The 2008 financial crisis revisited


Sometime after 1987 I decided to keep a collection of books about financial crisis.

“Barbarians at the Gate,”1 was a good read, with smaller-than-life villains, but I gained more insight from the revisionists like Fenton Bailey2 defending Milken and his financial revolution.

It would hardly be possible to start a similar collection after the 2008 crisis, because so many books have been written and films made, but also because there are, as yet, few interesting revisionist works.

Financial markets today look very different to those in 2008. Banks are no longer important liquidity providers in many securities markets, yet they have more capital and generate lower returns on that equity capital. Regulatory and compliance costs are a much larger burden.

Financial institutions are much larger and barriers to entry for new players are a bigger burden than ever before. Regulations micro-manage bank asset holdings. Persistent extremely low interest rates have changed trading and investment strategies in a “stretch for yield.” Central bank balance sheets are enormous, and their floor-driven operating procedures are very different.

These are odd outcomes from a financial crisis that was arguably caused in part by a long-term decline in bond yields, loose monetary policy and a stretch for yield that provided the impetus for creating the risky assets that collapsed in value in 2008. During the crisis, practitioners were struck by the focus of policy makers on treating symptoms of the crisis, but often compounding the underlying problems by setting aside established practices and the rule of law, which generated uncertainty. We can now look back with more perspective and more data to assess what created the deepest financial collapse since the 1930’s.

Monetary policy is central to understanding the crisis and the Federal Reserve was the most active government agency in the response. The Fed fueled the sub-prime boom from 2001, by reducing interest rates to levels that were too low for too long in the face of rising productivity. This not only encouraged lending and credit excesses on the supply side of credit markets, it also increased risk appetite from investors with an insatiable demand for yield. Many of the egregious examples of fraudulent loan origination practices, rating agency inadequacies, poor due diligence, vulnerable structuring and excessive leverage are symptoms of these earlier monetary mistakes. However, with short-term interest rates at 5.25 percent by 2006-7, these problems started to show up in the market with the most excess, for property-secured mortgage loans.

Credit has been given to the Federal Reserve for its crisis response. However, now that minutes from the meetings of the time are becoming available, it is increasingly clear that they made grave mistakes in the early stages of managing the crisis. With oil prices driving up CPI inflation in early 2008, the FOMC offset emergency lending to collapsing domestic banks with large-scale sterilization3. With bad banks collapsing, the effect was to drain precious liquidity from good banks. On Oct. 6, 2008, the Fed started to pay interest on excess reserves (IOER), providing an immediate incentive for banks to hoard reserves, rather than lend. Over time, IOER became central to monetary policy and the new “floor” as the Fed moved away from its former open market-based interest rate setting operations.

These domestic mistakes understate the failure of the Fed to grasp the problems. Offshore “Eurodollar” debt markets had become very large sources of U.S. dollar liquidity for international markets. Outside the domestic purview of the Fed and easy access to emergency liquidity facilities, these money markets relied on access to “safe assets,” which could be offered in repo markets as collateral to secure liquidity. Agency securities (largely Freddie Mac and Fannie Mae) were very important, with their perceived semi-sovereign risk.

Graphic with the words 'Financial Crisis' above graphs and financial data.Safe assets were in short supply and were created through insurance and structures that created safe “tranches” from underlying risky credit. Inherent in these structures was a lot of counterparty risk – to banks, insurers and special purpose vehicles.

We now know how this structure collapsed. Falling property asset prices were already creating a scramble for safe assets and reducing liquidity in more structured sources of collateral. When Bear Sterns closed two large mortgage funds, counterparties fled the firm, creating a classic run. Support for Bear Sterns from the Fed in March 2008 left markets complacent about counterparty risk. The failure of Lehmann in September, without attention to counterparties, followed by the collapse of the largest credit insurer AIG, led to a collapse in Eurodollar markets that created a more global crisis. Collateral values tumbled or, more honestly, those values became unknowable. The collapse of Freddie Mac and Fannie Mae put at risk formerly unquestioned security values. A money market fund “broke the buck.” Mark-to-market accounting requirements reinforced uncertainty, where “marks” were unavailable in illiquid markets. Short-term financing, particularly in the commercial paper and asset-backed commercial paper market4, dried up for all but a few institutions.

It is hard to exaggerate the enormity of the monetary failure. The broad (Divisia M4) measure of money supply collapsed -8.3 percent between October 2008 and June 2010, despite the quantitative easing measures of the Fed. This decline was not made up until October 2012, four years after the decline began. Whilst broad money growth slowed in prior recessions, the money supply had not contracted since the 1930’s. Broad money growth in the U.S. remains below the pre-2008 period. We do not have global measures for broad money, but excluding China, the collapse was likely even more acute.

In retrospect, we can see that the problem of QE was (and remains) different to the inflationary fears that were initially generated. The real monetary problems were:

1. Privately generated “money”-like assets collapsed, feeding directly into the “real economy”;
2. Limited understanding of Eurodollar markets left many of the biggest problems unaddressed;
3. Interest on excess reserves reinforced “hoarding” of reserves by U.S. banks;
4. New capital and liquidity rules for banks and insurers further increased the demand for safe assets relative to the impaired supply;
5. Distortions in the prices of assets from QE undermined bank profitability and made it more difficult for markets to restructure and discover low risk alternatives to sovereign assets as collateral;
6. Regulatory uncertainty and higher costs of regulation reduced competition and innovation, impairing the intermediary functions of financial institutions; and
7. Fines and financial penalties on institutions increased capital demands on shareholders and undermined counterparty confidence.

QE only partially addressed the financial system issues. It was not an application of Bagehot’s dictum that a lender of last resort should lend freely, at a high rate of interest against good security5. Bagehot’s approach would have worked where it was needed, to provide liquidity and stabilize collateral values. Other measures taken by the Fed, such as putting in place swap lines with foreign central banks and emergency liquidity facilities, were consistent with Bagehot and vital to stabilizing markets.

Implemented with more of a view to theory than actual markets, QE added massively to the money base and the Fed believed that in doing so, it was avoiding the monetary mistakes of the Great Depression. However, broader money aggregates collapsed as there was a run on formerly safe assets and counterparties. The supply of broad money collapsed at a time when the demand for money and money substitutes was very high. Not only did QE distort prices, but the massive additions to bank reserves incentivized by the Fed program withdrew non-reserve money from the broader financial system. With negative real interest rates, the opportunity cost of holding money balances was low, increasing demand for those assets.

Graphic of an arm of a man in a suit pointing at an exploding dollar sign.

Fragile by design

It has been argued that the U.S. has a financial system that was “fragile by design”6, reflecting political compromises and populist preferences. The banking systems of Canada and Australia proved more robust. We can now see with more clarity the fragile elements of the system.

“Too big to fail” financial institutions, many protected by deposit insurance, created asymmetric risk and return payoffs for bank managers. Investors were also protected from having to price risks appropriately. Shocks to these assumptions about counterparty risk showed up this key fragility. After the crisis, removing these moral hazards was a focus of regulators and politicians. An elaborate structure of “living wills,” stress tests, “macro-prudential controls” and new capital instruments was designed to reduce the fiscal impacts and chances of bank failure. However, after all of those measures, it is now more apparent than ever that governments have assumed the responsibility for failure and it would remain untenable to let such a closely regulated institution fail.

Financial institution capital had become driven by regulation, rather than markets, with key institutions far too leveraged. BIS (Bank for International Settlement) capital rules favored some assets (mortgages, agency and sovereign debt) over others and distorted bank operations. New BIS rules require more ordinary equity for banks, but banks remain highly levered and risk weightings for assets arbitrary and distorting.

Money markets had provided liquidity based on collateral from assets that were not nearly as “safe” as presumed. The crisis increased reliance on interest-earning reserves and treasury collateral as safe assets for liquidity. Regulation since the crisis has increased the requirements to hold liquid assets and narrowed the assets considered liquid. This might have created a ready market for profligate governments to issue their securities to, but it is not clear that it has added to system stability.

Many of the problems with asset quality were in areas where banks were required to lend to meet “community reinvestment” obligations or were encouraged to lend to meet financial inclusion goals. Unfortunately, responses to the crisis reinforced some of these problems, with fines of banks dedicated to funding community organizations and the focus of the new CFPA running counter to sound origination standards.

Accountants escaped a lot of criticism after the financial crisis, but the creation of rules that “mark to market,” where real markets do not exist, and “mark to model,” where model parameters are indeterminate, created problems during the crisis that have not gone away.

The failure and “conservatorship” of the government-sponsored entities (GSEs) Freddie Mac and Fannie Mae was central to the crisis, revealing a fragility in the U.S. system that was absent in other countries. Yet there has been essentially no reform of these institutions. With the GSEs, FHA and the FHLB system7, the role of government in the U.S. mortgage market as an insurer or provider of mortgage securities is unique internationally and a key fragility in the system. It insulates from markets one of the largest sources of lower volatility assets and embeds in the system interest rate risk that is absent in other housing markets.

Key fragilities of the financial system that caused the crisis that began in 2008 have not been adequately addressed. Where government regulation failed, the role of governments and their agencies have increased. Where markets had worked well (equity markets and hedge funds), governments are more active. Where market mechanisms are needed, such as the creation of more liquid and safe assets, they have been largely prohibited. The reliance of the system on assets backed by the ever more fragile fiscal power of governments to tax has been vastly increased.

Banks have more capital, but they are less efficient and innovative. If there is hope, it is that outside the heavily regulated banking system, refugees from banks are teaming up with technology innovators to create alternatives. New blockchain-based transactional platforms promise settlement of transactions immediately, reducing counterparty risks. Opportunities for direct provision of credit through online marketplaces can introduce new equity to credit markets, without the need for highly leveraged intermediaries. New opportunities are emerging to pool and structure risks that match investors with those who need money or to hedge risks.

John Cochrane8, one of the best revisionist thinkers about the financial system, has argued convincingly that risks in the current system remain too large. That has prompted a stifling regulatory overlay that is reducing growth. He argues that with modern technology we can have a fully equity-financed banking system, that would require little or no regulation. It might well be that new innovations will enable a global financial system that is less fragile, more market driven and far more efficient. That will only emerge if governments stand down from fighting the last war.


1 Bryan Burrough and John Helyar Barbarians at the Gate: The Fall of RJR Nabisco, Harper and Row, 1989
2 Fenton Bailey The Junk Bond Revolution: Michael Milken, Wall Street and the ‘Roaring Eighties’, Mandarin, 1991
3 George Selgin Sterilization, Fed Style (
4 Marcin Kacperczyk and Philipp Schnabl “When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009”, Journal of Economic Perspectives – Volume 24, Number 1 – Winter 2010 – Pages 29-50
5 Although as pointed out by George Selgin (Fatalistically Flawed: A Review Essay on Fragile by Design, International Finance 18:1, 2015, pages 109-128), Bagehot did not advocate the Bank of England’s lender of last resort role, but his proposals as a second best alternative if there were not competing sources of reserves.
6 Charles Calomiris and Stephen Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, Princeton 2014
7 FHA is the Federal Homeloan Administration, FHLB refers to the 11 Federal Homeloan Banks
8 John H Cochrane, Equity-financed banking and a run-free financial system,

What lessons did we learn from the global financial crisis?

Graphic of a tree shaped like a dollar sign getting blown apart by strong wind.

