: sovereign wealth funds in the Middle East that currently hold tens of billions of dollars in U.S. debt, for instance, could find themselves effectively penalized if their home nations are judged to impose unfair digital levies. African institutional investors, which have historically funneled a portion of their reserves into U.S. government securities, may rethink allocations, especially if they face additional layers of bureaucracy or withholding. The ripple effects may ultimately crystallize in emerging-market currency movements as well: a weakening dollar, spurred by capital outflows, might help to stabilize some commodity-exporting nations but could destabilize those reliant on dollar-denominated debt.

Industry Lobbying and Potential Modifications

In response, industry coalitions representing foreign pension funds, multinational banks, and global insurance firms have mobilized to persuade Congress to exclude sovereign-backed holdings of Treasuries from Section 899’s purview. One high-profile coalition, comprising several European and Asian pension authorities, argues that without an explicit carve-out, foreign governments will dramatically downsize their U.S. debt coffers. Meanwhile, Wall Street’s largest investment banks are drafting contingency plans for secondary-market liquidity in Treasuries if retail and institutional buying retreated. Their white papers emphasize that a stable base of long-term foreign holders is essential to maintaining narrow bid-ask spreads and low volatility.

Some observers predict that heavy lobbying may push the final tax rate to a compromise level—perhaps 5 percent—while carving out Treasuries, agency mortgage-backed securities, and U.S.-listed corporate debt. Others caution that any concession could be offset by expanding the definition of “covered foreign country” to include more jurisdictions, thereby keeping the net of affected investors wide. These uncertainties compound the anxiety among global portfolio managers, who must decide in the coming weeks whether to preemptively adjust their positions or await further clarity in legislative language.

Even as debates rage in Washington, market data are beginning to reflect heightened caution. According to published custodial balances, foreign holdings of long-dated U.S. Treasuries dipped by approximately $50 billion in the last quarter—an unusual contraction given that historically those levels trended upward. At the same time, spreads between U.S. and German 10-year government bonds briefly inverted earlier in May, a reflection of European rates catching up as ECB policymakers signaled a slower pace of rate cuts. While some of this movement can be attributed to divergent monetary policies, many traders interviewed in New York and London point specifically to the looming Section 899 discussions as a driver of shifting demand.

Currencies have felt the tremors as well. The euro-dollar exchange rate, which hovered near parity in mid-Q1 2025, briefly climbed to €1.02 by late May—even as Eurozone growth indicators remained mixed. Traders attribute part of this rally to expectations that if the U.S. taxes foreign bondholders, those investors will buy fewer dollars. The yen has likewise strengthened against the dollar, with Japanese institutional investors rotating out of dollar assets into higher-yielding local bonds. Yet some contrarian strategists caution against reading too much into short-term moves, noting that the Fed’s hawkish tilt on interest-rate policy and relative economic strength continue to underpin the greenback’s appeal.

Broader Economic Implications

At its core, the debate over Section 899 raises deeper questions about America’s fiscal trajectory. The federal budget deficit, buffeted by elevated defense spending, rising entitlement costs, and recent tax cuts, is projected to remain above 5 percent of GDP for the foreseeable future. Servicing that debt requires reliable buyers; higher yields on Treasuries—whether driven by Fed policy or market demands—translate into billions more in annual interest payments. If foreign capital dries up or demands a steeper premium, domestic taxpayers may ultimately shoulder more of the burden, whether through higher taxes or reduced government services.

Conversely, some economists argue that a modest tax on foreign passive income could be calibrated so as not to trigger significant dislocations. They suggest structuring the levy as a gradual phase-in over several years, tied to reciprocal tax reforms from trading partners. Under that scenario, foreign investors would have time to reassess without abrupt capital flight, and the U.S. could still signal its commitment to addressing perceived unfair digital taxes abroad.

As lawmakers in both chambers of Congress prepare for a critical vote in early June, the fate of the foreign-passive-income tax remains up in the air. Will negotiators carve out exemptions for core sovereign holders of Treasuries? Will the top rate be scaled back? Or will the provision stay intact as written, sending a clear message that Washington is prepared to penalize foreign governments enacting taxes on American tech companies? Whatever the outcome, Wall Street analysts agree on one point: the final contours of Section 899 will matter far beyond the immediate revenue projection. They will shape the perceived safety and appeal of U.S. assets for years to come—one way or another.

Congressional decision-makers must weigh the potential trade-offs of defending political objectives abroad against the need to sustain a robust, liquid market for U.S. government debt. With global central banks and large institutional investors watching closely, even modest changes could produce outsized moves in yields, exchange rates, and cross-border capital flows. For now, traders, fund managers, and policymakers alike are adopting a “wait and see” approach—while quietly charting alternative strategies in case the final legislation imposes an unwelcome tax burden on non-U.S. holders of dollar-denominated assets.

(Adapted from Reuters.com)