Sidebar: Delaware and Britain
There are three issues that those concerned with the future of offshore financial centres ought to consider, which address some critical questions we all now face.
Those issues are:
- the roles jurisdictional competition plays in inducing change in the law,
- the discipline – and the limits to the discipline – provided by jurisdictional competition and
- whether there is a linkage between jurisdictional competition and economic growth.
The American experience has something to offer in considering these issues.
Before turning to the specifics, you might want to think about the American experience with respect to these questions because we’ve been doing jurisdictional competition for a couple hundred years and we’ve struggled with difficult issues in trying to get the balance right between leaving things to be sorted out through economic competition amongst our states versus settling things by national policy.
That experience has something to say about the struggle to figure out what to leave at the national level, what to move to supra-national institutions and what to make the responsibility of global institutions.
In considering these issues, we need to think about two important historical facts that are often neglected in debates over economic policy. First, the puzzle we seek to explain is not why some nations are poor but rather why all nations are not.
For most of human existence, almost everyone lived in poverty and even the few who were relatively best off lived in conditions we would regard as appalling. Economic growth is a very recent development. It is a wonderful development.
Growth has given us lower child mortality rates, longer life expectations, literacy, and iPhones. Everyone agrees, or ought to agree, that places that haven’t yet had much of it would be better off if they experienced it sooner rather than later.
To put it in perspective, the growth in consumption levels from 1800 to today is about 16 fold per capita and 5.7 billion out of the 6.7 billion people in the world today are doing really well by historical standards.
Second, we don’t really have a good explanation for why people stopped being poor all the time or why that changed first in the Netherlands and Britain around 1800. It is embarrassing for the economics profession but we can’t seem to explain how we got a 16 fold increase in consumption.
Economic historian Deidre McCloskey’s recent book Bourgeois Dignity offers a systematic, data-driven, and depressingly convincing demolition of every serious theory economists have proposed to explain that increase, from capital accumulation to imperialism to education to legal institutions.
Hernando de Soto documented with similar depressing thoroughness in The Mystery of Capital how time after time formal institutional transplants from developed economies have failed to yield results in developing economies.
And economic historian Gregory Clark’s least controversial conclusion in his controversial book A Farewell to Alms was that “God clearly created the laws of the economic world in order to have a little fun at economists’ expense” since we are unable to explain the most significant economic event in world history – the Industrial Revolution. So we need to be cautious in evaluating efforts to restructure the world economy, as critics of OFCs often suggest we do.
In addition to the big picture of the world economy, we can also consider what happened in individual countries. Before 1820, the United States was a backward economy on the periphery of the world economy. In 1871 – just a few years after we had a Civil War of staggering human cost and property destruction – just a few years after that colossally destructive episode, we passed Britain in GDP.
America was transformed from a series of regional markets of mostly poor subsistence farmers who rarely saw cash into a national market that spanned a continent, one in which business enterprises of previously unimaginable size and complexity operated at scales formerly undreamt of and in which ordinary people’s standard of living improved substantially.
During that time we dramatically changed our tax, business entity and regulatory laws. And we did it within a system that granted relatively little authority to the national government compared either to today or to our then-contemporaries in Europe.
It relied instead on state governments competing amongst themselves for economic development.
Jurisdictional competition in promoting innovations in the law
Competition among jurisdictions for economic transactions is not simply a 19th century American phenomenon. It is growing. Larry Ribstein, the preeminent scholar of competition in law in the US today, and his coauthor, Erin O’Hara, describe it this way in their book The Law Market:
“Any state can make rules, but not every state legitimately can enforce them in all circumstances, especially those involving people or assets outside the state. Because no single government can extend its courts and enforcement powers to cover the world, multiple states end up competing with no state able to exercise effective monopoly power over mobile entities. In the end, states compete for mobile parties and their assets by attempting to provide the laws people want.”
This competition is not just about taxes and finance. The territory of Wyoming, even before it became a state, became the first American jurisdiction to grant women the vote because it wanted to lure women to the territory.
