Unfunny fiction: TJN’s The Price of Offshore Revisited

Read the article in the Cayman Financial Review Magazine 

The Tax Justice Network has been getting lots of press for its report, The Price of Offshore Revisited: New Estimates for “Missing” Global Private Wealth, Income, Inequality, and Lost Taxes (2012), which estimates that $21-32 trillion of offshore private wealth exists.

If you liked John Grisham’s The Firm, you will enjoy this entertaining work of fiction as it attacks “one of society’s most well-entrenched interest groups” to uncover what it claims is “the tip of the iceberg” of secretive wealth in an “underground economy”.   

Surely Hollywood has already optioned this for a thriller. 

The report is authored by James S Henry, identified as a “senior advisor/global board member” who claims to be using four “models” to calculate the revenue lost to governments from the existence of international financial centres (IFCs).  Henry terms his report “an exercise in night vision” as the “subterranean system” of offshore finance “is the economic equivalent of an astrophysical black hole”. 
 

Unfortunately, his economics are as accurate as his astrophysics metaphors.  Despite dressing the calculations up as “models”, there is nothing formal or rigorous about his methods.  And, despite constant reiteration in the report about how open TJN is about the methodology, neither Henry nor anyone at TJN responded to repeated requests for information on the details of their calculations or sources of data.  For a report calling for transparency, Henry’s report is remarkably opaque on the details of the calculation.  For example, nowhere does it identify the 139 “key source” countries or the 80 “offshore ‘secrecy’ jurisdictions”. 

There are two deep conceptual errors in Henry’s analysis worth noting.  As was the case with previous TJN efforts at estimating “lost” tax revenues (which Henry concedes was “a quick and dirty analysis”), Henry claims that “if we could figure out how to tax all this offshore wealth without killing the proverbial Golden Goose, or at least entice its owners to reinvest it back home, this sector of the global underground is also easily large enough to make a significant contribution to tax justice, investment, and paying the costs of global problems like climate change”. 

Conceptual error number one is that the governments “losing” this revenue will spend it on “global problems like climate change” rather than on armaments, villas for corrupt political elites or sophisticated surveillance equipment with which to oppress their citizens.  To take just one example, the Wall Street Journal documented in a 30 August, 2011 article how the Gadhafi government established a sophisticated technology centre using French firm Amesys to spy on email and chat room messages of dissidents. 
 

As the WSJ noted, “Amesys in 2009 equipped the centre with ‘deep packet inspection’ technology, one of the most intrusive techniques for snooping on people’s online activities, according to people familiar with the matter.” Similarly, Criminal Justice International Associates (a group with at least the same legitimacy as TJN) estimated deceased Venezuelan president Hugo Chavez’s family wealth at between $1 and $2 billion – an impressive amount considering his impoverished beginnings and approximately US$41,000 annual presidential salary.  As one commentator sarcastically noted, “By controlling his lifestyle and spending less than he makes, Hugo earns $34,000,000 per year after lifestyle, taxes and other expenses.”1

Such problems are not limited to corrupt dictatorships like Gadhafi’s – governments in wealthy, developed nations engage in misbehaviour as well.  Advocating for relaxing budget constraints on any government in pursuit of social justice requires not only specifying what exactly “social justice” is but also showing why the government in question will devote additional resources to projects that serve those ends.
 

The behaviour of the United States government during the current sequester dispute between the president and Congress suggests that even democratically elected governments have serious problems identifying priorities that make sense.  All Henry can offer in this regard is his “sense” that “most countries operate very, very far from this ‘tax compliance vs.  freedom-and-prosperity margin,’ along which increased tax compliance automatically leads to increased liberty, entrepreneurship, and growth.” He also claims that “in a variety of different [but not specified] fora, [TJN has] effectively demolished pretty much” all such arguments. 

A quick glance at Transparency International’s 2012 Corruption Perceptions Index suggests that this “sense” is mistaken.  See Figure 1.

Two-thirds of nations scored below 50 on this index, which Transparency International termed “a serious corruption problem”.  In such countries, increasing government resources is far more likely to lead to additional abuses since the governments in question are already engaged in abusive behaviour.  It takes more than a “sense” to overcome data like this.

