EU blacklist presents new offshore challenges

An image used by Süddeutsche Zeitung to illustrate its coverage of the ‘Paradise Papers.’

On Dec. 5, the EU Council agreed on a blacklist of 17 countries that the European finance ministers consider uncooperative in tax matters. They also voted on a commitment list of 47 countries that would be deemed uncooperative, according to the EU’s own criteria, had they not agreed in writing to remedy their shortcomings by the end of 2018.

EU finance ministers said American Samoa, Bahrain, Barbados, Grenada, Guam, South Korea, Macau, Marshall Islands, Mongolia, Namibia, Palau, Panama, Saint Lucia, Samoa, Trinidad and Tobago, Tunisia and the United Arab Emirates had not done enough to crack down on tax evasion and avoidance schemes.

The EU claimed tax legislation, policies and administrative practices in blacklisted countries have caused or may cause a loss of revenues for its member states. The listed countries are therefore strongly encouraged to make the changes requested of them, but the EU Council stopped short of agreeing specific sanctions. The lists will be updated once a year.

Another eight Caribbean jurisdictions – Anguilla, Antigua and Barbuda, the Bahamas, British Virgin Islands, Dominica, Saint Kitts and Nevis, Turks and Caicos Islands, and the U.S. Virgin Islands – affected by last year’s hurricanes will be assessed by the EU by February.

The Cayman Islands and other U.K.-linked offshore centers were placed on the graylist of 47 countries and jurisdictions that have made written commitments to meet the EU criteria applied to the process of singling out countries for their lack of tax transparency and “tax fairness.”

Cayman complied with most EU criteria in relation to the exchange of tax information or the implementation of the OECD’s base erosion and profit shifting (BEPS) program. It also does not offer preferential tax regimes that would treat local companies differently than Cayman-registered overseas companies.

But, according to the EU Council, Cayman has fallen foul of a fair tax criterion aimed at tax regimes that facilitate offshore structures which attract profits without real economic activity. The Cayman government, together with Bermuda, Guernsey, Isle of Man, Jersey and Vanuatu, has committed to addressing the concerns relating to economic substance by 2018, the EU said.

In a statement, Cayman’s Ministry of Financial Services said, as part of this particular criterion, the EU wants to ensure that jurisdictions do not facilitate letterbox companies. These companies, which are set up to circumvent tax obligations, do not have a physical presence, and therefore do not perform tangible economic activities, in the country where they are established.

Exempted companies in Cayman rarely have staff on island and under the law they are not allowed to trade with any person or business locally, except to further the business of the exempted company carried on outside the Cayman Islands.

This means that exempted companies can, and some do, have substance but often they are mere legal structures, a fact that may be at odds with the EU’s desire to ensure that jurisdictions do not facilitate letterbox companies.

Premier Alden McLaughlin acknowledged that the majority of Cayman’s companies “are not bricks and mortar,” but he insisted, “they also are not letterbox companies,” i.e., entities that are solely used to avoid certain tax obligations rather than pursue economic objectives.
Instead, he stated, “they are financial instruments that pool investment capital and facilitate international transactions.”

Taking into account the existing transparency regime that shares information with foreign tax authorities, including all EU member states and the G20, the premier noted, “there is no interest in setting up these companies to circumvent tax obligations.”

In cooperation with the EU, the government said it is further assessing the fair taxation criterion, and will work with EU Council officials to address this issue by December 2018.
The Crown dependencies in the British Channel indicated they are prepared to change their laws to introduce legal substance requirements and some stated that this would be an opportunity to grow their local economies.

Howard Quayle, the chief minister of the Isle of Man, said his government had a constructive dialogue with the EU’s Code of Conduct Group, which developed the tax criteria, about their concern “relating to a potential lack of substance, which it highlighted may be due to the absence of legal substance requirements for entities doing business in, or through, the Isle of Man.”

Quayle said his government will create an island of enterprise and opportunity: “We have a strong and diverse economy which we will grow, alongside encouraging a skilled workforce to relocate to the island. We can do that while ensuring we meet our EU and international commitments.”

Jersey’s Chief Minister, Senator Ian Gorst, said his government’s discussions with the Code of Conduct Group may include changes to Jersey’s legislation on economic substance.
“We have already begun the necessary preparations, having regard to the Code Group requirements and Jersey’s best interests. I am committed to ensuring that, working with the finance industry, this process will be completed by the end of 2018,” he said.

Appleby sues the BBC and Guardian over Paradise Papers

Appleby took legal action against the BBC and The Guardian over their reporting of offshore transactions by the law firm’s clients based on what Appleby calls confidential information taken in a “criminal act.”

Appleby is suing for breach of confidence and seeks a permanent injunction against further use of the information, as well as the disclosure and return of the documents.

The BBC claimed the leak of financial documents, branded the “Paradise Papers,” had revealed “how the powerful and ultra-wealthy secretly invest cash in offshore tax havens.”
A spokesperson for the BBC said the organization’s “serious and responsible journalism is resulting in revelations which are clearly of the highest public interest,” and has revealed matters which would otherwise have remained secret. As a result, authorities were taking action.

The Guardian said the legal action was an attempt to “undermine responsible public-interest journalism.”

Media organizations are typically allowed to disclose confidential documents, provided their content is deemed to be in the public interest. Data protection legislation in most countries, including the incoming Data Protection Law in Cayman, contains such exemptions for the media.

Appleby, in turn, argues that the documents were stolen in a data breach and that there was no public interest in the stories published about it and its clients, according to reports in the BBC and The Guardian citing legal documents Appleby sent to the organizations. About half of the 13.4 million leaked “Paradise Papers” documents belonged to the offshore law firm.

An image used by Süddeutsche Zeitung to illustrate its coverage of the ‘Paradise Papers.’

The documents were first obtained by the German newspaper, Süddeutsche Zeitung, which shared them with the U.S.-based International Consortium of Investigative Journalists (ICIJ). The ICIJ then coordinated the Paradise Papers project with 380 journalists from 96 media organizations in 67 countries.

The consortium also included the New York Times, Le Monde, the ABC in Australia and CBC News in Canada. However, Appleby has only taken legal action in the U.K.

A spokesperson for The Guardian told his own newspaper that the claim does not challenge the truth of the stories that were published. “Instead it is an attempt to undermine our responsible public interest journalism and to force us to disclose documents that we regard as journalistic material.”

The Guardian spokesperson added that the claim could have serious consequences for investigative journalism in the U.K. “Ninety-six of the world’s most respected media organizations concluded there was significant public interest in undertaking the Paradise Papers project and hundreds of articles have been published in recent weeks as a result of the work undertaken by partners. We will be defending ourselves vigorously against this claim as we believe our reporting was responsible and a matter of legitimate public interest.”

In a statement, Appleby said it was “obliged to take legal action.”

“Our overwhelming responsibility is to our clients and our own colleagues who have had their private and confidential information taken in what was a criminal act. We need to know firstly which of their – and our – documents were taken,” Appleby said.

“We would want to explain in detail to our clients and our colleagues the extent to which their confidentiality has been attacked. Despite repeated requests, the journalists have failed to provide to us copies of the stolen documents they claim to have seen. For this reason, Appleby is obliged to take legal action in order to ascertain what information has been stolen.”

Colin Riegels, a partner at Harney Westwood & Riegels, published a brief analysis of the case, arguing that the media companies’ defense would rely on establishing that either the disclosure of confidential material was necessary to prevent serious harm to the public or justified by the so-called “defence of iniquity.”

While the former was difficult to prove, mainly because most of the reported cases happened in the past and therefore the publication of confidential information could not “prevent” anything, the latter relies on case law that no duty of confidentiality should protect any “crime, civil wrong or serious misdeed of public importance.”

This will largely rely on the ability of the media company’s defense to demonstrate actual illegal activity in the reported cases and data dump, unless the court will “hold that tax planning is morally offensive, which is something the courts have historically refused to do,” Riegels said.

Gerard Ryle, the director of the ICIJ, said the lawsuit is a potentially dangerous moment for free expression in Britain. “By sharing the data with journalists across the world, we are able to bring a new kind of scrutiny to power.

“The BBC and The Guardian have been part of recent collaborations into financial secrecy that have changed laws from the United States to New Zealand to Europe, sending a strong message to the corporate world that some of the behavior we revealed is no longer acceptable,” Ryle said.

Wolfgang Krach, the editor-in-chief of Süddeutsche Zeitung, which received the data first, said his newspaper would not allow The Guardian, or any other partner, to make the leaked documents available to third parties.

“At the same time, Süddeutsche Zeitung is extremely worried about the attempt to force a journalistic enterprise to hand over highly sensitive data that could endanger the life and well-being of sources,” Krach said.

“Journalists must be allowed to protect their sources by all means, especially when they clearly report in [the] public interest. Therefore, we appeal to the court and the public to support The Guardian’s legitimate wish to keep the material protected.”

Is artificial intelligence the future of financial services?

The financial world stands on the edge of a technological revolution that will fundamentally alter the way people use financial services.

The explosion of data in the financial sector is so vast and overwhelming that it has become impossible to understand it without automated support to drive better, data-driven decisions and leveraging automations to fast and convenient service.

It is in this context that artificial intelligence (AI) is poised to transform business in ways we have not seen since the impact of computer technology in the late 20th century and, as a center that is immersed in the global financial services landscape, the Cayman Islands needs to be right at the forefront of the AI revolution.

New normal

Industry analysts today opine that artificial intelligence is the new normal, and will rise to become the core of any technology-centered financial organization, fostering improved operational efficiency and data analytics, enhanced client services and cost reductions.

Imagine a scenario where data coming from the real economy could be used to discern price, predict performance, understand risk and make better investment decisions through the use of computing power to understand data correlation and causation, and deduce rapidly enough how to respond: artificial intelligence has now advanced to the stage where this is possible.

AI will reinforce the business model of financial institutions: since they need access to vast amounts of data to efficiently train an AI system, banks have a clear advantage over potential new entrants because they can leverage their huge internal data sets.

Not surprisingly, interest in AI is evident from increasing investments by major financial institutions, as well as technology and fintech companies. For example, fund managers such as BlackRock, Two-Sigma and Renaissance Technologies are now competing and collaborating with a growing batch of emerging technology companies including Sentient Technologies and Kensho, as well as established players such as Google, Facebook and Microsoft. According to Venture Scanner, a technology powered start-up research firm based in San Francisco, there are now 1907 artificial intelligence (AI) start-ups that have raised $21.2 billion in venture capital funds.

As AI will decrease the value of traditional services, data and technology providers such as exchanges will have to accelerate build up and acquire services in the unstructured data space as the value of traditional market data will quickly diminish.

Compelling technology

The rise in innovation is slowly letting automation replace mundane tasks that businesses nowadays face, and is gradually replacing human decision making with more compelling technology. These algorithms can determine and predict decisions, and can also be integrated into business-models to recognize patterns to save time for repetition.

AI technology has a broad array of potential applications in the financial services space, a number of which have clear resonance in terms of the services offered by the Cayman Islands, including:

  • Personalization of financial services through analytics-driven recommendation engines;
    Automation of traditional retail functions through the deployment of smart assistants and voice recognition technology;
  • Robo-advisory services in the wealth management space;
  • Automated fraud detection, as well as anti-money laundering and anti-terrorist financing compliance monitoring; and
  • Predictive cybersecurity monitoring and response systems.

In short, the consumer revolution set off by AI opens the way for massive disruption as both established businesses and new entrants drive innovation and develop new business models grounded on the potential to understand customer behavior and anticipate and respond to their individual needs with unprecedented foresight.

In fields such as customer profiling and cyber protection that lie at the heart of commercial interactions, the economic impact of AI will be mainly driven by productivity gains from businesses automating processes and increased consumer demand resulting from the availability of personalized and/or higher-quality AI-enhanced products and services.

According to general industry analysis, global GDP will be up to 14 percent higher in 2030 as a result of the accelerating development and take-up of AI – the equivalent of an additional $15.7 trillion, more than the current output of China and India combined.


Many see AI as a tool that will help improve financial institutions’ risk management by virtue of its breadth and depth of insight, for example through more in-depth assessment of risk in portfolios and more incisive, comprehensive and informed credit-risk assessment.

However, many experts also acknowledge a degree of risk surrounding the use of AI. As a result, the risk of malfunctioning algorithms and concerns surrounding the security, privacy and quality of data, has led to calls for new regulation. Indeed, there is a great deal of uncertainty as to whether organizations understand the risks associated with new financial technologies.

One risk is corporate liability. Flawed investment decisions could be made as a result of poor data, erroneous analysis about company performance, or malfunctioning algorithms, which could cause investors significant losses. Liability could also arise should machine learning models make flawed decisions about credit risk: financial losses could occur to lenders, or alternatively borrowers’ reputations could be damaged.

Secondly, data and privacy risks will increase by virtue of the much larger volumes of data that AI-driven models will collect and analyze. Intellectual property disputes are also likely to increase, as the ownership of algorithms causes friction between companies and regulators. Contract and litigation risk may also emerge, in the likely event of AI malfunction and programming errors.

Another area of concern is around the lack of a suitable regulatory framework to provide adequate oversight to this emerging technology, in large part stemming from the absence of skills and knowledge amongst regulators to respond to the challenges brought by the implementation of AI.

Lastly, from a human capital perspective, given its disruptive force AI will undoubtedly alter both the headcount and the nature of skills required in the industry, with potentially negative effects within the next few years. The adoption of ‘no-human-in-the-loop’ technologies will mean that some posts will inevitably become redundant, but others will be created by the shifts in productivity and consumer demand emanating from AI, and through the value chain of AI itself.

Research shows that in AI specifically the jobs we create will be centered on machine learning initially, and the creative application of AI contextually in the world around us. Even in trading, where automation is already widespread, human roles will remain critical in areas such as algorithm validation and monitoring, as well as compliance. All of this will facilitate the creation of new jobs that would not have existed in a world without AI.

What is clear is that advances in AI and data analytics are leading to a great expansion in the quantity and type of data being used to inform decision making. Whereas before investment decisions were being made on traditional metrics such as market prices, interest rates or earning figures, AI can factor events and sentiments into the asset price prediction process. This suggests that AI could change the parameters by which financial institutions make investment decisions.

Traditional metrics will decline in importance as the subject of analysis, as financial institutions gather huge amounts of unstructured data. As AI technology matures and gains broader traction across industries, there is no doubt that regulators, technology companies and entrepreneurs will need to engage to identify the proper role of regulation in addressing concerns with respect to AI-enabled products with a focus on lowering the costs and barriers to innovation without adversely impacting safety and market fairness.

The advancement of digital technologies, data, advanced analytics, computing power combined with changing consumer preferences and new competition is creating a new technology-induced tipping point. As other industries move forward with artificial reality, the finance industry – and specialist financial services jurisdictions like Cayman – will need to determine if they will move forward as well.

Learning from the present: What financial economics tells us about bitcoin

The ongoing saga of ever-rising market valuations for cryptocurrencies, has captured pages and pages of mainstream news and attracted millions of new investors. If six months ago, Chinese traders and miners dominated the market for bitcoin, today, the hype has spread globally, drawing in young hipsters from South Korea, older retail investors from Japan, scores of desperate middle-class types from Venezuela and crowds of techies from the U.S. At the same time, bitcoin and other cryptos have earned attention of armies of financial analysts and academics, all trying their hand at figuring out what exactly determines the market value of the new ‘currency.’ Within one month, the cryptos have moved from obscurity to Bloomberg terminals and to the futures trading on the Chicago Board of Exchange.

What’s behind the cryptos?

There are five key features of the cryptocurrencies that, as their most ardent proponents allege, underpin their fundamentals:

  1. Decentralized and global nature of the cryptos, which in common language means their independence from the monetary and financial authorities;
  2. High degree of blockchain security;
  3. Limited supply of key cryptocurrencies, most importantly, bitcoin, which theoretically implies their ability to hedge inflation risks;
  4. Anonymity, or put differently, ability to hold bitcoin and/or other cryptos beyond the reach of the coercive powers of the state; and
  5. High degree of blockchain efficiency in transmitting and storing information – an argument that basically says that bitcoin demand is underpinned by the blockchain technology use in a range of sectors, and by the potential for using bitcoin as a medium of exchange.
    The problem with these claims is that they cannot be substantiated either empirically, or theoretically. In other words, the worldview of bitcoin fans ignores the reality of modern finance.

Bitcoin decentralization

The myth of bitcoin’s decentralization is based on the autonomous nature of the cryptocurrency.

The technological aspect of the public blockchain being outside the regulatory and supervisory net of the national monetary authorities is true. However, as modern financial economics shows for a range of other asset classes, the decentralized nature of the asset itself does not mean that asset valuations, prices and return properties are independent of the central authorities’ decisions. Take, for example, gold – a financial asset largely unregulated directly by the financial authorities in the majority of the advanced economies, and traded globally.

Theoretically, with storage of gold available at remote locations, including safe haven jurisdictions, gold can be decentralized and act as a hedge against central banks’ policies and regulatory controls. Alas, due to its financialization via a range of investment funds, regulated investment vehicles holding gold claims, options and other derivatives traded in exchanges, and due to the fact that investors trading in gold are subject to regulations, gold does not behave independently from the regulatory interventions and monetary policy decisions.

Authorities interventions that influence the broader financial markets also tend to spill over into the gold markets.

Some recent academic research already points to the fact that bitcoin price dynamics are linked to the U.S. Federal Reserve’s rates decisions. Given growing concentration of bitcoin trades in Japan over recent months, the cryptocurrency is also likely to be paired with the Bank of Japan monetary policies into the future. Worse, Chinese monetary policies are clearly ‘centralizing’ bitcoin, both in terms of the cryptocurrency responsiveness to the Chinese money supply and capital control policies.

The key lesson from this is that in modern financial markets, multiple levels of interconnections between investors, asset classes, and monetary and regulatory policies mean that no asset class – be it purely private or directly regulated – is truly decentralized. Like gold, bitcoin is not an island in the world of traded investment instruments either.

The second part of this argument is that the markets for cryptocurrencies are truly global and, as such, have high levels of liquidity. This confuses two key aspects of investment finance: the geography of investors (which can be a potential support for arguing in favor of bitcoin’s risk diversification properties) and the concept of liquidity, suggesting that cryptocurrency enthusiasts are desperately lacking the basics of financial education.

The global markets for cryptocurrency are highly concentrated. According to Bloomberg research around 1,000 individual investors currently hold about 40 percent of the entire supply of cryptocurrency. Adding to this some additional 10 percent or so held by the various investigative agencies as a part of international and domestic money laundering and criminal investigations, around half of the bitcoin supply is tightly controlled by a small number of players. The balance is predominantly held in the U.S., China, South Korea and increasingly Japan. This is a far cry from the global diversification offered by more traditional asset classes, including U.S. and European equities, bonds and major currencies, as well as gold.

Bitcoin is hardly a safe haven for liquidity risk. A recent warning issued to bitcoin investors by the world’s largest cryptocurrency exchange, Coinbase, is case in point.2

Another set of liquidity indicators flashing red is the bid-ask spread and transactions costs, both of which are not only in excess of those found in other markets, but are prohibitive in comparison to traditional payments technologies. These create meaningful barriers to trading in bitcoin.3

Beyond those considerations, there is also an added risk to bitcoin liquidity stemming from the recent cryptocurrency-based initial coin offerings (ICOs). ICO issuers hold relatively concentrated positions in BTC, used as a capital reserve currency for the fundraising start-ups. These positions support wider bid-ask spreads on the cryptocurrency, entailing higher trading costs for currency purchasers in the rising markets and currency sellers in any downward correction. In financial terms, ICOs and other concentrated positions imply amplified liquidity risks at the time of any liquidity shock. Coupled with the Coinbase warning, the global nature of bitcoin holdings, touted by the crypto supporters can turn into a large scale market panic, should a liquidity event arrive.

Imaginary security

Like other purported strengths of bitcoin, the cryptocurrency security is also a myth. While the blockchain mechanism is costly to hack, the real vulnerabilities in the system rest in exchanges and storage wallets. To date, there have been no major hacking successes with respect to larger traditional financial exchanges. This does not mean that they are not vulnerable to attacks, but it does suggest that regulatory and supervisory pressures exerted by national authorities do provide for some measures of centralized security in traditional asset markets. Also to date, there have been at least 11 documented attacks or breaches in cryptocurrencies exchanges.

In general, frequency of hacks and security breaches in cryptocurrency markets is growing in line with the bitcoin price-induced incentives to undertake such hacks and is already exceeding the comparable event frequency for major corporates listed on the main stock exchanges. As our recent research shows4, cybercriminals respond strongly to financial incentives in undertaking criminal hacking activities. As bitcoin value continues to rise, so will the attempts to crack the security codes protecting cryptocurrency investors. As the criminals continue to pick up the low hanging fruit by attacking individual wallets and exchanges, the incentives to systemically attack the blockchain will also rise. It is only a matter of time before the crypto’s security holy grail falls prey to the hackers.