The global financial crisis began on Aug. 9, 2007 when BNP Paribas halted redemptions in three hedge funds that had invested in U.S. subprime residential mortgage loans. The most intense phase of the global financial crisis commenced on Sept. 15, 2008 when Lehman Brothers Holdings, Inc. filed for Chapter 11 bankruptcy protection and ended on Oct. 14, 2008 when Secretary of the Treasury Henry Paulson, chair of the Board of Governors of Federal Reserve System Ben Bernanke, and Federal Deposit Insurance Corporation (FDIC) Chair Shelia Baer effectively ordered Bank of America, JPMorgan-Chase, Wells Fargo, Citigroup, Merrill Lynch, Goldman Sachs, Morgan Stanley, Bank of New York-Mellon and State Street to accept Troubled Asset Relief Program (TARP) funds in the form of preferred shares. A decade later, it is worthwhile to ascertain what really caused the global financial crisis.


Many observers have assigned blame solely on their favorite hobbyhorse – (1) the Great Moderation that lessened the perception of risk; (2) financial models that lessened perceptions of uncertainty; (3) the Fed’s overly accommodative monetary policy between 2002 and 2006; (4) financial services deregulation; (5) Fannie Mae’s and Freddie Mac’s exploitation of the implicit guarantee of their debt and residential mortgage-backed securities (MBS); (6) affordable housing quotas for Fannie Mae and Freddie Mac; (7) the Community Reinvestment Act (CRA); (8) house flipping by speculators; (9) recklessness among investment bankers; and (10) the failure of rating agencies to asses risk in MBS and complex financial products properly. However, the global financial crisis had multiple, interacting causes.

Briefly, greed was not a cause of the global financial crisis. If greed were a cause, one would have to explain how and why greed increased or became more potent in the early 2000s. No one can, since greed has been a constant in human affairs.

Risk and uncertainty

A combination of policy changes produced long and strong expansions and moderate inflation in the 1980s and 1990s. This Great Moderation lessened the perception of risk in financial products. Simultaneously, increasingly sophisticated risk models lessened the perception of uncertainty in financial markets. While perceptions of less risk and uncertainty promoted financial risk-taking in the early 2000s, they alone could not cause a global financial crisis without major policy mistakes.

Inflation-targeting misfire

Monetary laxity was a necessary, but not a sufficient, cause, for the global financial crisis. Inflation targeting helped the Federal Reserve and other central banks to stabilize inflation and inflationary expectations in 1980s and 1990s. Inflation targeting provides central banks with useful guidance to respond to demand shocks since real GDP and prices move in the same direction. In contrast, inflation targeting does not provide useful guidance to respond to supply shocks since real GDP and prices move in opposite directions.

Between 1989 and 1992, the opening of the People’s Republic of China, the abandonment of autarky in India, and the collapse of the Soviet Bloc, the world trading system added 1.5 billion potential workers. That was a 90 percent increase in the potential labor supply, about one-half of which was attributable to China.

The rapid expansion of Chinese manufacturing and China’s increasing share of global trade in manufactured goods, particularly after China acceded to the World Trade Organization (WTO) on Dec. 11, 2000, intensified global price competition for manufactured goods. This positive supply shock reduced the prices for U.S. manufactured goods by 7.6 percent between 2000 and 2006 and depressed inflation as measured by price indices both in the United States and around the world.

Inflation targeting misled the Federal Reserve to pursue an overly accommodative monetary stance between 2001 and 2006. Not all disinflations or deflations are bad. The Fed should counter disinflations or deflations from negative demand shocks with accommodative monetary policy, while disinflations or deflations from positive supply shocks should flow through to households, boosting real wages through lower prices. By trying to achieve its inflation target of 2 percent, the Fed left the world awash with liquidity and ignited a credit explosion that helped to inflate an unsustainable housing bubble in the United States. Through the U.S. dollar’s status as the world’s reserve currency, the Fed’s monetary policy influenced other central banks. This linkage helped to inflate asset bubbles in a number of other countries as well.

Why housing?

U.S. laws and regulatory policies caused excessive liquidity from the Fed to flow into housing and escalate housing prices to unsustainable levels. During the early 1990s, four economic and political trends interacted in unexpected ways to begin inflating a housing bubble.

First, community groups such as ACORN perceived lending discrimination in the extension of residential mortgage loans to low-income and moderate-income households in majority-minority neighborhoods. Community groups blamed this perceived discrimination on (1) the underwriting standards that Fannie Mae and Freddie Mac used for securitizing conventional residential mortgage loans, and (2) the ineffectiveness of CRA.

Second, Fannie Mae and Freddie Mac decided to exploit their funding advantage from the perception that their debt securities and their residential MBS had the implicit guaranty of the U.S. Treasury. Instead of holding only the residential mortgage loans necessary for ongoing securitization, Fannie Mae and Freddie Mac wanted to balloon their balance sheets by issuing debt securities to invest in residential mortgage loans and residential mortgage-backed securities. Since their new business models depended on their funding advantage, Fannie Mae and Freddie Mac were willing to do anything to preserve it.

Third, after states began repealing their prohibitions on multistate bank holding companies in 1980s, President Bill Clinton signed the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, completing the geographic deregulation of U.S. banks. A wave of bank acquisitions and mergers followed.

Fourth, the Budget Enforcement Act of 1990, the Federal Credit Reform Act of 1990, and the Omnibus Budget Reconciliation Act of 1990 restricted the ability of Congress to increase housing subsidies for low-income and moderate-income households through on-budget programs at the Department of Housing and Urban Development (HUD) and residential mortgage loan guarantees by the Federal Housing Administration (FHA). Consequently, Congress sought off-budget ways to increase housing subsidies.

Regulatory-induced relaxation of underwriting standards

In 1992, the Federal Reserve Bank of Boston published a study using Home Mortgage Disclosure Act (HMDA) data that claimed minorities were denied residential mortgage loans at higher rates than whites were after controlling for variables associated with creditworthiness. After correcting for flaws in Boston Fed study, subsequent studies found scant or no evidence of discrimination. Nevertheless, the Boston Fed study influenced (1) Congress to (a) impose affordable housing quotas on Fannie Mae and Freddie Mac in the Housing Enterprises Financial Safety and Soundness Act of 1992 (a.k.a. GSE Act), and (b) strengthen the CRA in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994; and (2) federal regulators to press originators to relax traditional underwriting standards for residential mortgage loans.

In 1994, President Bill Clinton declared, “More Americans should own their own homes.” According to HUD documents, Clinton sought to “reduce down-payment requirements and interest costs by making terms more flexible” and “increase the availability of alternative financing products in housing markets throughout the country.”

Employing the CRA, the Clinton Administration pressed banks to relax their underwriting standards, reduce down-payment requirements, and promote exotic alternatives to traditional fixed-rate, fully amortizing residential mortgage loans. The administration ordered the FHA to relax its underwriting standards for guaranteeing residential mortgage loans. Consequently, the percentage of FHA-guaranteed residential mortgage loans with down payments of 3 percent or less rose from 13 percent in 1992 to 50 percent in 2000. Moreover, the administration directed the FHA to press mortgage bankers, not otherwise subject to federal regulation, to agree to “Fair Lending, Best Practices” that relaxed underwriting standards.

Because of their duopoly in securitizing conforming conventional residential mortgage loans, the relaxation of underwriting standards for residential MBS by Fannie Mae and Freddie Mac affected all originators. Indeed, a Fannie Mae Foundation report (2002) asserted, “The GSEs have introduced a new generation of affordable, flexible, and targeted mortgages, thereby fundamentally altering the terms upon which mortgage credit was offered in the United States from the 1960s through the 1980s.”

These regulatory initiatives were successful in relaxing underwriting standards for residential mortgage loans. Down-payments fell dramatically. In 1989, only one in 230 homebuyers had down payments of 3 percent or less. In 2003, one in seven homebuyers had down payments of 3 percent or less. In 2007, one in three homebuyers had down payments of 3 percent or less. Low-income households that could not qualify for conventional residential mortgage loans under traditional underwriting standards began to receive interest-only and negatively amortizing residential mortgage loans.

CRA exploitation

Exploiting the wave of bank consolidation, community groups filed the CRA protests against bank acquisitions and mergers and triggered lengthy investigations by federal regulators. To avoid costly delays, banks settled these protests by pledging among other things to make more residential mortgage loans to low-income and moderate-income households in majority-minority neighborhoods. Indeed, the National Community Reinvestment Coalition reported that banks made $4.5 trillion in CRA commitments between 1992 and 2005 in contrast with $8.8 billion between 1977 and 1991.

While banks would have extended many of these loans regardless of the CRA, a substantial number of CRA-induced loans were high-risk subprime and alt-A residential mortgage loans. Bank CEOs agreed to these settlements, knowing that the risk to their banks was limited since most of these CRA-induced residential mortgage loans would be bought and securitized by Ginnie Mae (if FHA-qualified) or by Fannie Mae and Freddie Mac (if not).

Regulatory-induced demand

The GSE Act directed the HUD Secretary to set affordable housing quotas for Fannie Mae and Freddie Mac quadrennially beginning in 1996. These affordable housing quotas gave Congress an off-budget means of increasing housing subsidies, while Fannie Mae and Freddie Mac acquiesced to these quotas as the political price for maintaining their funding advantage.

On Oct. 31, 2000, HUD Secretary Andrew Cuomo boosted the affordable housing quotas for 2001 to 2004. Fannie Mae and Freddie Mac could not meet their higher quotas by purchasing of conforming residential mortgage loans for securitization. Speaking to the American Bankers Association on Oct. 30, 2000, Fannie Mae Vice Chair Jamie Gorelick stated, “We want your CRA loans because they help us meet our housing goals.” Moreover, Fannie Mae and Freddie Mac began purchasing AAA-rated tranches of privately issued residential mortgage-backed securities containing subprime and alt-A residential mortgage loans.

Advocating an “ownership society,” President George W. Bush accelerated Clinton’s housing policies. Indeed, HUD Secretary Alphonso Jackson boosted the affordable housing quotas even higher for 2005 to 2008.

The regulatory-induced demand from the affordable housing quotas on Fannie Mae and Freddie caused the explosive growth of subprime and alt-A lending and the private securitization of subprime and alt-A residential mortgage loans from 2001 to 2006. The origination of subprime residential mortgage loans boomed from $190 billion in 2001 to $600 billion in 2006, while the origination of alt-A residential mortgage loans soared from $11.4 billion in 2001 to $400 billion in 2006. Private MBS issuance increased $241 billion in 2001 to $1.033 trillion in 2006.

Moreover, the composition of private MBS shifted dramatically from jumbo residential mortgage loans (i.e., prime residential mortgage loans that are too large for Fannie Mae or Freddie Mac to securitize) to subprime and alt-A residential mortgage loans. In 2001, private MBS issuance was 59.1 percent jumbo mortgages, 36.2 percent subprime mortgages, and 4.7 percent alt-A mortgages. In 2006, private MBS issuance was 21.2 percent jumbo mortgages, 43.4 percent subprime mortgages, and 35.4 percent alt-A mortgages.

Speculators and flipping

After the stock bubble crashed in 2000, speculators flocked to the housing market. The combination of rising housing prices, low interest rates, and relaxed underwriting standards made house flipping attractive to speculators. In 2005, the National Association of Realtors estimated that 28 percent of all home sales were speculative. Generally, speculators focused on homes in middle-income and high-income neighborhoods rather than homes in low-income neighborhoods.

Thus, the regulatory-induced relaxation of underwriting standards for residential mortgage loans to redress perceived lending discrimination artificially boosted housing demand among marginal buyers and increased the prices for starter homes and homes in low-income to moderate-income neighborhoods. Simultaneously, the regulatory-induced relaxation of underwriting standards boosted housing demand among speculators for homes in upper middle-income and upper-income neighborhoods and increased prices for more expensive homes.

