The Dollars and Sense of Tax Havens: The Necessity of the Offshore Economy

The recent controversies over the lack of transparency of Mitt Romney’s 2012 tax returns and the existence of several offshore accounts in the Cayman Islands and Switzerland raise important questions on the role tax havens play in the global economy. While the public image of such havens may be that of a tool of tax cheats and criminals, a closer look at the role of tax havens in a global context provides a perspective of the reality of tax competition.

Groups like the Tax Justice Network perpetuate the negative imagine of the tax haven, most recently through the release of a report entitled “The Price of Offshore Revisited,” in which the Network contends that the total size of top 50 offshore client assets exceeds $21 trillion and lies in the hands of a “tiny elite.”

James Henry, principal author of the report and former chief economist at the McKinsey consultancy highlights the study’s four main points: the trillions that “leak” from tax-heavy jurisdictions into so-called shelters are “large enough to make a significant difference to all of our conventional measures of inequality”, that the lost tax revenue that the study predicts is substantial enough have a real economic impact on developing states, that the offshore sector which “specializes in tax dodging” is not operated by small, less-than-savory banks, but rather the world’s largest banks, law firms and accounting institutions.

Finally, he concludes, “it is scandalous that official institutions like the Bank for International Settlements, the IMF, the World Bank, the OECD, and the G20, as well as leading central banks, have devoted so little research to this sector.” These groups’ toleration of the offshore sector’s growth is made worse, says Henry, by the fact that they already have much of the data needed to estimate and regulate the industry.

What Henry, the Tax Justice Network, and those attacking Romney for his offshore holdings neglect to consider how tax havens fit into the larger framework of tax competition.

Indeed, the notion that those engaging in offshore banking are simply avoiding paying their “fair share” unfortunately prevails– that while they make money in the U.S., they don’t pay to fund the public transport that brings consumers to their stores or the roads that their goods travel on.

In fact, those in the top income bracket have been paying for these public services for years. The top 1% of earners in the U.S. pay about 40% of the nation’s federal income taxes, so the money not part of the offshore economy still goes to shouldering these costs.

Richard Rahn, in a Wall Street Journal piece entitled “In Defense of Tax Havens,” sees havens as

…no more than way-stations to temporarily collect savings from around the world until they are invested in productive projects, such as building a new shopping center or semi-conductor plant in the U.S. This enables a better allocation of world capital, leading to higher, not lower, global growth rates.

Indeed, as the Tax Justice Network’s report points out, many of the interests flocking to such havens are U.S. institutions or individuals. And despite their “mobile” nature, a portion of the capital saved through the haven inevitably goes toward to funding U.S. projects.

Foreign nationals do the same thing in the United States, as the U.S. government does not tax most of the dividend, interest and capital gains’ earnings of non-citizens investing in the U.S. Essentially, the U.S. is the world’s largest tax haven for foreigners, and the U.S. public benefits from hundreds of billions of dollars of invested capital.

The Foreign Account Tax Compliance Act (FATCA), which takes effect January 1 of 2014, is an attempt to cut down on tax haven usage by requiring foreign financial institutions (FFIs) to provide annual reports to the IRS detailing each U.S. client, as well as their largest annual account balance, as well as their total debits and credits. If a foreign institution does not comply, the U.S. will impose a 30% withholding tax on all transactions with U.S. securities.

While the Obama administration’s motives for the Act are clear (closing gaps in the offshore economy while increasing domestic spending and taxes), FATCA will undoubtedly cause more problems than it solves. Already postponed a year because of logistical problems, the Act’s provision requiring FFIs to report U.S. investor activity necessitates a determination of U.S. citizenship—which is fine if the individual dealing directly with the FFI is the client—but such is often not the case.

Rather, there may be three or four layers of intermediation between a fund manager and a client, making such determinations lengthy and difficult undertakings. This, along with conflictions with the privacy laws of the FFI’s state, concerns over withholding taxes and mounting costs leading FFIs to refuse American investors all together are rendering the FATCA’s provisions a nightmare for all involved.

There’s an easier way— by reducing the U.S. corporate and income tax rates, the playing field can be effectively leveled and U.S. corporations can be rendered more internationally competitive, at the same time promoting a tax infrastructure that does not so rigorously punish savings and productive investment. Tax havens and their rampant use by U.S. entities are merely a response to this inequality.

The Heritage Foundation’s Daniel J. Mitchell has referred to tax havens as the “sharp point at the end of the spear of tax competition.” After all, the most damaging taxes are those on capital, and the freedom of choice that  tax havens provide not only promotes economic reforms to lower taxes globally, but also serves to limit the levels of double taxation of investment and savings.

To an extent, offshore accounts can also serve as a motivation for reform in unstable or unpopular regimes—overseas investors are unlikely to trust their resources to a government in the midst of civil unrest or upheaval—rather, the mere potential of substantial foreign investment may spur humanitarian initiatives on the part of regimes hoping to benefit from such investment.

In Dharmapala and Hines’s “Which Countries become Tax Havens?”, the authors contend that,

For a typical country with a population under one million, the likelihood of a becoming a tax haven rises from 24 percent to 63 percent as governance quality improves from the level of Brazil to that of Portugal. The effect of governance on tax haven status persists when the origin of a country’s legal system is used as an instrument for its quality of its governance.

Low tax rates offer much more powerful inducements to foreign investment in well-governed countries than elsewhere, which may explain why poorly governed countries do not generally attempt to become tax havens — and suggests that the range of sensible tax policy options is constrained by the quality of governance.

Tax havens have historically served as a type of insurance policy for those living under an unstable regime. In 1934, for example, Switzerland’s Banking Act of 1934 allowed thousands of Jews to escape the oppression of the Nazi regime, and in the 1990s, Argentinians who held offshore accounts in Miami were able to remain financially afloat after the economic collapse of 1998.

In some Latin American states, kidnapping gangs and extortion groups have been known to bribe corrupt tax authorities for information about wealthy individuals and their vulnerabilities– in these situations, offshore banking is more than a way around taxation—it is a matter of life and death.

It is been proven time and time again that reducing rates and slimming tax codes bolster both compliance and encourage growth. When Ireland faced 17 percent unemployment, a 50 percent corporate tax rate, a 65 percent top income-tax rate, and a 50 percent capital gains tax, it was only when such rates were slashed that GDP per capita in the OECD prosperity ranking rose from 21^st in 1993 to 4^th in 2002.

Likewise, in Great Britain and the U.S. in the 1980s, when income tax rates peaked at 83% and 70% respectively, the Thatcher and Reagan cuts took effect and capital began flooding the U.S. and the U.K. prompting global a rate decrease.

Global experiences like those of the U.K. and those of our own past are indicative of the reality of taxation– that reducing tax rates and simplifying the tax code improve both tax compliance and economic growth, and that tax protectionist policies are as stimulating to growth as tariffs.

Initiatives like the FATCA are nothing more than half-hearted attempts at treating a symptom of the larger syndrome of inequality between the U.S. and international income and corporate tax rates, attempts that ultimately have an adverse impact on liquidity and capital inflows into the U.S.

William F. Buckley once famously proclaimed that anyone who uses the word “fair” in connection with income tax policies should be electrocuted. Indeed, under the conditions of the current system, the use of tax havens should not be looked upon as a dishonorable endeavor, but simply a reaction to a deeply flawed and outdated system of taxation.