Three cheers for tax havens
I once made myself somewhat unpopular at an economics conference by presenting a paper on “why economists don’t understand tax”; it is good to have my theory confirmed.
What I argued then was that economists have to simplify and make assumptions in order to create their theories, so they view tax in a theoretical way that has no connection with how tax systems and tax administrators work in the real world. Since then I have been pleased to meet some economists who can do tax, but at least 355 are stuck in the old ways.
There might be no need for tax havens in the sort of ideal world that most economists inhabit, where taxes were set to maximise utility, to reduce deadweight costs and to avoid double taxation. When that has happened, come back to us and we can talk about removing tax havens, but you will have a long wait.
In the real world, national tax systems are often badly designed, and the interactions between them are even worse. Try to set up an international business and you will soon become bogged down in the international tax system – although to call it a system is overly flattering; what we actually have is a mishmash of 19th century colonialism, 1930s League of Nations internationalism and 1950s bureaucracy.
The result of this is that, for anyone attempting cross-border business or investment, or even just an expat worker trying to operate a bank account, the main worry is not how to do tax avoidance but the risk of double or even triple taxation.
Add to that the global web of contradictory regulation, particularly the sort of protective legislation designed to save small investors from being conned but which is irrelevant to the capable large investor, and it is a wonder that any international business happens at all.
Profits are legitimately taxed in the hands of the business that earns them and in the hands of the investors who ultimately receive them, but should not be taxed as they merely flow through intermediary investment managers. But if an investment fund is trying to attract money from sources in different countries, locating it in a high tax country risks adding an additional layer of tax where it should not be due. If the investors and the businesses invested in are all in one country, that double taxation is usually removed by the tax system, but if they are in several different countries the system often cannot – or does not – cope.
The role of offshore finance centres – “tax havens” in the prejudicial term of the Oxfam letter – is to give a neutral, stable platform where this international investment can take place. That doesn’t affect the taxation of the businesses invested in – their profits are taxed or exempted by their national governments as they see fit. Nor does it affect the tax ultimately payable by the investors – that again is determined by their national governments.
Whatever might have happened forty or fifty years ago, offshore finance centres are no longer significantly used by people to hide their income from the tax authorities. Yes, there will no doubt be some; there are always criminals and they will often have bank accounts, but do we blame the High Street banks every time someone who happens to be one of their customers is arrested, or do we blame the car manufacturer whose product is used as a get-away car?
With the well-established network of tax information exchange between countries, including the so-called tax havens, any attempt to hide income to enable tax evasion simply doesn’t work these days. Look at the Panama Papers leaks we have seen so far; David Cameron had declared his offshore income and paid tax on it; the Indian tax authorities have investigated their nationals who were named and found that over 90% of them had also paid all the due tax. Looking back further, the Liechtenstein leaks a few years ago raised far less tax than the campaigners claimed was being “hidden” there. Illegal tax evasion using offshore centres is simply not common.
Often the investors are not even taxable; pension funds, charities, international organisations, or expats working in Gulf countries that do not have income tax. Even the World Bank uses offshore financial centres to channel its development investments. These organisations are not improperly avoiding tax because they are not taxable anyway, but they are avoiding the complexities of paying tax that they would then have to try to reclaim.
Nor do I believe the claim of £170 billion of tax revenues lost to poor countries every year. Various reports from development charities have made similar claims in the past, but when examined they turn out to be baseless. Their source data is unreliable; one report had a quarter of its total global lost tax revenue for a year coming from one data entry error in the trade statistics, which claimed that Spain had imported 7 million shearing machines (one for every two sheep in the country) at a low price.
If the initial data were not bad enough, what they do with it is worse; one claimed that the cheapest and most expensive quarter of all transactions in each trade category were the result of artificial price manipulation in order to save taxes. So if the average price of a laptop is around $500, the more expensive or cheaper brands are apparently priced simply to avoid taxes.
The other flaw in the Oxfam letter is the assumption that giving more money to governments will always be beneficial. Given the civil wars, oppression of minorities and general corruption in some countries, that is a dangerous leap of faith. Would the world really be a safer place if the governments of Somalia or Yemen, or even Russia, had more tax revenue to spend?
That brings us to another aspect of offshore finance centres that I listed above; “stability”, a secure, familiar, well-understood legal system. Sadly a lot of countries do not have that; many less developed countries and even some emerging markets have unstable legal and political systems, or high levels of crime and corruption (indeed it is often these problems that keeps them less developed). Investors considering putting money into such countries want their investment structures to be somewhere more reliable, and offshore tax centres provide that security.
These two points – the need for a neutral platform to collect and pool investment, and the need for a stable legal and political framework – are part of the service that offshore finance centres provide to the world.
But these services are most important for investment into developing countries and emerging markets, because collecting capital for a niche market requires investments to be pulled together and pooled from various sources, with all the complexities of international tax and regulation that brings. Not surprisingly, an investment fund investing in British companies, looking to attract British investors, will often be located in London, because the tax can generally be sorted out within a country, but it is the more complex funds investing in developing countries, new technology or other niche areas that often need to be based offshore.
So if the government follows the Oxfam letter’s call for action, perhaps helped by Cameron’s media embarrassment over his own tax affairs, and stops “tax havens”, what will be the result?
If investment is made more difficult, there will be less of it; businesses will have less money for new equipment and technological advances, and the cost of the remaining investment will go up. That will, in time, reduce jobs and services.
But worse, the ones to suffer most from the reduction in investment will be developing countries; they are the most difficult to get investment to successfully anyway, so if the investment routes that actually work are closed off, they will see less investment. That means less development, less access to new technologies, less opportunity to learn better business and management skills, and fewer opportunities for their people. Instead, investment will tend to become nationalist, each country’s wealth staying within its borders and with less to share.
Far from increasing inequality, as the Oxfam letter claims, the massive growth of international trade and investment over the last 25 years has lifted a billion people out of poverty – the biggest anti-poverty campaign in world history. If the governments of the wealthy and powerful nations “end the era of tax havens”, they will cut off the best conduit of this investment and that great poverty reduction process will stall.
Is that what Oxfam and the other development charities want – a world where poor countries are kept in poverty, dependent on their aid? I hope not.
Tellingly if you look at the list of signatories to the Oxfam letter, you will see very few from developing countries; barely half a dozen from the really poor countries who benefit from investment via the offshore finance system. Instead, around two thirds of the signatories are from EU countries with above-average public sector deficits. That suggests what might be really driving this campaign – not a desire to help poorer countries, but a desperate search for more money to prop up Western governments whose spending is out of control.
For those of us who live in the real world, offshore finance centres do have a real and beneficial role to play, particularly for developing nations and funding the adaptation of new technologies. If a media storm of innuendo and smear, whipped up by campaigners in the wealthy, comfortable West, is allowed to shut off access to global finance, the world will be poorer for it.
Read IEA monograph ‘The Benefits of Tax Competition’ here.