Because post-crisis studies found that defaults and foreclosures were not highly concentrated among less creditworthy, low-income and moderate-income households, some supporters of relaxed underwriting standards have mistakenly claimed that the regulatory-induced relaxation of underwriting standards did not contribute to the global financial crisis. The post-crisis studies actually proved that the effects of relaxing underwriting standards were bifurcated. In the bottom half of the housing market, defaults and foreclosures were concentrated among less creditworthy, low-income to moderate-income households. In the top half of the housing market, defaults and foreclosures were concentrated among speculators.

And the rest

The contributions of investment banks and rating agencies to the global financial crisis were very minor. Investment banks were a part of the shadow banking system that collectively performed the liquidity and maturity transformation functions of commercial banks without access to a lender of last resort. While this flaw proved fatal to investment banks during the global financial crisis, this flaw did not cause the crisis. Finally, the payment-by-the-issuer model may have biased ratings on complex financial products by the rating agencies. But even if the rating agencies had assigned less favorable ratings, the global financial crisis would have occurred largely as it did.


In summary, the Great Moderation reduced perceptions of financial risk, while sophisticated risk models reduced perceptions of uncertainty. Inflation targeting during a positive supply shock misled the Fed into pursuing an overly accommodative monetary policy between 2002 and 2006, leaving the world awash with excess liquidity. In response to the lending discrimination alleged in a Boston Fed study that was subsequently discredited, U.S. policymakers used their regulatory authority to (1) relax underwriting standards, and (2) create a demand for subprime and alt-A residential mortgage loans. These policies ensured that excess liquidity would flow into housing. As the housing bubble inflated in the early 2000s, speculators were drawn into the housing market. Relaxed underwriting standards and low interest rates made flipping common. Every asset bubble must eventually pop. Once the housing bubble began to deflate, a global financial crisis became inevitable.

The author of this article, who goes by the name Hamilton, is a senior U.S. economist who frequently writes under a nom de plume.

Brexit – the story so far and what happens next

Two hands - one painted with EU flag, one with UK flag.

It is more than two years since the U.K. narrowly voted to leave the European Union and yet the terms of the departure, scheduled for March 29, 2019, seem as unclear as ever. Indeed, there is still an outside chance that Brexit will be delayed, using the flexibility allowed in Article 50 of the EU Treaty. Brexit could even be cancelled altogether. It is unlikely that those calling for a “People’s Vote” (in reality, another referendum) will get their wish, but it would be unwise to rule anything out.

Crisis? What crisis?

Given all this uncertainty, though, the U.K. economy has performed remarkably well. GDP growth has settled at a lower but still decent pace, while unemployment has fallen to the lowest rate since the 1970s, at just 4 percent. This contrasts to the recession that many predicted in the wake of a vote to leave.

The much-feared “Brexodus” of City jobs has also been more like a trickle. London is still way ahead of its European competitors in surveys of the world’s top financial centers and as a destination for inward investment. The advantages of the U.K. in this sector – including the favorable business environment and supporting infrastructure – are largely “Brexit-proof.”

Many see the election of a Labour government under Jeremy Corbyn as a far greater threat.
That said, the initial economic impact of the vote to leave the EU has clearly been negative. The additional inflation resulting from the fall in the pound has squeezed real incomes, while the heightened uncertainty has held back business investment. It is also notable that many other major economies have picked up, whereas the U.K. has slowed.

However, this tells us very little about the longer-term impact. The fact that the U.K. has not yet left the EU means that it is too soon to expect the bulk of any benefits from Brexit to come through, as well as any additional costs. Even the initial hit may be partially reversed, especially if investment snaps back once uncertainty clears.

The big issues

This relatively upbeat view assumes, of course, that Brexit itself will be positive, or at least not as bad as feared. There are many unknowns here, including the nature of the future relationship between the U.K. and the EU, and what the U.K. government will do with the control it will regain over trade policy, domestic regulations and migration. But this essentially comes down to two related questions.

The first is what to do about the border on the island of Ireland, between the Republic of Ireland (part, of course, of the EU) and Northern Ireland (part of the U.K.). All parties recognize the importance of avoiding a “hard border,” meaning any form of physical infrastructure, such as customs posts, that could compromise the peace process.

The second question is how far the U.K. will move away from the two central pillars of the EU: the Customs Union (which eliminates tariffs between member states, but requires them to operate common external tariffs), and the Single Market (underpinned by the four freedoms of movement, covering goods, services, capital, people, and a set of regulations and standards that apply to the whole economy, not just goods and services traded internationally).

At the moment, the EU seems convinced (and has apparently managed to convince the U.K. government too) that the only way to fix the Irish border is for Northern Ireland to remain in some form of customs union with the EU. It has therefore offered the U.K. two options.
One is a free trade agreement for Great Britain only, with a new customs border drawn between Northern Ireland and the rest of the U.K. This is, of course, completely unacceptable to the U.K., including the unionist MPs from Northern Ireland, who hold the balance of power in Westminster.

The other option is only slightly more palatable. This is associate membership of both the single market and customs union for the whole U.K. Many would regard this as “Brexit in name only” (though there are also some in government and business who might welcome this too).

For now, the U.K. has responded with the “Chequers Plan,” named after the prime minister’s country retreat. This also has two main elements. The first is a “Facilitated Customs Arrangement,” where the U.K. runs two customs systems at its borders, applying U.K. tariffs to goods destined for the U.K. and EU tariffs to those destined for the EU. This may well prove to be too cumbersome, and it has already been rejected by the EU.

The second element – just as controversial – is a “common rulebook” for goods, where the default position is that the U.K. accepts all EU regulations and standards with little, if any say, on how these are determined. This would severely limit the scope for independent trade deals.

In summary, the Chequers Plan is a compromise that appears to please nobody. So, what’s the alternative? Yet again, there appear to be two. The first is to take a step back towards the plan the government was originally working on, before Chequers was proposed.

This starts from the assumption that the Irish border is fixable by a mix of technological solutions, trusted trader schemes and exemptions for small businesses, which together allow customs systems to be operated away from the border itself. Northern Ireland then need only keep EU rules in a few, relatively uncontroversial areas, like animal welfare (the island of Ireland has long been regarded as a single unit for these purposes anyway).

The rest of the plan then comprises a comprehensive free trade agreement between the U.K. and the EU, similar to, but better, than the EU-Canada deal, which would eliminate tariffs, streamline customs, and allow for mutual recognition of rules in areas such as financial services. The U.K. would then be free to look outwards too, with a new U.S.-U.K. free trade agreement an early priority.

Graphic showing two 'hands' of cards of two cards each. We can see the EU cards that have 'deal..' and 'no deal..' on them.

How bad would ‘no deal’ be?

The other option would be “no deal,” meaning the U.K. leaves in March 2019 without a withdrawal agreement and is simply treated by the EU in the same way as any other third country. The U.K. public is currently being bombarded with warnings of potentially devastating impacts of “no deal” on the economy, their security and their welfare.

This has generated some truly daft headlines. My favorite is that U.K. would run out of food by August 2019 (the 7th, to be precise). This relies on the bizarre assumption that the U.K. would no longer be able to import food, not just from the EU but from anywhere in the world, and that the U.K. would continue to export food even as its own people starve.

Some other warnings do need to be taken much more seriously. But almost all describe hypothetical scenarios that are (very) unlikely to happen in practice. After all, “no deal” does not have to mean no new agreements at all, on anything. In reality, the EU has lots of arrangements with other countries that are not dependent on EU membership, let alone signing up to all the rules of the Single Market and Customs Union. A good example is the air service agreements that allow planes to fly.

These warnings also often assume that the EU would ignore its other legal obligations and the threats to its own economy. There is a rather fruitless debate about whether the U.K. or the EU would suffer more from a “chaotic” Brexit. But the key point is that both sides would be worse off, and therefore it is in their best interests to cooperate. Just talk to German car manufacturers, or French cheese-makers.

Finally, the warnings assume that the U.K. cannot fix problems on its own, or even that the U.K. government would do things that actually make problems worse. For example, the U.K. government has already said it would allow the U.K. regulator to decide the medicines authorized in the EU are safe in the U.K. too. Similarly, scare stories about labor shortages and higher food prices assume that the U.K. would choose to restrict migration in crazy ways, or impose new tariffs rather than reduce existing ones.

So what happens next?

The clock is running down quickly, and there is an awful lot that would still need to be done to allow a clean break in March 2019. A “no deal” scenario would be a risky second best. But I believe that both sides will show more flexibility (especially on the Irish border), allowing a smooth departure, with a time-limited transition period to work out the finer details of the future relationship.

Once this period is out of the way, there will be all to play for. For sure, the consensus is that the long-term impact on the U.K. economy will be negative, including the government’s own published analysis. However, this observation is not as persuasive as it may first appear.
First, modeling the economic impact of Brexit is inherently difficult, because the benefits from independent trade and regulatory policies are harder to quantify than the initial costs of looser ties with the rest of Europe. In my view, this reinforces the danger that policy-makers focus too much on keeping as close as possible to the status quo, rather than seeking an outcome that makes the most of the opportunities created by the U.K.’s departure from the EU.

Second, the conventional wisdom has often been wrong (for example, on the case for joining the euro, and even the immediate economic impact of the vote to leave the EU). This does mean, of course, that the consensus is wrong this time too, but it should be taken with a large pinch of salt.

Third, estimates for the impact need to be put in their proper context – recognizing the uncertainties and kept in perspective, especially when they represent relatively small changes in the level of GDP compared to the growth that might otherwise be expected over long periods.

For example, conventional modelling of all the easier-to-quantify costs and benefits of Brexit might suggest that the level of U.K. GDP will be 5 percent lower than otherwise in 15 years’ time. However, this would be relative to a baseline where GDP might be 25 percent higher. In other words, GDP would still increase by 20 percent over this period, even without allowing for the harder-to-quantify gains, both economic and non-economic, that the departure from the EU might bring.

Hopefully, we will look back at this period of extraordinary uncertainty and upheaval and wonder what all the fuss was about. In the meantime, though, it is worth taking comfort from the fact that, outside the Westminster and Whitehall, ordinary U.K. consumers and businesses seem to be keeping calm and carrying on.

Do ‘economic substance’ tests have any substance?

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The European Union, through its Code of Conduct Group on Business Taxation, is drawing up a blacklist of “non-cooperative jurisdictions” that will be subject to sanctions.

The main threat behind the blacklist was of tax sanctions, which could include denying deductibility for business payments by EU taxpayers to entities in a non-cooperative jurisdiction, and “increased audit risks for taxpayers benefiting from the regimes.” But there are also threats of non-tax sanctions, including denial of access to EU development funds and a vague proposal for the EU and its member states to “take the EU list of non-cooperative jurisdictions … into account in foreign policy [and] economic relations.”

If that sounds threatening, it is intended to. These sanctions were specifically designed to bully non-EU jurisdictions into complying with their demands, or as the EU put it, to “effectively discourage non-cooperative practices in the jurisdictions placed on the list.”

The blacklist requirements include the usual exchange of information and lack of harmful tax regimes, but in 2017 they added a new requirement, that entities based in a low-tax jurisdiction will have to demonstrate that they have “economic substance” there.

The onus is on the governments of lower-tax jurisdictions to design and enforce these rules, and report back to the EU on the results. Failure to do so to the Code of Conduct Group’s satisfaction will see the jurisdiction added to the EU blacklist.

In response, the governments of various international finance centers made commitments to the EU that they would introduce “economic substance” requirements so that companies, funds, trusts and others located there would be required to demonstrate a sufficient level of local activity.

The Cayman Islands government made this commitment towards the end of 2017, as did Jersey and most of the other significant international finance centers, promising to put the required systems in place by the end of 2018.

They therefore have just a few months, until Dec. 31, to fulfil this commitment, but because of the vagaries of the EU’s demands, and the difficultly of applying substance tests to the finance industry, we still have very little idea of what the tests will actually look like.