Limited supply of unlimited forks

The argument about the limited supply of key cryptocurrencies, most importantly, bitcoin, implies their ability to hedge inflation risks. There is no empirical evidence to support either one of these assertions.

From the very top of the argument, bitcoin supply is technically restricted to 21 million units, assuming the current technology remains unaltered. However, the supply of cryptocurrencies remains unlimited due to arrival and maturing of new cryptocurrencies, and due to ongoing bitcoin forks. The argument in favor of restricted supply of bitcoin, therefore, rests on imperfect substitutability across different crypto currencies. This imperfection today is not technologically determined, but is market driven. Largest exchanges and crypto investment platforms, such as Coinbase, are de facto Bitcoin-maximizers, offering no more than two to three alternative cryptocurrencies for investors to choose from. As this market constraint is lifted over time by growing demand for other cryptos, the substitutability between bitcoin and other currencies will improve. With this, the argument of algorithmic restriction on bitcoin supply will also be diminished. Ripple, litecoin and ethereum offer an illustration of how this process works. Based on evidence from our forthcoming study, the largest substitutes for bitcoin are already starting to dilute dynamic price properties of bitcoin.

Anonymous currency, identifiable investors

The issue of anonymity of bitcoin and cryptocurrencies holdings is similar to the issues relating to its security. While the actual holding of the currency can be anonymous, investors in these currencies are still subject to legal, taxation and regulatory controls operating in the jurisdiction of their domicile and/or jurisdiction where they intend to use these funds. More importantly, need for regulated and data-captured intermediaries required to transact in the real economy using these currencies implies that what is anonymous in holding is no longer anonymous in use, or trading.5

This ambiguity between the promise of anonymity and the requirement upon the investors to disclose their holdings to tax and legal authorities in relevant jurisdictions is an added pitfall for many retail investors who can end up with unexpected legal and tax bills, facing potential penalties and fees, simply because they assumed at the point of investment that their holdings are truly anonymous.

Bitcoin is not free from capture by the coercive action of the state.

How efficient is bitcoin?

The argument that the market valuation of bitcoin is justified by the promise of the blockchain technology in reducing transactions data verification and storage costs is hard to justify in today’s markets. Current valuation of cryptocurrencies in the markets exceed US$500 billion, even though the transactions volume supported by these cryptos amounts to just a tiny fraction of one percent of the total volume of financial transactions. In contrast, Visa and Mastercard account for 55 to 60 percent of credit transactions markets and similar percentage of payments markets, with the underlying companies’ capitalization tenfold below that of the cryptos.

Beyond the disconnect between price and market shares today, there is an issue of technology itself. Currently, rapid appreciation of cryptocurrencies in investment markets has resulted in severe constraints placed on blockchain systems, with processing times running into double digit minutes even for Bitcoin-based chains. This is hardly an improvement on existent legacy systems that can process transactions with less than 1 second lags. The above bottlenecks in public blockchain technologies are manifested in shrinking, not growing, volume of real economic transactions supported by bitcoin.6

In terms of future promise, private or proprietary blockchains offer the promise of greater security and efficiency than the public cryptocurrencies. This is reflected in the proliferation of private blockchain solutions across the financial and IT services platforms (think investment banks, payments providers and IT services giants like IBM, Amazon etc). Evolution of cloud technologies and a promise of edge networks beyond today’s technological world constraints further puts into question the value of cryptocurrencies-linked blockchains as platforms for transactions management.

In summary, at present, there is no justification for the current valuations of bitcoin and a range of other cryptocurrencies. The market for cryptos exhibits all the hallmarks of a large scale, rapidly inflating bubble, driven solely by the irrational, behaviorally biased expectations of investors chasing speculative gains. All the arguments in favor of a fundamentals-based anchoring of bitcoin prices are nothing more than an attempt to justify buying the hype.

Global economic policy in the era of Trump


Donald Trump has been a never-ending source of controversy since becoming president, but his ascent to the White House has not caused the collapse of western civilization. And even though he has now been in the Oval Office for an entire year, his presidency has not even caused any measurable damage to the United States.

Indeed, there is a very plausible argument that his first year in office has been a net plus for the U.S. economy. The regulatory state has been curtailed and a semi-significant tax reform has been enacted. And since the reduction in the U.S. corporate tax rate presumably will trigger a virtuous cycle of tax competition, it is reasonable to speculate that Trump’s policies indirectly will lead to better policy and more growth in other parts of the world as well.

Equally important, Trump has not destabilized global trade. His protectionist rhetoric has not (yet) translated into major anti-trade initiatives. Nor has he implemented any populist policies on immigration or the budget.

In other words, we have dodged a bullet. Other than the 24-hours-a-day outrage generated by presidential tweets, not much has changed in Washington. Bismarck was reputed to have said there is “a special providence for drunkards, fools, and the United States of America,” and the first year of the Trump Administration does indeed suggest he had a point.

That is the good news. The bad news (or, to be fair, unsettling news) is that Trump still has at least three more years in office. He still has plenty of time to pull the United States out of the North American Free Trade Agreement. Or maybe even cause problems at the World Trade Organization. He has three more years to trigger something unpleasant on the Korean Peninsula. Or in the Middle East.

Perhaps the bigger question, though, is whether the Trump presidency signals the start of something. Is America heading into a period where politics is characterized by a strange mix of populism and celebrity? Considering that Washington is rife with rumors that Oprah Winfrey and/or Dwayne “The Rock” Johnson may run for president, this is not as outlandish as it seems.

And this leads to an even larger question about what this means for public policy. Professional politicians are deeply flawed, to be sure, but they operate within conventional boundaries. If Hillary Clinton had prevailed, she would have proposed incrementally left-wing policies. If Jeb Bush has won, he presumably would have advanced an incrementally right-of-center agenda.
The fact that Trump’s first year has been characterized by a “normal” set of Republican policies is besides the point. Almost everyone assumes he is capable of doing something out of the ordinary. He spent most of his life as a Democrat and even donated to Hillary Clinton, so it is unclear if he has any underlying principles.

By the way, the United States is not alone. Populist politicians – on the left and right – have generated record levels of support in many developed nations. We may even see the ideologically incoherent Five Star movement prevail in the upcoming Italian elections, which would probably trigger a fiscal crisis given the nation’s huge debt burden and anemic economic outlook.

One lesson to learn from the global shift to populism is that the negative consequences of bad policy are now larger. Voters are anxious and impatient, so periods of economic stagnation can produce unpalatable political results. Some have persuasively argued that this represents a “failure of the elites” since monetary policies and regulatory interventions, particularly in the United States, led to the global financial crisis, which then triggered the populist backlash against bailouts and favoritism.

In other words, Trump and Trumpism may simply be a symptom of a deeper malaise.

Economic impact of US tax reform

On Dec. 22, 2017, the president signed into law major tax reform legislation. This legislation had been known as the Tax Cuts and Jobs Act but at the last minute, due to quirks in the Senate parliamentarians’ interpretation of parliamentary procedure, the Act’s name was stripped from the bill. It is, therefore, nameless.

Economic impact

Because the new law reduces marginal tax rates, reduces the user cost of capital and makes other policy improvements, the legislation will have a positive impact on the U.S. economy. The positive economic impact, however, will be substantially less than had tax reform initiatives offered earlier in the legislative process been enacted. Politically plausible well-crafted major tax reform had the potential to increase long-run gross domestic product (GDP) – economic output – by about 10 percent. The tax legislation signed into law will probably increase GDP in the long-run by about two percent relative to baseline. Most of this gain is likely to occur in the first five or six years.

The Joint Committee on Taxation (JCT) provides the official estimates used by Congress. JCT maintains three models: (1) the Macroeconomic Equilibrium Growth (MEG) model; (2) the overlapping generations (OLG) model; and (3) the dynamic stochastic general equilibrium model (DSGE) model. It is not clear which model contributed to what degree in arriving at the JCT staff’s estimate of a 0.7 percent increase in GDP. Both the Tax Foundation and the Heritage Foundation models are neo-classical models that focus on the impact of the tax system on incentives or, in other words, have microeconomic or price theoretic foundations. The Urban Institute-Brookings Institution Tax Policy Center uses a neo-Keynesian model in which “aggregate demand” is a central factor. Although they receive much press coverage, the Tax Policy Center’s estimates are based on faulty economic thinking and are not credible.

Business taxation

The most important pro-growth aspect of the legislation is the permanent reduction in the U.S. corporate tax rate to 21 percent starting in 2018. This will reduce the cost of capital and increase investment and productivity. It will make the U.S. a more attractive to place to invest and in which to headquarter a multinational company. The corporate alternative minimum tax (AMT) is repealed.

Under U.S. law, pass-through businesses (primarily S corporations, partnerships, limited liability companies, sole proprietorships, real estate investment trusts and cooperatives) do not pay tax at the entity level. Instead, the owners of the business pay tax at the individual level on their share of the business’s income. The legislation reduces the tax rate for many pass-through businesses by introducing for the first time a lower tax rate for certain pass-through businesses than applies to other forms of individual income. These new rules, overwhelmingly applicable to smaller businesses, are complex.

In general, pass-through businesses are accorded a 20 percent deduction, which means that the tax rate is 4/5ths of what it otherwise would be. Thus, a 25 percent bracket taxpayer would have an effective marginal tax rate on his or her pass-through income of 20 percent. However, this deduction is not allowed for certain service businesses in the fields of health, law, consulting, athletics, financial services, brokerage services, nor any “trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.” Engineering and architecture services were excluded from the definition of service business in the final bill, so they are eligible for the rate reduction. The limitation on the deduction for specified service businesses only applies to the extent a taxpayer’s taxable income exceeds $157,500 ($315,000 joint). The 20 percent deduction also cannot exceed the greater of (a) 50 percent of the wages paid with respect to the trade or business, or (b) the sum of 25 of percent of the wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis in depreciable property. This latter limitation does not apply to lower income individuals. The 20 percent deduction only applies with respect to U.S. source income. It does not apply to investment income such as dividends, interest and capital gains. It does not apply to income that must be treated as “reasonable compensation” under existing rules. There are also a series of special rules governing various particular situations.

The cost of most equipment purchased by businesses will be expensed (i.e. immediately deducted rather than depreciated) for five years. Beginning in 2023, these rules phase-out and by 2023 normal capital cost recovery rules will apply. The legislation, however, increases the section 179 threshold to $1 million, so small business will be able to deduct the cost of equipment purchases.

In general, the deduction for business interest expense may not exceed the sum of business interest income plus 30 percent of adjusted taxable income. Adjusted taxable income is determined without regard to depreciation, amortization, or depletion for the first five years. This limitation applies to both C corporations and pass-through entities.

International tax

The tax bill moves the U.S. tax system substantially towards a territorial system. It deems as repatriated previous overseas earnings on which taxes have been deferred and taxes them at a reduced rate. In contains a number of base erosion prevention provisions that effectively retain aspects of the current world-wide U.S. tax system. On balance, these provisions will make the U.S. a more attractive place to headquarter a multinational business and should, combined with the substantially reduction in the corporate tax rate, substantially reduce inversions and the acquisition of U.S. corporations by foreign corporations.

The legislation provides a 100-percent deduction – a dividend received deduction or DRD – for the foreign-source portion of dividends received by U.S. corporation from specified 10-percent or more owned foreign corporations. The DRD is available only to C corporations that are not Regulated Investment Companies or Real Estate Investment Trusts. In general, the foreign tax credit is repealed.

In general, accumulated post-1986 foreign earnings and profits (E&P) that have not been previously taxed must be included in gross income. This provision applies to all controlled foreign corporations (CFCs) and certain other foreign corporations. These earnings will be taxed at a rate of 15.5 percent for earnings held in the form of cash or cash equivalents and 8 percent on other earnings. This deemed repatriation tax may be paid over eight years with the bulk of the liability being due toward the end of the eight-year period.

The legislation provides for current taxation of some foreign source income at reduced tax rates. The effective tax rate on foreign-derived intangible income (FDII) is 13.125 percent and the effective U.S. tax rate on global intangible low-taxed income (GILTI) is 10.5 percent. The rules governing what is FDII or GILTI are extremely complex and it is not immediately apparent what their actual effect will be. In general, however, intangible income is all income in excess of the product of 10 percent and the net of depreciation value of depreciable property. There is also a new base erosion minimum tax designed to target related party transactions.

Individual taxes

From 2018 through 2025, the legislation reduces federal individual tax rates. The top tax bracket is reduced from 39.6 percent to 37 percent and most other taxpayers will see their federal tax bracket reduced by one to four points. The thresholds for the lower brackets are also increased. However, because the state and local tax deduction is limited to $10,000 the combined effective marginal tax rate for many upper middle and upper income taxpayers, especially those in high-tax states, will increase.

The standard deduction is nearly doubled but the personal and dependent exemptions are repealed. The child tax credit is doubled to $2,000 and up to $1,400 per child is refundable (paid even if no tax is due). Mortgage interest is deductible except that interest on acquisition indebtedness of over $750,000 is not. Only the first $10,000 of state and local taxes are generally deductible.

Estate and gift tax

The bill increases the size of estate exempt from the estate and gift tax from $5 million to $10 million. The $10 million amount is indexed for inflation occurring after 2011, so in 2018 it will be nearly $11 million. The exemption returns to $5 million (indexed from 2011) in 2026.


Because of lower marginal tax rates for businesses, expensing for equipment and international tax improvements, the legislation will improve the U.S. economy. Investment will increase, productivity will improve and the size of the economy can be expected to increase relative to baseline by about two percent over a period of five or six years. Accountants and tax lawyers can, however, rest easy. The tax reform bill in many cases increases complexity – especially for businesses.

Macron’s fine line to walk

U.S. Commerce Secretary Wilbur Ross, Formula One racing champion Lewis Hamilton, Queen Elisabeth II, Madonna. These are some of the names revealed in the “Paradise Papers” leak that shocked the Anglo-Saxon world. Across the channel in France, however, the revelations have triggered less inquiry towards celebrities as it has reignited public indignation towards their government’s apparent policy of tolerance regarding offshore accounts and tax optimization.

Within hours of the Paradise Papers story breaking, France’s young president Emmanuel Macron came under criticism from political rivals.

Jean-Luc Mélenchon, who finished fourth with 20 percent of the vote in this year’s hotly contested first round of the presidential election, lamented what he views as the French government’s lack of assertiveness in fighting tax evasion. “Systematic feet-dragging” was the popular firebrand’s way of describing the French government’s approach. Mélenchon’s condemnation was followed by the implication that as the former minister of the economy,

Macron played a role in the scandal by neglecting his duty to put into place measures to prevent tax evasion.

The Socialist Party applauded the International Consortium of Investigative Journalists for their investigation, calling on Macron to continue the anti-tax evasion policies put into place by President François Hollande. The Green Party also issued a statement to denounce sophisticated, “barely legal” tax arrangements that generate what is estimated to be 350 billion euros annually of lost tax revenue for governments around the world, 20 billion euros of which is tax revenue lost for the French state.

The left was not the only force in the French political landscape to pressure the Macron administration in the wake of the Paradise Papers. Marine Le Pen’s far right Front National party issued a press release on the same day as Mélenchon’s comments, denouncing a Macron government that lacks the political courage to fight tax optimization or challenge the European Union bureaucracy that protects the preferential tax policies of some EU member states, specifically Ireland, Malta, and the Netherlands.

This was not the first time that the Front National has tried to leverage the offshore account issue to gain an edge over Macron, who positioned himself at the intersection of laissez-faire economics and progressive social values. Newcomer internationalist Macron and far-right nationalist Le Pen were the top two presidential candidates who advanced into the second round run-off election, representing conflicting visions of France’s role in the world. During their head-to-head televised debate, Le Pen pressed Macron about his personal finances: “No one understood your explanations about your estate …. I hope that we will not learn that you have an offshore account in the Bahamas!”

This accusation was based on unverified documents published anonymously on an online forum a few hours prior to the debate. Macron reacted forcefully, decrying “fake news” in a press release and filing a defamation complaint in court the day after the documents appeared. Although Macron is a new face in the French political scene, he is savvy enough to understand that the offshore issue touches a raw nerve in France.

Shortly before Macron’s arrival at the Finance Ministry, a scandal engulfed the Hollande administration’s Budget Minister, Jérôme Cahuzac. The independent French media organization Mediapart published accusations against Cahuzac of holding an undeclared account in Switzerland. Cahuzac stood before the National Assembly and publicly denied the existence of undeclared foreign bank accounts, yet evidence would emerge exposing his offshore accounts. Years after his resignation in March 2013, the Panama Papers would also reveal Cahuzac as the owner of a shell company based in the Seychelles. The former budget minister was convicted in December 2016 of tax fraud and is currently appealing his prison sentence.

The affair dealt irreparable damage to the image of François Hollande, a lesson that may not have been lost on Macron who would later resign from Hollande’s cabinet. He dedicated himself to his newly formed political party En Marche!, which swept into public office across France with no pre-existing constituency or infrastructure, successfully dislodging France’s two historically dominant political parties the Socialists and the Republicans.

What forces and what policy proposals propelled the new political actor Macron and his new political party into power? There is no simple explanation as Macron won with a politically diverse alliance that does not resemble any past administrations of the ancien régime.

Despite the criticism from both the left and the right, the enigmatic Emmanuel Macron has been silent on the matter of offshore accounts. One explanation may be that Macron remains relatively popular although he nimbly avoids weighing in on contentious issues such as tax optimization.

The President of the French Republic received a terrific gift for his 40th birthday this December: A new poll shows that 52 percent of French people are satisfied with Macron’s performance, a figure that is up by 11 percent versus the previous month. Not all the news from the poll is positive, however, as 67 percent of respondents judged Macron to be the “president of the wealthy.” A similar epithet was effectively applied to the personal style of President Nicolas Sarkozy by his opponents – the re-election of the “bling bling president” did not appeal to a majority of the French electorate who preferred voting for the candidate who promoted himself as the “normal president,” François Hollande.

To prevent these perceptions from gaining ground, Macron is working to bolster his credibility with the left after having expended political capital on labor reforms, the abolishment of a direct wealth tax on high net worth individuals, and reduced housing benefits. There has been an ongoing pivot in Macron’s political agenda towards issues such as urban renewal and anti-discrimination measures.

This pivot to the left is indicative of the fine line Macron is walking. How can a French President help his country battle economic stagnation and a 10 percent unemployment rate? How can the President do this and avoid the baggage that comes with opponents labelling his solution as right-wing or neo-liberal? How can Macron’s fledgling En Marche! party satisfy both a restless public and the international business community without alienating key constituencies of his broad coalition?

Offshore accounts are one such subject where the administration’s balancing act can be observed. The Macron administration cannot completely ignore an issue that occupies a large space in the public mind after years of hostile media attention. For example, last year’s Panama Papers leak elicited headlines such as Le Parisien’s “The Worldwide Heist,” Charlie Hebdo’s “Fiscal Terrorism,” and Le Monde’s interactive online feature “Stairway to Tax Heaven: The Game.”

Contrary to President Sarkozy’s bold 2009 promise to put an end to tax havens, the statements issued thus far by the Macron administration have been received by some critics as inconclusive and equivocal. “This is a concern,” stated the government’s spokesperson Christophe Castaner in reaction to the Paradise Papers. Castaner added that a distinction must be made between legal and illegal tax optimization practices. “If there were violations, they will be immediately prosecuted,” he said.

Macron’s Minister of the Economy, Bruno Le Maire, reacted with harsher rhetoric. Tax evasion is an “attack against democracy,” stated Le Maire at the National Assembly. Le Maire then promised that he would go to Brussels to propose measures to increase transparency with the support of his European counterparts.

On Dec. 5, the 28 Finance Ministers of the European Union came together to take their first concrete action against the sort of tax evasion revealed in the Paradise Papers. The ministers agreed on a blacklist of 17 countries identified as tax havens, or jurisdictions which fail on tax good governance standards. Another 47 countries were specified in a “graylist,” including countries such as Switzerland, which are expected to pass reforms to comply with EU standards. The sanctions for noncompliance are to still be defined.

On a European level, the blacklist is being welcomed as a good first step. Pierre Moscovici, Commissioner for Economic and Financial Affairs, Taxation and Customs, declared: “The adoption of the first ever EU blacklist of tax havens marks a key victory for transparency and fairness. But the process does not stop here …. There must be no naivety: promises must be turned into actions. No one must get a free pass.”

This sounds very similar to the rhetoric of the head of the France Insoumise party, Jean-Luc Mélenchon, who has not minced words: “I think that we should shift from indignation to action. The president of the Republic and the prime minister must tell us how much longer they plan on tolerating the pillaging that is happening in our country, either by fraud or by evasion.”

Bruno Le Maire was quick to celebrate the EU’s action, highlighting the political courage it took to publish a list which includes states close to the EU and to France. However, critics were quick to respond. Green Party Eurodeputy Eva Joly criticized the hypocrisy of the EU for conspicuous omissions in their list: “The EU must sweep in front of its doorstep” and that the list effectively “whitewashes notorious tax havens.” Oxfam France’s Manon Aubry tweeted that the list is “not very credible” as the world’s principal tax havens are absent: Switzerland, the Cayman Islands, and others including EU member states such as Ireland.