Conceptual error number two is that “enticing” wealth owners to invest in a jurisdiction does not require taxing them but instead requires making the jurisdiction friendly to investors by protecting them against corruption, confiscation and crime.  In addition, analysing this error requires understanding separating where legal entities are located and where money is actually invested.  Most of the calls for higher taxes on allegedly untaxed wealth come from developed nations, notably the United States, France, Germany and the UK.  The allegedly secret wealth that Henry identifies is not in offshore centres, but has been invested elsewhere.  There simply are not sufficient local investment opportunities in small jurisdictions to absorb all the money flowing through them.

CORRUPTION PERCEPTIONS INDEX 2012 

 

 TransInt.jpg The perceived levels of public sector corruption
in 176 countries/territories around the world. 
 

 

RANK

 


COUNTRY/TERRITORY
 
 

SCORE
 
 
 41
 
Poland58
 
1Denmark90 43Malta57
1Finland90 43Mauritius57
1New Zealand90 45Korea (South)56
4Sweden88 46
 
Brunei55
5
 
Singapore87
 
 46Hungary55
6
 
Switzerland
 
86
 
 48Costa Rica54
7Australia85 48Lithuania54
7Norway85 50Rwanda53
9Netherlands84 51Georgia52
 
11Iceland82 51
 
Seychelles52
12Luxembourg80 53Bahrain51
13Germany79 54Czech Republic49
14Hong Kong77 54Latvia49
15Barbados76 54Malaysia49
 
16Belgium75 54Turkey49
17Japan74 58Cuba48
 
17United Kingdom74 58Jordan48
 
19United States73 58Namibia48
20Chile72 61Oman47
20Uruguay
 
72 62Croatia46
22Bahamas
 
71 64
 
Ghana45
 
22France71 64Lesotho45
22Saint Lucia71 66Kuwait44
 
25Austria69 66
 
Romania44
25
 
Ireland69 66Saudi Arabia44
27Qatar68 69Brazil43
27United Arab Emirates68 69FYR Macedonia43
29Cyprus66
 
 69South Africa43
30Botswana65 72Bosnia and Herzegovina42
30Spain65 72
 
Italy42
32Estonia64 72Sao Tome and Principe42
33Bhutan63 75Bulgaria41
33Portugal63 75Liberia41
33Puerto Rico63 75Montenegro41
36 Saint Vincent and
the Grenadines
62 75Tunisia41
37Slovenia61 79Sri Lanka40
37Taiwan61 80China39
 
39Cape Verde60 80Serbia39
39Israel60 80Trinidad and Tobago39
39Dominica58 83Burkina Faso38
RANK COUNTRY/TERRITORY SCORE     
83
 
El Salvador
 
38
 
 130
 
Uganda
 
29
 
83
 
Jamaica
 
38
 
 133
 
Comoros
 
28
83
 
Panama
 
38
 
 133
 
Guyana
 
28
83
 
Peru
 
38
 
 133
 
Honduras
 
28
88
 
Malawi
 
37
 
 133
 
Iran
 
28
 
88Morocco37 133Kazakhstan 
 
28
88Suriname37 133Russia28
 
88Swaziland37 139Azerbaijan27
 
88Zambia37 139Kenya27
94Benin36 139Nepal27
94Colombia36 139Nigeria27
94Djibouti36 139Pakistan27
94Greece36 144Bangladesh26
94India36 144Cameroon26
94Moldova36 144Central African Republic 
 
26
94Mongolia36 144Congo Republic26
94Senegal36 144Syria26
102Argentina35 144Ukraine26
102Gabon35 150Eritrea25
102Tanzania35
 
 150Guinea-Bissau25
105Algeria34 150Papua New Guinea25
105Armenia34 150Paraguay25
105Bolivia34 154
 
Guinea24
105Gambia34 154Kyrgyzstan24
105Kosovo34 156Yemen23
105Mali34 157Angola22
 
105Mexico34 157Cambodia22
105Philippines34 157Tajikistan22
113Albania33 160 Democratic Republic
of the Congo
21
113Ethiopia33 160Laos21
113Guatemala33 160Libya21
113Niger33 163Equatorial Guinea20
 
113Timor-Leste33 163Zimbabwe20
118Dominican Republic32 165Burundi19
118Ecuador32 165Chad19
118Egypt32 165Haiti19
118Indonesia32 165Venezuela19
 