What is economic substance?

One problem with the EU’s process has been a lack of agreement or certainty as to what “economic substance” actually is, and there has been criticism that finance center governments have signed up “blind” to an open-ended commitment.

The International Chamber of Commerce has said that “the challenge with any economic substance requirements is their factual nature and the wide leeway for varying interpretations of their content,” which is a reasonable summary, although it does not go far enough. The fundamental problem with the “economic substance” approach is that once you depart from the certainty of whether there is a legal entity, there are no definite answers. How much substance is needed for any particular business is an open-ended question.

There was some broad understanding of economic substance over recent years, in particular from various court cases looking at the residence of companies and trusts. A leading example is the Laerstate case (Laerstate BV v HMRC (2009)), a decision of the U.K. tax tribunal on whether the board of directors of a company actually controlled the company, or if the true “management and control,” and hence tax residence, was elsewhere.

One of the tests adopted in the Laerstate case was whether the directors had the “minimum amount of information … in order to be able to make a decision.” This was effectively an early substance requirement, insisting not just on formal control by the board of directors but that the directors had the ability to actually exercise that control in a meaningful way.

A similar requirement was seen in the Barings case (re Barings plc, Secretary of States for Trade and Industry v. Baker (No.5) (1999)), where the court held that a company’s directors must “acquire and maintain a sufficient knowledge and understanding of the company’s business to enable them properly to discharge their duties as directors.”

Although not a tax case, the requirement in Barings was similar to Laerstate; not just the formal right to control the company and going through the correct forms, but also the need to show that the board had the necessary knowledge and resources to actually consider and take the relevant decisions.

Other countries have used similar tests; the Supreme Court of Canada in the Fundy case (re Fundy Settlement (2012)) held that the trustees of a trust “had only a limited role – to provide administrative services – and little or no responsibility beyond that,” so that although the trustees had formal control, in reality they did not actually exercise it.

In the Cayman Islands, of course, there was the Weavering case (Weavering Macro Fixed Income Fund Limited (In Liquidation) v Peterson and Ekstrom (2011)); again, not a tax case, but once again looking at the ability and capacity of a company’s directors to see whether they were actually controlling the company.

Other jurisdictions have adopted other tests of substance, for example the Netherlands require that, to be resident there, a company must have least half its board members resident in the Netherlands, and that those board members should be sufficiently qualified to carry out their duties, such as “evaluating and making strategic decisions.”

So, we thought we had a rough understanding of what economic substance might mean, and the Learstate line of cases gave a reasonable requirement to comply with. Unfortunately, the EU had different ideas.

Moving beyond a board test

Our understanding of substance, from these residence rules, was effectively a board-level one (or trustee-level for a trust). What was important was that the company or trust was actually and genuinely being run from the jurisdiction that was claimed, and to demonstrate that you had to be able to show that the people who claimed they were running it had the ability and capacity to actually do so.

But the OECD and EU are now demanding more. They are looking not just at the strategic management level, but at actual day-to-day business activity.

There have been a few signs of this before; for example, the tax treaty between India and Singapore requires that, for a Singapore company to benefit from the treaty, it needs to demonstrate sufficient economic ties to Singapore by incurring at least S$200,000 (~US$150,000) of costs and expenses there. That has the benefit of simplicity, but is very inflexible, not taking account of the different situations of different organizations.

More recently, the U.K.’s Diverted Profits Tax of 2015 has an “insufficient economic substance condition,” under which the “non-tax benefits referable to the contribution … by that person, in terms of the functions or activities that that person’s staff perform, would exceed the financial benefit of the tax reduction.”

This moves away from the Laerstate approach, looking not just at the directors of the company and their ability to take strategic decisions, but at the value created by the company’s workers.

Under the U.K. test, the level of economic activity required has to be greater than the tax benefits, to demonstrate an economic effect of the structure that outweighs any tax motives.

The EU’s approach

In June 2018 the European Union issued some guidance on how it will approach economic substance, finally giving the finance centers some idea of what they have signed up for.
Unfortunately, their guidelines are still very inconclusive, and difficult to apply to most of the business activity in the Cayman Islands, leaving business and investors in a state of great uncertainty.

The circumstances when substance might be required are very broad, including where “there is an express obligation in a regime that business should be conducted outside the state or territory,” or when the jurisdiction “does not specify a requirement that activities need to be … real economic activities,” or even when “a regime allows an activity that may under certain circumstances be considered not to constitute a real economic activity.” This seems designed to catch anything that the Code of Conduct Group wishes to object to.

Also, many of the activities carried out in international finance centers are specifically listed by the EU as being likely to require investigation, including “intra-group financial services, intra-group captive insurance, and co-ordination centers.”

What the Code of Conduct Group requires is “an adequate number of employees with necessary qualifications and an adequate amount of operating expenditure with regard to the core income generating activities.” Those core activities might include:

  • For financial services, “agreeing on funding terms, monitoring and revising agreements and managing risks”;
  • For insurance, “predicting and calculating risk, insuring or re-insuring against risk and providing client service.”
  • However, “pure equity holding companies” need only perform more administrative roles, such as “must respect all applicable corporate law filing requirements.”

This shows one of the practical difficulties of the economic substance test; the level of activity that might be expected will be different for different businesses.


One major change for jurisdictions like the Cayman Islands is that the EU is also insisting that finance centers must monitor the economic substance of the entities in their jurisdiction. This is going to require much more information to be collected from companies, funds, trusts and other registered bodies, which is going to cause additional costs, for both business and government, and lack of privacy.

The well-priced model of many international finance centers, getting the level of regulation right, neither too lax nor too expensive, is in danger of being destroyed.

The jurisdiction also has to provide aggregate information to the EU, such as “the number of taxpayers benefiting from the regime” and “the aggregate amount of net income benefiting from the regime.” The concern here is that the Code of Conduct Group will use this information to launch further attacks on those finance centers that continue to be successful, using their compulsory information powers to find where they think they can grab the most money.

Investment funds

For the Cayman Islands, one very important question will be how to deal with investment funds. Predictably the EU does not give any guidance on this.

What level of activity would be expected for an investment fund?

Surely very little; where there is a separate fund manager, the only normal activities of the fund would be administration and a certain amount of high-level management, both of which can be done on Cayman already. So, it may be that investment funds will not be greatly affected by these changes.

Might the Code of Conduct Group go further and insist on the day to day fund management being carried out on Cayman in order for a fund to be regarded as having economic substance there? That would be absurd; the whole point of investment advisers is that the management of investments can be (and usually is) separated from ownership of the assets.
Doing so would cause problems for investment management around the world.

The future

So, what does the future hold for those finance centers that have committed to following the European Union’s economic substance rules?

One problem is that the requirements are vague, but there is no independent system to rule on whether jurisdictions have complied. The sole arbiter is the EU Code of Conduct Group, and if it decides that a jurisdiction is not demonstrating sufficient commitment to economic substance – in its laws, its enforcement and its reporting – then that jurisdiction can be placed on the blacklist.

The EU has been attacking international finance centers for over twenty years now, so we have some experience of their way of operating. Sadly, what we have seen very clearly is that compliance with the EU’s demands does not make you its trusted partner. Whenever offshore finance jurisdictions have changed their systems to comply with the EU or OECD demands, rather than satisfying them it merely means that those demands are very soon increased. What may be acceptable to the Code of Conduct Group in 2019 is unlikely to remain so in 2022.

How will Cayman fare? That depends on how much and what economic substance the EU demands for its main business sectors. Up to a point, Cayman can provide more substance, and benefit from it; it can expand, up-skill, perform more business activities than it currently does, and benefit from capturing a bigger proportion of each company’s operations as they move more activities offshore to demonstrate substance. However, at a certain point the physical limitations of a small island will make further expansion difficult. But what we will not see overall is operations and investments, or taxable profits, returning to the EU.

Studies into the reaction of businesses and investors to these requirements have found that, rather than moving operations back to high tax countries and facing ever-increasing tax bills, they will do the opposite and move more of their actual activities to low-tax locations, to make it easier to demonstrate economic substance there.

This will be a huge problem for the European Union, because when those economic activities are moved out, they do not only lose corporation tax, but they lose jobs, income and employee taxes as well. The competition will not be between Cayman and the high-tax EU countries, but between Cayman and the low-tax ‘onshore’ centers – Ireland, Estonia, Luxembourg, which can more easily handle more activities and so have more scope to demonstrate substance.

Offshore substance legislation draws nearer

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The European Union last year accused several offshore jurisdictions – the Cayman Islands, Jersey, Guernsey, the Isle of Man, Bermuda and the BVI – of violating the EU’s fair tax criterion, which stipulates that jurisdictions should not facilitate offshore structures that attract profits without real economic activity.

To avoid being placed on a blacklist of countries that are deemed uncooperative in tax matters, the jurisdictions committed in Nov. 2017 to addressing the perceived lack of tax fairness before the end of this year.

Cayman officials have been in constant dialogue with Brussels to determine the exact changes that offshore centers are expected to make in their local legislation to be deemed compliant.

So far, there have been very few details on what would constitute economic substance mainly because for some time EU member states had not agreed on a definition.

When they did, the EU’s guidance was not prescriptive but rather provided a framework.
The governments of Jersey, Guernsey and the Isle of Man were the first to act when they launched a public consultation in August, asking businesses for their views on proposed new legislation that will require certain tax-resident companies to demonstrate they have sufficient substance.

The three jurisdictions have collaborated in developing proposals that will require companies that are tax resident, and engaged in key activities identified by the EU, to demonstrate that they meet minimum substance requirements as part of their annual tax return.

The key activities identified by the European Commission’s Code of Conduct Group are: banking, insurance, fund management, financing and leasing, shipping, intellectual property, collective investment vehicles and holding companies that generate income from any of these key activities.

The substance requirements vary for each key activity to reflect the different needs of the companies involved.

Under the proposed legislation, companies generally have to demonstrate that the board of directors meets at certain intervals in the respective jurisdictions with a quorum of directors being physically present. The board of directors as a whole must have the necessary knowledge and expertise to discharge their duties as a board.

Strategic decisions must be made at the board meetings and reflected in the minutes of the meeting. Minutes and other company records must be kept in the jurisdiction.

In addition, companies have to ensure that core revenue-generating activities are carried out locally.

The core revenue-generating activities will be defined for each sector in the respective legislation, but the consultation documents noted certain elements.

For instance for fund management, the activities include taking decisions on the holding and selling of investments; calculating risks and reserves; taking decisions on currency, interest fluctuations and/or hedging positions; and preparing relevant regulatory and other reports for government authorities and investors.

If a business functions as the headquarter of a group, all relevant management decisions must be taken there, and group activities must be coordinated or expenses incurred on behalf of group entities to demonstrate core activities.

Holding companies, which purely hold equities, will need to confirm they meet all applicable corporate law and tax-filing requirements.

In addition, all companies that carry out relevant activities must be able to show that they have an adequate level of qualified employees in the relevant jurisdiction, as well as adequate physical office space and expenditures or corresponding outsourced activities in the jurisdiction.

Collective investment vehicles, however, should have reduced substance requirements in line with the local regulatory framework.

Tax resident companies that generate income from intellectual property will be required to show that they are managed in the jurisdiction and undertake income-generating activities like research and development, marketing, branding, distribution, risk management or other underlying trading activities to demonstrate sufficient substance.

How onerous these requirements are remains to be seen. It is also not certain how flexible the rules are for companies that outsource certain core activities to service providers outside of the relevant jurisdiction.

Cayman, meanwhile, has formed several working groups to review the EU’s guidance and provide input into legislative proposals to address the economic substance requirements.
In July, the Cayman government announced that it plans to consult the general public on the matter in due course.

