Not foreign investors. They have other investment options and only invest if the return on Swiss securities is high enough to compensate for the tax. In the end, it is the Swiss borrowers that pay, to the benefit of the state, but also of Swiss investors.
A simple portfolio choice model
We analyze the issue with a simple model where Swiss and European investors put their wealth in Swiss and European bonds. No one pays taxes on European bonds, which have a fixed yield of 5%, because the Swiss market is too small for developments there to affect the European market.
A withholding tax is levied on Swiss bonds. In the end, it does not affect Swiss investors, because they get it back, while Europeans do not (so «Swiss» investors are those who get the tax back, including foreigners, and «European» investors are those who do not ask for or get it back).
The figure below shows the share of Swiss bonds in the portfolios, as a function of the return on Swiss bonds.
Investors consider Swiss and European bonds to be very similar (we consider a fixed exchange rate). If the rates of return differ, they put all their assets in the bond with a higher return (the technical appendix also considers the case where substitution is limited).
The blue line shows the choice of a Swiss investor, or a European investor in the absence of taxes. He does not invest in Swiss bonds if they yield less than European ones (5%). He is willing to hold both bonds if the Swiss yield 5%, and invests only in Swiss bonds if they yield more than 5%. The red line shows the choice of the European taxable investor. The logic is the same, but with a threshold return of 7.69% and not 5%, because a return of 7.69% before tax gives a net return of 5% once the 35% tax is paid, equivalent to the European bond.
Market equilibrium
The Swiss bond rate of retunr reflects the demand by investors, which increases with the yield, and the supply by Swiss corporate issuers, which is inversely proportional to the yield. The figure below shows the balance between supply and demand.
The black line shows the volume of bonds issued as a function of the return. Investor demand is affected by the presence of the withholding tax, and the weight of Swiss in the investor population.
The red line shows investor demand in the absence of taxes, which takes the form of a plateau. Investors are willing to hold Swiss bonds as long as the return is at least 5%. The balance is at point A where Swiss and European bonds offer the same return. The weight of Swiss investors in relation to European investors is irrelevant, because in the absence of taxes they are identical.
In the presence of the tax, the demand takes the form of two tiers, and the presence of Swiss investors plays a role. Let's first consider the case of a strong presence of Swiss investors (60% of investors, green line). The balance (point B) is then the same as in the absence of tax (point A). The composition of investors is different, however, as only the Swiss are present when the tax is levied on returns. Since the market is dominated by investors who are not subject to the tax in the end, removing the tax does not change anything.
The blue line shows the case of a more moderate, but not insignificant presence of the Swiss (40% of investors). The equilibrium is then given by point C with a higher return (6.25%). As this return is insufficient for tax-paying Europeans, only Swiss investors are present on the market. They obtain a higher return than on European bonds because their weight is too limited to absorb the supply of bonds at 5%. The abolition of the tax shifts the equilibrium from point C to point A because it attracts European investors to the Swiss market, thus equalizing the returns. The abolition of the tax benefits the issuing companies, which see their financing costs fall. This is to the detriment of Swiss investors who lose their dominant position on the market. There are no consequences for foreign investors, who still get 5%, and for the Swiss government, which does not raise any taxes because of the initial absence of European investors.
The last case is where the Swiss represent only a small part of the investor population (20% of investors, orange line). The balance is then at point D with a sufficient return (7.69%) to attract Europeans despite the presence of the tax. The small size of the Swiss investor group implies that they alone cannot absorb the supply of bonds, which makes the presence of Europeans necessary, at a price. The abolition of the withholding tax shifts the balance from point D to point A. Issuing companies benefit from the lower financing costs. This benefit is at the expense of Swiss investors, who see their returns fall, and of the state, which loses tax revenue. European investors are not affected because they still have a net yield equal to that on European bonds.
In the end, a Swiss-Swiss question
The model considered is of course very stylized. It shows, however, that developments in the financial markets of a small open economy have a much smaller effect on foreign investors than one might think.
The reason is that these investors have other investment options, and the net return they get in Switzerland has to be similar to what the other options provide. In other words, investor demand for Swiss securities is very return elastic. A tax on the return is then compensated by a change in the pre-tax return. Foreign investors are not affected, and the presence of a tax is ultimately a domestic distributional issue between borrowers, Swiss investors, and the state.