118Madagascar32 169Iraq18
123Belarus31 170
 
Turkmenistan17
123Mauritania31 170Uzbekistan17
123Mozambique31 172Myanmar15
123Sierra Leone31 173Sudan13
123Vietnam31 174Afghanistan8
128Lebanon30 174Korea (North)8
128Togo30    
130Côte d´Ivoire29    
130Nicaragua29    

If, as Henry claims, that money is invested in developed economies to the disadvantage of developing nations, adopting the measures advocated by the US, UK and EU is unlikely to shift the money back to developing nations since these large market countries are not interested in reducing investment in their economies.

Henry concedes at one point that offshore “fiscal paradises” are not the final destinations for money but instead “destination havens”.  He also points, briefly, to Delaware, Nevada and South Dakota, which he criticises for “offering inexpensive legal entities like ‘limited liability corporations’ and ‘asset protection trusts’ whose level of secrecy, protection against creditors, and tax advantages rival those of the world’s traditional secretive offshore havens”.

Let’s set aside errors like referring to LLCs as “limited liability corporations” – one that suggests some conceptual confusion, since corporations are, by definition, limited liability entities – rather than “limited liability companies”. 

Let’s also set aside sleight of hand such as implying that the “tax advantages” of LLCs are somehow tax avoidance rather than the opportunity to receive pass-through taxation like partnerships combined with the limited liability of a corporate form.  Given Henry’s experience, it is implausible that he doesn’t know the difference.  Focus instead on the assumption that underlies the entire report: that structuring one’s affairs to reduce a taxpayer’s total tax burden is illegitimate.

Two important courts have commented on this.

The United States Supreme Court, in Gregory v.  Helvering, 293 U.S.  465 (1935) said, “The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”
 

Helvering was a tax shelter case in which the courts ultimately disallowed a transaction in which a taxpayer caused a corporation to be created and then dissolved six days later, in pursuit of a capital gains rate rather than a dividend tax rate.  Helvering thus demonstrates both that US taxpayers have the legal right to structure their assets to avoid paying additional taxes and that the government has the tools to control abuses of such efforts.

Similarly, the UK courts have long followed the “Westminster Principle”, as pronounced by the House of Lords: “Every man is entitled, if he can, to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be.  If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax”, Duke of Westminster v.  Commissioners of Inland Revenue [1936] AC 1. 
 

Again, this case involved an effort to avoid tax through re-characterising a transaction.  The UK also allows courts to inquire, in at least some circumstances, into the nature of transactions to bar tax advantages deriving from transactions done only for the purpose of gaining a tax advantage under the “Ramsay principle”, WT Ramsay Ltd.  v.  IRC [1982] AC 300.  Again, the UK courts have consistently upheld both the right of the taxpayer to avoid higher tax payments through organisation of her affairs to minimise tax obligations and the tax authorities’ ability to object to abusive efforts.

What Henry and TJN are advocating is a rejection of this effort to balance the interests of individuals to retain as much of their income and wealth as is legally possible with the interests of governments in maximising revenue.  What they fail to recognise is that the public has an interest in both objectives.  Preserving a tax system based on the rule of law – that is, a tax system in which governments collect taxes based on clear, accessible rules which are equally applied to all taxpayers – is a significant part of real tax justice.  By giving this interest short shrift, Henry and TJN seek to undermine the rule of law.

Henry also argues, however, that there are many assets which “sit idle in relatively-low-yield [sic] offshore investments”, which he suggests would be put to productive use if only they were taxed properly.  Again, this represents a fundamental misunderstanding of the nature of international financial transactions. 
 

Investors, even criminal masterminds like those Henry believes are responsible for most investments in jurisdictions he does not like, prefer higher returns to lower returns.  Idle money does not remain idle for long.  If the criminal masterminds do not invest it, the institutions holding it will for their own accounts.  And those investments flow out of IFCs into economies where there are opportunities to earn higher returns.  Any jurisdiction seeking such investment need only roll out the welcome mat by offering foreign investors protection against corruption, confiscation and crime. 
 

One strategy many governments employ for this purpose is to promote the use of financial centres offering the rule of law as vehicles for investment.  China promotes Hong Kong as a financial centre for precisely this purpose.  Another strategy is to offer foreign investors special tax rates to induce them to risk investing in a jurisdiction.