Cayman’s credit rating confirmed

Rating agency Moody’s reaffirmed the Cayman Islands’ Aa3 government bond rating.
The rating, which applies to all bonds issued by the government, regardless of the currency, remains in the top tier of Moody’s rating matrix, three notches below the highest possible rating.

In its annual credit analysis, Moody’s noted that even though Cayman’s economy continues to be highly dependent on financial services and tourism, “the potential cruise terminal project and Cayman Enterprise and Health Cities could boost growth and help diversify the economic base in the medium to long term.”

Moody’s found that Cayman is wealthier and growing faster than other countries with the same credit rating but warned that the economy will slow marginally as large construction projects near completion.

Nevertheless, the rating agency expects tourism projects and infrastructure investments to continue to support the economy.

The rating report highlighted specifically the expansion of the Owen Roberts International Airport, the residences of Health City Cayman Islands, the construction of the 350-room Grand Hyatt Hotel and Residences, and a new cruise terminal in George Town.

Despite Cayman’s susceptibility to hurricanes, the overall risk profile is low, according to Moody’s, as a result of a strong institutional framework, fiscal oversight by the U.K. and low political risk.

The relative wealth of Cayman provides a strong buffer against weather-related shocks as evidenced by Hurricane Ivan in 2004, the report said.

Even though the storm inflicted damage equivalent to 200 percent of GDP, the country was able to recover quickly.

However, long-term economic risks from the loss of competitiveness in tourism or financial services could affect government finances, the rating agency noted.

Unemployment drops to pre-crisis level

Unemployment in the Cayman Islands has dropped to levels last seen before the financial crisis.

Estimates by the Economics and Statistics Office show the unemployment rate was 3.4 percent in April 2018, the lowest since 2007 when the rate stood at 3.0 percent. The unemployment rate was also significantly lower than the 4.1 percent seen a year earlier in spring 2017.

The figures were part of the Spring 2018 Labour Force Survey, carried out in April and May, which showed that unemployment among Caymanians had declined to a rate of 5.3 percent, compared to 6.2 percent in 2017.

Cayman’s economy has seen a consistent downward trend in Caymanian unemployment since it reached a peak of 10.5 percent in 2012.

The unemployment rate among permanent residents with the right to work fell from 4.8 percent in spring 2017 to 2.9 percent, and that among non-Caymanians from 1.7 percent to 1.3 percent.

The fall in unemployment coincided with a 1.5 percent rise in the total labor force.
According to the estimates, Cayman’s economy employed approximately 42,700 people in April. This is about 2.3 percent more than at the same time in 2017.

The Labour Force Survey estimates that, as of June 2018, Cayman’s population has reached 64,240, about 2.1 percent higher than 12 months earlier.

Despite the figures, Premier Alden McLaughlin said, government must do more to deliver on its commitment to full Caymanian employment.

He said red tape, inefficiencies and ministerial misalignments in the past had prompted the creation of the new Workforce Opportunities and Residency Cayman (WORC) Department, which is due to launch in the coming year.

One of the improvements expected from this initiative is a new government function that will work with key private sector employers to plan for the long-term labor market needs of the economy.

Economy grows faster

The fall in unemployment followed a period of stronger than anticipated growth in 2017.
Gross domestic product grew by 2.9 percent in real terms following similar growth of 3 percent in 2016 and 3.1 percent in 2015.

The economic expansion was significantly higher than previous forecasts of 2.1 and 2.4 percent throughout last year.

The construction industry and tourism were the main drivers of the economy last year.
Construction activity, which showed growth of 7.2 percent, dropped off slightly after even stronger growth years in 2016 (7.6 percent) and 2015 (7.9 percent), but this was due to the completion of the Kimpton Seafire resort in late 2016.

Still, construction activity saw a $800 million-record high of project approvals.

Meanwhile, tourist arrivals reached 2.15 million visitors last year as Cayman benefited from the misfortune of other holiday destinations in the Caribbean that were forced to close after they were hit by hurricanes Irma and Maria.

As a result, tourist arrivals in Cayman were 2.4 percent higher than in 2016 and stay-over tourism increased by more than 8.5 percent, especially coming from the U.S. and Canada.
Tourism-related services such as hotels, restaurants and bars also showed a combined growth of 8.5 percent during the year.

The financial services industry, which includes banking and insurance and makes up 41 percent of the economy, grew 1.4 percent, partly due to the low demand for domestic credit by the public and private sector.

Combined with professional services, such as corporate registration, legal and accounting services, which are largely finance-related but classified separately under international statistical standards, the finance sector in Cayman contributes more than half of the economy – 55.6 percent of GDP.

The professional services sector grew by 3.6 percent last year.

The economy is projected to grow by 3 percent in 2018, 2.7 percent in 2019 and 2.2 percent in 2020.

The slight downward trajectory is a reflection of growth forecasts by the International Monetary Fund for the U.S. and other advanced economies that Cayman relies on.

Optimism for the economy is mainly based on the continued strong performance of the construction sector, with many tourist accommodation and residential projects already well under way.

However, two key challenges remain and could put economic projections in jeopardy.

Firstly, the threat of instituting a public register of beneficial ownership in Cayman through an order in council could have an effect. For the time being, government must wait until an order in council is made before it can challenge it. This is unlikely to happen before the year 2020.

In the meantime, government will consult with its legal advisers about the necessary steps, involving judicial review and a potential appeal, should it be necessary.

The second key challenge is the ongoing risk that Cayman may still be placed on the EU blacklist of non-cooperative countries in tax matters, which could attract punitive measures.

To avoid such a blacklisting, Cayman has committed to resolve any issues concerning a lack of economic substance among Cayman-registered entities, identified by the EU.

Cayman remains top center for offshore M&A deals

The Cayman Islands saw more mergers and acquisition transactions than any other offshore jurisdiction in the first half of 2018, as the total value of Cayman deals increased by nearly 50 percent over the second half of 2017.

However, Cayman mirrored other offshore centers with a slight drop in the volume and an increase in transaction value, according to a report by offshore law firm Appleby.

Cayman-incorporated companies were the target of 421 transactions worth a combined US$60.9 billion in the first half of 2018. This represented 31 percent of all offshore deals and 28 percent of total offshore deal value during that time.

Transactions were down 9 percent from the second half of 2017, while deal value was up 49 percent. The higher deal value is caused by Cayman being the home to four of the 10 largest offshore deals in the first six months of the year.

A total of 1,344 offshore M&A deals recorded in the first half of 2018 equated to a 10-percent decline compared to the last six months of 2017. However, the total deal value of $216 billion marked a 68-percent jump over the second half of last year.

It was driven in part by the $62 billion acquisition of Jersey-incorporated Shire PLC by Japan’s Takeda Pharmaceutical. Each of the offshore region’s 10 biggest deals was worth more than $2 billion.

In terms of deal activity, Cayman was followed by Hong Kong (334 deals), the British Virgin Islands (236 deals) and Bermuda (146 deals). Jersey was the offshore leader in terms of total value in the first half of 2018 as a result of the Shire PLC acquisition, Appleby’s Offshore-i report noted.

Meanwhile, the record activity around offshore IPOs in 2017 continued in 2018, with 180 companies announcing their intention to go public in the first half of the year. Offshore IPOs typically occur on U.S., London or Hong Kong stock exchanges, with Hong Kong being an especially popular choice for the Cayman Islands. Cayman is by far the busiest jurisdiction for IPOs involving offshore companies, as 71 of the 80 IPOs completed in the first half of 2018 involved Cayman entities.

Opportunities for crypto-havens to capture business

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Blockchain technology is set to drive a new era of global public policy competition. In May 2018, the premier of Bermuda, David Burt, announced to the 8,500 attendees of the Consensus blockchain and cryptocurrency conference his country’s new Digital Asset Business Act and Initial Coin Offering Act. This legislation is intended to establish Bermuda as a premier destination for blockchain business by providing regulatory certainty around new business models.

But Bermuda is hardly the only jurisdiction seeking to attract blockchain firms. Singapore, Switzerland, Dubai, Estonia, subnational jurisdictions and dependencies like Illinois, Zug, the Isle of Man and Gibraltar are all positioning themselves to capture blockchain services. In October 2017, the then prime minister of Slovenia, Miro Cera, declared the country was “setting itself up as a blockchain-friendly destination.”

What we are seeing right now is an aggressive policy-driven grab to become a world leader in blockchain technology, and to capture some of the enormous value that this can unlock. Where once we saw global tax competition – as small nations attracted investment with business-friendly tax and regulation policy – now we are able to watch the green shoots of global blockchain competition. Blockchains are a unique technology, and that uniqueness presents some unusual public policy challenges. They offer us a new platform to organize economic activity: to make trades, to arrange production processes, to store information about assets and property ownership. Blockchains provide an economic infrastructure on which parallel technological developments, such as artificial intelligence and machine learning, the Internet of Things, 5G, and automation, can be built.

We expect to see a great deal of economic activity that currently takes place in firms, in markets, even in government, to be displaced by distributed ledger technology. Blockchains will tie organizations together that have currently cooperated only through market exchange, or by the force of regulation. It will lead to demergers, as large firms realize that a decentralized ledger is an alternative to complex multidivisional corporate structures.

But we have spent hundreds of years building complex taxation and regulatory systems around these institutions. The dominance of large firms has led governments to impose anti-trust laws. Principal-agent problems between owners and firm managers has led to the introduction of complex schemes of directors duties and manager controls. Securities law is built around the dominance of the public offering, taxation law around a sharp distinction between currency and other assets, and labor law around the employer-employee divide.

As a new technology of governing economic activity, blockchain applications pull at the threads of all these traditional regulatory frameworks. Globally, there are still deep uncertainties over the most basic questions around cryptocurrencies, such as when they are taxed, and as what: currency or security? The initial coin offerings that have brought so much money into the industry exist in a legal gray area almost everywhere in the world.

Blockchains are an incredibly young technology – just ten years old. Distributed autonomous organizations, decentralized labor markets, blockchain-secured intellectual property assets and blockchain-enhanced international trade will raise complex issues about fundamental regulatory structures, like labor, competition, and companies law – structures which have been reasonably fixed for the better part of a century. As more applications around economic problems, such as identity management, charities, healthcare, finance and global trade, are developed and introduced into the real world, they will face a spiraling number of regulatory and policy barriers that will need to be overcome. We face decades of regulatory uncertainty and demand for reform.

This is where crypto-friendliness matters. Crypto-friendliness does not mean the government needs to subsidize, plan or control blockchain technology. The sector is awash with funds: a happy by-product of the enormous speculative investment in cryptocurrencies that has occurred over the last eighteen months. No government planner could predict how this technology is going to develop, and given its global nature, no regulator has a hope of controlling it.

But blockchains do require governments to facilitate adoption. Because of the many ways blockchain use cases interact with existing regulatory frameworks they will need the help – or at least the acquiescence – of public policymakers to reform those frameworks to suit. The biggest regulatory risk in the blockchain space is uncertainty. Right now, those uncertainties are about how crypto-assets will be taxed, how and when they will be treated as securities, and the levels of disclosure around anti-money laundering and know-your-customer rules.

Governments that want to attract blockchain firms to their jurisdictions need to be resolving those uncertainties as soon as possible.

A crypto-friendly government is one which is not only focused on resolving current uncertainties but is able to credibly commit to facilitating the sorts of regulatory reforms needed in the future. Technological change is unpredictable. We do not know what blockchain applications are going to be the most successful and disruptive. Consumer demand is unpredictable. Governments should ensure, as far as possible, that regulation is both predictable and adaptive, that shape-changes in regulatory regimes do not occur, and that yet there is adequate space for entrepreneurial experimentation.