Again, Macron is faced with a political dilemma that has no easy answers. How can the administration reconcile its statements that they will fight tax evasion while also pushing an image of a new France that is open for business, enticing multinationals to invest and French tax exiles to repatriate?

The answer, as with many aspects of French life, may be in the nuance. Spokesperson Castaner was careful in his statement to distinguish violations of French tax law from tax optimization which is grounded in national and international law. This much can be known: individuals and businesses who are found to have violated French tax law will be prosecuted. This is especially true within Macron’s political circles. After witnessing the taint left by Cahuzac and the embezzlement investigation that derailed the campaign of one-time presidential favorite François Fillon, Macron and his team will do what is necessary to protect his carefully crafted image.

In terms of new legislation on offshore accounts, it is likely that any further developments would come under the auspices of the EU rather than France’s national government. The trading bloc will want to act in unison, reassuring European citizens that corrective actions are being made while not isolating any key trade partners. The 17-country blacklist should be watched closely: The severity of the sanctions and the treatment of the 47 gray list countries will ultimately determine if these efforts amount to a communications campaign or if the EU is serious in its pursuit to punish tax evaders and to limit tax optimization.

In France, Macron has laid out an ambitious legislative agenda for 2018 which will make major reforms to economic, immigration, and fiscal policy. This busy agenda, Macron’s popularity, and his influence on French media will likely spare him from addressing the sensitive topic of offshore accounts. Additionally, any push to strengthen offshore account regulations would risk drawing attention to Macron’s personal fortune and previous life as a banker at Rothschild & Cie, exposing a political vulnerability and reinforcing the growing perception that Macron advances policies that benefit the wealthy at the expense of the lower class.

Lastly, what forces external to the Macron administration could play his hand? The opposition appears to be disorganized. Macron defeated Marine Le Pen by a margin of 10.1 million votes in the second-round run-off election, winning with 66 percent of the vote. Adding to Front National’s woes following the defeat, Le Pen was charged with misappropriating European Parliament funds, HSBC closed Le Pen’s personal bank account, and Société Générale closed a party account.

With the Socialist Party’s poor election showing and key members of the Republican Party defecting to the Macron administration and En Marche!, Mélenchon is one of the only national political figures left to vocally oppose Macron. While his election performance exceeded expectations, Mélenchon’s left-wing rhetoric can be divisive. By positioning himself closer to the center, Macron’s appeal is much broader than Mélenchon’s, limiting any meaningful opposition from the left.

In summary, Macron’s position of strength after his first eight months in office and the absence of an organized opposition to bring the issue to the forefront has resulted in an official response that ranges from reticence to ambiguity. If more leaks come, Macron makes a misstep that alienates parts of his coalition or the media, or a new opposition voice emerges, then the new political calculus may goad the administration to pursue a political victory by limiting offshore accounts. The offshore issue will not be going away soon in France’s ideological climate, but with no impetus to catalyze significant reforms, investors and citizens ought to distinguish threats from sanctions, promises from legislation, and rhetoric from action.

Capital taxation and employee compensation

Measures of gross domestic product and employment tell us how the economy is doing in producing goods and services and creating jobs. Measures of productivity link what the economy produces to the inputs – technology, labor and capital – used to produce it. When productive capital becomes scarce, then output per worker – labor productivity declines, hiring slows and so do wages for new hires. Historically, productivity growth has led to gains in compensation for workers and greater profits for firms. This has big implications for tax policy – especially the degree to which capital is taxed since capital – an essential ingredient to improvements in workers’ living standards – is highly responsive to changes in the tax climate.

Countries that reduced taxes saw large increases in productivity; countries with a higher tax burden saw lower productivity gains.
See figure 1

Ireland, with the largest tax climate improvements, has seen the largest increase in labor productivity. Ireland, with a corporate income tax rate of 12.5 percent, tops the list of recipient countries for U.S. companies that shift their place of incorporation to another country. The large decline in capital taxation that took place in Ireland in the 1990s coincides with large worker productivity gains.
See figure 2

Lessons from Chamley and Judd

According to Chamley (1986)2 and Judd (1985)3: 1), capital should not be taxed in the long run, and, 2) it is impossible to tax capital income, hand all of the tax revenue to workers and not wind up with a smaller economy in the long run. However, since these famous results, many economists have questioned the model’s assumptions in an attempt to disprove Chamley and Judd’s conclusions.

First, capital is an intermediate input used for future production. That means the taxation of capital is inefficient, since it will put the economy inside its production frontier. Second, a tax on capital today is an ever-increasing tax on future consumption but not current consumption, thus making future generations worse off. Third, a tax on capital reduces the size of the capital stock and aggregate output in the long run, because it takes time to build new capital goods and only finished capital goods are part of the productive capital stock that can then be transformed into consumption goods. Half-finished factories are not part of the productive capital stock. For example, the average time between the decision to undertake an investment project and the completion of it is 21months. In addition, the average lag between the design of a project and when it becomes productive is about two years.4

Finally, increasingly interconnected markets have contributed to more elastic responses of capital flows to tax changes. The importance of capital goods for the production process cannot be overstated and any tax on capital discourages capital accumulation.

Should capital be taxed in the short term? What about the long term?

The standard theory of optimal taxation argues that a tax system should maximize social welfare subject to a set of constraints. The goal should be to enact a tax system that maximizes households’ welfare, given the knowledge that household members respond to whatever incentives the tax system provides.

Pioneering work on optimal taxation is the work of Frank Ramsey (1927), who suggested that if a social planner must raise a given amount of tax revenue, he must do so such that only commodities with inelastic demand are taxed. Another important contribution on this topic is the work of James Mirlees (1971), who posits that when a tax system aims to redistribute income from high ability to low ability individuals, the tax system should provide sufficient incentive for high-ability/high-income taxpayers to keep producing at the high levels that correspond to their ability, even though the social planner would like to target this group with higher taxes. This is because a higher tax on high-income individuals would discourage them from exerting as much effort to earn that income.

The Mirlees result implies that consumption and labor elasticities – the responsiveness of consumption and labor supply to their respective prices – are crucial for determining the optimal tax rates. If high-income workers were more responsive to an increase in their tax bill, this would imply lower optimal marginal tax rates on high incomes, all else equal. In other words, optimal tax policy should not cause the tax base to shrink.

Optimal taxation implies no taxation of human and physical capital because both are intermediate inputs used for both current and future production (see, Diamond and Mirrlees, 1971). Optimal taxation also rules out taxes with differential effects across time periods.

Since individuals ability and earnings change over time and since individuals are forward looking, tax policy that aims to redistribute efficiently should be both backward- and forward-looking, thus making redistribution a very challenging proposition.

Most recently, Chari, Nicolini and Teles (2017)5 employ a standard open economy macroeconomic model to show that capital should never be taxed both in the long run and in the short run. It is never optimal to introduce inter-temporal tax wedges, meaning that it is never optimal to tax capital. If consumption and labor elasticities are constant over time, then optimal taxation implies that consumption and labor should be taxed at constant rates over time. However, when current capital is being taxed or confiscated, it imposes higher taxes on future goods. Lastly, any taxation that aims to redistribute income across individuals should be such that individuals’ consumption and labor decisions aren’t distorted.

What does the empirical evidence suggest?

Theoretical wonder aside, it turns out that the empirical evidence on the effects of taxation largely supports a move away from capital taxation.

Economists agree unanimously that higher tax rates have a negative effect on economic growth.

Romer and Romer (2010)6 find that exogenous tax increases have a negative effect on real GDP. The maximum effect of a tax increase equivalent to 1 percent of GDP is a fall in output by almost 3 percent after 10 quarters. Tax increases have a very large and sustained negative effect on output.

To understand why output declines, Romer and Romer (2010) find that a tax increase (tax on labor and capital) of 1 percent of GDP leads to a 2.55 percent fall in personal consumption expenditures, a 11.19 percent fall in gross private investment. Exports rise substantially and imports fall. The rise in net exports is consistent with the tax increase lowering interest rates and hence reducing capital inflows.

These results are also consistent with the findings of Blanchard and Perotti (2002)7 and Mountford and Uhlig (2009).8 Investment falls in response to both tax increases and government spending increases. Consumption does not rise significantly in response to a fiscal policy change. Government spending increases have a negative effect on the real wage of workers.

Can workers be made better off by taxing the owners of capital?

The economic effect of tax and spending policy is nontrivial. On one hand, higher taxes on capital income discourage investments in productive capital. This reduction in productive capital causes workers to become less productive, thus causing the real wage to decrease.

Declining real wages make workers worse off and reduce the incentive for market work relative to leisure or home production. On the other hand, a lower after-tax income raises the need to work, save, and invest in order to maintain the same living standard. The first effect lowers economic activity – economists refer to it as the substitution effect – while the second effect normally raises activity through the so-called income effect. The impact of the tax hike depends on which one of these effects dominates the other in magnitude.

Now, consider a tax that lowers the real wage of workers and yet at the same time eliminates a negative income effect by providing workers with a windfall – lump sum transfer. Under such a tax scheme, the fall in the real wage generates a substitution effect that discourages work and the transfer mitigates some of the decline in income resulting in a substitution effect that exceeds the income effect in magnitude. For that reason, workers become less attached to paid market work and economic growth slows.

Tax hikes lower productivity, harming both capital owners and workers. This is because of a large negative response of capital investments to tax hikes. The decrease in investment results in declining living standards.

What Ramsey and Mirlees taught us is that good tax policy should not diminish productive capacity and cause the tax base to shrink. The large negative response of capital investments to taxation qualifies capital as a commodity that should never be taxed.


  2. Chamley, Christophe, “Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives,” Econometrica, 1986, 54 (3), pp. 607–622.
  3. Judd, Kenneth L., “Redistributive taxation in a simple perfect foresight model,” Journal of Public Economics, 1985, 28 (1), 59 – 83.
  4. Kydland and Prescott, 1982. “Time to Build and Aggregate Fluctuations,” Econometrica, vol 50, 6, pages 1345-1370.
  5. Chari, Nicolini and Teles, 2017. “Ramsey Taxation in the Global Economy” Federal Reserve Bank of Minneapolis Working Paper 745
  6. Christina D. Romer & David H. Romer, June 2010. “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review, American Economic Association, vol. 100(3), pages 763-801.
  7. Blanchard O and Perotti R. 2002. “An empirical characteriz ation of the dynamic effects of changes in government spending and taxes on output.” Quarterly Journal of Economics. 117(4): 1329–1368
  8. Mountford A. and Uhlig H. 2009. “What are the effects of fiscal policy shocks?” Journal of Applied Econometrics 24: 960-992

Kowtowing to China

President Trump, by his own admission, has “been soft” on China’s trade practices, in the hope that its leaders will pressure North Korea to abandon its nuclear weapons program. This position represents an astonishing reversal from his campaign rhetoric in which he railed against allegedly unfair Chinese trade practice, and made his vow to strike back at China a central tenet of his campaign. For example, in a May 2016 campaign rally, Trump stated that “We can’t continue to allow China to rape our country. It’s the greatest theft in the history of the world.” One suspects that the realization that China owns a large part of the U.S. debt, and that Trump has developed a strong personal relationship with Chinese President Xi Jinping have also contributed to this profound shift in his view of U.S.-China relations. In early November 2017, Trump stated that he has “great chemistry” with Xi, and said: “I don’t blame China. After all, who can blame a country for taking advantage of another country for the benefit of its citizens?”

But is this conversion from China hawk to China dove justified by the real threat posed to the U.S. economy by the China price, which has typically been 30 percent to 50 percent below the U.S. price? The inability of U.S. companies to compete with this price has resulted in the destruction of many U.S. manufacturing industries. The China price is the reason that China has captured over 70 percent of the world’s market share for DVDs and toys, more than half for bikes, cameras, shoes and telephones; and more than one-third for air conditioners, color TVs, computer monitors, luggage and microwave ovens. It has also established dominant market positions in everything from furniture, refrigerators and washing machines to jeans and underwear. China is currently running a $46.7 billion per month trade surplus with the world, while the United States runs about a $42 billion per month trade deficit.

What is required is a granular analysis of the elements of the China price. Once the relative importance of those elements is understood, the policy prescriptions that the Trump Administration should take to counter the China price become apparent.

A. Elements of the China price

1. Labor costs

The largest single element in the China price is its lower labor costs. According to the research done by Peter Navarro, lower labor costs account for 39 percent of the China Price advantage and clearly represent the dominant element of the China Price advantage over U.S. manufacturers. At first glance, one could say this is just an aspect of the Law of Comparative Advantage, with China possessing a comparative advantage in labor resources.

The problem with that analysis is that workers in China frequently are paid less than the official minimum wage, forced to work excessive overtime, denied overtime pay, denied collective bargaining rights, subjected to abusive treatment, forced to work around hazardous wastes, and in crowded and unsafe working conditions. So, mercantilist elements are in fact an integral part of the ostensible Chinese labor cost advantage. Fortunately, this is starting to change, due to pressure from shareholders and organized labor in the United States.

The example of Apple is instructive. In 2010 conditions at Foxconn, the principal supplier for Apple in China for iPhones and iPads, were so oppressive that there was a rash of worker suicides. Despite the promises that Apple had made to the Fair Labor Association, the group it hired to audit workers’ living and working conditions, workers at Foxconn bitterly complained in September 2012 that they were being forced to work 80 overtime hours a month, and that students were being coerced by teachers to leave school to crank out iPhones at record rates. As a result of worker riots and external pressures, Apple has pressed its Chinese supplier Foxconn to increase its wages and improve workers’ living conditions.

Apple is not alone. The same labor issues persist at the factories of Samsung, Nokia and other brands in China.

A more recent, and politically controversial, example of the long hours and low pay endured by many Chinese workers is the case recently brought to light about Ivanka Trump’s clothing-maker in China. The factory that manufactures the Ivanka Trump fashion line in China requires its workers to work nearly 60 hours a week to earn wages of little more than $62 per week, according to a factory audit issued on April 25, 2017.

The data indicate that, even adjusted for productivity, China’s hourly compensation costs are about one-fifth of U.S. labor costs. China’s wages are four times lower that Brazil and seven times lower than Mexico.

In most cases, one would expect this type of wage advantage to shrink over time as labor markets tighten in tandem with economic growth. The problem with China, however, is that the Chinese government is seeking to move 400 million people from the countryside and into China’s cities over the next several decades. To put these numbers in perspective the current work forces of the United States and Europe combined number less than 400 million.

Thus, despite much higher growth levels than the United States, and external pressures such as the Apple case mentioned above, wage pressures will remain a significant driver of the China price for decades to come.

2. Subsidies by China

The second largest element in the China price is export subsidies provided by its governmental units. This accounts for about 17 percent of the China price advantage. As a condition of its entry into the World Trade Organization (WTO) in 2002, which I argued for publicly, China agreed to eliminate or scale back its complex web of subsidies and tax preferences that benefit its export manufacturers. Unfortunately, this has not happened rapidly enough. Apart from significant domestic subsidies such as heavily subsidized energy and water, China continues to use its state-owned banks to provide non-performing loans (NPLs) to the state-owned enterprises (SOEs) centered in heavy industries such as steel and petroleum. These non-performing loans allow otherwise inefficient SOEs, known in China as the dinosaurs, to export when by all rights they should be allowed to go bankrupt, as would happen in a true market economy.

China’s exports are further aided by its extensive value-added tax rebate system. The Chinese VAT is imposed over multiple stages of production, in the range of 13 percent to 17 percent. By exempting this tax on its goods destined for export, China gains a huge competitive advantage over its counterparts in the Americas.

Other direct subsidies to Chinese manufacturers include its Export Development Fund for the larger firms, the Fund for Small and Medium Enterprises, and the Chinese Export-Import Bank. Clusters of subsidies around specially designated regions.

3. Chinese currency manipulation

No Chinese trade-related practice has received more publicity than its currency manipulation. Here we are dealing with a moving target. In 2006 Navarro estimated that currency manipulation contributed 11 percent to the China price advantage. But the yuan at that time was trading at about an 8 to 1 ratio to the U.S. dollar. At that point estimates by others of the undervalued yuan ranged from 40 percent by Ernest Preeg to 25 percent by the Institute for International Economics. However, the yuan now (rate prevailing on Dec. 29, 2017) trades at a ratio of 6.507 to the dollar, so China has gradually appreciated its currency over time. The Obama Administration declined to name China a currency manipulator, noting that it had let the yuan rise nearly 10 percent in value against the dollar since June 2010. The Trump Administration has followed suit, also declining to name China as a currency manipulator, despite the promise of President Trump that he would name China as a currency manipulator on the first day of his presidency. Trump defended his U-turn on China’s currency manipulation by stating, “Why would I call China a currency manipulator when they are working with us on the North Korean problem?”

A major problem in the currency manipulation debate is that the alleged practice lies largely in the eyes of the beholder. China has alleged that the United States, through the quantitative easing policies of its Federal Reserve System, has effectively devalued the U.S. dollar, thus manipulating its currency. And, in fact, other countries, such as Singapore, Korea, Taiwan and Japan, also manipulate their currencies.

Mexico has also complained about China’s currency manipulation, as the Mexican peso appreciated 21 percent against the dollar from the mid-1980s through 2006 by 21 percent, while the Chinese currency depreciated. And the Brazilian Government has called for a revaluation of the yuan, contending that the cheap Chinese yuan is flooding into Brazil and hurting local manufacturers. So, this is an issue for all of the Americas, not just the United States.

4. Network clustering

Perhaps the most unexpected competitive advantage China possesses is network clustering. This currently amounts to a 16 percent competitive advantage for China. Network clustering refers to the practice of locating all or most of the key enterprises in an industry’s supply chain in close physical proximity to one another. China has raised network clustering to an art form, with whole cities dedicated to the production of particular products. For example, Yanbun is the underwear capital of China; Foshan and Shunde are the major hubs for appliances like washing machines, microwave ovens and refrigerators; Huizou in the Pearl River Delta area of China is the world’s largest producer of laser diodes and a leading DVD producer. Leilu focuses on bicycles, Wenzhou on commercial kitchen equipment, Chencun on flowers, and so on.

The importance of network clustering is that it reduces transportation costs by locating the factors of production closer to one another. It reduces inventory costs by speeding up throughput times. And it reduces downtime in the supply chain by smoothly moving all links in the supply chain in a coordinated fashion.

In other words, China has specialized in turning logistics and supply chains into profit centers.
How has China been able to do this? The reason is that it is a planned economy, with 5-year plans organized and approved by the State Council. The United States is simply not organized in such a fashion, but I would suggest that freedom for our enterprises to locate where they wish to locate is a trade-off worth making. However, this raises the broader issue of industrial policy, targeting, and what will work best in the 21st century: The Beijing Consensus or the Washington Consensus, which emphasizes free and open markets?

Generally speaking, the countries in the Americas have opted for the Washington Consensus, through the fairly rapid liberalization of its trade and investment regimes, and the general decrease of the role of the state in economic affairs. Mexico, for example, shifted from its state-led industrialization strategy in 1988 to pursue a market-led strategy. At this point Latin America is one of the more open market regions in the world.

5. Foreign direct investment

The fifth driver of the China price has been direct foreign investment. As massive amounts of foreign capital flood into China its efficiencies improve dramatically. Foreign investment into China has grown at 17 percent annually for five years, and among developing nations, China has become the leading destination for Foreign Direct Investment (FDI). Since 1983, FDI into China has grown from less than $1 billion per year to over $60 billion. And 72 percent of China’s FDI targets manufacturing. One can see the synergy here, as its undervalued currency, provides a huge incentive for FDI.

Ironically, so does the U.S. tax code. The U.S. multinational enterprises are actually encouraged to invest abroad as a result of the tax privilege of deferral. Under the U.S. tax code a U.S. multinational enterprise established as a subsidiary is not taxed in the United States on the foreign source income that it earns abroad unless such foreign income is repatriated in the form of dividends, except in very limited situations. This tax privilege of deferral is in essence a subsidy that encourages U.S. multinationals to operate abroad. Deferral amounts to an interest-free loan by the U.S. Government for income that is accumulated until dividends are repatriated to the parent. Deferral thus encourages overseas investment over new investment in the United States.

Since approximately 30 percent of the exports from China to the United States are from affiliates in China we can see the untenable situation that now exists. Inter-affiliate imports, so-called “captive imports,” encouraged by the U.S. tax code, are made in China and re-exported to the Americas. Obviously the MNEs are going to China to reap the benefit of China’s other competitive advantages as well, but the U.S. tax code gives them a running start.

And with the increased FDI comes increased technology transfer, as Chinese enterprises will form joint ventures that contractually obligate their foreign partner to share knowledge and technology with the local partner.

In an effort to escape this technology transfer trap, foreign investors are now increasingly establishing wholly-owned foreign enterprises (known as WOFEs). Today WOFEs account for 65 percent of new FDI in China and they dominate high-tech exports. WOFEs account for 62 percent of industrial machinery exports, 75 percent of exports of computers, components and peripherals, and 43 percent of exports of electronics and telecommunications exports.
Navarro estimates that catalytic foreign direct investment accounts for 3 percent of the China price advantage but this appears low, since 30 percent of China’s exports to the United States are inter-affiliate exports, i.e., from an affiliate of a U.S. enterprise to its parent.

5. Counterfeiting and piracy

Counterfeiting and piracy account for about 9 percent of the China price advantage.

Counterfeiting and piracy enables Chinese companies to save research and development and the marketing expenses required for brand building. Much of China’s counterfeiting and piracy is state-sanctioned. In one case I worked on it was the Chinese Government’s official printing press in Shanghai that was knocking off the chemical abstracts, costing the American Chemical Society, which was my client, $40 million per year. China had 9 subscriptions to cover its 1.3 million scientists, and dozens of universities, research institutes and think tanks that were using the publication. And the rate of software piracy in China is well over 80 percent, with the government often the worst offender.

On average 20 percent of all consumer products in the Chinese market are counterfeit. And, if a product sells, it is likely to be duplicated. Of small comfort is the fact that U.S. companies are not being picked on in this regard, as pirates and counterfeiters target both foreign and domestic companies.

6. Other aspects of the China price

The remaining areas where China secures a competitive advantage over other countries include minimal worker health and safety regulations and lax environmental regulations and enforcement. Cumulatively, according to Navarro, these factors amount to about 5 percent of the China price advantage.

B. Countering the China price

How should the United States counter the China price? The answers to this question lie in the realm of U.S. tax policy and U.S. trade policy.

1. International tax provisions in the new U.S. tax legislation

Interestingly, the first significant steps to counter the China price have not occurred in the area of trade policy but with the passage of the new U.S. federal tax legislation passed in Dec. 2017, and entered into force on Jan. 1, 2018. The international tax provisions of this legislation will have a dramatic impact on the decisions of U.S. multinational enterprises to invest in the United States or overseas. Reductions in overseas investments will result in reduced imports from foreign affiliates, which amount to 30 percent of the U.S. imports from China. The new tax legislation reduces the U.S. corporate rate of taxation from 35 percent to 21 percent, which will encourage investment in the United States over foreign locations.

Moreover, the new legislation has a deemed repatriation rate of 15.5 percent on the undistributed earnings of overseas affiliates that consist of cash or cash equivalent, and a rate of 8 percent on undistributed earnings that do not consist of cash or cash equivalents.

The U.S. shareholder will be allowed to pay the newly assessed U.S. tax over an 8-year period. The latter provision represents a significant erosion of the current policy of deferral of taxation on foreign affiliates. Coupled with the newly granted 100 percent U.S. tax exemption for dividends received from a foreign corporation, the new U.S. international tax policy will discourage direct foreign investment by U.S. enterprises, and encourage the repatriation of dividends, steps that should significantly increase investment in the United States, and decrease foreign imports.

2. Trade policy steps taken by the Trump administration

a. The antidumping laws of the United States

The most significant trade-related step taken thus far by the Trump Administration regarding China has been the decision it announced on Nov. 30, 2017, to reject China’s bid for market economy status, and to continue its classification of China as a non-market economy. This will increase the effectiveness of the U.S. antidumping law. This designation permits the U.S. Commerce Department to refer to the economy of a third country at a comparable stage of economic development to calculate the home market “fair value” price, and the economy usually chosen for that analysis is India. This exercise is generally referred to as calculating the “constructed value” of the home market price. China has argued, citing its WTO 2001 accession protocol, that it is a market-oriented economy. If it were to be so classified, it would be virtually impossible to assess antidumping duties against China because its home market prices are so low. China has launched a complaint against the United States regarding this decision with the World Trade Organization. The Trump Administration’s determination that China is a nonmarket economy is, however, correct. For example, China’s foreign exchange regime is still controlled by its State Administration for Foreign Exchange (SAFE), and its many state-owned enterprises still dominate the economy.

Individual unfair trade practice petitions have also been filed at a record rate in 2017, apparently reflecting the view that the Trump Administration will more vigorously enforce the U.S. unfair trade practice statutes: 23 new trade petitions have been filed in 2017, making 2017 the busiest year for trade cases since 2001. These cases involve fights over Chinese products such as aluminum foil. An aggressive technique employed by the U.S. Department of Commerce has been to self-initiate antidumping and countervailing duty petitions against China on common aluminum sheet. This marks the first time since 1985 that the Commerce Department has self-initiated an antidumping case. The investigations launched on Nov. 28, 2017, cover more than $600 million worth of imports, and may signal stricter enforcement of the U.S. antidumping laws.

b. The countervailing duty laws of the United States

The countervailing duty law of the United States permits the United States to assess duties equal to foreign subsidies, bounties, or grants for foreign goods entering the U.S. market. It appears that this statute will be more vigorously enforced. For example, there is an action now pending against Chinese subsidies for its aluminum exports to the United States. China’s aluminum exporters now benefit from government reductions on their energy bills and tens of millions of dollars in cash infusions. Subsidies such as these have propelled the surge in China’s aluminum production in recent years, which has increased from 24 percent 10 years ago to 55 percent of global production in 2015. China has also been circumventing prior countervailing and antidumping duties amounting to 374.15 percent by importing products such as aluminum pallets from China, which is just aluminum being reshaped to avoid the punitive U.S. duties. China started to use these new methods to sell aluminum in the United States after the tariffs were imposed, indicating that they were designed to avoid trade barriers.

c. Intellectual property

A major tool in the tool kit to improve the U.S. trade posture is Section 337 of the Tariff Act of 1930, which permits the United States to issue exclusion orders and cease and desist orders against imports that compete unfairly, and covers patents, copyrights, trademarks and potential antitrust violations. The majority of Section 337 actions are against China, and the majority of those cases involve patent-based violations. Section 337 enforcement needs to be expanded. It is the “catch all” statute designed to limit imports that are competing unfairly in the U.S. market.

On Aug. 18, 2017, President Trump launched an investigation under Section 301 of the Trade Act of 1974 to determine whether acts, policies and practices of the government of China related to technology transfer, intellectual property and innovation are unreasonable or discriminatory and burden or restrict U.S. commerce.

Section 301 of the Trade Act of 1974, as amended, gives the U.S. Trade Representative broad authority to respond to a foreign country’s unfair trade practices. If the USTR makes an affirmative determination of actionable conduct, it has the authority to take all appropriate and feasible action to obtain the elimination of the act, policy, or practice, subject to the direction of the president, if any.

The statute includes authorization to take any actions that are within the president’s power with respect to trade in goods or services, or any other area of pertinent relations with the foreign country. This decision will be closely watched, and the only criticism of the investigation thus far has come from Democrats, who say the investigation does not go far enough.

d. Fairly priced imports

A consensus exists that imports that are unfairly competing the U.S. market need to be limited. The controversy exists with regard to goods that are fairly priced that are still entering the U.S. market in numbers large enough to seriously injure U.S. industries.

During the presidential campaign, Trump called for a tariff of 45 percent to be imposed on China’s imports. There are two statutes that would now permit the president to carry out the threat of higher U.S. tariffs. The first statute is Section 232 of the Trade Expansion Act of 1962. Under this statute the president can declare that for national security reasons he can limit imports coming into the United States. The problem with the use of this statute is that with current U.S. unemployment levels at 4.1 percent, which most economists would term nearly full employment, it is difficult to make the “national security” case under Section 232.

Nevertheless, President Trump has launched an investigation under Section 232 with regard to the U.S. steel and aluminum industries. With the United States down to one aluminum smelter it is possible that an affirmative decision may be made on aluminum, but it is highly unlikely that an affirmative decision would be made with regard to steel, where the United States still possesses a major, if declining, productive capacity. Hearings have been held on both steel and aluminum, and the steel industry is divided on the issue. Manufacturers that use steel and aluminum as inputs into their final products oppose import restraints, while certain domestic producers favor import restraints. There is also a statute, known as the “safeguard” provision, that allows the president to limit imports if they are seriously injuring a U.S. industry, U.S. solar panel manufacturers are currently seeking relief under the “safeguard” law against China. They argue that over the past few years, a flood of less expensive Chinese solar panels has undermined the ability of the industry to compete. The ITC ruled in favor of the two manufacturers, SolarWorld and Suniva, in October 2017, but the companies have said that the duties recommended by the ITC are too small.

C. When will the China swoon end?

Predictions are always a dangerous game with President Trump, but it is likely that the China swoon will end in 2018. The key reason is that China has simply not delivered on Trump’s unrealistic expectation that it would rein in North Korea. Kim Jong Un has proven to be a tougher, more resilient leader than was generally expected, and China has been ineffective in stopping North Korea’s nuclear development. Nor has China taken any significant steps to reduce its aggressive steps in the South China sea. But most important are the domestic U.S. political factors. With the 2018 elections for Congress already underway, and with it being a distinct possibility that the Democrats could win back both the Senate and the House, it is likely that the warmth in U.S.-China relations will diminish, and that Trump’s protectionist rhetoric will return. Early markers will be the decisions of the Trump Administration in its probes against the Chinese intellectual property practices and Chinese steel and aluminum industries under the national security trade statute. The jury is still out, but it is likely that 2017 will prove to be the calm before the coming China trade wars.

The world should embrace medical tourism

Americans are increasingly turning to medical tourism as a means to find affordable healthcare. In simple terms, medical tourism refers to patients traveling from their home country to another country to obtain medical care.

Traditionally, medical tourism consisted of people traveling from developing nations to prestigious medical centers in developed nations for sensitive medical treatments unavailable in their home country. But the game has changed in recent years. Elaine McArdle at Harvard Law Today highlights some newer trends in the medical tourism front: “Once the province of the uber-wealthy seeking radical cosmetic surgeries or treatments unavailable in the U.S., medical tourism has become an attractive option for many, especially the uninsured, since the cost savings are so dramatic. According to some estimates, about 2 million Americans a year are traveling overseas for major health procedures, from knee replacements to neurosurgery, with the number growing rapidly.”1

At first glance, medical tourism seems like a niche industry exclusively confined to the wealthy. However, Patients Beyond Borders, a leading source for medical tourism, details the growing scope of this industry: “Patients Beyond Borders’ editors define a medical traveler as anyone who travels across international borders for the purpose of receiving medical care. We do not count in-country expatriates, tourists in need of emergency medical care, companions accompanying medical travelers, or multiple patient episodes that occur over the course of one medical visit. With these variables in mind, we believe the market size is US$45.5-72 billion, based on approximately 14 million cross-border patients worldwide spending an average of $3,800 to $6,000 per visit, including medically-related costs, cross-border and local transport, inpatient stay and accommodations. We estimate some 1,400,000 Americans will travel outside the U.S. for medical care this year (2017).”2 Some of the most popular destinations of medical tourism include: Costa Rica, India, Israel, Malaysia, Mexico, Singapore, Taiwan, Thailand, Turkey and the United States.

Why do tourists opt for these countries when it comes to their medical care?

Patients Beyond Borders notes that the aforementioned countries are chosen for the following reasons:

  • Government and private sector investment in healthcare infrastructure
  • Demonstrable commitment to international accreditation, quality assurance, and transparency of outcomes
  • International patient flow
  • Potential for cost savings on medical procedures
  • Political transparency and social stability
  • Excellent tourism infrastructure
  • Sustained reputation for clinical excellence
  • History of healthcare innovation and achievement
  • Successful adoption of best practices and state-of-the-art medical technology
  • Availability of internationally-trained, experienced medical staff

It is very clear that medical tourism is now a widespread occurrence as both citizens from developed and developing countries use it as a means to receive healthcare. As the healthcare affordability dilemma in the U.S. continues, we can expect more Americans to continue to go abroad to receive medical procedures.

Understanding the U.S. healthcare dilemma

With one of the most technological advanced healthcare systems in the world, why are growing numbers of U.S. citizens still opting for medical tourism?

The answer lies in the U.S. healthcare affordability crisis. It is no secret that healthcare costs have risen substantially in the U.S. over the past few decades, with statistics indicating an increase of approximately 118 percent from 1992 to 2012.

Naturally, this has evoked emotional debate on both sides of the political aisle.

Despite the popular appeal of interventionist proposals by politicians, these prescriptions completely miss the mark. In fact, they ignore the real elephant in the living room in the current healthcare affordability crisis: government intervention in the healthcare sector.

Mike Holly at the Mises Institute provides a sobering analysis on the origins of the U.S. healthcare crisis in his article “How Government Regulations Made Healthcare So Expensive”3:
“The U.S. ‘health care cost crisis’ didn’t start until 1965. The government increased demand with the passage of Medicare and Medicaid while restricting the supply of doctors and hospitals. Health care prices responded at twice the rate of inflation. Now, the U.S. is repeating the same mistakes with the unveiling of Obamacare (a.k.a. ‘Medicare and Medicaid for the middle class).”

The degree of intervention in the healthcare sector cannot be pinned on just one piece of legislation, but rather multiple decades of anti-market legislation pushed by bipartisan actors.

Holly further illustrates this unholy consensus: “The majority of policymakers support either monopolization (typically Republicans) or nationalization (typically Democrats). Both have claimed “physician supply can create its own demand,” which means increasing the supply of doctors and hospitals will just motivate them to convince “ignorant” consumers to order more unnecessary and expensive health care. During the 1970s, Frank Sloan, a Vanderbilt University health care economist, explained the success of the most influential pro-regulation health care economist, Uwe Reinhardt: “His theories are highly regarded because he is so clearly understood. Unfortunately the evidence for them is not good; it is not bad either, it is just not there. And it would be a shame to see federal policy set on such a poor, unscientific basis.””

Excessive bureaucratic red tape, anti-market price controls, and subsidies would become fixtures in the American healthcare sectors after decades of consistent government intervention.

The results have been nothing short of dismal – rising administrative costs that which are ultimately passed on to customers, rationing, and declining quality of healthcare services.

While politicians are busy bickering over which top-down policy prescriptions will bring about affordable healthcare for all, Americans continue to go to foreign destinations like the Cayman Islands for medical treatment. This has become the new reality in the era of Obamacare which has only made healthcare in the U.S. more expensive and cumbersome.

In 2014, Medical Tourism Magazine reported on the attractiveness of the Cayman Islands as a destination for American medical tourists: “Since opening earlier this year, Health City Cayman has put the tiny island of just 55,000 residents on the international map for more than Stingray City or Seven Mile Beach. Once complete, Health City will house 2,000 beds, a medical research team and an assisted-living center to form one of the largest healthcare complexes in the Caribbean for cardiac surgery, cardiology, orthopedics, pediatrics, endocrinology and pulmonology. … Analysts say deductibles for Americans who purchased Obamacare plans can top $5,000 for individuals and $10,000 for families. Faced with the prospect of substantial price increases next year or the inconvenience of changing plans, many of these 7.3 million Americans might not hesitate to forgo the high out-of-pocket costs and make the one-hour flight to the Cayman Islands for affordable care instead.”
If the U.S. cannot reverse the growing tide of interventionism in the healthcare sector, jurisdictions like the Cayman Islands will serve as a convenient alternative for medical tourists in need of quality medical treatment at an affordable price.

Medical tourism beyond the U.S.

Citizens going abroad for healthcare is not just confined to the U.S.

Like the United States, the United Kingdom has traditionally been a recipient of medical tourism due to its state of the art medical facilities and world class physicians. But since the establishment of the National Health Service in 1948, the U.K.’s healthcare sector has been riddled with all sorts of inefficiencies and misallocation of resources. Such inconveniences brought about by government-run healthcare have reversed the U.K.’s status as a net recipient of medical tourists.

In 2013 a team led by researchers at the London School of Hygiene and Tropical Medicine calculated that the number of U.K. residents seeking treatment elsewhere had risen sharply to 63,000 in 2010, compared with just 52,000 coming into the country – a figure that has grown far more slowly in recent years.

Government intervention does not discriminate against countries, it is an equal opportunity distorter wherever it takes root. And the U.K. is no exception to this rule.

The recent Charlie Gard case4 illustrated the degree of overreach the NHS has over personal health matters.

This case involved a terminally-ill infant that suffered from a rare genetic disorder that would have required experimental treatment. Gard’s parents were able to successfully raise £1.4 million in private donations so they could take their son to America to receive this treatment.

Sadly, a series of courts ruled in favor of the government doctors who believed that this experimental treatment would be futile, effectively killing Charlie Gard.

Such a grisly case not only demonstrates the cold-hearted, inefficient nature of the NHS, but also the willingness of U.K. citizens to leave their country in order to find the best medical care possible.

This tragic case should serve as a firm reminder of why unimpeded medical tourism must be embraced around the globe.

Healthcare needs market forces

At the end of the day, the provision of healthcare is a service. Like any good or service, healthcare is best allocated in a market setting where supply and demand are allowed to function freely. Globalization has allowed for unprecedented increases in the volume of trade of goods and services, healthcare included.

In the same way that they respond to onerous levels of taxation, American citizens as free consumers can take their services elsewhere when it comes to healthcare. On a micro-level, most would just go from one healthcare provider to another if the prices and quality of service are not up to par. However, in today’s globalized market economy, countless Americans have the opportunity to travel abroad and receive quality care.

Given the degree of government intervention that has accumulated over the years in the healthcare sector, citizens naturally respond by taking bolder steps such as medical tourism to obtain healthcare. This is only natural in market economies where the consumer is king and not necessarily shackled to a specific company or service.

Medical tourism is here to stay

Although it may be shocking that greater numbers of Americans are turning to medical tourism, there is nothing inherently wrong about this activity. In fact, market enthusiasts should embrace the development of medical tourism as a major industry. Americans, and citizens around the world, for that matter, now have the unique opportunity to obtain the medical care they desire in foreign lands at a reasonable price. For their citizen’s sake, governments across the globe should allow medical tourism to develop as freely as possible.

Intervening in the medical tourist sector will simply yield the same dismal results that similar interventions have generated at the domestic level. Consumers simply deserve better.

Medical tourism not only offers consumers more options for healthcare services, but it also puts pressure on governments to craft friendlier medical policies. The jurisdictions with the most competitive medical care environments will provide the best healthcare services for their own citizens, while attracting foreign consumers.

Medical tourism demonstrates how markets will find a way to serve customers even when the heavy-handed state gets in the way. Nevertheless, if the U.S. does not get its healthcare house in order, more U.S. citizens will continue turning to medical tourism as a means to get cost-effective treatments.

In the land of goods and services, the market is still king.



OECD issues BEPS guidance


Additional guidance has continued to roll out from the Inclusive Framework on Base Erosion and Profit Shifting (BEPS). Guidance on the implementation of Country-by-Country (CbC) Reporting (Action 13) was updated to address the definition of income, the treatment of MNE groups with a short accounting period, and the treatment of the amount of income tax accrued and income tax paid. Additionally, new guidance was offered regarding the appropriate use of information contained in CbC reports, and addressing a number of issues relating various accounting and reporting issues. The OECD boasts of more than 1,000 automatic exchange relationships that have been established among jurisdictions committed to exchanging CbC Reports by mid-2018.

The OECD also released new IT-tools relating to CbC reporting. The updated CbC XML Schema and User Guide now allows MNE Groups to indicate cases of stateless entities and stateless income, and to specify the commercial name of the MNE Group. A dedicated XML Schema and User Guide was also developed for structured feedback on received CbC information.

In September, the OECD solicited comments on BEPS Action 1 “related to the tax challenges raised by digitalisation and the potential options to address these challenges.” Of note was the submission from the Federation of German Industries, which warned that “the [political] debate about the taxation of the digital economy is currently too much dominated by a one sided perspective on digital business models and the threat they may pose to tax revenue.” A public consultation was subsequently held in November at the University of California, Berkeley, featuring speakers selected from among the commentators. It also released new guidance, “Mechanisms for the Effective Collection of VAT/GST,” related to BEPS Action 1.

A report, “Harmful Tax Practices – 2017 Progress Report on Preferential Regimes,” reviewed 164 “preferential tax regimes” against the BEPS Action 5 standard, finding that 99 required action, with 93 already completed or under way. And the first six peer review – for Belgium, Canada, the Netherlands, Switzerland, the United Kingdom, and the United States – on individual country efforts on dispute resolution mechanisms (Action 14) were released.

A regional meeting of the Inclusive Framework on BEPS for Eastern Europe and Central Asia was held in Bratislava in October. It featured 80 delegates from 20 countries and 11 organizations. Among other discussions, participants at the meeting raised concerns regarding the overlap with the EU directive on dispute resolution and BEPS Action 14, and business representatives emphasized the importance of preserving the confidentiality of taxpayer data.

The 11th meeting of the Forum on Tax Administration, bringing together more than 180 delegates, including 48 tax administrations from OECD and G20 countries, was held in Oslo, Norway in September. The meeting featured the release of “Tax Administration 2017,” an international survey on tax systems and their administration. It noted a “significant change that is taking place in tax administrations, with both internal and external drivers at work,” including “an increased focus on the security of taxpayer information and data.” The statement of outcomes from the meeting offered the usual praise for BEPS, CRS, and various other tax-grabbing initiatives.

The TIWB Experts Round Table & Stakeholders Workshop was held in Paris to “share experiences and identify best practices in the implementation of Tax Inspectors Without Borders (TIWB)” programs. The initiative flies in outside auditors to assist developing countries in their confiscation efforts, or as the OECD puts it, “to strengthen domestic resources mobilization.” It boasted of 27 programs under way in 23 countries, with seven so far in the pipeline for 2018.

The Fifth OECD Forum on Tax and Crime was held in London in November. The Forum produced a five-point action plan: “1. Focus on targeted responses to professional enablers. 2. Increase inter-agency co-operation across governments to partner in the fight against financial crime. 3. See the full picture – implement the Ten Global Principles necessary for fighting tax crime. 4. Improve international co-operation amongst agencies fighting tax crimes. 5. Strengthen capacity building for all to effectively combat financial crimes.”

The 10th meeting of the Global Forum on Transparency and Exchange of Information for Tax Purposes was held in Cameroon. It published peer reviews for Curaçao, Denmark, India, Isle of Man, Italy, and Jersey, and adopted the first report on the status of implementation of the AEOI Standard.

Economic Surveys were released for Slovenia, France, Estonia, Latvia, and the United Kingdom. The OECD participated in the UN Climate Change Conference, COP23, to help agitate for carbon taxes, so it should come as no surprise that higher taxes on energy were called for in Estonia, Latvia, and France. Though even the OECD has limits, as France was also encouraged to continue seeking to lower its tax burden and overall spending. Overall, the recommendations typically favored expansion of government programs, or pushed nations to “make full use of available fiscal space” with a willingness to run deficits if existing debt was low.

The Global Forum on Transparency and Exchange of Information for Tax Purposes added Greenland, Cambodia, Madagascar, and Haiti as members, bringing the total to 146 jurisdictions. Brunei Darussalam, Peru, and Qatar signed the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, which now includes 115 jurisdictions. Trinidad and Tobago became the 108th jurisdiction to join the Inclusive Framework on BEPS. Forty-nine jurisdictions began automatically exchanging information as part of the Common Reporting Standard approved in 2014. Another 53 jurisdictions will begin exchanges in September 2018. The OECD boasts of 2,000 bilateral agreements for the automatic exchange of CRS information.

The OECD published the second annual edition of “Tax Policy Reforms: OECD and Selected Partner Economies,” covering “tax reforms that were implemented, legislated or announced in 2016.” The accompanying editorial by OECD Secretary-General Angel Gurría provides yet more evidence of the organization’s shifting priorities away from economic coordination and toward a more ideological agenda.

Gurría asserts that “progressive taxation is central to income redistribution and can help reduce wealth inequalities,” and that “tax reforms that contribute to strengthening progressivity and redistribution will play a key role in addressing today’s high levels of income and wealth inequality between those who have benefited from growth and those who have not.” He also revived the OECD’s decades-long and deeply misguided war on tax competition by worrying that “an increase in corporate tax rate competition … raises challenging questions for governments seeking to strike the right balance between maintaining a competitive tax system and ensuring they continue to raise the revenues necessary to fund vital public services, social programmes and infrastructure.”

Australian economic reform: Lessons from the past, challenges for the future

The national anthem of Australia has some very pertinent lyrics to that country’s economic reform and performance path in recent decades. The reference to “free” and “wealth for toil” reflects the many positive economic reforms under Prime Ministers Hawke, Keating and Howard from the mid-1980s to mid-2000s. These were mainly in the areas of trade, finance, labor, tax, pensions and competition. These built on the beginnings of trade and finance reforms under Prime Ministers Whitlam and Fraser from the early-1970s to early-1980s. Unfortunately, from the late-2000s to the present, Australia has largely stalled under Prime Ministers Rudd, Gillard, Abbott and Turnbull. Both major political parties of Labor and Liberal-Nationals share the credit until the mid-2000s, as well as the blame since. See figure 1

Figure 1

Australia’s annual Economic Freedom Index score from 1970 to 2015, compiled by the Fraser Institute, is broadly consistent with this story [see above]. The Fraser index measures the degree of economic freedom present in five major areas: 1) Size of Government; 2) Legal System and Security of Property Rights; 3) Sound Money; 4) Freedom to Trade Internationally; and 5) Regulation. Australia had a low score of 6.06 out of 10 in 1975, which rose to 7.73 in 1990 in the wake of significant reforms in trade, finance and labor. This score rose yet further in 2000 to a high of 8.19 in the wake of significant reforms in tax, pensions and competition.

Historical developments

The so called “Australian Settlement” dominated the economy from the early-1900s to the early-1970s. This was the formal and informal arrangements between Big Government, Big Business and Big Labor, that incorporated both urban and rural Australia. According to Dr. Bernard Attard of the University of Leicester: “The constituencies they each represented were thus able to influence the regulatory structure to protect themselves against the full impact of market outcomes, whether in the form of import competition, volatile commodity prices or uncertain employment conditions.” He added that: “An important part of the Australian Settlement was the imposition of a uniform federal tariff and its eventual elaboration into a system of protection-all-round.” In conclusion, Dr. Attard writes: “Even before the 1970s, new sources of growth and rising living standards had been needed, but the opportunities for economic change were restricted by the elaborate regulatory structure that had evolved since Federation. … By the 1980s, however, it was clear that the country’s existing institutions were failing and fundamental reform was required.”

The Productivity Commission (PC) has played a key role in Australian economic reform since its formation in 1998, especially in trade. But the PC’s roots go much deeper. It is the lineal descendant of the Industry Commission, Industries Assistance Commission and Tariff Board, the latter of which was founded in 1921. The agricultural sector has a long history of intervention by Federal and State governments including domestic marketing arrangements and tariffs as well as a range of budgetary measures such as tax concessions, R&D funding and adjustment assistance. But by the late-1990s, tariff and border protection had been removed for barley, citrus, corn, cotton, dairy, dried vine fruits, fresh horticultural products, grain legumes, meat, oats, oilseeds, sugar, tobacco, rice, sorghum, wheat, wool and wine.

Trade-related manufacturing sector reform essentially began with the first systematic industry-by-industry review of protection in the early-1970s. This was followed by: the 25 percent tariff cut of 1973 under the Whitlam Labor Government; further tariff reductions in the late-1970s under the Fraser Liberal-Nationals Government; and phased tariff reduction programs of the late-1980s and early-1990s under the Hawke and Keating Labor governments. As a result, most manufacturing tariffs had fallen to 5 percent by the mid-1990s. The mining industry has generally received comparatively little government assistance and has been adversely affected by a lack of reforms in other areas such as in finance, labor and competition. Key reforms applying to mining included: the progressive dismantling of export and price controls from the mid-1980s with the result that by 1997 all export controls (except uranium) had been removed; and the removal of foreign investment controls by the early-1990s.

It was increasingly being recognized by the late 1970s that the Australian financial system was overly regulated and this was having many negative impacts on the effectiveness of monetary and fiscal policy, as well as on the economy more broadly. This was made worse by the ongoing development of stronger links between domestic and international financial markets. Thus, by the early-1980s, the Fraser government moved towards a more open and less regulated financial system through such reforms as: removing interest rate ceilings on all trading and savings bank deposits; withdrawing bank quantitative lending restrictions; and easing savings bank regulations. The Hawke government continued the process of financial deregulation in the mid-1980s through such reforms as: floating the Australian dollar along with most foreign exchange controls removed; removing the remaining bank interest rate ceilings; and deregulating Australian Stock Exchange membership along with inviting foreign banks to set up in Australia as subsidiaries but not branches.

From reform to stasis

There were two phases of positive labor reforms under the Hawke-Keating Labor governments in the late-1980s to early-1990s and the Howard Liberal-Nationals Government in the mid-1990s to mid-2000s. The Howard reforms were reversed in the late-2000s under the Rudd-Gillard Labor governments and then left as is under the Abbott-Turnbull Liberal-Nationals governments since. The first phase centered around the Industrial Relations Act and included such reforms as: allowing negotiating between employers and unions at the enterprise level; establishing the Australian Industrial Relations Commission for the settling of disputes and certifying agreements; and introducing the Enterprise Bargaining Principle which allowed parties to negotiate wage increases in exchange for productivity improvements, as well as allowing workplace agreements to be negotiated in non-unionized workplaces. The second phase centered around the Workplace Relations Act and included such reforms as: giving primary responsibility for industrial relations and agreement making to employers at the enterprise and workplace levels; allowing for individual contracts and non-union collective agreements; and amending the Trade Practices Act to include new anti-boycott provisions. The third phase centered around the Fair Work Act and is characterized by the Federal government: regulating the bulk of industrial awards; setting minimum wages; and having created three specialist bodies that collectively mediate disputes, provide information, register agreements, check compliance with the law and adjudicate on some key matters of labor law – i.e., the Fair Work Commission, the Fair Work Ombudsman and Fair Work Building and Construction.

Tax reforms in Australia have been a mixed bag. In the mid-1980s, the Hawke government introduced the capital gains tax and fringe benefits tax, as well as the Dividend Imputation Scheme and Foreign Tax Credit Scheme. They then reduced the corporate tax rate from 49 percent to 39 percent in the late-1980s. The Keating government reduced this rate further from 39 percent to 33 percent in the early-1990s. The Howard government reduced this rate further still from 33 percent to 30 percent in the early-2000s. They also introduced the goods and services tax (GST) in 2000 that replaced a variety of State and Federal taxes as well as Federal financial assistance grants to the States. The GST is a value-added tax of 10 percent on most goods and services sold or consumed in Australia. It is collected by the Federal government and remitted to the States as general revenue assistance subject to Horizontal Fiscal Equalization (HFE). One key problem with GST and HFE is that it incentivizes smaller and poorer States to not reduce their state-based tax burdens and government expenditures.

Government welfare payments in Australia include: allowances for carers, parents, students, the unemployed, widows and youth; supplements for carers, disabled, families, the poor and seniors; and pensions for carers, disabled, seniors and their wives, and veterans and their wives. There are income and asset tests for most of these payments. As a proportion of tax revenue, transfer expenditure declined from around 35 percent in the early-1980s to 25 percent in the late-1980s. After rising to approximately 40 percent in the early-1990s, it decreased to almost 25 percent in mid-2000s before rising again to nearly 40 percent in the late-2000s and 35 percent in 2010s. The economic reforms mentioned so far contributed to the first welfare payments fall and to a lesser extent the second. Pensions and competition reforms also contributed to the second fall, while the lack of reforms contributed to the rise since. The key pensions related reform was the superannuation guarantee introduced in 1992. It is a compulsory employer contribution to an employee’s superannuation account. Currently the contribution rate is set at 9.5 percent of employee earnings, and will gradually increase to 12 percent by 2025. It was designed to: increase individual lifetime savings so that each generation would make a greater contribution to its own retirement income; and provide a supplement that would improve post-retirement living standards above what can be afforded by the age pension.

I was one of the leaders involved in promoting, guiding and implementing Australia’s National Competition Policy (NCP) in the mid-1990s to mid-2000s. The National Competition Council still maintains a website devoted to NCP. The NCP reforms in summary were: formalizing prices oversight for government monopoly businesses; providing competitive neutrality for non-monopoly government businesses; separating the non-monopoly from the monopoly parts of large government businesses; removing anti-competitive legislation and regulation; creating a third party access regime for large monopoly infrastructure; and extending anti-trust laws to all government businesses. NCP also brought cost benefit analysis to the forefront; incentivized state and local governments to implement NCP through annual performance payments; and focused on the economically significant industries of electricity, gas, ports, public transport, rail, telecommunications, water and sewerage. The PC has undertaken three major assessments of the economic impacts of NCP (in 1995, 1999 and 2005) and concluded that NCP: (from 1995) could generate a net benefit equivalent to 5.5 percent of GDP; seeing in 1999 a boost in the level of GDP of 2.5 percent; and by 2005 did increase GDP by at least 2.5 percent above levels that would otherwise have prevailed. See figure 2

Since the economic reform heydays of the mid-1980s to mid-2000s, Australia has stalled in the areas of trade, finance, tax and pensions plus has regressed in the areas of labor and competition. The poster child for the latter is electricity. Climate and other environmental regulations and subsidies have artificially favored uncompetitive wind and solar power over competitive coal, gas, hydro and nuclear power. The impacts over the past 10 years on the price, quantity and quality of electricity in Australia are clearly and massively negative [see chart]. Australia went from best on the planet to worst, in a relatively short period of time. And this was entirely of its own making, through bad economic policies at federal, state and local levels. But there is cause for hope. A large and increasing number of Aussies are waking up, speaking out and even voting for serious change … as evidenced in part by the recent and meteoric rise of the three alternative right-wing parties of the Australian Conservatives, Liberal Democrats and One Nation.

Buy, sell or hold?

So, what does this all mean for investing Down Under? Given all of the positive economic reforms from the mid-1980s to mid-2000s, Australia was clearly a “buy.” This was epitomized by National Competition Policy (NCP) reforms. On the contrary, from the mid-2000s to the mid-2010s, Australia was predominantly a “sell.” This was due to the stalling of positive economic reforms, as supplemented by too many negative ones. The Renewable Energy Target (RET) best exemplifies the latter. Signs at home and abroad, such as the rise of right-wing parties and the passing of the Trump tax cuts, suggest Australia is now a “hold.” This is because these will put strong pressure on the two major parties in Australia, i.e. the Liberal-Nationals and Labor, to not only put the brakes on negative policies like RET but to revisit positive ones like NCP … and thus get back on track to Advance Australia Fair.


Lessons from winners and losers

The good news for 2018 is that world economic growth is accelerating after a decade of sluggishness. And history shows that any country can grow rapidly and achieve a high-income level, if it follows the correct set of policies.

Sixty years ago, Singapore, New Zealand, Estonia, Ireland, Finland, Bulgaria, Panama, and Honduras were considered relatively poor countries. Now, the first five are rich countries, Bulgaria and Panama are middle-income countries, and Honduras remains poor. The accompanying table shows the per-capita income of selected small countries along with their rank on the Index of Economic Freedom. These countries, with the exception of Honduras and particularly Venezuela (with the world’s largest oil reserves), lack much in the way of natural resources. Some have warm climates, and some have cold, especially Finland.

For measure of relative economic well-being I have used the conventional IMF numbers as a measure of per-capita income on the basis of a purchasing power parity (PPP), and rounded off to the nearest thousand dollars. There are many flaws in such a measure but it does a reasonable job in showing relative well-being.

The standout country for economic progress is Singapore, whose current per-capita income is now roughly twenty times what it was in 1960, and a good deal higher than the U.S. More than any other country, Singapore has employed the classic limited-government model, wherein government spending only accounts for 17 percent of GDP. In contrast, total government spending in the U.S. net of intergovernmental transfer payments is about 37 percent of GDP. Singapore has little government corruption and a competent and honest judiciary. It has a very high degree of economic freedom, including free trade. It has a stable government (despite many ethnic and religious differences among its people), and property rights are well secured.

The lesson from Singapore is that economic freedom works, and that a country does not need a large government to ensure that its citizens are well cared for, including health needs (it has the 3rd highest life expectancy in the world at 83.1).

Switzerland has long been the poster child for good governance, economic prudence, and stability. Despite three major official languages and religious differences, there is little conflict, in part, because most governance occurs at the local level. The Swiss have little corruption, a very sound judicial system, with very strong protection for property rights. They have effective measures to control the size and growth of government. All of these have resulted in Switzerland being a magnet for money, and the country is regarded for good reason as the ultimate safe-haven.

Switzerland is an improbable success. It is landlocked with at times very unruly neighbors – yet for two centuries it has overcome these obstacles to provide its citizens with one of the world’s highest standards of living and a very civil and attractive society. Countries that are struggling to find their way could do no better than adopt the Swiss political and economic model.

The lesson from Switzerland is that with the construction of proper institutions and polices, language and religious differences, and lack of natural resources are impediments that can be overcome to provide a very high standard of living for the populace.

Little Estonia has also been an improbable success. Like all of the other countries in the late Soviet Union, it was poor and corrupt. When it obtained its freedom in 1992, it, more than any other former communist country, embraced the free market. As its reformist Prime Minister Mart Laar said at the time, the “only economics book I ever read was Milton Friedman’s “Free to Choose.” It sounded good, so we went ahead and did it.” One of Laar’s greatest innovations was the creation of “e-government,” which is the short hand for doing as many government functions over the Internet and electronically as possible. The system was designed to both reduce the cost of government and eliminate much of the potential for corruption, by reducing face-to-face contacts with government employees and having a full electronic record of all interactions with government. The Estonians have been so successful with this model, they now have a number of firms which are selling e-government products and technologies to governments around the world.

The Estonian lesson is that new technology properly utilized can go a long way in destroying corruption, and moving rapidly to free markets from statism provides better results than a more gradual approach.

Finland is a quiet success, like its people. Finland claims to be the safest country in the world with the least organized crime and the most personal freedom. Finnish banks have been ranked as the soundest in the world. Finland ranks in the top three when it comes to the protection of property and the rule of law. It also has the lowest risk to natural disasters in the world – if you don’t count bitterly cold winters. The OECD ranked the Finnish education system as the best in the world with highest level of literacy. The country ranks near the top in innovation, research and development, and digital knowledge on a per capita basis. It has the lowest infant mortality rate in the world. And its capital, Helsinki, has been ranked as the most honest city in the world.

Finland is also an oddity in that it is successful even though it has a very high level of government spending (55 percent); but unlike almost any other place on the planet, the people actually get a lot for their money. It is also arguably the most homogenous country in the world, and before Finland entered the EU, it was not open to immigration. Most Finns are descended from a small tribe of people who lived in a harsh climate for thousands of years where they were mutually dependent for survival, and had relatively few interactions with the outside world. The close bond and high trust among Finns even today may well explain why their government works so well. Their unique history does not serve as a path for other countries. In fact, a good case can be made if their government was smaller, their real incomes would be higher, particularly given all of the Finns other constructive attributes.

The lesson from Finland is that a high-trust society with exceptional honesty makes everything work better. Unfortunately, these qualities are very difficult to transplant to other societies.

Bulgaria is in many ways the opposite of Finland – a low-trust society with poorly developed civil institutions. But it is neither a great success nor a big failure. At the end of the communist era in 1990, Bulgaria was poor, and it took a number of years, unlike Estonia, to institute many of the necessary reforms. It is now a thriving democratic free-market state, but is plagued with lingering corruption in the courts and government, which has undermined economic growth. Bulgaria has a stable currency fixed to the euro, relatively little debt, and a flat ten-percent income tax on both individuals and corporations.

The main lesson from Bulgaria is that relatively good monetary and fiscal policy cannot fully offset corruption and repeated failures in the rule of law.

As the old adage goes, “no one is totally useless, they can always serve as a bad example.” It is equally true of countries. Greece is the bad example when it comes to fiscal mismanagement. The question is often asked, how much debt can a country manage as a percentage of GDP before it is sucked into a downward spiral. For decades, the Greeks lived beyond their means by borrowing more and more from their EU neighbors, but finally the bill came due. Greece has gone through a succession of bailouts, but the situation continues to get worse. The politicians failed to cut spending as much as would be necessary to stabilize the situation. Instead, they keep increasing taxes in an attempt to get back to balance, but it only makes the situation worse. The tax increases cause the economy to shrink at a faster rate than the higher rates can produce revenue (they are on the wrong side of the Laffer curve). The Financial Times reports: “Unemployment is at 23 percent, and 44 percent of those aged 15 to 24 are out of work.” Greece was a developed European country but is rapidly becoming a less developed country as it continues to consume capital rather than invest it. The government has increasingly resorted to seizing property of those who are in tax arrears. It has now reached the point where more than half the taxpayers are behind in their payments. Those who still have some wealth are fleeing the country, further eroding the tax base. Economic output is now lower than it was in 2005. At some point, the legal economy will collapse and the only goods and services that will be provided will be by the black economy. This situation occurred in Eastern Europe and the Soviet Union at the end of the 1980s and early 1990s. The people suffered greatly until a new market economy was established with fiscally responsible governments.

The Greek lesson is that government debt does matter, and once the debt becomes more than the populace is willing to service, a downward spiral becomes self-fulfilling until painful collapse and hopefully ultimately renewal.

Honduras is a country that should be rich. It has both Caribbean and Pacific ports, which could, if developed, service both Asia and the Americas. The highlands have a pleasant climate, and the country has many natural attractions. But Honduras has never had a core of far sighted leaders to create an economic and social renaissance. The country suffers from a high degree of lawlessness and corruption, and property rights are not secure. One can only imagine what the country could look like if the Swiss had been in charge for the last half century. As an optimist, I expect sooner or later some of the ruling elite will decide to make the necessary changes to make Honduras prosper.

The lesson from Honduras is without strong and visionary leadership like Singapore with Lee Kuan Yew, little progress will be made if the country is poor.

Venezuela is the best current example of what not to do. For many years, it was democratic and the most prosperous country in South America. However, all too much of the prosperity was based on oil exports. The government increasingly spent much of the oil revenue to feed friends of the government leaders as a way of buying political support, and engaged in a variety of socialist experiments. The dependence on oil revenue had the side effect of not developing a broad economic base which could have been a cushion during periods of low oil prices. As socialist and other irresponsible governments often do, when the revenue bowl runs dry, the Venezuelans started printing money, leading to very high rates of inflation.

A long-time observer of Venezuela and international monetary expert, economist Steve Hanke, recently wrote in Forbes: “Venezuela has had a long history of producing junk. Venezuela began central banking in 1939, when the Banco Central Venezuela was established. Back then, the exchange rate was 3.35 old bolivars per U.S. dollar. Today, it takes 103,000 to fetch a greenback. That’s equal to 103,000,000 old bolivars.” The government now has a new scheme to issue commodity-backed currency, but would anyone trust the corrupt and incompetent government to honor a currency redemption pledge, when it has reneged many of its other pledges?

The lesson from Venezuela is that no matter how rich a country is in natural resources, socialists and the corrupt can drive it into poverty.

There are many reasons for optimism as the new year unfolds. In most countries, real incomes are rising as a result of more market friendly policies. The danger is the know-nothings and the historically ignorant will continue to push for socialist and other statist policies which always end the same way – more misery.

Corporate taxation in Europe – feeding Leviathan

Since the Treaty of Rome, the scope and intensity of EU policymaking has steadily increased. The shift of power is unidirectional and exhibits two characteristic features. First, failure of EU interventions did never shake the general faith in delegating further competencies to the EU. Second, the self-interest of the European bureaucracy in expanding its discretionary powers was a main driving force of the centralization. Today the EU possesses vast supranational powers and the principle of subsidiarity, which was a fundamental pillar for the original idea of a Europe to be “united in diversity,” has been continuously diluted. Despite the extension of powers, however, the direct fiscal role (budget) of the EU has only grown comparatively slow and so far remains limited. When listening to Jean-Claude Juncker (Sept. 13) and Emmanuel Macron (Sept. 26) outlining their visions for the future of Europe, however, there can be no doubt that with the envisioned further centralization, the fiscal rule of the EU will greatly increase – including, sooner or later, giving the EU the power over corporate taxation.

Being aware of these general developments is crucial for grasping the implications as well as assessing the likelihood for one of the pet-projects of EU-centralists to be enacted, the Common Consolidated Corporate Tax Base (CCCTB). When I started writing for Cayman Financial Review about three years ago, I focused on highlighting the negative implications of the CCCTB – outlining that its adoption would be equivalent to the death knell of tax competition in Europe. I specifically outlined why formulary apportionment type of profit allocation, which is the defining feature of the CCCTB, is based on nothing but a political decision about a “fair” distribution of profits among EU member states. Attempting to defend the arm’s length approach to transfer pricing, which is based on replicating (simulating) market process to distribute profits among related companies, I explained that CCCTB, which completely disregards the value creating processes within multinational companies (i.e., neglecting the value contributed by intangibles), is conceptually ill-suited to ensure that the place of value creation coincides with the place of taxing respective profits (at least when adhering to more “conventional” notions about value-added).

A rather arrogant response to my previous article from one of the kingpins among the advocates of the CCCTB, has motivated me to complement my earlier writings with an updated analysis of the political state-of-play regarding the CCCTB. In his valiant effort to mock my earlier warnings against the CCCTB, this self-proclaimed father of the CCCTB wrote: “If Herr Treidler and the Cayman Financial Review were the only obstacles to progress I think we’d be over the finishing line on this campaign very soon. As it is, I think things will take a little longer than he predicts. But he’s got one thing right in his article: public CBCR and the CCCTB are going to happen. Of that I am sure.”

I was tempted to thank him for confirming that my analysis, and warning, is pretty much on target. As we agree that CCCTB is indeed likely to be adopted, I want to focus today on reviewing the recent statements of Mr. Juncker and Mr. Macron which illustrate just how close to the finishing line we really are.

Let’s start with some on the comments made by Mr. Juncker in his state of the Union Address which sum-up the centralists agenda: “Our 27 leaders, the Parliament and the Commission are putting the Europe back in our Union. And together we are putting the Union back in our Union.”

One can readily see what the Eurocrats have learned from Brexit. Nothing. The unidirectional extension of powers certainly featured prominently among the reasons for the Brexit. There is no trace in Juncker’s statement, however, to suggests even the slightest deliberation about a more flexible architecture for Europe – strongly suggesting that the five “scenarios for Europe” presented in a White Paper in March were nothing but elaborate window-dressing. There can be no mistake, Juncker is all about the United States of Europe. A demand that was loudly echoed by Martin Schulz, the poster boy Eurocrat and runner-up in the German elections, in mid-December. In view of the imminent coalition talks between the social democrats and the conservatives this casts can be interpreted as a first stab at nudging Germany foreign policy into alignment with France (see below).

Focusing on taxation, Juncker specifies his centralist agenda: “I am also strongly in favor of moving to qualified majority voting for decisions on the common consolidated corporate tax base, on VAT, on fair taxes for the digital industry and on the financial transaction tax.”

Of course, “qualified majority voting” would virtually ensure adoption of the CCCTB. With the U.K. being a non-factor, only the Netherlands, Ireland, Luxembourg, Malta and Cyprus (all of which are treated like “tax-outcasts” for their policies already, especially by Competition Commissioner Margrethe Vestager) seem likely to cast a no-vote. In other words, it is pretty much a certainty that the required 55 percent of EU countries or at least 65 percent of the total EU population vote in favor of the CCCTB. The German Ministry of Finance, realizing that Germany, being export oriented and having local companies with plenty of intangibles, would be surrendering a great chunk of tax revenues to other member states when adopting formulary apportionment, was also not completely hooked on the CCCTB. With the German government being in limbo and Mr. Schulz putting the United States of Europe on the agenda, it is difficult to guess what stance Germany would eventually take in a respective vote. Ultimately, it would not matter under qualified majority voting – which is the lesson to be learned here.

To add some punch to the structural reforms and to pave the way for a more pronounced and discretionary fiscal role of the EU, Juncker continues by proposing: “We need a European Minister of Economy and Finance: a European Minister that promotes and supports structural reforms in our Member States. […]. The new Minister should coordinate all EU financial instruments that can be deployed if a Member State is in a recession or hit by a fundamental crisis […] assume[ing] the role of Economy and Finance Minister. He or she should also preside the Eurogroup […] We do not need a budget for the Euro area but a strong Euro area budget line within the EU budget.”

It does not require too much imagination to assume that a European Minister of Economy and Finance would also wield substantial influence over the realm of taxation, most likely determining the specific features of the CCCTB. How far respective powers are likely to extend can be seen from the speech of Mr. Macron. In his “initiative for Europe”, Macron indeed left little to imagination when he clarified that a “fair tax” is high on his agenda: “France, with its partners, has begun supporting an initiative [aimed at] the taxation of value created, where it is produced, which will allow us to overhaul our tax systems and to stringently tax companies which relocate outside of Europe for the specific purpose of avoiding tax. […] there are common goods to be financed and that all economic actors must play their part […] It is therefore fair and legitimate that when they make profits elsewhere, they contribute to this solidarity where they create value.”

In respect to the CCCTB and the timetable, he is vision is even more explicit: “Efforts are already under way, but we must work faster to harmonize the tax base. And France and Germany should be able to finalize plans within the next four years. We have the opportunity of a clear mandate – let’s move forward with this […] we cannot have such disparate corporation tax rates in the European Union. This tax divergence fuels discord, destroys our own models and weakens all of Europe […] This is why I would like to see a binding rate range that member states must commit to […] I commend the European Commission’s recent initiatives in this regard and, through the efforts of Margrethe Vestager and Pierre Moscovici, its push for certain players and countries to make changes.”

So, the French president is not only committed to implementing the CCCTB, but would like to shift the power to determine tax rates towards the EU – i.e. to new European Minister of Economy proposed by Juncker. Naturally, Macron also does not fail to call for expanding the fiscal role of the EU: “… We need a stronger budget within Europe …. This budget’s resources must reflect its ambition. European taxes in the digital or environmental fields could thus form a genuine European resource to fund common expenditure. And beyond that, we must discuss partly allocating at least one tax to this budget, such as corporation tax once it has been harmonized.”

Note that Macron uses “once” (it has been harmonized), not “if.” Thus, it is fair to conclude that we are indeed close to the finishing line. Centralization and higher taxes go hand-in-hand, with the CCCTB being a convenient vehicle for the EU centralists to fund their ambitious agenda. Once, the power to levy corporate taxes is shifted to the EU, there can be no doubt that tax rates will also exhibit a unidirectional development. Indeed, the EU is already busy to indoctrinate children with the corresponding mind-set. In a truly dystopic educational computer game called “Taxlandia,” the EU asks the kids to “save” a virtual economy from collapse (naturally caused by “low tax rates”). After completing a brief tutorial, the kids are cheerily instructed as follows: “You can start the game by increasing the tax level.”

As it is notoriously difficult to anticipate the timeline for policy proposals in the EU, I have thus far refrained from making a prediction as to when CCCTB may happen. Considering that adoption of the CCCTB will mostly likely follow a further shift towards centralization of powers, a timeframe between four to ten years appears to be a good guess. Granted, the “United States of Europe” (in whatever constellation) will not emerge overnight. In case the proposals of Macron and Juncker gain further momentum, however, the CCCTB will likely be regarded as “low-hanging fruit”; i.e., the adoption does certainly not require too much further centralization. The main reason for the adoption of the CCCTB being virtually automatic in case of further centralization, is that the arm’s length principle together with tax competition in general are defenseless within the EU.

Attending the 5th Symposium of International Taxation, hosted by the German Ministry of Finance in Berlin in the beginning of December, I witnessed a rather symbolic scene. In the closing minutes of the expert panel, a representative of the ministry asked the panelists for their advice on a sensible policy stance on the taxation of intangible property. One renowned German transfer pricing consultant (Reimar Pinkernell) rose to the occasion to give some visionary closing remarks and straight-faced and without any apparent reservations advocated the adoption of the CCCTB. Most of the other panelists as well as the audience (roughly 90 percent business men and woman) nodded along dutifully. If one would have casted a vote, I fear, the CCCTB would have won by a landslide. Why should the ministry of finance hesitate to adopt the CCCTB and agree to the mandatory rates demanded by the Eurocrats? The business community as well as the leading academics keep signaling their approval. Four to ten years it is.

Book Review: Flat tax in Bulgaria: History, introduction, results

Institute for Market Economics1

Estonia became the first European country to introduce a flat tax on income when it collapsed a progressive rate structure for personal income with a top marginal rate of 33 percent to a flat (proportional) rate of 26 percent in 1994. At the same time, it reduced its single (i.e. flat) rate on corporate income of 36 percent to the same 26 percent rate as on personal income. Over the following years these rates were gradually reduced until they now stand at 20 percent across the board. To this day Estonia is rated as the most competitive tax system in the OECD by the Washington DC based Tax Foundation.

Estonia’s Baltic neighbors, Latvia and Lithuania quickly followed suit and all three (especially Lithuania) quickly became the fastest growing economies in Europe, growing at more than double the rate of, for example, Germany.

In 2001, Russia switched from a system of 12, 20 and 30 percent tax rates on personal income to a 13 percent flat income tax and lowered its single corporate tax rate from 35 percent to 24 percent and enjoyed rapid economic growth in the years there after. Adjusted for inflation, revenue from Russia’s personal income tax increased by 26 percent2 in the year after a flat tax was implemented, and by nearly one-fifth as a percentage of GDP
Over the next two decades 20 European and Former Soviet Republics had adopted flat taxes of one form or another. Where did such radical ideas come from? Mart Laar, who served as the Estonian prime minister from 1992 to 1994 and 1999 to 2002 saw Estonias’s emergence from communism as an opportunity to reform. Looking to Lescek Balcerowicz, the designer of the Polish economic reformation, Laar noted that a radical economic program, launched as quickly as possible, had a better chance of success than several prolonged measures. As Deena Greenberg writes in “The Flat Tax: An Examination of the Baltic States”3: “In the early years of Estonia’s transition, there were a number of sources that helped shape Laar’s and the early government’s thinking about reforms. Think tanks from abroad, such as the Heritage Foundation, the International Republican Institute, and the Adam Smith Institute in addition to the newly formed local Estonian think tanks, served as one influencing.” (p. 27)

“With regard to the flat tax specifically, Laar looked to Milton Friedman, who proposed a proportional income tax when creating its tax reform.” (p. 29)

Cayman Financial Review editorial board member Daniel Mitchell has long promoted and written about flat taxes. In the case of Russia, Putin’s economic advisor, Andrei Illarionov met Alvin Rabushka in 1997 who discussed the rationale for flat taxes contained in his book on the subject with Robert Hall. In the spring of 2000, together with German Gref, then Russia’s Minister of Economy, Illarionov convinced Russian President Vladimir Putin to adopted a flat tax. Flat tax systems were clearly not the only factors contributing to rapid economic growth in this period. The Baltic countries, again led by Estonia, had adopted currency board rules for their central banks in which the central bank’s passively supply all of the currency the market was willing to pay for at a fixed price for the German mark. This rapidly ended high inflation rates providing a stable foundation for growth. In addition, many other market-friendly reforms were undertaken.

Not only did flat tax countries grow more rapidly, but they raised more tax revenue as well. As explained more fully below, this was primarily because lower, simpler, proportional taxes drew large numbers of people from the informal to the formal, tax paying, sectors. Flat (i.e. proportional) tax systems win the prize for the best tax systems in the category of minimizing distortions in the allocation of society’s productive resources and thus promoting economic growth; similarly for simplicity and enforceability.

The case for fairness is more controversial. Is it fair for a person with twice the income to pay twice the tax, as would be the case with a flat or proportional tax rate? If fairness calls for someone with twice the income to pay more than double the tax, how much more?
Flat taxes come in a variety of flavors. Some have relatively high non-taxable minimum incomes and some have none at all with no deductions for investments (e.g. education) or other costs of generating income or for favored (tax subsidized) activities (e.g. charitable giving). Each of these impacts attitudes toward fairness while generally undermining tax neutrality.

A 2006 IMF study of flat taxes noted that: “Reforms that involve an increase in the basic tax-free amount are beneficial to both the lowest and the highest earners, and compliance effects may in themselves plausibly lead to an increase in effective progressivity. There is thus no general presumption that movement to a flat tax in itself is associated with a reduction in progressivity, though the commonly used summary indices of progressivity—which, in the few studies of this issue, show an increase in progressivity—may overstate the point.”4

The Economist magazine noted that: “Under systems such as America’s, or those operating in most of western Europe, the incentives for the rich to avoid tax (legally or otherwise) are enormous; and the opportunities to do so, which arise from the very complexity of the codes, are commensurately large. So it is unsurprising to discover, as experience suggests, that the rich usually pay about as much tax under a flat-tax regime as they do under an orthodox code.

“Estimates for the United States, whose tax regime, despite the best efforts of Congress, is by no means the world’s most burdensome, put the costs of compliance, administration and enforcement between 10% and 20% of revenue collected.”5

Compared with most other former Soviet and Eastern European countries Bulgaria was slow to reform, wasting a decade. It adopted its flat tax regime (10 percent on personal and corporate income) in 2007 (implementing it in 2008) one decade after its adoption of currency board rules following the financial/inflation crisis of 1996. The decade following the adoption of currency board rules and preceding the adoption of a flat tax saw strong growth (well above Germany’s).

The Institute for Market Economics (IME) played an important role in bringing the flat tax idea and debate to Bulgaria over a decade before its adoption. It is thus welcomed that IME should publish a collection of studies of Bulgaria’s experience with its flat taxes and the history leading up to their adoption. They address the questions of how did Bulgarians come to support flat taxes, and the income and tax revenue results? The IME publication also addresses the issue of fairness. The studies find that Bulgaria’s adoption of a flat tax was strongly influenced by its wide spread adoption by other European countries, that its very low rates were strongly influence by competition for foreign investments and the low tax rates in the region, that tax revenue increased significantly under the flat tax regime because of a significant increase in compliance (the move of activity from the informal to the formal sector), and that it contributed along with other market reforms to more rapid economic growth. They also find that levying the same tax rate on all income fit Bulgarian’s notion of fairness. This extended to the elimination of the untaxable minimum income, i.e. all income, however large or small is taxed at the same rate.

Some authors were more informative than others. Georgi Sarakostov’s first person singular speculations on tax policy, do not fit well, Petar Ganev’s discussion of the impact of flat income taxes on labor is hard to follow, and Georgi Stoev’s discussion of the fairness of flat tax presents a fallacious calculation. Georgi Ganev’s discussion of fairness is much richer and more convincing.

Krasen Stanchev discussed the impact on growth and efficiency: “In 2006 real GDP per capita was 4,500 euro; in 2014 it was 5,500 euro. The total GDP at the beginning of the period was 22 billion euro and in 2014 it was 42 billion euro. In purchasing power parity terms, Bulgaria’s GDP compared to the average EU level was 38 percent in 2006 and 47 percent in 2014, probably 49 percent in 2015… Unemployment in 2006 was 9 percent, in 2008 it reached its lowest level for the last 20 years, 5.6 percent.” (page 12)

“Since 2006 the efficiency of the Bulgarian tax administration in tax collection has improved four times. It is measured using the ratio of the expenses on the collection of tax revenue to the revenue itself. This indicator ranks Bulgaria before Australia, Belgium, Canada, the Czech Republic, France, Germany, Hungary, Ireland, Japan, Luxembourg, the Netherlands, Poland (two times better) Portugal, Slovakia and Slovenia.” (page 14)

Georgi Sarakostov flagged tax competition: “It is my belief that the decisive role for that change was played by the developing tax competition between countries in combination with the persuasiveness and persistence of economists who had been calling for the introduction of a flat rate since 2003.” (page 15)

Georgi Angelov reviewed the reforms and resulting increase in tax revenue: “In 1993 income tax followed a scale with nine different rates – between 20 and 52 percent (accompanied by high social security tax). Company profits were taxed at almost 40 percent, plus additional payments to the municipalities which reached 10 percent.” (page 22)

“The grey economy in the 90s increased dramatically to reach between 35 and 40 percent according to different estimates, mostly due to the failure in tax payment and social security contributions (including mass scale failure to issue receipts and invoices, employment without contracts, ubiquitous cash payments, taking advantage of ‘loopholes’ and exceptions in tax legislation).

“Increased tax collection could not be achieved without lowering the rates and simplifying the tax system, including limiting the “loopholes” in tax laws. What is more, encouragement of the private sector and attraction of investment also required reforms and lowering the rates for direct taxes as many other countries offered much better tax conditions.” (page 23)

Kaloyan Staikov reviewed experience with corporate tax reforms: “A variety of studies show that corporate tax most seriously harms economic growth, followed by personal income tax, consumption tax and property tax…. An IMF study of 170 episodes of fiscal consolidation in 15 developed countries in the last 30 years: lowering public spending is considerably less harmful for short-term economic growth compared with raising taxes.” (page 32)

“In 1999 corporate tax was 34.3 percent while revenue from that tax was 10 percent of tax revenue and 3 percent of GDP. In 2008 the corporate tax rate was already 10 percent and the revenue collected was 9.3 percent of all tax revenue and 2.8 percent of GDP…. At the same time, the real growth of the economy was over 6 percent annually.” (page 33)

“[E]valuation by the Ministry of Finance of the positive effects from the tax policies carried out between 2003 and 2008, even though that was a period of economic crisis followed by a political one. Lowered rates for corporate tax and lowered expenses on tax compliance created positive incentives for investment, fixed capital accumulation and thus – raised productivity, economic growth and wealth in the country. The lowered rates led to no loss in tax revenue.” (page 36)

Desislava Nikolova examined the results of the proportional tax rate on personal income on the revenue raised: “The reasons for this positive impact of flat income tax on the budget can be found mostly in the shrinking of the grey economy, more specifically, in the smaller number of informal employment relationships.” (page 42)

Georgi Ganev concludes the book with what I found to be the most interesting chapter. He explores how Bulgarians came to accept the low flat rate as the fairest. “By 2005 it had already become clear that a personal income tax with an untaxable minimum at the bottom and, further up with a progressive scale of marginal rates: 10, 20, 22, and 24 percent of income over the respective thresholds was practically and experientially indistinguishable from a flat rate with an untaxable minimum and a rate of 23.5 percent. […] By 2007 it was already obvious that flat tax was spreading all over the world. Only among the countries Bulgarians are in the habit of comparing themselves to, after the pioneers from the Baltics, in the years just before the tax was formally proposed in Bulgaria, it was adopted in Russia, Romania, Slovakia, Ukraine, Serbia, Macedonia, Georgia… the feeling that an established international trend was followed also contributed to the idea’s theoretical acceptance.

“The main objection to lowering the rates [to 10 percent] has always been that it will lead to a considerable drop in revenue and thus to a lower capability of modern Bulgaria to be a welfare state. But one decade of rates going down – in the case of the highest personal income tax rate from over 40 percent to 24 percent and in the case of corporate tax from 40 percent to 10 percent, showed no drop or a minimal drop in revenue at most. What is more, in the very year of the debates on flat tax the corporate tax lowered to 10 percent was registering a considerable increase in collection.” (pages 59-60)

“Unlike truly progressive taxes, which, due to the relentless logic of the political process include complex and numerous exceptions, conditions, and possibilities left to the tax collectors’ discretion, flat tax is simple, clear and without exceptions. In combination with the low rate, its simplicity considerably reduces both the opportunities and the stimuli for evasion. Whatever gray economic activity there is in Bulgaria, it has long stopped being caused by attempts to save tax on behalf of individuals.” (page 61) Bulgaria adopted its 10 percent flat personal and corporate income taxes because strong intellectual cases had been made for it and many neighbors had do so with good outcomes, and because of tax competition. Bulgaria’s experience with the resulting tax revenue and economic growth were even better than their high expectations. The mystery is why such successes have stopped spreading.


  1. The book can be downloaded at:
  3. Deena Greenberg, “The Flat Tax: An Examination of the Baltic States” 3/2009, pages 20-21
  5. April 14, 2005

Will proposed tax changes make the Netherlands a less attractive tax haven?

On Oct. 17, 2017 our article for the Cayman Financial Review on the use of the Netherlands as a tax haven was published. Among the topics covered were the benefits of the tax treaties of the Netherlands on the dividend withholding tax and the absence of a withholding tax on royalties and interests. In the same month, however, the new coalition government announced substantial changes in the Dutch tax code, most importantly the planned “abolition” of the dividend withholding tax and the introduction of a withholding tax on royalties and interest.

Because the new coalition government has a majority, albeit of just one seat, in both houses of parliament, the plan to do away with the tax is almost certain to become law, unless lawmakers from the ruling parties reconsider it. The first changes are not to be implemented before 2019 (likely 2020) and many details remain unknown. Since the “abolition” of the dividend withholding tax has led to a storm of reactions, we decided to discuss arguments for and against the proposed changes.

Current situation

Under current law there is no withholding tax on royalties and interest at all. There is a dividend withholding tax of 15 percent.

Dutch tax payers receive a full tax credit for the dividend withholding tax levied and this results in a repayment if there is no income tax to credit it against. As such the dividend withholding tax is effectively zero for resident tax payers.

Dividends distributed to foreigners are also subject to dividend withholding tax. If an exemption like the EU parent subsidiary directive applies, this may lead to the administrative costs of filing a zero tax return. In case of a reduction, like under a tax treaty, the tax is levied but partially repaid. If there is no Dutch income the dividend withholding tax is in effect an actual tax. So, in practice the dividend withholding tax is borne almost exclusively by non-resident retail shareholders and non-resident institutional shareholders like pension funds.

These non-resident shareholders may not be able to claim a full refund or exemption of the Dutch dividend withholding tax or a full home country tax credit may not always be available.

The proposal is not to abolish the tax, but to no longer levy dividend withholding tax in most cases. The tax remains for distributions to low tax jurisdictions and in case of “abuse.” A total ending of the tax is expected to result in a tax savings of 1.4 billion euros ($1.6 billion) for foreign investors according to the new coalition government analysis of the budgetary impact of the measures.

The dividend withholding tax

The plan to abolish the dividend withholding tax has been circulating for decades around Dutch academia and tax professionals. However, since the tax burden is primarily borne by foreign shareholders, the idea has never been popular amongst politicians. During the latest national election, no party campaigned on it or even mentioned it in its platform. Only during the formation of the new coalition government it was suggested by Shell and the employers’ organization VNO/NCW. Therefore, it was completely unexpected that it ended up in the new coalition agreement. This October surprise led to a parliamentary debate where various arguments were discussed.

The new coalition government argues that the ending of the tax is necessary. The exit of the United Kingdom from the EU affects the competitive position of the Netherlands. The United Kingdom has no dividend withholding tax. Even though the U.K. is the only direct neighbor that offers this significant advantage, there are many more countries in Europe and even the EU that do not tax outgoing dividends either. The Prime Minister stated that the abolition is of crucial importance for the international position of the Netherlands and maintaining the investments in its economy.

Senior executives from two of the largest Dutch corporations – Shell and Unilever – agree, there is insufficient home-grown capital to fuel large companies, making them dependent on foreign shareholders who can fund their growth and investments. The corporate executives point to the lack of domestic capital as a key reason why the country’s 15 percent tax on dividend distributions is a major burden on resident multinational corporations.

Opponents say the government is giving in to pressure from corporations and the business lobby – an accusation denied by both the government and corporations. Furthermore, they claim there is no positive effect on the Dutch economy, based on statements of the Central Planning Bureau.

But what are the facts? A recent study of SOMO (Centre for Research on Multinational Enterprises, part of the Oxfam strategic alliance) of the ten largest companies listed at the Amsterdam Stock Exchange claims that most shareholders will gain no tax advantage from the abolition, as most of them receive either a refund or are exempted. Additionally, insofar the Netherlands do not tax outgoing dividends, this advantage is often taxed away in the recipient’s country. So there is a case to be made that in many instances there is no tax benefit for the investor. But this does not take into account that the process of withholding and claiming reductions, exemptions and credits gives rise to significant administrative burdens. It is estimated 80 percent of the tax is returned. Therefore, it is clear that there will be significant savings in administrative costs.

Will there be an effect on the economy? To claim there is no positive effect on the economy, based on statements of the Central Planning Bureau, is insincere. The Central Planning Bureau stated that since it has no studies that show either a positive or negative effect, it simply does not know. What is known to politicians, economists and anyone else with common sense is that if you increase the cost of something you get less of it, be it a tax on smoking or investments. Moreover, tax professionals indicate that large companies, especially U.S.-based companies, consider the dividend withholding tax to be an important factor when deciding where to locate their (European) headquarters. This point is illustrated by the fact that FiatChrysler and chemical giant LyondellBasell both moved to the U.K. because of the abolition of the dividend withholding tax in that country in 1999. So even though no one has a crystal ball to predict the future effects, a logical and empirical statement can be made regarding the effects on the economy.

Opponents of abolishing the dividend withholding tax point out there will be a loss of tax revenues which could have been used for infrastructure or education, which is also of value for investing companies. That there will be some net reduction in tax revenues is likely, but how much remains to be seen. We note the tax will not be abolished entirely, but it will still be levied in “abuse” situations and on dividend distributions to low tax jurisdictions. It is currently unclear what the relevant tax rate(s) will be, or when a jurisdiction will qualify as ‘’low tax,” or what situations will be regarded as abusive. It is especially the case in these situations that no tax treaty applied in the first place, so that the dividend withholding tax was effectively paid.

As for the tax revenue loss that may occur, even if it would be the total amount of 1.4 billion euros, it is doubtful that this amount (less than half of one percent of the total budget) would be used for meaningful incentives for international investors or even economic growth in general. None of the opponents take into account the increased tax revenue from economic growth, because they do not believe the abolition will have any positive effects. In other words, they make their predictions based on the static model, rather than the dynamic model.

Obviously, many tax payers have already found ways to avoid the current dividend withholding tax, as explained in our previous article, and it is unlikely that these tax payers will decide to start paying this new “anti-abuse” dividend withholding tax. Tax payers that decided to avoid tax where it pays to do so, will most likely find ways to do so in this future regime as well. Therefore, it remains to be seen how much tax revenue will be raised from this remnant of the dividend tax.

The interest and royalty withholding tax

As much attention as the “abolition” of the dividend withholding tax has garnered, so little attention the announced introduction of the royalty and interest withholding tax has received.

One reason is that still little is known. These new withholding taxes apparently would be introduced as of 2023. Details are expected earliest the first half of 2018.

The announced withholding tax demonstrates the intention to reduce the attractiveness of the Netherlands as a passive flow-through jurisdiction, while seeking to improve the country’s attractiveness for active business operations and headquarters by abolishing the dividend withholding tax. The coalition agreement’s budget assumes that no revenues will be raised through the new withholding tax, apparently because the new Dutch government expects that the relevant companies will either restructure or relocate these activities.

To the extent that these new taxes are hard to avoid for companies that do not relocate, they may very well lead to a loss in other tax revenues, because currently the government of the Netherlands collects a huge amount of revenues from the significant number of international holding companies, finance companies and royalty (conduit) companies and their staff, tax advisors, accountants, lawyers, notaries, trust companies and other service providers. Research by SEO (Foundation for Economic Research), paid for by an organization of major trust companies, shows that economic gains for the Netherlands are estimated at 3 billion euros. Therefore, it seems the measure’s purpose is simply to send a message to the world that the Netherlands is serious about fighting tax avoidance. In short: virtue signaling.

In the context of countering tax avoidance through the use of tax havens, the coalition agreement also proposes the introduction of a blacklist of non-cooperative jurisdictions.

It is striking that the arguments for abolishing the dividend withholding tax also apply to not introducing an interest and royalty withholding tax. It also reduces the effectiveness of earlier legislation to make the Netherlands more attractive for innovative companies.


Although details are not yet known, the planned abolition of the withholding tax on dividends looks promising for the use of the Netherlands in tax planning and will be an administrative relief for foreign and domestic investors alike. On the other hand, if the announced withholding tax on royalties and interests is implemented, it will be a deterrent for investment and will result in an increase in administrative burdens, even if they can be avoided with proper tax planning. The effects of these tax changes on the image of the Netherlands as a tax haven remains to be seen. If it helps to keep the Netherlands off the radar of zealous foreign tax inspectors, it would actually help to the keep the country attractive to tax avoiders. Now wouldn’t that be the ultimate irony?

Cram-up, take two: Efficient markets and forced-refinance interest rates


Yet another crucial distinction between New York and Delaware restructuring practice has emerged from the latest stage of the Momentive (MPM Silicones) case. The Second Circuit Court of Appeals in October 2017 dealt secured creditors both a surprising defeat and a potentially far-reaching victory, both in notable contrast to opposing positions taken in Delaware.

On the one hand, yield-maintenance, prepayment premiums triggered by automatic bankruptcy acceleration remain unenforceable in New York, as opposed to Delaware’s affirmation of such payments in the Energy Future Holdings case. This mild defeat for secured lenders can likely be avoided by simple redrafting of loan agreements and bond indentures, as noted a year ago in this column.

The potentially more significant victory lies in a departure from longstanding practice allowing debtors to refinance secured debt at rates largely divorced from market valuations. As noted in last year’s Q1 column, Momentive convinced the New York bankruptcy court to impose a restructuring plan on dissenting secured creditors, forcing them to accept full payment of their claims in the form of replacement bonds. These new bonds bore below-market interest rates artificially established by the court using a so-called “formula approach” developed by the U.S. Supreme Court, adding a 1 to 3 percent risk premium to a risk-free U.S. Treasury rate. This produced interest rates of about 100 basis points less than arms-length market rates available from and actually quoted by contemporaneous lenders, depriving the bondholders of between $150 to $200 million in future payments.

The bondholders won a mild but significant victory in challenging these depressed interest rates on appeal. Such a nonconsensual refinancing of secured debt is possible under the Bankruptcy Code only if the replacement bonds provide total payment equal to the full amount of the secured bond claims, valued “as of the effective date of the plan.” This statutory language is an inarticulate but intentional incorporation of the notion of present value; that is, payments to be made over time (via replacement bonds) have to be increased to account for the greater value of a payment in full immediately (as of the effective date of the plan). The generally agreed method of arriving at this present value is by identifying a discount rate (interest rate) that will reflect the time value of money, the risk of inflation, and the risk that the borrower in question might default before completing full payment.

The courts have long struggled with identifying the proper interest rate to reflect these factors, but also to avoid overcompensating secured bondholders at the expense of unsecured creditors and debtors’ reorganizations. US courts, including the Supreme Court, have clearly signaled their preference for market-based evidence of value and risk in the bankruptcy context, but they have also expressed concern that an otherwise healthy and efficient market might be skewed by the unique circumstances of a debtor forcibly refinancing defaulted obligations in bankruptcy.

So, for example, the U.S. Supreme Court in 2004 in a case called Till v. SCS Credit Corp dealt with a similar context involving reorganization of an individual’s affairs under chapter 13 of the Bankruptcy Code. Establishing the proper approach to “cram down” replacement financing of a subprime auto loan, the court concluded that the distressed debt market did not accurately reflect the desired rate for a forced-refinancing in bankruptcy because market rates included such factors as transaction costs and profits, which should be excluded from the establishment of a court-implemented and supervised refinancing. Instead, a divided court directed lower courts to begin with a risk-free rate, such as the prime rate (or similar maturity U.S. Treasury bills), and add a risk factor of 1 to 3 percent to account for the specific debtor’s risk of default. This ruling was confined to the individual reorganization context, but the court wondered aloud in a much-debated footnote whether in a Chapter 11 business reorganization case “it might make sense to ask what rate an efficient market would produce.”

While most lower courts after Till simply extrapolated the “prime+” formula to Chapter 11 reorganization cases, the Second Circuit in the Momentive case took up the Supreme Court’s suggestion and directed the Bankruptcy Court to explore “if an efficient market rate exists and, if so, apply that rate, instead of the formula rate.” The Momentive court noted with seeming approval the bondholders’ expert evidence “that, if credited, would have established a market rate.” Momentive had sought exit financing to pay off its bonds in full, and the rates quoted in this search exceeded the formula rate by about 100 basis points. The court acknowledged that this evidence did not lead to an undisputed conclusion of an efficient market rate, but by directing the lower courts to consider the possibility, the Second Circuit set the stage for a radical transformation of cram-down interest rate calculation in New York and a potentially substantial redistribution of value to secured bondholders, away from unsecured creditors and reorganizing estates.

The battle is far from over, and the victory may be Pyrrhic. Vast sums will now likely be spent on competing economics and finance experts offering theoretical argument about whether the market for Chapter 11 exit financing represents an “efficient market” and whether that market reflects the proper value (discount rate) for non-consensual refinancing of secured debt like that in Momentive. If free-market adherents win the day, debtors might be forced to pay substantially more to impose their refinancing plans on nonconsenting secured creditors.

On the other hand, if courts take the Supreme Court’s comments in Till seriously, the market rate for distressed debt may end up being simply a different starting point on a path to a similar destination. Even if, for example, the market quoted Momentive exit financing at higher rates, those rates very likely include factors that the Till court directed should be backed out, such as transaction costs and profit (though the bondholders’ expert predictably denied this, the bankruptcy judge seemed unconvinced), not to mention the skewed effects of a now-healthy debtor still bearing the stigma of its sojourn in bankruptcy. Add to this the lack of (positive) information the market could have absorbed about the reorganizing debtor, and it seems most likely that the “market” rate should be slightly reduced in light of such factors, just as the risk-free rate is increased to take into account actual risk in the Till formula approach. If the formula rate is generally calculated by increasing the risk-free rate by at least 100 basis points, it may well be that the unadjusted market rate should be reduced by at least that much, which is the spread under controversy in Momentive. Much ado about nothing?

Staying a step ahead: A new wealth structuring forum for Cayman


Demonstrating that the Cayman Islands is a well-regulated, innovative, and sophisticated international financial center is the responsibility of everyone who is engaged in the jurisdiction’s financial services industry. However, for organizations such as the Cayman Branch of the Society of Trusts and Estates Practitioners, it is equally important to ensure that these promotional endeavors are supported by further efforts to educate the public and promote high professional standards across the industry.

STEP Cayman has recently redoubled its efforts in this regard, not only to highlight the Cayman Islands as a leader in the wealth management industry but also to offer its own leadership in the form of industry forums where STEP members and the public alike can be informed about, and debate, developments and offerings in the jurisdiction. Having held the successful “STEP Cayman Forum,” hosted by representatives of STEP Cayman at the Institute of Directors in London in September 2017, STEP Cayman is now preparing for its inaugural international wealth structuring forum in the Cayman Islands on Jan. 29-30, 2018, at the Kimpton Seafire Hotel.

What is STEP?

STEP is a global network of professionals who specialize in family inheritance and succession planning, including the provision of advice related to trusts and estate matters. The primary purposes of STEP are to improve public understanding of the issues families face in relation to inheritance and succession planning and to promote education and high professional standards among STEP’s members. In 2017, STEP Cayman celebrated the twentieth anniversary of the opening of the Cayman Islands branch of STEP and its membership base is presently approximately 240, including lawyers, accountants and other trust and estate specialists.

Curating local content

As a key part of the global financial framework, the structures and solutions that the Cayman Islands provides to clients continue to evolve. The jurisdiction is enjoying a period of substantial and transformative investment in its infrastructure, and is increasingly able to provide greater substance for its clients and their advisors; a crucial factor for the future as the international BEPS initiatives are implemented. The ongoing push for international cooperation and cross-border transparency also requires a greater understanding of the ways in which different jurisdictions interact, and the fostering of stronger relationships between professionals engaged in the financial services industry worldwide.

In addition, as the jurisdiction grows and enhances its position in the global financial system, the professionals who work with the Cayman Islands must also be willing to embrace continuing professional development. STEP is one of the key cross-industry organizations that is in a unique position to do this, working with government and lawmakers, advisors and other professionals to seek better client and industry outcomes.

The STEP Cayman Conference

The STEP Cayman Conference is an international wealth structuring forum which will explore the topical issues pertinent to the trust industry with a special focus on wealth structuring. It has already attracted international experts as speakers, and confirmed attendance by delegates from a range of both onshore and offshore jurisdictions. Running for two days, the STEP Cayman Conference will be offering informative and insightful discussions on the latest local and global developments impacting the private client industry, including legislative updates, recent cases and guidance to professionals and practitioners. The content is expansive and delegates will have the opportunity to attend sessions concerning notable developments in trust litigation, data protection and private client confidentiality, holding unusual assets in trusts, and guidance as to succession planning in the light of advances in medical science and technology. The conference has also garnered significant local and international support, with businesses, firms and organizations such as Butterfield Trust, CIBC Bank and Trust Company (Cayman) Limited, Rawlinson & Hunter, and Harneys, and Sharp Partners P.A joining Appleby, Maples and Calder, and Ogier as key sponsors.

Promoting Cayman

Having created an enviable opportunity to promote the Cayman Islands as a leading offshore jurisdiction to both local and international attendees, STEP Cayman expects the local forum to be a well-attended and successful event and, looking to the future, a key component of the jurisdiction’s regular marketing efforts.

The Non-Profit Organisations Law, 2017

This year has been a busy year, not only for legislators, but also for trusts and private client practitioners. While a great deal has already been written about our Trusts Law (2017 Revision), the Confidential Information (Disclosure) Law and last, but by no means least, our new Foundation Companies Law, this year has also seen the introduction of the first charities legislation to have reached the statute books in the Cayman Islands.

Although the Attorney General has always had supervisory responsibility for the administration of charities here in the Cayman Islands and indeed, had and still has the right to enforce charitable trusts on behalf of charity, the Non-Profit Organisations Law 2017 (NPO Law) for the first time introduces a system by which certain NPOs should be registered.

Registration has been introduced with a view to easing oversight and regulation of NPOs, consistent with the Cayman Islands’ obligations in the fight against international crime and terrorism. This law came into effect on Aug. 1.

So, what exactly is an NPO for the purposes of the NPO Law? An NPO is defined as a company or body of persons, whether incorporated or unincorporated, or a trust:
(a) Established, or which identifies itself as established, primarily for the promotion of charitable, philanthropic, religious, cultural, educational, social or fraternal purposes, or other activities or programs for the public benefit or a section of the public within the Cayman Islands or elsewhere; and
(b) That solicits contributions from the public or a section of the public within the Cayman Islands or elsewhere.

This definition covers ordinary companies, exempted companies and foreign company branch offices registered under Part IX of the Companies Law (2016 Revision) if they are established for these purposes and solicit contributions from the public. It will also cover foundation companies, STAR trusts and charitable purpose trusts if similarly established and administered.

It is important to remember that the NPO Law does not simply relate to NPOs; it must also solicit contributions from the public or a section of the public for it to fall within the ambit of the new law. For wealthy philanthropists, therefore, who settle their own funds in a foundation company or on a STAR trust or charitable trust and fund their charity or philanthropy from either the capital or the income generated by its investment, the NPO Law will not apply.

All NPOs that were in operation on Aug. 1, 2017 are required to register within six months of that date, so the registration period is already well under way. Any NPOs that came into existence after that date will need to register within six months of establishment. An application for registration should be made in prescribed form by the controller of the NPO. A controller for these purposes includes:
(a) A trustee of a trust, where the NPO is established as a trust;
(b) A director of a company, where the NPO is established as a company;
(c) A general partner of a partnership, where the NPO is established as a partnership;
(d) A person responsible for the management and administration of an unincorporated association, if relevant;
(e) A member of a corporation established under the Churches Incorporation Law (2007 Revision); or
(f) A person not specified in sub-clauses (a), (b), (c), (d) or (e) where the NPO is established by that person.