Women’s property rights and contract rights advanced first and faster in the American west because conditions there made it more practical for women to be able to legally contract and hold property; the idea spread from the west to the east as a result. Competition among jurisdictions affects all dimensions of law.
One of the most important examples of regulatory competition within the United States that I think illustrates some of the important advantages competition offers: the story of how the tiny state of Delaware took the corporate charter business away from New Jersey in 1913 and has kept it ever since.
Here is the short version: New Jersey was the initial winner in the competition for corporate charters in the 1890s, for a variety of reasons, including having laws permitting purchase of property with stock and rules permitting holding companies.
In 1913, however, Gov Woodrow Wilson led an effort to restrict holding companies. Delaware moved to win the charter business away from New Jersey by adopting a corporate law that mimicked New Jersey except with respect to Wilson’s innovations. Companies shifted their charters to Delaware.
After Wilson left to become president, New Jersey tried to win the business back by repealing the provisions that had sparked the exodus but to no avail. Delaware’s story has two important lessons.
First, Delaware won the business away from New Jersey by offering firms a choice between New Jersey’s offering of New Jersey corporate law with the Wilsonian innovations and Delaware’s New Jersey corporate law without the Wilsonian innovations.
One conclusion we might draw would be that Delaware undercut New Jersey’s sovereignty by preventing New Jersey from having a law it wanted. That’s not quite right. Of course, what Delaware actually did was prevent New Jersey from simultaneously having two things – the law Gov Wilson wanted plus all the revenue from corporate charters.
New Jersey could have one or the other but it couldn’t have both. And what that means for us in the post-Delaware-taking-away-New-Jersey’s-corporate-charter-business world is that from then on, legislatures had to think hard about whether they wanted a change in the law that might motivate people to move elsewhere activities that generate revenue for a government and wealth for a jurisdiction.
When New Jersey repealed the Wilsonian laws and said, in effect, “come home” to the businesses that had taken their charters to Delaware, the businesses said, “well, we don’t quite trust you as much as we did and we think we like it here in Delaware.”
The second point is that no other state has taken Delaware’s business in corporate charters away since, proving that learning does occur. It is not that other states haven’t tried, but what Delaware discovered is that it wasn’t enough to have a copy of the old New Jersey corporate charter law. If it wanted to keep the business, it had to come up with something more – which it did.
Delaware has what corporate law scholars Jon Macey of Yale and Geoffrey Miller of NYU call “an important capital asset in the form of a legal environment that is highly desired by consumers of its corporate law both for the present structure of its rules, and –perhaps more importantly – for the reliable promise it makes that rules adopted in the future will also be highly desired”.
Delaware today leads in corporate charters of large public companies for several reasons, outlined in the accompanying box. The reason Delaware keeps the business is that Delaware is good at it. Better at it, in fact, than any other state, including much larger states.
And an important reason why Delaware is better at it than other states is that Delaware is sort of the Liechtenstein of United States. By that, I mean it is a small jurisdiction that lacks many options in developing its economy.
There is a common skeptical reaction to this claim that I want to address: Delaware may be winning but what kind of race is it winning? A race to the top or one to the bottom? After all, the decision on where to incorporate is one made by the board of directors of the firm and won’t they just choose the jurisdiction that offers them the greatest opportunity to transfer value from the shareholders to the directors – or, if you think the directors are just pawns of management, to the management?
Opinions are mixed on this but Roberta Romano of Yale, the preeminent scholar of the charter competition concludes that on balance shareholders have benefited from the competition based on event studies showing a positive price effect for reincorporations to Delaware and higher Tobin’s Q for Delaware firms.
This isn’t the only example of the role jurisdictional competition plays in changing the law for the better. The recent spread of LLCs in the United States and internationally is another example. Delaware does not lead in LLCs; it faces tough competition and Nevada is the market leader.
Trust law is another good example. University of the West Indies professor Rose Marie Antoine has written about how offshore jurisdictions have led to developments in trust law that are quite significant, including the development of the protector and the evolution of the business purpose trust.
Similarly, in hedge funds, it is offshore that we’ve seen the initial moves toward having boards with duties – and ones that we now know carry significant risks for board members who do not perform those duties after the Cayman courts’ decision in Weavering Macro Fixed Income Fund Ltd v. Peterson.
Jurisdictional competition as a disciplinary device
Now consider the second role competition can play – as a means of preventing monopoly. We often talk about the need for competition to address monopolies in the marketplace – monopolies restrict output and raise prices and so cause social welfare losses.
Is competition among governments different? There are at least three ways in which it is not and so we should try to foster competition among governments even when it is uncomfortable for us in our roles as government officials or citizens of particular states who may benefit from monopoly privilege.
First, the economic analysis of monopolies often focuses on price, which doesn’t necessarily have a clear analogue in competition among governments, but there are lots of other problems with monopolies. One of the most important is what economist JR Hicks identified back in 1935:
“The best of all monopoly profits is a quiet life.” For example, it is easy for governments and regulated industries to fall into an easy coexistence in which they don’t innovate and so problems don’t get solved.
That is exactly what the United States faced during one of our periodic medical malpractice insurance crises in the 1970s – state insurance regulators and the insurance industry weren’t responding to the needs of the insured.
State level regulation was impeding market competition producing new competitors. Our federal Congress stepped in and authorised Bermuda and Cayman captive insurers to enter the markets to add competition.
This was a resounding success – not only did offshore captives enter the market but other states adapted as well and started competing for this business, so that today Vermont, Cayman and Bermuda vie for captive market leadership in the American market.
As a consumer, I think this is tremendous news – health care providers, trucking companies and dozens of other industries are now using captives to lower costs and so lower the cost of providing services to me.
Such cost-lowering innovations are largely in creating more cost-effective business structures like structured portfolio companies and more efficient regulatory bodies focused on business insurance issues rather than on consumer insurance issues.
Moreover, since many captive owners are non-profits and many offshore captives opt for domestic tax treatment even though they are offshore, this isn’t about the “t” word either.
Second, regulatory competition turns out to be good at preventing particularly pernicious – to an economist – forms of rent-seeking behaviour. One of the problems with regulations is the creation of hidden cross-subsidies that conceal from voters the costs of regulatory policies that serve special interests.
This has been a major problem in everything from telecommunications to energy regulation. Because indirect rent-seeking through things such as cross-subsidies are costlier than direct subsidies, regulatory competition puts relatively more pressure on the exact kind of special interest behaviour we have the most trouble restricting through the political process because of its lack of transparency.
There are many examples of rent seeking creating such inefficiencies around the world – inefficient state owned companies, often with monopolies, are an all too common feature of developing economies. Any means of inducing additional competition into such sectors is a plus.
Lowering trade barriers has been one means of doing so. International business structures are another.
Third, competition occurs through multiple avenues. One of them is by value-added regulation. We know financial markets work better when investors have confidence in markets’ fairness. We also know that different investors look for different types of protection.
Securities markets in the United States, for example, are dominated by a costly regulatory regime aimed at protecting individual investors through a system of costly disclosure and registration.
This system works less than perfectly, as the Madoff scandal, among others, illustrates. But institutional investors and sophisticated financial investors do not need the consumer-oriented regulations that the US provides to be protected. Developing a regulatory regime that focuses on such investors would produce one quite different from the US system.
Note that such a regulatory regime would be different, not that it would be better or worse. The US system has virtues with respect to individual investors. It doesn’t work particularly well for complex financial products aimed at institutional investors like pension funds because it is focused on retail investors.
It also doesn’t work well in a crisis – the American government is large and cumbersome. Smaller governments aren’t so cumbersome precisely because they are smaller. They can do things large governments can’t.
When I take students to the Cayman Islands to study off-shore financial regulation, they are amazed at the broad powers the Cayman Islands Monetary Authority has.
Last spring when I took students to Cayman– we surprised them by having as guest speaker among the accountants and lawyers and insurance executives, Mr James Osterberg, better known as Iggy Pop – who is a part time resident of Cayman.
When one of the students asked him why he chose Cayman as a place to live, he replied with no hesitation and no prompting from me: “Rule of law”. That’s exactly what small jurisdiction financial centres have to compete on if they are going to get business.
Moreover, there must be a broad range of jurisdictions competing for financial transactions if we are to see effective competition. It is good that New York and London compete for financial business and that both compete with Tokyo.
But it is even better that, nipping at their heels, are places like BVI, the Bahamas, Singapore, Hong Kong, Cayman, Bermuda and Liechtenstein, each trying to peel off a slice of this business and a bit of that one.
Those jurisdictions can play the role Delaware and Nevada play within the United States, the roles of innovators who are driven by their dependence on revenue from their financial industries to keep the pace of innovation up.
Jurisdictional competition and economic growth
Tax competition is something that many of us think about quite a bit and which provokes heat in the discussions about the role of IFCs. But while tax is important, taxes should just be one part of the discussion. Unfortunately, the discussion of tax competition has been far too narrow and it needs to be widened.
First, as a general matter, let us start by recognising that the optimal tax structure for different countries will vary. IFCs have good arguments about why their particular tax structures make sense for each of them.
As an economist I generally think consumption taxes rather than income taxes create excellent incentives for conditions that lead to economic growth. If I was advising a small island economy that imported virtually all of its consumption goods, I would think it quite sensible to have a tax structure that collected consumption taxes as duties on goods as they entered. That would both encouraged wealth-creating activities and save a great deal on tax administration expenses. That is just what the Cayman Islands did.
If I was advising a relatively poor country with high unemployment and an educated workforce plus access to the European market, I’d suggest a low tax rate to encourage foreign firms to use that country as their European base of operations, just as Ireland did.
On the other hand, if I were advising a country with a more extensive social welfare system that needed to be financed, I’d be understandably annoyed that raising tax rates to get that revenue might turn out to be harder to do given those low tax jurisdictions’ choices.
The existence of Ireland surely constrains the rest of Europe in ways that are – at the least – annoying for other European countries. Ireland’s tax choices restrict the feasible range of France’s taxes, although we might argue over how much it does. But does that make Ireland’s decision “unfair” competition? If the rules require harmonised rates, doesn’t France’s choice constrain Ireland just as much as vice versa?
These are interesting questions but it is more important that we realise that we are rarely discussing competition among ideal tax systems of different designs – but are discussing particularly unappetising sets of quite imperfect compromises, as the quotes in the accompanying box illustrate.
Tax competition goes well beyond rates – one point of contention in the debate over taxes in the United States is precisely that nominal rate comparisons between our relatively high corporate tax rates and some European corporate tax rates overstate the effective rates in the United States after taking into account assorted tax credits, exclusions and deductions.
Taxes are complex because we choose to make them so – often because special interest groups have succeeded in obtaining a word here and a subsection there – and each jurisdiction’s tax system reflects a wide range of decisions that make some transactions more advantageous than others within that jurisdiction.
Despite decades of work by the OECD through its model conventions, and the League of Nations before that, we are not going to harmonise most details of our tax systems, nor should we necessarily want to, for governments have different goals for their tax systems and those goals will be reflected in differences in how the systems operate well beyond rates. To single out nominal rates as distinct from the rest of the tax code is to mistake a few leaves on a single tree for a forest.
Complicating this discussion is that many of the jurisdictions that complain the most about competition from low tax jurisdictions – jurisdictions like the United States, for example – turn out to play significant roles as offshore jurisdictions with respect to other countries.
The US long exempted interest on deposits in US banks by non-residents from income tax, seemingly the definition of a ring-fenced tax regime yet somehow not within the OECD’s effort to define “harmful tax competition”.
The US has also been what we could be fairly called “less than fully cooperative” with governments such as Mexico’s on automatically providing other governments the sort of tax information the US wants other jurisdictions to provide it automatically – namely interest payments by US banks to Mexican residents.
We also have lots of jurisdictions in the United States where the beneficial ownership of a business entity is anonymous, something we object to elsewhere.
Second, and this is a point on which those favouring more competition ought to be prepared to see value in organisations like the OECD, we need to recognise that the thousands of differences, some small and some large, in definitions, exclusions, credits and so on that exist between the tax codes of even modest-sized economies require a framework that reduces the transactions costs of doing business internationally.
The OECD and its predecessor the OEEC took on the relatively thankless role of creating conventions that structured discussions on how to avoid or reduce the problem of double taxation. In many respects, it is impossible to imagine the expansion of international business transactions that followed the dramatic reductions in trade barriers, elimination of currency controls, and decline in transportation and shipping costs occurring without the framework provided by the OECD model conventions.
But there are two issues missing from the discussion of this point. First, the vast majority of the tax competition literature in economics has taken the same approach: treating all government expenditures as producing public goods and demonstrate that when there is competition among jurisdictions through tax rates, and the general result is that competition increases the revenue for the jurisdiction that cuts rates but decreases total revenue summed across all jurisdictions.
In an important way, such models assume the conclusion. We know not all government expenditures are on public goods. Some expenditures are simply wasteful, others are on what we might term “public bads”.
There are “public bads” like investing in technology used to oppress citizens as with the former Libyan government’s technology purchases that allowed it to monitor phone and internet communications.
Of course, these things are not just limited to developing countries and dictatorships. If you are not a fan of American foreign policy in recent years, you might think the war in Iraq was a pretty large public bad. If you are a fan of US foreign policy, you might think Saddam Hussein’s regime largely bought public bads with its tax revenues.
There are also smaller public bads, like building a dam that causes environmental harms – which the United States Army Corps of Engineers enthusiastically did for over a century – or subsidising a firm like Solyndra in the United States.
Analysts like Peter Wallison have argued that the role of Fannie Mae and Freddie Mac over the past 20 years in the United States has been largely to produce a giant public bad of a dysfunctional housing market.
We don’t need to agree on which things are public goods and which are public bads to agree that the categories exist. The critical point is that once you take away the assumption that all public revenue results in the purchase of public goods, these models give us much less useful guidance on how to think about tax competition’s effects because we don’t have any way to tell whether or not increasing or decreasing public revenues gets us more or less of things we want or things we don’t want.
The conclusion I draw from these examples is that embracing competition among jurisdictions across a broad range of substantive legal areas offers considerable benefits for everyone involved.
No doubt there have to be rules to the game – we want to make sure we are all playing the same game when we agree to meet for a football match.
And there are important limits to some aspects of the competition where Europe has done better than the United States – Kenneth Thomas’ recent book Competing for Capital makes a compelling case that the EU has done a much better job than the United States in limiting what is euphemistically called “state aid” to firms considering opening plants in different jurisdictions.
But we don’t want to stifle competition. We need competition to drive down transactions costs of doing business internationally by encouraging innovation. We need competition to restrict rent-seeking.
And we need competition to restrain special interests’ advantages in tax and regulatory policy. These are important considerations that need to be part of the discussion going forward.
Jurisdictional competition has played an important role in the United States for over 200 years. It isn’t always pretty, it isn’t always comfortable, but it has been a major force for improvement in our economy and our legal system. Expanding its role internationally ought to be an important objective for all of us.
It’s customary in debates over tax competition to talk about Ugland House in Cayman or the equivalent building in Delaware, with all those companies stuffed into relatively small buildings. Rather than complaining, we ought to all embrace the competition these places exemplify.
This article is an extract of remarks delivered by the author at the IFC Forum in London in September 2011.