Which governments are likely to be the most crypto-friendly? At the first instance, the governments which have already demonstrated themselves as business-friendly environments are obvious candidates for blockchain friendliness. The ingredients of long-run economic growth – liberal, responsive institutions, the rule of law, limited government, regulatory modesty, and low taxes – are as important for blockchain firms as they are for other industries. The Isle of Man, for instance, has long been an established global leader in gambling and e-gaming, thanks to a deliberate effort on its part to establish welcoming and certain public policy. The Isle of Man is now a thriving site of blockchain innovation. As this suggests, blockchain technology presents a historically significant opportunity for the Cayman Islands, and any other jurisdiction which has a reputation for business-friendly policy. The last few decades of global tax competition have shown that smart policy can shape the geography of global capitalism just as strongly as labor or natural resources. Blockchains are a decentralized network but their developers, entrepreneurs and users exist in a real world, subject to real laws. Crypto-havens can capture that business.

Chris Berg, Sinclair Davidson and Jason Potts are with the RMIT University’s Blockchain Innovation Hub in Melbourne, Australia.

The administrative state

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King George III decried Thomas Jefferson in America’s Declaration of Independence “has erected a multitude of new offices, and sent hither swarms of officers to harass our people, and eat out their substance.” While Jefferson was channeling the colonists’ ire at imperial customs officials, his words resonate with anyone forced to deal with modern administrative bureaucracy.

Indeed, the problem with bureaucracy has gotten so bad that, in the U.S. at least, that it is often referred to as a fourth branch of government – the “administrative state,” or even the “deep state.” All of these descriptions mark an admission that administrative law has some form of existence outside the norms of western liberal democracy. Tackling the problem will require a return to those norms.

The administrative state is legitimate in the strict sense of the word. Everything about it has been set up by act of either Congress or Parliament. Courts have repeatedly found this process legitimate under the relevant constitutional requirements. The legislature, courts have found, has the right to delegate certain of its legislative powers to the executive, allowing the administration to write rules that have the force of law.

To American eyes, this may seem strange. The Constitution says that “all legislative powers … shall be vested in a Congress of the United States.” This would seem to preclude the delegation of such powers to the executive, which is a separate but equal branch of government. Delegation would seemingly breach this principle of separation of powers.

However, early in the republic’s existence, the U.S. Supreme Court blurred this once-bright line. In 1825, the court ruled that while Congress must deal with “important” subjects, mere details could be left up to the executive (Wayman v. Southard). A century later, in 1928, the court went further, saying that the legislature may delegate powers as long as there is an “intelligible principle” to which the executive must conform (J. W. Hampton, Jr. & Co. v. United States).

The edifice built on this slim foundation has proved mighty indeed. Huge numbers of executive agencies have sprung up – so many that even federal agencies cannot agree how many there are – the Department of Justice says 252, the U.S. Government Manual says 316, and says 443. Not only do these have rulemaking and enforcement powers, many of them have their own courts, whose procedures must be exhausted before one can even think about appealing to the U.S. federal courts.

In the beginning, these agencies generally regulated via enforcement, which generated great uncertainty for those on the receiving end of regulations. That meant that one might not know one was running afoul of administrative law before being charged with an offense.

Resulting quasi-judicial decisions set precedents for regulated parties to follow.

The recognition that this was a problem led to the passage of the Administrative Procedure Act, which set out “rules about rules.” All rules had to go through a period of notice and comment. The agency would publish a draft rule and request comment from affected parties and the public. The agency would assess the resulting comments in order to improve the draft rule.

Theoretically, this would mean significant stakeholder involvement in the creation of the rule, but it does not always work that way. Some controversial rules receive hundreds of thousands of comments, which are often simply ignored or dismissed. Some laws require a cost-benefit analysis, which sometimes takes the form of a discursive discussion of potential costs and benefits, when it is performed at all. Rules that are supposed to be submitted to Congress are sometimes never submitted at all, raising questions as to their actual validity.

In some cases, the agency performs an end run around the Administrative Procedure Act by implementing policy via guidance documents and other issuances. These notes, manuals, interpretations, and even web postings can significantly alter the way a given rule is applied, without a notice-and-comment period. In one case, the Obama administration changed a significant rule about the classification of independent contractors by means of a blog post.

All of this means that it is very hard for anyone to know whether they are affected by a regulation or not. According to my Competitive Enterprise Institute colleague Wayne Crews, 24,557 notices pertaining to regulation appeared in the Federal Register in 2016. He calculates there have been 550,489 public notices since 1994 and well over a million since the 1970s.

All this might be less of an issue if the courts imposed an effective block against excessive regulation. Yet courts have time and again found ways to defer to agency interpretation and imposition of law. The current guiding doctrines are known as “Chevron” and “Auer” deference.

Chevron deference holds that courts should defer to agency interpretation of a law passed by Congress as long as the agency does not misinterpret an unambiguous instruction and if the agency has a rational basis for its action. That means that even when another more reasonable interpretation is available, the courts should defer to the agency interpretation.

Auer deference goes further, saying that courts must defer to the agency that wrote a regulation for its interpretation, unless the interpretation is plainly erroneous.

Combined, the Chevron and Auer deference doctrines mean that what agencies say generally goes when it comes to regulation.

These doctrines are based on the notion that agencies generally have more expertise regarding the details of regulation and regulated industries than courts. It would take up a lot of court time to fully understand the complexities of a regulation and come to a ruling, so it is easier for courts to defer to the experts. Such an assumption of expertise is an example of what economist Harold Demsetz called the “Nirvana fallacy,” which assumes a perfect alternative, in this case to the unregulated state.

Predictably, Chevron and Auer deference tilt the playing field in favor of more activist government. All an agency has to do is come up with a rational basis for its regulation and write it in a manner consistent with that rationale – and the courts will not stand in the way.

It makes judicial challenge to a burdensome regulation extremely difficult. This is especially a problem in cases where agencies have discretion to promote new rules consistent with a general mission. The lawmaking process becomes a matter of executive whim rather than deliberation involving the people’s elected representatives, constrained by judicial review.

Yet, executive agencies still face a modicum of democratic accountability. The president, as head of the executive branch, may constrain hyperactive deputies via executive order. But Congress has set up agencies that are independent of the executive branch. These agencies, which are even more removed from the democratic process, generally have wide discretion to make rules or undertake enforcement actions. A commission structure provides a democratic fig leaf. Under this arrangement, commissioners are nominated by the president and confirmed by Congress. The ruling party generally has three commissioners and the opposition party has two, allowing for a form of internal deliberation that mimics Congressional decision-making.

Recently, however, there has been a move towards ignoring even the commission structure. Agencies like the Federal Housing Finance Agency, the Office of Financial Research, and the controversial Bureau of Consumer Financial Protection (BCFP) have been set up to be led by one individual director. Isolated from presidential control and effective oversight by the Congress or courts, these agencies have almost complete discretion to do what the director likes within the powers granted to them by Congress. In the case of the BCFP, those powers are extensive.

With such concentrated power and so little oversight, other considerations come into play. The theory of “public choice,” developed by the Virginia school of economics, suggests that bureaucrats will work to expand their power to their own advantage. The suggestion of a former head of the BCFP that it should “push the envelope” in exercising its powers is a case in point.

Similarly, during the Obama administration, a team of Department of Justice lawyers came up with a way to stop businesses they did not like from operating. “Operation Choke Point,” as they named it, used increased supervision of banks to dissuade them from providing banking services to a range of industries, including porn stars, firearms dealers and payday lenders. The rational basis was that these industries posed a “reputational risk” to the banks.

Yet, Congress had passed no law restricting these industries. Indeed, porn stars and firearms dealers are supposed to be protected by the First and Second Amendments, respectively. Nevertheless, a team of bureaucrats took it upon themselves to try to regulate them out of existence.

Another public choice-based critique of the administrative state is that the people who go to work at interventionist agencies generally agree with the interventionist mission. This implies that they are more likely to seek to expand their power than not, even in a burdensome manner. This problem is compounded by labor and employment law, which generally make it extremely difficult to fire a civil servant working under a union-negotiated collective bargaining agreement. This further insulates bureaucrats from any repercussions for following an agenda aimed at expanding their powers.

The modern administrative state has become a significant burden on the American economy. Wayne Crews estimates that the cost of regulation is roughly $2 trillion annually, around 10 percent of gross domestic product, and imposes a substantial burden on every U.S. household.

Remedies to this situation need to begin with the delegation principle. Congress should stop delegating as much as it has and reclaim some of the powers it has delegated away. One way to do this would be to establish a bipartisan “Regulatory Reduction Commission” that would be tasked with reviewing existing regulations and recommending a package of regulations that are too costly, burdensome, or outdated to roll back every year. New regulations and agencies should be established with sunset clauses whereby the rules can be repealed and agencies shuttered when they have run their course (although the persistence of the Export-Import Bank after its authority expired suggests this is more easily said than done).

Courts must also play their part. There is some appetite on the current Supreme Court to revise the deference doctrines, but if it declines to do so, Congress can instruct them. The rational basis test needs to be addressed. If a less burdensome solution presents itself, there should be some way for an affected citizen to petition the government to adopt it.

The administrative state has been around for about a century. Its evolution into the current overarching problem should not have been a surprise. When British ministers were beginning to accrue similar powers to themselves in 1929, the then Lord Chief Justice, Lord Hewart, wrote a book warning of the erosion of self-government it represented. He titled it, “The New Despotism.”

Cayman’s economic substance

The Ritz-Carlton, Grand Cayman

When talking about the economic substance of an offshore jurisdiction, I believe this is an area where the Cayman Islands particularly excels. Unfortunately, the perception of many still remains that an offshore jurisdiction is purely a tax haven rather than what they actually are, a place that facilitates sensible tax planning within the laws of the land.

While the Cayman Islands leads the way in many facets of offshore financial services globally, the substance to our economy lies in the fact that it is diverse and has many successful pillars. This is why individuals and companies choose to relocate here, making these islands so much more than just an offshore financial services jurisdiction.

There are multiple pillars that help support our economy. While the financial services industry contributes the most to our GDP, tourism, real estate, construction, development and medical tourism all also play an important part in diversifying our economic base. Part of the draw of this location has been powered by the internet, giving people the ability to do business from anywhere in the world and, as such, many different individuals and companies have, and will, take advantage of this, with the lucky few who are able to do so taking up residence here.

I say the “lucky few” because the islands do have strict immigration policies to which prospective residents must adhere. There is only so much physical space available and a quick monitor of the real estate industry will reveal that we are definitely in a state of demand rather than supply at the moment.

Many people who decide to relocate to Cayman do so because of the extraordinarily great lifestyle it offers residents. Cayman is a place where our children can grow up in harmony in a healthy environment that is conducive to outdoor activities and where they can engage with their surroundings. As such, those looking to relocate here and take advantage of this incredible environment ought to do so sooner rather than later.

Investment indicative of substance

One only has to look at the sheer size of investment currently being made into Cayman’s infrastructure at the moment, such as the expansion of the Owen Roberts International Airport, the improvement to our road networks, and the proposed new dock in George Town, all multi-million-dollar projects to help grow our economy. These projects offer tangible substance where some jurisdictions might not have the same level of investment to demonstrate their own claims of substance.

Other indications that our economy is growing and maturing include the way we are currently implementing first-world solutions to issues such as waste management and energy issues, for example, by creating the solar farm in Bodden Town and implementing other renewable energy projects. As a nation, we have become conscious of the environment and we want to protect what we have and what we leave behind for our children.

