Offshore and the benefits of capital mobility


An age of ever greater affluence

The great economic fact of our time is the imminent eradication of extreme poverty. In the thirty years between 1981 and 2011, the share of the world’s population living on less than $1.90 per day, adjusted for purchasing power, dropped from 42.3 percent to 13.8 percent. It was 10.9 percent by 2013. This trend is even more remarkable when one considers that the global population grew by three billion over those three decades.

What caused this stunning reversal was the spread of free markets and the institutions that have long underpinned their functioning in the West.

China and India, which account for half of the absolute reduction in poverty, opened up their economies in the late 1970s and early 1990s, respectively. Liberalization involved a number of distinct policies, from the recognition and enforcement of private property rights in agriculture, to the removal of onerous government restrictions and mandates on industry, to the encouragement of foreign investment. An international environment of ever freer trade and fluid capital mobility bolstered the impact of domestic reforms.

The enemies of capital mobility fight back

Despite its overwhelmingly beneficial impact, globalization has been under relentless attack for the past decade.

President Trump’s vituperative tweets against America’s trade partners have lately captured the headlines. Yet, a more relentless and consistent strand of anti-liberalism has for years been deployed against perhaps the purest illustration of international economic integration: offshore financial centers.

That activists should set their sights on these tiny jurisdictions, scattered all over the world, which since the 1950s have pursued economic development by attracting international capital, might not come as a surprise. OFCs have little political clout. They feature in popular culture mostly as the setting of twisted plots in James Bond novels. Furthermore, their field of specialization, banking and financial services, has historically evoked resentment among people who struggle to understand how something intangible can add value.

This ignorance has provided fertile ground for “tax justice” campaigners and politicians greedy for headlines. Moreover, at a time of budgetary restraint and low growth, offshore finance has become a convenient scapegoat for the underperformance of Western economies.

But, as I argue in a recent paper for the Institute of Economic Affairs, giving in to the enemies of capital mobility would do much more than stifle the future prosperity of offshore centers.

It would make international investment costlier and more uncertain. It would hamper growth in poor and emerging economies. And it would reduce the opportunities for ordinary people in rich countries to save adequately for retirement.

When globalization turns to retrenchment

To understand how damaging a drive against offshore finance would be, it helps to become acquainted with the global trends that brought it about. On the eve of World War I, the world economy had experienced nearly seven decades of expansion, underpinned by broadly free trade and monetary stability in the form of the gold standard. Tax rates were low, government outlays were small as a share of national income, and international investment in Europe and into the frontier markets of Asia and the Americas was in full swing.

Just how free and interconnected the world economy was before the Great War was probably best described by John Maynard Keynes, writing in The Economic Consequences of the Peace, his 1919 obituary for the world that had been lost:
“The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages ….”

We tell ourselves that we live in an era of unparalleled economic integration. But there was a precedent, which the twin shocks of global conflict and, a decade later, the Great Depression unraveled.

Indeed, according to some measures, the level of globalization that prevailed before 1914 would not be reached again until the turn of the millennium. To rekindle economic integration after World War II took international organizations like the International Monetary Fund and the World Bank, as well as monetary stability underpinned by the U.S. dollar.

OFCs as catalysts for international investment

However, the postwar global economy was much different from its counterpart 30 years prior. Since 1918, the role of the state in national economies had grown steadily. Where few Western governments had taken up more than 15 percent of GDP before 1914, most accounted for 30 to 40 percent, and sometimes half, of income in the postwar decades. Regulation of labor and financial markets had also become pervasive, as had controls on capital flows between countries.

It was in this context that the need for international financial centers became apparent. Two further developments aided their emergence and flourishing, to wit, the accumulation by ordinary households of a growing pool of savings, intermediated by banks and mutual funds, and deployed to projects around the world; and the shift of industrialization from Western Europe and North America toward Asia, Latin America, and Africa.

The rise of investment intermediaries made tax efficiency a prime consideration, since mutual funds added a new administrative layer that was susceptible to taxation. Triple taxation of corporate profits – at the company level, the fund level, and the investor level – can easily slash investment returns by several percentage points. Over time, the difference compounds. Thus, eschewing fund-level taxation, as OFCs do, benefits not just investors but the firms in which they put their money.

Meanwhile, perceived opportunities in emerging markets underscored the need for neutral and stable jurisdictions with reliable courts, since many of the new destinations of international investment were politically fragile and prone to disregard the rule of law. The existence of OFCs helps to shield investors from rapacious country rulers and the vagaries of domestic legislation. In so doing, it encourages investment in underdeveloped parts of the world.