Of course, competing for investment by offering lower tax rates encourages behaviour that Henry condemns, such as “round tripping” in which an investor in Country A exports capital to an entity in Country B, then re-exports it back to Country A as “foreign” investment. 
 

Of course, to the extent this occurs, it undercuts Henry’s claim that money is not returning   options – which are available only because the destination country (ie, Country A in the example above) chooses not to require foreign investors to prove they are not round-tripping, a step which requires no international cooperation whatsoever – limits the ability of the destination country to raise its tax rates domestically, as there would be no tax-related reason to round-trip if the domestic and foreign rates were the same.  But that is not a problem with illegal activity but rather a refusal to recognise that nations, like firms, are limited by competition.

The problems with the report extend to the data and analysis.  Henry uses what he calls an “offshore investor portfolio model”, which he says is based on Bank for International Settlements (BIS) data on cross-border deposits.  This is a clever rhetorical move, since, by focusing attention on BIS data, Henry appears to be using a neutral source of authoritative statistics. 
 

The data cover only 30 of the 80 jurisdictions, again something that suggests he is making a conservative estimate.  Having cloaked himself in objectivity, Henry then “scales up” the data by a factor of three to obtain his estimate.  This “scale” is justified by “a simple model of offshore investor portfolio behaviour” and “interviews with private bankers and wealth industry analysts”.  This is a theme in the report – Henry repeatedly resorts to arbitrary scaling factors, which he justifies with uncited references to interviews with unidentified banking and wealth management professionals. 

Henry also relies on estimates of “private cross-border financial wealth under management” at the top 50 private banks.  Henry provides no evidence that this wealth is illegally acquired, but simply assumes that it is – an assumption that drives the entire report.  Moreover, he provides no evidence that this wealth is not being taxed. 
 

He then “scales” the data up by a factor of 1.25, to account for funds he says are not included in the data.  Then – again without any supporting evidence – he claims that this needs to be inflated further to account for “underreporting and other data problems”.  The scale of these adjustments can be seen in the difference between the starting figure of $12 trillion under management by the top 50 private banks and his final estimate of $25 trillion in offshore wealth.

Henry attempts to bolster his conclusion by using four separate “models”.  However, his models are actually interrelated and rely on the same foundational assumptions.  For example, his “accumulated offshore wealth model” relies on the capital flows in his “sources and uses” model.  Any errors in the sources-and-uses estimates would be repeated in the other model.  He then adds new potential errors by simply asserting that 50 per cent to 75 per cent of offshore wealth is never repatriated to the source countries.

Here again, Henry makes assumptions that drive his conclusion.  For example, he lists four potential motives for “unrecorded capital flows”:
 

  • short-term speculation (‘hot money’);
  • longer-term portfolio diversification;
  • asset protection (including protection against political risks and illegality); and
  • more dubious motives, like money laundering, income tax evasion, ‘round-tripping’ (taking money offshore, dressing it up in secrecy structures then pretending to be ‘foreign’ investors in order to take advantage of tax breaks and exchange rates only available to ‘foreigners’); back-to-back lending games; export subsidy fraud; avoidance of import duties; corruption and more.

Henry then concedes that “all of the above” are involved in “unrecorded” capital flows, mixing legitimate and illegitimate transactions.  We hear little more about diversification or avoidance of political risks, with subsequent discussion focused only on the illegitimate motives.

What TJN has done in The Price of Offshore Revisited is to provide a pseudo-scientific estimate for money the organisation feels is under-taxed.  This provides a convenient, and conveniently large, number for use by anyone who wants to restrict international financial flows or looking for a scapegoat for government deficits.  After much talk about transparent methods and reliable data, The Price of Offshore Revisited resorts to unsupported assumptions to “scale” its estimates in just one direction. 
 

This report is a work of fiction, with just enough factual plausibility to enable unsophisticated readers to believe it is non-fiction. 

Endnotes:

1http://www.richbutbroke.com/93/Hugo-Chavez-Net-Worth
 

 

locations-of-offshore-tax-jurisdictions_GTsm.jpg

infographic from http://visual.ly/locations-offshore-tax-jurisdictions