Real estate industry’s contribution

The fact that so many businesses and individuals over the years have chosen to relocate to Cayman has undoubtedly made a positive impact on our real estate industry. But it should be noted that this is not the only reason why we see such a buoyant market in the Cayman Islands. Vacationers are often drawn back here to relocate permanently or semi permanently, plus the local population also inputs tremendously into our industry. As a result, the active real estate market adds substance to our economy, which in turn is backed up by the many different arms to the economy, which equals depth and breadth that is unmatched by most other offshore jurisdictions.

Cayman is currently in an exceptionally strong position, with good economic growth, good population growth, financial stability and political stability. It has a great deal going for it as a country. The fact that Cayman is so successful is in itself the momentum to drive even more economic activity. The challenge for the Islands now is to ensure that the economic growth is sustainably managed to the point that the Cayman people want, to ensure that it reaches and does not surpass the levels that offer the right balance of economic success while maintaining this beautiful environment that we call home.

South Africa’s dangerous land confiscation game

South Africa
Although the African National Congress (ANC) backed off its recent land confiscation push, the threat of economic redistributionism still looms in the African nation.

Trouble may be brewing in South Africa.

Although the African National Congress (ANC) backed off its recent land confiscation push, the threat of economic redistributionism still looms in the African nation.

The threat started when the ANC and the (ironically named) Economic Freedom Fighters (EFF) voted for a Constitutional Amendment allowing land confiscation without compensation. This motion was approved by a 241-83 margin and was set to go through a constitutional ratification process. The socialist coalition that spearheaded the land confiscation initiative justified its passage arguing that it would tackle racial disparities.

But this bill was not without its fair share of international backlash. After considerable international outrage and U.S. President Donald Trump’s concerns over the nature of these expropriations, the South African government has put the brakes on land expropriation for the time being. Nevertheless, there are still talks to reintroduce this bill with more politically palatable language and provisions.

The underlying problem is government meddling

Although the cries of the racist overtones behind these expropriation attempts are warranted, the real problem lies in the socialist nature of these measures. What is at stake in these debates is the integrity of private property, the bedrock of any stable economy.

Attacks on South African property rights are the first steps in destabilizing one of Africa’s most prosperous economies. Not only will land confiscation affect economic output in the short-term, but it will have negative spillover effects into other sectors of the South African economy.

Land confiscation will very likely create regime uncertainty throughout the South African political economy. This concept, which economist Robert Higgs coined, refers to the uncertainty that arises after a government intervenes strongly in an economy. In the South African case, the uncertainty surrounding the legal and political status of property could produce substantial declines in investment and production. Due to this uncertainty, property owners are reluctant to invest in their property holdings or maintain them for fear of confiscation.

In the same vein, foreign investors will become leery about investing their resources in South Africa. But unlike the capital-rich residents of South Africa, they can take their capital out of the country with ease. Many historical cases of out of control government interventionism have shown that governments are willing to put the clamps on citizens who dare take their talents abroad. In sum, when private investment drops off, economic malaise follows. This is a very realistic scenario should South Africa follow through with its confiscation gambit.

And scaling back economic irrationality is no easy undertaking. Once economic interventions are initiated, they become very difficult to reverse. Given the capricious nature of politics, more interventions could follow, thus exacerbating economic downturns.

How South Africa arrived here

South Africa has been playing a dangerous game of economic interventionism over the past few decades. After ridding itself of the unjust Apartheid system, South Africa established itself as one of Africa’s most prosperous and economically free countries. But as time progressed, it has fallen for the false allure of statism.

Since 2000, South Africa has expanded its public sector and increased overall public spending, with no meaningful attempts to liberalize other sectors of the economy. Additionally, South Africa has witnessed its tax hiking strategy to be ineffective in raising revenues. The result has been slower economic growth and a considerable drop in South Africa’s economic freedom rankings. Once ranked at 36th place, South Africa found itself at 88th place in economic freedom as of 2014.

Despite troubling indicators, South Africa continues to go down the path of big government. But now it might be entering a new phase of government growth; one that threatens the country’s institutional underpinnings.

Is South Africa following in Zimbabwe’s footsteps?

With the recent call to expropriate white land-holdings, South Africa is taking a page from its northern neighbor’s ‒ Zimbabwe ‒ playbook. Since Robert Mugabe came into power in 1980, Zimbabwe went from one of Africa’s most prosperous countries to a complete basket case.
In 2000, Mugabe started out by targeting the landholdings of affluent white farmers. This made for good politics given Zimbabwe’s colonial past. Channeling anti-imperialist rhetoric and scapegoating the affluent is the hallmark of Third World demagogues.

Under Mugabe’s regime, easy money, land expropriations, and big spending were policy fixtures. Logically, these policies produced disastrous results ‒ inflation and the destruction of Zimbabwe’s productive capacities. Reports from the Commercial Farmers’ Union revealed that agricultural production fell by $12 billion from 2000 to 2009 thanks to Mugabe’s confiscation measures.

But confiscation was only one part of the all-inclusive package of economic statism.

Throughout his regime, Mugabe made sure to turn the Zimbabwean Central Bank into his personal printing press. Monetary policy was based on satisfying political whims and financing government largesse, instead of focusing on sustainable growth. The result was a world famous hyperinflation that forced Zimbabwe to dollarize after the government destroyed its local currency.

With its economy in dire straits, Zimbabwe saw millions of citizens leave the country in search of better prospects. Although a recent military coup deposed the Mugabe regime, its remains to be seen if Zimbabwe will opt for more market-oriented policies and get its institutions in line.

One thing from the Zimbabwean experience is clear: The genesis of its economic tragedy was land confiscation.

South Africa should look toward Botswana

In stark contrast to Zimbabwe, Botswana offers a pragmatic alternative for South Africa to follow. Since gaining its independence in the 1960s, Botswana started out as one of Africa’s poorest countries. However, that did not stop it from embracing audacious economic reforms.

Unlike many of its Third World counterparts, Botswana discarded victim politics and looked toward the market as its vehicle for progress. By establishing the rule of law, defending property rights, and avoiding foreign aid dependency, Botswana established itself as a regional exemplar.

Botswana, exploited its comparative advantage, diamond production, to become one of the world’s fastest-growing economies and arguably the most institutionally sound country in the African continent. Botswana’s dedication to pursuing rational economic policies has landed it in 35th place according to the Heritage Foundation’s 2018 Index of Economic Freedom.

So not all hope is lost in South Africa. It at least has a positive neighborly influence to look at for policy inspiration. Third World countries are not poor because they are culturally backwards. They are poor because they do not possess political institutions that are conducive to economic growth.

South Africa cannot rest

Despite the positive example set by its northern neighbor in Botswana, South Africa is preparing to emulate the same land confiscation prescription that destroyed Zimbabwe. Zimbabwe serves as a stern warning to South Africa should it embrace the tempting mistress of socialism.

Since the 20th century, it has been fashionable for the political class to pursue interventionist policies such as easy money, price controls, and fiscal irresponsibility. Should South Africa proceed with land confiscation, it will likely go down this interventionist death spiral. Left unchecked, the state’s natural tendency is to grow. And economic crises give demagogic politicians the perfect opportunity to justify their interventions.

On the investment front, there is a lot at stake for South Africa. Foreign investment is key for many developing countries to advance economically. But when property rights are on the chopping block, investors will give South Africa the cold shoulder.

In fact, jurisdictional competition is already very strong worldwide. Nations are constantly competing for investment and human capital across the globe. When one country tries to brazenly destroy wealth, foreign investors can find more lucrative options. South Africa is no longer alone as an attractive option for foreign investment in Africa. Its northern rival Botswana offers a more institutionally sound and economically free alternative to the increasingly statist South African system. All things being equal, investors will likely shift their operations to Botswana should the situation in South Africa continue to deteriorate.

The political class never learns

Sadly, many in the South African political class like the ANC and EFF parties believe that doubling down on economic interventionism will somehow put South Africa on the path to economic prosperity. The allure of trying to correct supposed injustices through state force is politically tempting. When dealing with state intervention, however, the devil is always in the details.

Channeling redistributionist politics is a great strategy for myopic politicians whose only concern is to rack up vote counts. Sprinkle in some race politics, and you have an attractive political platform.

Sadly, modern-day politicians do not look beyond stage 1. They pay no attention to the potential long-term effects of their economic policies. There is no telling what kind of demagogues will succeed them once they’re long out of office. More often than not, political successors in statist environments ratchet up previous interventions.

And it makes sense. Government growth is already hard to scale back. Disgruntled voters will clamor for more government, despite evidence showing that the economic crisis they face was caused by government meddling in the economy in the first place. Alas, contemporary politics based on feel-good intentions does not allow for such farsighted thinking.

Expropriating private property could take South Africa to a point of no return. It is easy to boil economic policy down to figures and graphs, but the implications of interventionism go beyond fancy numbers. South Africa’s social fabric could be in jeopardy.

South Africa’s path to prosperity is simple: It should discard any idea of property confiscation and look to deregulate its economy as much as possible. The primitive form of statism South Africa is flirting with will condemn it to the soup kitchen of national poverty.

Socialist state confiscation has failed repeatedly, but political demagogues insist on defying the basic laws of economics. The facts show that socialism is an economically and morally bankrupt system.

But old political habits die hard.

More than a bubble

Cayman Financial Review Logo

Ten years ago, massive uncertainty roiled financial markets. Major firms collapsed or teetered on the edge of insolvency. Asset values plunged. Every TV show and news story speculated about bankruptcies and bailouts. It seemed like the beginning of another Great Depression.

We did not get a repeat of the 1930s, but there was a serious recession in most nations. Moreover, many of those countries have not enjoyed strong recoveries, which some argue is a characteristic of downturns caused by bubbles and debt.

That economic hangover is augmented by a political hangover – at least to the extent that one believes that populism in various countries is driven by economic angst. Trump and Brexit could be interpreted as the most visible signals, but voters in many nations rebelled against the establishment.

At the very least, the financial crisis presumably was the most meaningful economic event since the stagflation and malaise of the 1970s. Perhaps even since the Great Depression.

Causes and consequences

Unsurprisingly, there is not agreement on the consequences of the financial crisis. And there definitely is not agreement on the causes of the crisis.

We are contributing to the debate in this magazine, with articles by Bill Stacey, chairman of the Lion Rock Institute, and “Hamilton,” which is the pen name of a senior Washington economist who must remain anonymous.

They identified some of the key issues that have not been resolved.

Monetary policy – To what extent did central banks create the conditions for the housing bubble? Perhaps more important, did they learn from that mistake, or are we currently still in the midst of a period of artificially low interest rates? Everyone likes the sugar high when excess liquidity is being created. But it is never fun when the party comes to an end.

Housing subsidies – The United States has numerous policies designed to boost residential real estate. There are preferences in the tax code, as well as spending programs that funnel money to the sector. But Fannie Mae and Freddie Mac were the most important drivers of last decade’s housing bubble. For what it is worth, those two government-created entities still exist and there are concerns that they are repeating their mistakes.

Rating agencies and regulatory standards – What is the point of having the government mandate the use of firms like Moody’s when such firms have a less-than-impressive track record? On a related note, what is the value of Basel standards that inaccurately rank the safety and soundness to mortgage-backed securities and government bonds?

Risk perception – The private sector also deserves a portion of the blame. Did individual investors and financial institutions rely on poorly designed models that understated risk and/or failed to capture important variables? Did they blithely assume that everything was okay so long as they could point to the credit-rating agencies and/or technically comply with regulatory standards?

Our authors suggest some answers to these questions, though it is not clear that regulators and policy makers are listening.

If you look at the response from Washington and other national capitals, the knee-jerk response to the crisis started with panic, then shifted to finger-pointing, and eventually ended with either the status quo or more regulation.

