The ‘useful purpose’ of offshore financial centers

Recently, 355 economists signed a letter co-ordinated by Oxfam arguing that tax havens have “no useful purpose.” There is a history in the U.K. of letters being signed by more than 350 economists who make outlandish claims and, in doing so, undermine their own reputations. Back in March 1981, 364 economists wrote to The Times to object to the policies of the then-Conservative government which was trying to get government borrowing under control. The 364 argued, among other things, that “present policies will deepen the depression.” This proved rather embarrassing when the economy came out of depression literally in the month the letter was drafted. Similarly, the claim that tax havens have “no useful purpose” is so over the top that it is difficult to take the correspondents seriously. Nevertheless, at least for a day, it remained at the top of the U.K. news agenda.

Rather oddly, over half the signatories to the tax havens letter came from Italy or Spain, with well over one-third from Italy alone. And the signatories included people who work for the UN which, in effect, acts as a tax haven for its employees. So, perhaps we should not take too much notice of the precise number of signatories.

But, it has to be said, that there were a few luminaries among the signatories of the tax havens letter. In particular, whenever Angus Deaton, winner of last year’s Nobel Prize for economics, says something, one should sit up and take notice. His views on foreign aid are a very wise contribution to the debate and he has a very acute understanding of the problems caused by corruption and the need to develop functioning tax systems in poor countries. But, on this occasion, I believe he is wide of the mark.

 

So, what useful purpose do tax havens serve?

Offshore centers allow companies and investment funds to operate internationally without having to abide by several different sets of rules and, in the process, paying more tax than ought to be due. This is important. If, for example, a property fund is being managed in which there are investors from all round the world, some of them might be tax exempt, such as charities and pension funds in the U.K., and the other investors might pay widely varying rates of tax levied according to completely different principles depending on where they live.

International tax treaties just cannot deal with the complexities that are involved in such situations. The simplest approach for all concerned is to base the investment fund in a tax haven and allow the investors to pay the tax that is due in the investors’ own jurisdictions. If tax havens were not used, it would be very difficult to manage many pooled funds which allow investors to access a wide range of international investments in a way that reduces risk and ensures the efficient allocation of capital across the world. Investment markets would become parochial once again and everybody would lose.

It should be noted that there is no avoidance of tax here. Certainly, tax havens often allow those who should not pay tax – such as pension funds in the U.K. and charities – to avoid paying tax that is not due. Furthermore, they allow investors to simply pay the tax that is due in their place of residence, as is right and just. Indeed, if the recently released Panama papers demonstrated anything, it was that tax havens are much more benign than people think they are. For all the furore over David Cameron, for example, the fact is that he paid all the tax which was due to the British government on the offshore investments which he held.

 

Tax havens also simplify complex international corporate relationships.

There are 19,000 pairs of countries in the world and devising consistent taxation arrangements between every possible pair would be fearsomely difficult. Double taxation treaties and other international agreements simply cannot cover every eventuality. Offshore centers allow complex multinational businesses to do business efficiently, especially across countries with very different tax rules.

For example, if a U.K. firm wishes to do business in Nigeria, it may well choose to set up a subsidiary in the Cayman Islands which will, in turn, own the Nigerian arm of the business. Relationships can then be simplified – the Cayman Islands would need to have appropriate agreements with other countries, but it would not be necessary for every pair of countries in the world to have agreements with each other. Perhaps more importantly, it might be helpful for the Nigerian and U.K. partners to establish a subsidiary in a ‘neutral’ territory. This would also avoid the potential for double taxation if the U.K. firm wished to repatriate profits from Nigeria.

And the idea that tax havens are shady and corrupt places where people wish to hide economic activity is completely wrong. Indeed, the opposite is the case. Switzerland and Luxembourg which come high on the list of tax havens, are in 7th and 10th place in Transparency International’s Corruption Perceptions Index. Italy, from where one-third of the signatories come, is 61st. When it comes to money laundering, Switzerland ranks among the better countries in the world while Luxembourg is rather average, ranking close to Japan. Italy is a shocking 98th – perhaps the Italian economists should have written to their own government.

flagAnd this leads us, perhaps, to the most interesting aspect of this debate. One of the reasons groups such as Christian Aid and Oxfam have got involved in this debate is that they believe that large corporations are avoiding tax in shady places instead of paying it to the governments of developing countries which could use the revenue to reduce poverty.