Politicians want to have their cake, eat it, and tell you it’s for your own good
Most public officials understand that globalization, including of international capital flows, has benefits. Even when these officials are unconcerned about the welfare of poorer countries, capital mobility makes their own jurisdiction more attractive to domestic and international investors.

Yet, politicians also wish to retain control over how the income of their citizens is taxed. And they want to minimize the extent to which other jurisdictions compete with them by offering a more investor-friendly environment. This leads to a “tax trilemma”: Politicians can keep the right to set taxes independently of other countries, and they can maintain freedom of capital movements. But then they expose themselves to tax competition from other jurisdictions.

Conversely, they can curtail tax competition and keep capital mobility, but this would necessitate large-scale harmonization of tax policies around the world. The point is that, when choosing between tax sovereignty, capital mobility, and the elimination of tax competition, policymakers can have two in each case, but never all three together.

That is no bad thing. If history is any guide, it teaches that politicians unconstrained by tradeoffs will err on the side of avarice, at the expense of their countrymen’s long-term well-being. That they are confronted with the tax trilemma should be a relief to investors and to workers in developing countries, who are the oft-overlooked victims of capital controls.

How opaque are OFCs, really?

The argument that offshore centers must be clamped down on because they are “sunny places for shady people” has been used to great effect by their enemies. Whether the allegation conforms to the truth is a different story.

The OECD has four criteria to classify jurisdictions as tax havens. They must have no or only nominal taxes; a lack of “effective exchange of information” with other jurisdictions; a lack of transparency in their operations; and no substantial activities other than “purely tax driven” ones.

Most offshore centers regularly accused of being a tax haven fail to meet the OECD’s definition. The average share of all taxes in GDP in these jurisdictions is 28 percent, hardly insignificant, and comparable to the average OECD share of 34 percent. The difference is not so much in the burden of taxation in each of the two groups as in the types of taxes that they levy. OECD member countries raise the majority of their tax revenue from personal and corporate income, as well as employment taxes. Offshore centers eschew income taxes and rely instead on sales taxes – generally deemed more efficient – and import tariffs.

Nor are OFCs intransparent. Many have signed not just information agreements with other countries, but also tax agreements that involve more extensive cooperation with onshore jurisdictions. In an experiment conducted by American and Australian academics that involved the creation of fictitious companies across key jurisdictions, the researchers found Seychelles, Jersey, the Cayman Islands and the Bahamas – among others – to be more compliant with transparency standards than larger centers such as Britain and America.

As for the charge that offshore jurisdictions do nothing of substance, it is evident that financial hubs such as Cayman, home to 85 percent of the world’s hedge funds, and Bermuda, with a long-standing insurance industry, perform an important role for the global economy that would have to be fulfilled elsewhere, and likely at greater cost, if they did not exist. At a time when much value creation happens not by piling brick upon brick but through the productive use of intangible human, financial, and intellectual capital, to accuse those places that have made a strength of the latter seems anachronistic.

The fight for globalization is on – and it’s not just about Trump and China

The looming imposition of tariff barriers by the USA, China and the EU – which together account for two-thirds of global income – has captured the attention of business and the public. Rightly so: Global merchandise trade, the sum of exports and imports, accounts for 40 percent of world GDP. Furthermore, developing economies are particularly dependent on goods trade to prosper, so a reversal in trade would hurt the most vulnerable most.

But it would be a mistake to think that the battle stops there. For longer than China and America have quarreled over trade in goods, a coalition of activists and politicians eager to get their hands on taxpayers’ money have lambasted the freedom of movement of capital.
In many ways, capital mobility is an easier target for those who seek to undermine it.

Financial capital involves intangible assets whose value is more difficult to comprehend than that of manufactured goods and agricultural produce. Furthermore, to many people, financial services evokes the trading of esoteric instruments in distant locations that have nothing to do with their well-being.

Nothing could be further from the truth. Retail investors in high-income countries use the services of offshore centers for their pension plans and insurance policies. Ordinary people in developing countries rely on the foreign investment that these jurisdictions facilitate to make a living. And we all benefit from an environment in which the savings of most people in most countries cannot be expropriated or devalued at the whim of autocrats.

The rising tide of protectionism may be most apparent in the ongoing spar between America and its key trading partners. But the greatest damage to globalization will be wrought when opponents of the freedom to invest around the world get their way, starting with offshore financial centers. If the strides made against poverty in the last 40 years are to be preserved, they must not succeed.

Diego Zuluaga is a policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives.