Wall Street analysts are cautioning that a tax targeting foreign investors in the U.S. budget bill progressing through Congress could end up weighing on demand for U.S. Treasuries and the dollar.

The U.S. House of Representatives has approved a sweeping tax and spending bill that includes the possibility of imposing a progressive tax burden of up to 20% on foreign investors' passive income, such as dividends and royalties.

The levy, included in section 899, would be paid by entities or individuals from countries that impose taxes the U.S. considers unfair. If it is also approved by the Senate, it could raise $116 billion in taxes over 10 years, the Congressional Budget Office estimates.

"We see this legislation as creating the scope for the U.S. administration to transform a trade war into a capital war if it so wishes," George Saravelos, head of FX research at Deutsche Bank, said in a note on Thursday, adding the new tax could have an adverse impact on demand for U.S. Treasuries.

If passed by the Senate, the rising tax rate on foreigners' investments would come at a time global investors have started to question so-called "U.S. exceptionalism," or its unique ability to outperform other financial markets, amid a growing fiscal deficit and a new trade policy based on tariffs.

"Indian investors are already paying a withholding tax of 25% on dividend income and hence not much of a direct impact for Indian investors," said Rajeev Thakkar, chief investment officer and director at PPFAS Mutual Fund.

"However an increase in tax rates on investors like sovereign wealth funds may reduce their appetite somewhat and have a sentimental impact," he said.

DOLLAR WEAKNESS

Geoff Yu, EMEA macro strategist at BNY in London, said that based on his observation of investor flows, there had not been an immediate reaction.

"Treasuries are offering value right now - you're getting higher yields, the dollar is weaker," he said, which are both compensating for other factors.

U.S. 10-year Treasury yields are trading at around 4.4% .

Others noted a more bearish longer-term outlook for U.S. markets.

Morgan Stanley said in a note that the new tax would weaken the dollar, as it would reduce foreign appetite for U.S. assets.

The U.S. currency is down roughly 8% this year against a basket of other major currencies and is on track for its worst year since 2017.

Morgan Stanley strategist Michael Zezas singled out European investors with passive income in the U.S. as particularly vulnerable to the tax. The bank did not provide any estimate for the impact.

According to law firm Davis Polk, nations that could be considered "discriminatory foreign countries" include many that are part of the European Union, as well as India, Brazil, Australia and the United Kingdom.

The White House did not immediately comment on the impact of the new tax burden.