The registration application must contain the following information:
(a) The purposes of the NPO;
(b) The identity, address and other contact information of the controller and other senior officers or members of the management of the NPO;
(c) Copies or particulars of the trust, trust deed and any other organizational documents or if a company or foundation company, copies of the constitution, or the memorandum and articles of association;
(d) Information with respect to the location of the money and other property of the NPO and its banking arrangements;
(e) The source or anticipated source of contributions;
(f) How contributions are to be applied;(g) Certified copies of Government-issued photo identification of controllers and senior officers; and
(h) Any other evidence that reflects the organizational structure and functions of the NPO.

As will be clear from the nature of the information being sought, the application process is very much geared towards obtaining what is essentially due diligence and KYC information from the NPO.

The Attorney General retains his powers in relation to NPOs and indeed has wide powers under the NPO Law to institute his own investigation or enquiry into the operation of an NPO if it is suspected of breaching the Terrorism Law or the Proceeds of Crime Law or similar. The AG also has wide powers under the NPO law to obtain information and documentation in relation to an NPO.

As mentioned earlier, the NPO Law provides for a Registrar who has various powers conferred on him or her by the NPO Law, including responsibility for the processing of applications for registration, the collection of fees, annual returns and annual financial statements. These largely supervisory administrative functions are more notably supplemented by powers to investigate or authorize the investigation of NPOs who are suspected of operating illegally and to impose financial penalties for breach of the NPO law.

The Registrar is empowered to ensure that appropriate internal AML systems and controls are in place to identify criminal conduct, including the financing of terrorism and to offer guidance to NPOs with regard to best practice. Similarly, the Registrar has power to suspend or even cancel the registration of an NPO if, after the conclusion of an investigation into wrongdoing, it is proved that it was in fact engaged in wrongdoing, or failed to maintain proper accounts, pay its fees and / or submit annual returns. There is a right to appeal to the Cabinet if the NPO does not agree with the Registrar’s decision and if dissatisfied with that decision, there is an onward right of appeal to the Grand Court.

The Registrar can decline to register an applicant if:
(a) The applicant does not fall within the definition of NPO;
(b) If the NPO is established for an illegal purpose or has no connection with the Cayman Islands;
(c) There are manifest errors in the application, it contains profanity, or if the name of the NPO is identical to that of an NPO which is already registered;
(d) If the name includes the word ‘Royal’ or ‘Imperial’ or ‘Empire,’ or is described in a way that infers the patronage of the Queen or a member of the Royal Family or a member of H.M. Government;
(e) If the name of the NPO includes the words ‘gaming,’ ‘lottery,’ ‘bank’ or ‘insurance’ or any other word calculated to suggest related activities; or
(f) If it is different from the name by which the entity was known if it was already established as a company, trust, foundation or partnership in the Cayman Islands, so it must maintain the name that it started out life with.

The controller of an NPO will be responsible for ensuring that proper financial statements are maintained in respect of all money received and spent, all sales and purchases of property, all sums of money raised through fundraising, all non-monetary transactions, assets and liabilities. The aim is for the NPO to be able to demonstrate at any time with reasonable accuracy, its financial position. There are financial penalties for controllers who fail to comply.

There are exemptions set out at s21 of the NPO Law. There were a number of concerns raised about the concept of an NPO law when it first came under consideration, one of those concerns being the unnecessary duplication of a regulatory regime already in place for some NPOs. Accordingly, the NPO law does not apply to:
(a) An NPO that has a government entity as its principal regulator;
(b) An NPO that is a trust, the trusteeship of which comprises or includes a trust company licenced under the Banks and Trust Companies Law, or a controlled subsidiary of that trust company; and
(c) Any other entity that the Cabinet exempts.

Importantly, notwithstanding these exemptions, the Registrar does retain the power to request documentation from exempt NPOs to evidence compliance with various requirements under the law that governs their operations. For trust companies this will of course mean complying with the Banks and Trust Companies Law as well as the Trusts Law.

Two concerns have been voiced about the NPO Law: one is the financial and administrative burden the NPO Law may place on smaller NPOs, and the other is whether the financial statements will be required to contain a level of detail which might stray into sensitive information, in particular, to whom charitable donations and gifts have been directed.

Whether those concerns are well founded remains to be seen. It is clear however that the NPO Law is designed to try and prevent the use of NPOs for money laundering or from diverting their funds to support international crime or terrorism. Hopefully this will help to prevent misuse of funds and fraud as well as ensure that the Cayman Islands are not troubled by the sort of scandals which have attached to certain charities in the U.K. and U.S. which were allegedly used as a front to fund terrorism.

Why Cayman Islands Trustees need to care about UK tax – December 2017

1 U.K. tax obligations of people connected to trusts

Part 1 of this article, appearing in last quarter’s Cayman Financial Review, looked at the main situations in which a non-U.K. resident trustee might have direct U.K. tax obligations arising in respect of the trust. This Part 2 focuses on situations in which others might have their own U.K. tax obligations, arising out of their connections to the trust.

These rules are directly relevant to settlors and beneficiaries of non-U.K. resident trusts but are also of significance to Cayman trustees who are responsible for those trusts. In many cases the settlor and the beneficiaries will turn to the Cayman trustee for information to allow them to correctly calculate their U.K. tax liability. In some cases, the tax position of the settlor and beneficiaries will impact the way in which the trustee runs the trust.

1.1 Settlors

The settlor is the name given to the person who establishes a trust. In the U.S., that person is called the grantor. In some cases, the settlor of a trust will be directly charged to U.K. taxes. This treatment applies where the trust is considered to be “settlor interested.” The question of whether or not a trust is settlor interested is not a simple one, particularly because the definition is different for U.K. income tax and U.K. capital gains tax (CGT) purposes.

Income tax

For income tax purposes, a trust will be settlor interested if the settlor or his/her spouse has an interest in the trust or is able to benefit in any way from the trust. So, for example, all revocable trusts will be settlor interested under this test as the settlor’s power of revocation is an “interest” in the trust and can be used to confer significant benefit on the settlor.
Two different regimes apply to attribute income arising in trusts, to the settlors of those trusts, potentially creating income tax liabilities for the settlors. The first is the “Settlement’s Code” and it applies whether or not a settlor is U.K. resident. By virtue of these rules, a settlor will be charged directly to U.K. income tax on U.K. source income whenever U.K. source income arises within the trust. In other words, the settlor is treated as though he or she received the trust income, even though he or she may not actually receive it from the trustee, and may not even be entitled to receive it under the terms of the trust. However, the Settlement’s Code applies only to income arising at trust level and so for most Cayman trusts, it is unlikely to be in point given the prolific use of underlying companies to hold most trust assets.

The second set of rules is known as the “transfer of assets rules” and may apply if an offshore trust holds 100 percent of shares in an underlying non-U.K. company. The transfer of assets rules can also to apply to beneficiaries, as we will consider below, but there is also a section dealing with the taxation of a “transferor of assets abroad” (i.e., relating to a settlor of a non-U.K. trust). The substance of these rules is that if a trust does not receive U.K. source income, but the underlying company does, an income tax liability can still arise to the settlor of a settlor interested trust. In contrast to the Settlement’s Code, the transfer of assets rules only apply to U.K. resident settlors. If a company receives U.K. source income, a U.K. resident settlor of the trust which owns the company may be subject to a U.K. source income tax on the U.K. source income arising within the company. We say may, as this particular rule is subject to what is known as the “motive defence.” To claim the motive defence, a settlor would need to demonstrate to an officer of HM Revenue & Customs that the transfer of assets by the settlor into the trust structure was (a) not for the purpose of avoiding a U.K. tax liability; or (b) was for a bona fide commercial transaction.

To the extent that a settlor is liable for a U.K. income tax charge (whether or not the remittance basis applies), this will apply instead of the charge on the trustee; there is no double charge to U.K. income tax.

There is one further complication that Cayman trustees should be aware of regarding U.K. source income arising at the level of the trust, where a trust is settlor interested. Even though the settlor has the liability to pay the tax, the trustees are still obliged to report and pay income tax on all U.K. trust income at the trust rate of 45 percent. The settlor must include the income on his self-assessment return but will receive a credit for any tax paid by the trustees. If the trustee has paid more tax than the settlor would have done, the settlor can claim the overpaid tax from HMRC. The settlor must then pay the repayment back to the trustee. This is an overly complicated series of steps but is something that a trustee of a trust that is subject to this regime must not overlook.

U.K. capital gains tax

What constitutes a settlor interested trust for U.K. CGT purposes is both narrower and wider than the definition for U.K. income tax purposes. This may sound oxymoronic, but let us try and explain. The definition is narrower, because a settlor must be U.K. domiciled and U.K. resident in the year in which gains accrue to the trustees. Assuming the settlor is U.K. domiciled and U.K. resident, the definition is then wider, because if any of the settlor’s immediate family can benefit (which extends even to stepchildren, spouses of children or stepchildren or a company controlled by such settlor’s immediate family) the trust will be settlor interested.

Non-U.K. residents can not be subject to U.K. CGT, apart from in one limited circumstance; on the disposal of U.K. residential property. Therefore, a settlor of a settlor interested trust will only be subject to U.K. CGT if he or she is U.K. resident (or the limited exception applies). If a settlor is generally subject to U.K. CGT, he or she will be subject to U.K. CGT on all gains realized by trustees (for example on a sale of investments) and regardless of whether or not the gains are U.K. or non-U.K. gains, as such gains arise and whether or not he/she receives a benefit.

Many Cayman trustees will be trustees of trusts created by settlors who are not U.K. domiciled, but are U.K. resident – so called “res non-doms” (RNDs). If an RND settlor settles a trust, he or she will not create a settlor-interested trust for U.K. CGT purposes, because he/she will not be U.K. domiciled. Accordingly, such a settlor will not be subject to U.K. CGT on an arising basis. There is one nasty trap to look out for and that is if an RND settles a trust with assets comprising income/gains (i.e., not “clean capital”). If a benefit is then remitted to the U.K. from such a trust (and the topic of “what is a remittance” could take up a separate article!) by a relevant person in connection with the settlor (for example his/her spouse or minor child), this may trigger a U.K. CGT charge, which falls on the settlor. To add to the ever-growing trustee action list, the Cayman trustee needs to know what is going into the trust in the first place and how such funds are characterized under U.K. law, to determine how it will be taxed going forward.

1.2 Beneficiaries

The above deals with the potential liabilities of settlors to U.K. tax, but what about beneficiaries?

Income tax

In respect of income tax, the transfer of assets rules outlined above also have a section dedicated to the taxation of beneficiaries. The rules only apply to U.K. resident beneficiaries, and so non-U.K. resident beneficiaries cannot be liable for U.K. income tax. A charge will arise if a U.K. resident beneficiary receives a “benefit” from a trust which is “matched” to “relevant income” in the trust. These rules are informally known as the “matching rules” and are complex. The italicized words above require some explanation so that this matching regime can be understood.

A “benefit” is very broadly defined and can include things like an outright distribution of trust property, a loan which is not subject to HMRC’s Official Rate of interest or rent-free occupation of trust property etc. In the case of a loan, the taxable value of the benefit will be the difference between the Official Rate of interest and the rate of interest charged (if any) and in the case of rent-free occupation, the value of the benefit will be the value of the rent forgone.

So, we now know what a benefit is, but what is meant by “relevant income”? This is essentially all foreign income in a structure that has not been spent, for example, in trustee expenses. Also, we do not need to worry about U.K. income as this will already have been subject to tax by the settlor, or alternatively, the trustee. If income is accumulated by the trustees, that income is still relevant income (it does not become capital for U.K. tax purposes, even if it becomes capital for trust law purposes). Relevant income forms what is called an “income pool” in the trust, which is available for matching.

When a U.K. resident beneficiary receives a benefit, the taxable value of the benefit is “matched” to the same amount, if available, in the income pool (or as much as possible if the amount in the income pool is less). The beneficiary is liable for U.K. income tax on the matched amount (at the beneficiary’s marginal rate), subject to the remittance rules discussed below, and the amount available in the income pool for matching against future benefits is reduced accordingly. Trustees should note that benefits conferred on non-U.K. residents are not matched and so such distributions do not reduce the income pool available for matching against future benefits to U.K. resident beneficiaries.

To add a further level of complication, beneficiaries may be RND’s and so whether or not such beneficiary is then a remittance basis user (RBU) needs to be considered. Whether or not an RND has to actually pay the beneficiary charge to U.K. income tax depends on (a) whether or not the RND is an RBU; and (b) if so, whether the benefit on which the charge arises is “remitted” to the U.K. The position can be summarized as follows:

If he/she is not an RBU: on the value of the benefit, to the extent there is relevant income in the structure to match to the value of such benefit; and

If he/she is an RBU: on the value of the benefit only to the extent that the benefit is actually remitted to the U.K. and to the extent there is relevant income in the structure to match to the value of the benefit which has actually been remitted to the U.K. The concept of a remittance is also a complicated one which broadly means that the income in question is brought into the U.K., or used in the U.K., by the beneficiary, or various other people connected to him.

U.K. capital gains tax

A matching regime similar to the U.K. income tax regime also applies for U.K. CGT purposes. One important difference is that the term “benefits” is used in relation to U.K. income tax and the term “capital payment” is used for U.K. CGT. Broadly speaking, a capital payment is the same as a benefit, but a benefit is chargeable to U.K. income tax and a capital payment is subject to U.K. CGT. A charge to U.K. income tax is always applied in priority to U.K. CGT.
Just as a trust has an income pool, it also has a “gains pool.” Gains in the gains pool comprise the total untaxed gains arising to trustees on the disposal of trust assets, although losses are taken into consideration and trustees can also carry forward losses in certain circumstances. Gains might be realised by trustees selling assets or distributing an asset out to a beneficiary. In addition to this, a gain may be generated if a Cayman trustee transfers assets to another trust (even if both sets of trustees are the same) or a trustee makes a transfer of value which is linked to trustee borrowing. Yet more actions which need to be carefully considered by the Cayman trustee! There is also anti-avoidance legislation which means that gains realised by an underlying company form part of the trust’s gains pool so all assets held by an underlying company need to be taken into account.

As with income tax, an RND who is an RBU will only be chargeable to U.K. CGT to the extent that the capital payment is remitted to the U.K. If a U.K. resident beneficiary is charged to U.K. CGT, as for settlors, it will be at his/her marginal rate (which for U.K. CGT purposes will be 10 or 20 percent, unless in relation to residential property). However, if gains are not matched in the year they arise, a supplemental charge arises, bringing the tax charge up to potentially 32 percent.

So, what if a capital payment is made to a non-U.K. resident beneficiary? Under current law, capital payments can be made to non-U.K. resident beneficiaries which “match” against the gains pool, reducing the amount which can be matched to future capital payments. However, as such beneficiaries are not U.K.-resident, they are not subject to U.K. CGT and so no charge arises in respect of the capital payment, albeit the gains pool is reduced. The current rules therefore afford an opportunity to “wash-out” gains by making capital distributions to non-U.K. resident beneficiaries. This will no longer be the case with effect from April 6, 2018.

There is therefore a limited time period for Cayman trustees to wash out gains and reduce the gains pools in their trusts. Once these new rules some into force, the treatment of capital distributions to non-U.K. resident beneficiaries will be more in line with the treatment of benefits conferred to non-U.K. resident beneficiaries. U.K. income tax and U.K. CGT charges will therefore arise in similar circumstances.

2 Practical points

So, we have cantered through the various taxes and who they might apply to, but what does this mean for a Cayman trustee, on a practical level?

Keep good records – as you now know, U.K. taxation is incredibly complex and undoubtedly, settlors and beneficiaries will need to turn to the trustee for information to allow them to calculate their U.K. tax bill. What is income (or capital) for trust law purposes is not necessarily income (or capital) for U.K. tax purposes.

Consider timing – distributions whilst someone is resident in the U.K. are likely to have a very different tax profile to distributions when that person is not resident. If someone is about to move to the U.K., or about to leave, can the timing of a proposed payment be changed to improve the tax treatment?

Consider the beneficiary’s own tax position – are they claiming the remittance basis in a given year, or not? How is that relevant? Do they plan to come to or leave the U.K.? Is there some planning that can be done around that?

Are there any other steps that the trustee can take to legitimately mitigate the U.K. tax payable in respect of a given transaction?

Keep in contact with settlors and beneficiaries. Their residence and domicile status is vital to determining the tax treatment of any distribution. Help them to understand why you need to know about planned moves before they take place.

Take appropriate advice on matters of U.K. tax law. There are some well-trodden paths for dealing with Cayman trusts that have U.K. tax connections, whether that’s through the residence or domicile of the settlor or the beneficiaries, or because of the holding of U.K. assets within the trust.

3 Summary

What Paul Krugman said of economics – “if you can’t explain it to your mother … there’s a good chance that you yourself don’t really know what you’re doing” – is equally true of tax. Trustees cannot be experts in everything, but they do need to have a general awareness of a lot of different problems. U.K. tax is among those problems and the fact that a large number of the world’s wealthiest individuals and families continue to be attracted to the U.K. by the benefits of the “res non dom” arrangement mean that even trustees, sitting 4,800 miles away in the Cayman Islands, cannot escape the U.K. tax man’s influence.

Disclaimer: The aim of this article is to make the general reader aware of the range of situations in which the actions of a Cayman trustee might impact on some U.K. tax liability. It is not intended as a substitute for specialist advice.

Crypto: The need to know

If the answer to the question “how does the Cayman Islands treat crypto-currency or digital tokens?” is still “we have not decided,” there may be reason for concern. By now, most of us have heard Bitcoin and there is a sea of literature on how the innovative blockchain technology that underlies it and the development of new digital currencies, is rapidly evolving.
The global regulatory response to the phenomenon has been mixed, with some nations like Singapore taking a decisive regulatory position on the nature and offering of digital tokens; others like Japan, formally accepting it early in 2017 as an alternate currency and legal tender, and other countries rejecting it wholeheartedly, banning or restricting its use or trade.
What we know already is that the crypto-currency craze has reached frenzied proportions, with more corporate and individual participants piling in largely unchecked, some using Cayman vehicles. Subscribers to initial coin offerings (ICOs) allow companies to raise capital through token sales, typically in tranches at various offer prices, with the tokens ultimately intended to be “listed” on a digital currency or token exchange, for resale.

As a leading offshore financial center, it is imperative that the Cayman Islands make a definitive statement on how it perceives digital tokens and crypto-currencies. This in turn will inform the attendant regulatory treatment, and financial market expectations.

Digital currencies lack the hallmarks of a true currency under Cayman Islands law. Without engaging in a monetary policy debate, the recent volatility alone demonstrates that crypto-currencies cannot be relied upon to retain a stable store of value. Corporate entities are currently free to create their own private digital currencies which are being increasingly accepted as a means of barter or speculative investing.

Will these digital currencies and tokens issued by a Cayman Islands vehicle be subsumed into the existing legal framework under the Securities and Investments Business Law (as revised) and treated as securities? Will they be treated broadly as an asset or more narrowly as a commodity, or purely as technology or some combination of the these? What, if any, requirements will apply to companies making, advising on, managing or promoting ICOs? Will there be a requirement for third-party services providers to be clearly identified and or regulated, or at least a requirement for a public statement or disclosure document to be issued by a ICO company outlining the inherent risks associated with the ICO? Will a regime similar to the one that exists for IPOs under the Cayman Islands Stock Exchange Listing Rules be introduced or adopted, or will the approach be more light touch? There are many unanswered questions at this point.

Regulators should be concerned. Crypto- currencies and digital tokens, and their use to raise capital, present a vulnerability to money laundering, to terrorist financing and generally to criminal enterprise, because of the decentralized and largely anonymous nature of the electronic transactions. It also creates concern of fraud from an investor protection perspective, and ultimately reputational risk for the jurisdiction. Since digital tokens are not shares or stock in a company and will typically not attract corporate governance protections or obligations, we need to ensure that at the barest minimum, the AML/CFT and Sanctions and due diligence regime is cast widely enough.

Not surprisingly at the international levels, there has been increasing calls from financial regulators worldwide for oversight of crypto-currencies and the platforms upon which they are traded, with the French prime minister adding his voice late last quarter to ask the G20 to debate the issue. Given its status as a leading international financial center, one expects the Cayman Islands to step forward and sound its voice in the discussion. At the very least, to have an articulated position on how it expects to see its own corporate vehicles used, and the regulatory and compliance parameters that will, or will not, apply. Perhaps even a clear statement on how the various sector regulators intend to work together to use Cayman Islands’ flexible regulatory framework to regulate and supervise the gatekeepers of this new digital playground.

It has been said that the stone age did not end because we ran out of stones. In similar vein, whatever is decided about crypto-currencies, Cayman’s regulatory response should be clearly communicated, and must operate to embrace and not to stifle financial innovation while protecting the interests of the jurisdiction.