In fact, tax havens are normally well-governed – they have to be in order to attract business. Most corporations and financial institutions do not like doing business in places that have a reputation for poor governance.

A typical example cited by NGOs is that a company in a poor country will establish a subsidiary in a country such as Switzerland and transfer products between the subsidiaries using transfer prices that reduce profits in the poor country and raise profits in Switzerland. The fact that nearly all the examples cited relate not to complex intellectual property but to goods and services that have reasonably objective values at the intermediate stage of production suggests that the problem lies not with the tax haven but with governance in the country in which the company is operating. Firms are able to distort transfer pricing because of the lack of competence in the country in which they are operating.

Interestingly, Oxfam uses Malawi as a case study. It argues that, if it were not for money sheltered in tax havens, there would be more money to spend on healthcare for Malawians.

Malawi is a country beset by problems. Aid was suspended in 2013 due to public looting on a horrendous scale and government spending is an incredible 50 percent of national income.

Malawi’s problem is not that its government is too small in relation to its economy; it is that it is too big and also dysfunctional. Malawi languishes at 112 in the Corruption Perceptions Index. If too many Malawians are holding money in Switzerland and not paying tax in Malawi, the fault lies with the Malawi government and not the Swiss government.

The process of globalization, of which the internationalization of finance is part, has brought enormous benefits to the world’s poorest people. There have been bigger reductions in the number of poor people in the last 30 years than in the whole of the previous 6,000 years put together. The World Bank announced at the end of last year that, for the first time in recorded history, the share of the global population living in extreme poverty – defined as below $1.90 in daily disposable income – had dropped below 10 percent, down from 44 percent 35 years ago. At the same time, by any reasonable measure world inequality has fallen too.

We take this for granted. Anti-tax-haven campaigners cannot see the wood for the trees. The huge reduction in world poverty did not happen because of the efforts of NGOs, but largely because of the greater integration of a number of countries into the rest of world economy. Poverty will not fall still further by undermining the tax havens that have helped this process of international integration, but by encouraging better policy in those countries in which a large proportion of the world’s poor live. Such countries tend to have high trade barriers, stifling regulation and are beset by corruption.

Contrary to the claims made by the 355 economists and activists, tax havens do serve many useful purposes. Economic and legal institutions are still inadequate in many places, while international governance, such as the international tax system, remains imperfect and can stifle international investment. Offshore financial centers can help alleviate these problems and ensure that less-developed countries can benefit from the inflow of foreign capital – which is normally scarce relative to such countries’ labor resources. The stable and relatively transparent regimes in offshore centers help compensate for the rather less stable regimes in the countries in which the end investment usually takes place.

Indeed, it is interesting that NGOs are the first to complain about lack of competition and the cartelistic characteristics of big business. Yet there can be little worse than a tax cartel. Tax havens help ensure that governments provide reasonable environments in which to do business whilst not charging penal tax rates. They keep governments on their toes. If one country starts to exploit business or exploit investors, tax havens can provide a conduit that can circumvent such exploitation.

NGOs also tend to have few constructive views on fundamental reforms of the tax system. Such is their desire to see the world’s problems solved by levying more tax and giving more power to governments that they tend to avoid any thought of simplifying the tax system and reducing the tax burden. But, there is a simple solution to many of the perceived problems of tax havens. We should stop taxing corporations on the basis of their profits in the country in which profits are made. The owners of companies should be taxed in their country of residence according to the capital gains and income they receive from their shareholdings. In other words, equities should be taxed in the same way as bonds. If countries in which a company operates wish to levy additional taxes – such as land value taxes on business property – that would be a separate matter and such taxes could not be avoided via tax havens.

Of course, some individuals will try to hide their money in tax havens so that it escapes the attention of tax authorities altogether. But, it is the responsibility of governments to collect taxes from their own people. If some governments are not capable of doing so, that is a problem that needs to be solved. What we should not do is respond by excoriating offshore financial centers.