Tax Havens: Trouble in Paradise

We have all seen it in the movies – the enigmatic dungeon of a Swiss bank, or paradisiacal setting of a bank in the Cayman Islands.

But for most of us that is the extent of our knowledge of the “offshore world” of finance. Most of us think of this “offshore world” as a place saved for money laundering criminals, or the Gordon Gekkos of the financial world. However, what most of us do not know is that offshore tax havens hold an estimated US$ 9 trillion in global deposits, which is US$ 2 trillion more than total deposits held by American banks, cites the Tax Justice Network.

The results of the (relatively) recent increase in offshore activity are impressive: Mauritius – an island state in the Indian Ocean – is the largest foreign investor in India; the British Virgin Islands – an island territory of Great Britain – is one of China’s largest foreign investors.

As financial flows have been able to move more freely across borders, tax havens have become integral in how companies and wealthy individuals structure their finances. This has led developing countries to enter a global “race to the bottom”, in an attempt to keep capital within their borders and attract foreign capital from abroad.

So what exactly are tax havens? Tax havens, as defined by the OECD, are jurisdictions that impose relatively low tax rates: they are a destination for non-resident investors to escape tax burdens imposed in their country of residence. A tax haven can offer this service due to its laws or administrative practices that prevent the effective exchange of information regarding taxpayers that benefit from a low-tax jurisdiction. Often, but not always, these countries are sovereign nations – meaning they have the power to enact laws that solely influence and govern their territories.

There has been significant research on both sides of the argument: those on the economic right find that tax havens force tax competition between nations, which serves to benefit the global economy; those on the economic left believe they only increase the income gap; and then there is the research initialized through government bodies or international organizations, such as the OECD. This research is largely motivated by the increase in depleted government treasuries; it concludes that governments around the world need to put a stop to tax havens because of the strain they are putting on government treasuries through the flight of capital from their borders.         

Tax havens have become a topic of frequent discussion as the US, along with several European countries, face debt crises. In a deal recently signed on October 6, 2011, Switzerland agreed to tax money held in its banks by British residents. This comes in the wake of intense international pressure to lift banking secrecy, and is certainly a major shift in the direction to limit the power of tax havens. Although international standards on tax evasion are far from practical, the global demand for tax havens has only increased as legislative pressures mount on existing tax havens, and other countries with more leniant taxation policies have offered to fill the void.

Even with increased international pressure, strong arguments still exist for tax havens. The most controversial argument, held by the Swiss, is predicated on the argument that banking secrecy is a human right and that states trying to meddle with banking secrecy are violating that right. More pragmatic arguments state that it is the duty of companies to reduce levied taxes through any (legal) means in order to generate the most profitable returns for their shareholders. Those in favour of low tax rates argue that tax havens keep governments and regulatory institutions from raising taxes and/or implementing regulations to inefficient levels. While companies may earn higher profits from offshore subsidiaries, those profits will eventually flow back into the on-shore economy and will subsequently be taxed.

Recent economic theory suggests that tax havens actually play a beneficial role to the major global economies. As capital has become more mobile, distortionary taxes threaten to drive capital away from open economies. The intuition behind this is simple. Those factors in an economy which are immobile – that is, unable to move from the jurisdiction – will ultimately bear all tax incidence. Therefore, attempting to tax mobile factors will drive their owners to jurisdictions with better returns. By directly taxing immobile factors, the tax incidence will not change, and productivity will not be reduced through the flight of mobile capital.

However, we see that most countries do levy distorting taxes on mobile capital. Tax havens provide an outlet for that mobile capital to reside: they allow firms to invest in the country of residence, while still generating competitive capital returns. So, while the country of residence may not tax this capital, at least it stays productive within the resident country. If governments wish to impose restrictions and regulations on tax havens, they must alter their tax code to reduce the taxation on mobile multinational capital. However, as public faith in globalization and the benefits of financial markets shakes, these arguments have been subject to more scrutiny.           

Cries for equality instead of efficiency have made policymakers ready to enact legislation against offshore finance. They claim that tax havens have skewed the global distribution of wealth and depleted government tax bases. Some research has even used the term “parasitic” when describing them, and they seem to exacerbate the problem of tax competition by causing countries to reduce their tax rates below efficient levels. Tax havens lead to deadweight losses through firms participating in rent seeking and by governments, who attempt to enforce tax code.        

With little financial regulation in tax havens, it has become harder to identify where companies’ debt and risk lie. This has led to perhaps the most threatening uproar against them – investors want to know exactly what kind of assets and liabilities companies hold – resulting in a shift towards downgrading some companies’ equity valuations.

While public opposition against tax havens has increased in the past decade, it may end up being the source of outcry from investors who will actually change the face of tax havens. Unless international regulation is put in place, which seems to be very uncertain, we must once again rely on the market to fix the alleged disequilibrium tax havens have created.

By Zachary Nash

The original article can be found at www.WesternESA.com