Very little attention was given to structural reforms to remove housing subsidies. And there has been even less discussion of whether it is a good idea for central banks to engage in Keynesian-style monetary policy.

A debt bubble?

When we think about whether lessons have been learned, it is important to understand that not all bubbles are created equal.

If someone’s home doubles in value, that does not necessarily mean volatility and instability. At least if the homeowner is prudent and doesn’t decide to take on a large amount of new debt. If home prices come back down, our prudent owner simply shrugs. A paper gain is offset by a paper loss.

But what happens if the owner responds to higher home values by refinancing? Perhaps lured by the temptation of a low-rate mortgage, what if the owner decides to borrow against the additional value, based on the assumption that the home’s value will stay high, or even keep rising? This is the person who can wind up underwater, owing more than the property is worth. And if this happens often enough in an economy, it becomes a crisis.

The point of this simple example is to underscore that the problem is not necessarily the existence of a bubble. Instead, what we should worry about is a leveraged bubble.

Which brings us back to the issue of central banks keeping interest rates at artificially low levels. It raises the concern of tax codes that tilt the playing field in favor of debt over equity. And it should lead us to wonder about the wisdom of TARP bailouts and IMF bailouts that may lead to even more mis-priced debt because of the perception that there may be future bailouts.

Demographics and government debt

Last but not least, should we incorporate demographic projections into our analysis? What is going to happen as baby-boom generations in various nations leave the workforce and put additional strain on public finances?

This may not seem directly connected to the financial crisis, but it is worth noting that almost all governments incurred a lot of debt because of how they responded to insolvent financial institutions and/or sputtering national economies.

And it is also important to remember that the crisis in Greece (and less extreme debt crises in Spain, Portugal, Italy, and Ireland) could be considered part of the crisis. Especially since bailouts for those governments may have been indirect bailouts for the financial institutions that held large portfolios of government bonds.

So what happens when the next recession hits? Will bond vigilantes descend upon Italy? Other Club Med nations may be vulnerable as well. Perhaps even France and Belgium. At some point, investors are going to realize that debt levels in Europe are far higher than they were 10 years ago.


The history of the financial crisis is far from settled. People in financial markets understandably want to understand more about what happened because they have a bottom-line incentive to be aware of factors that may affect financial markets and asset values.

People in public policy, by contrast, care about political effects rather than economic effects. Advocates of more state intervention want the history books to teach that the financial crisis was the result of untrammeled greed, capitalist instability, and excessive deregulation (the same story they successfully – but inaccurately – told about the Great Depression).

The proponents of economic liberalism want historians to tell a story of misguided intervention and subsidies. They want the history books to talk about policies enforced by entities such as the Federal Reserve, Fannie Mae, and Freddie Mac (in large part because they have only recently had some success in correcting the record about the Great Depression).
It hardly matters, though, which side wins the battle to “control the narrative” if the underlying problems remain unsolved.

BEPS – more sticks than carrots and lots of teeth

The OECD addressed transfer pricing specific issues of intergroup financial transactions, such as treasury functions, intra-group loans and cash pooling.

The Base Erosion Profit Shifting (BEPS) reform has some serious punch. The true extent to which BEPS will reduce aggressive as well as abusive tax planning schemes only becomes clear when looking at the fundamental changes of transfer pricing regulations on the level of individual transactions. This article discusses the impact of BEPS on intercompany transactions involving intangibles as well as financial transactions, illustrating that there is no need for additional anti-abuse policies (“beyond BEPS”). It will also be discussed that most of the anti-abuse policies currently on the agenda of policymakers are not targeted at limiting tax avoidance, but rather aim to maximize tax revenues by high tax governments.

The OECD addressed transfer pricing specific issues of intergroup financial transactions, such as treasury functions, intra-group loans and cash pooling.In my previous contribution to CFR (3Q/2018, Issue 52), I have pointed out that the reforms resulting from the BEPS project will have a su bstantial impact on transfer pricing and tax structures in the years to come. I further stressed that there cannot be any doubt that the BEPS project will largely succeed in facilitating a closer alignment between the place where value is created and where taxes are paid. I have primarily made these comments to criticize the EU for continuing to conceive and implement new and increasingly suffocating tax reforms that go far beyond the OECD BEPS reforms – notably, tax-grabbing policy proposals such as the Common Consolidated Corporate Tax Base (CCCTB) and the new approach to digital taxation, which are pet projects of the EU bureaucracy and some high tax governments who are committed to eliminate tax competition.

The most recent discussions on the level of the OECD provide a good opportunity to further substantiate my previous comments by illustrating how far reaching the impact of the BEPS project is already. To be sure, interpreting discussions involves a fair deal of speculation when anticipating policy outcomes. Still, as the implementation of BEPS reforms now enters the nitty-gritty stage of hammering out the new or modified regulations for specific types of intercompany transactions, it does no longer require a crystal ball to clearly recognize the challenges ahead. In the following, I will focus on illustrating the impact of BEPS on transactions involving intangibles as well as on financial transactions. Two things shall become clear:

  1.  BEPS will seriously curtail any abusive transfer pricing practices, with the burden of proof for arm’s length compliant pricing gradually being shifted to the taxpayer.
  2.  Policymakers should take a deep breath and start recognizing that, provided curbing aggressive tax structuring is their honest aim rather than pushing ahead a blatantly tax grabbing agenda, there really is really no need to introduce any additional anti-abuse policy proposals beyond BEPS at this time.

Intangibles – the fight over the economic interpretation of ‘value creation’ is not about limiting tax avoidance

Intangibles have been a focal point of the BEPS project. Specifically, the OECD was determined to enshrine the emphasis on economic value added as the basis for an arm’s length profit allocation (opposed to legal ownership) into the transfer pricing guidelines. As pointed out in a recent contribution to Tax Notes International (Vol. 91, No.8, pp. 797 – 800) respective modifications can be observed most clearly in the introduction of the so-called DEMPE concept, which is designed to identify the value contributions of each party to a transaction involving intangibles by analyzing the functions of Development, Enhancement, Maintenance, Protection and Exploitation. The extent to which each of these functions contribute to the total value-added will obviously depend on the idiosyncratic value-chain of the taxpayer, which can be reflected in the analysis by assigning differing weights to individual functions. Introducing the DEMPE concept will thus ensure that profits, specifically the residual profits resulting from the exploitation of intangibles, are closer aligned with value creation. In the pre-BEPS world, the legal ownership of an intangible was basically enough for allocating the bulk of residual profits to an entity with minimal substance located in a low tax jurisdiction. The introduction of BEPS effectively renders one of the core mechanisms underlying aggressive transfer pricing schemes unfeasible for the future.

What is noteworthy in this context, is that the OECD coupled the introduction of the DEMPE concept with issuing new guidance for tax administrations on the application of the approach to hard-to-value-intangibles (the HTVI approach), which is important when determining a selling price for intangibles that are transferred between related parties. The somewhat nasty aspect of the HTVI approach is that it essentially permits tax authorities to use ex-post financial results as presumptive evidence that the ex-ante price-setting was not consistent with the arm’s length principle. This implies that the value of an intangible that was sold between related entities for $20 million in 2018 (i.e., with the transfer price being based on a DCF analysis) would be subjected to challenges in future tax audits based on actual future value.

As the valuation of intangibles invariably involves dealing with substantial uncertainties, it will often only be feasible to determine a price within a range of feasible values. Now, if market developments or other unforeseeable developments will impact the value of the intangible, i.e., imagine an update of the DCF analysis conducted on data available in 2022 yielding a value of $50 million, the HTVI approach would (in this highly simplified example) essentially allow tax authorities to make a transfer pricing adjustment based on the $50 million (i.e., a price adjustment of $30 million) and to retroactively levy tax of the adjusted price.

Unsurprisingly, there was quite some discontent in the transfer pricing community during the public consultation procedure, but to no avail, as the OECD insisted on keeping this harsh anti-avoidance mechanism on the agenda.

As far as transfer pricing regulations go, the introduction of the DEMPE concept could be interpreted as being sensible, as it reflects an adequate tradeoff between reducing aggressive transfer pricing schemes and sustaining the international consensus on the arm’s length principle. With introducing the HTVI approach, however, the OECD provided tax authorities with an unnecessarily harsh anti-avoidance tool that is bound to create many conflicts in future tax audits. Irrespective of how one evaluates the quality of the new regulations, it seems hard to argue that BEPS is a toothless placebo-type of reform.

The fact that the EU is still not content with anti-abuse measures facilitated by BEPS must thus be seen in the fact that they are not so much concerned with minimizing aggressive tax structures (tax avoidance) but are rather determined to generate as much tax as possible in their respective jurisdictions.

What we can observe in the context of the proposed digital taxation is that the EU will increasingly advance the thesis that the “value of things” largely depends on how (where) people use them. Based on this thesis, they will aim to design international tax rules that allocate the profits based on concepts such as “user innovation” rather than on money and other resources devoted develop intangibles (including high-profile patent generating R&D).

This new interpretation of value creation is quite different from the interpretation implied in the DEMPE concept and will be heavily relied on by the EU and other advocates of higher taxes in advancing their centralist and tax grabbing agenda. Further long-term policy implications of such an interpretation could be the introduction of limitations of Patent Box regimes and other R&D incentives.

The vital nature of the fight about the interpretation of value creation was recently discussed by Mindy Herzfeld (Tax Notes International Vol. 91, No.8, pp. 773-777). The support voiced by Mrs. Herzfeld for the user innovation thesis is based on critiquing the OECD for failing to clarify what creates value and for failing to provide guidance for determining where value is created. Naturally, the DEMPE concept is not perfect at this stage but it certainly provides sufficient guidance for determining an arm’s length allocation of profits. Again, if regulators would be really concerned with minimizing tax avoidance, they would devote their attention towards optimizing the DEMPE concept instead of going beyond BEPS and creating additional (interim) taxes on revenues instead of profits, i.e., for online advertising.

Financial transactions: MNEs face increased scrutiny and difficulties defending interest rates applied in intergroup financing

In its recent public discussion draft, the OECD addressed transfer pricing specific issues of intergroup financial transactions, such as treasury functions, intra-group loans and cash pooling. Alongside intangibles, intragroup financing activities have received a lot of attention throughout the BEPS project. Like intangibles, financial transactions (interest rates) provide an attractive lever for aggressive transfer pricing structures. Obviously, charging comparatively high interest rates to operating entities in high tax jurisdictions potentially enables MNEs to funnel profits to financing entities (often holding companies) located in a low tax jurisdiction. Hence, tax authorities were notoriously suspect when seeing interest rates applied for intercompany transactions that exceed rates that are observed in day-to-day transfer pricing transactions. For financial transactions, the price-setting is often based on interest rates observed in the financial markets for similar transactions, with one of the most important factors to consider in a comparability analysis being the creditworthiness (credit rating) of the borrower. The arm’s length analysis for defending the appropriateness of the interest rate is often based on a benchmark analysis. In case that taxpayers could substantiate that a low credit rating (and thus high interest rate) is justified for a specific transaction, it was usually in a good position to defend the arm’s length nature of the applied transfer prices – with the burden of proof falling on the tax authorities.

Now, in a nutshell (and without addressing technical details), the Leitmotiv of the OECD discussion draft seems to be that intercompany financing activities are – by default – to be viewed as mere (routine) or support functions – i.e., not contributing substantial value (again, note how crucial the interpretation of value creation is for transfer pricing). The immediate consequences are that the OECD suggests that the interest rate charged to a related entity (subsidiary) should be based on the group rating. Specifically, the OECD suggests introducing a “rebuttable presumption that tax administrations may consider to use the credit rating of the MNE group as the starting point, from which appropriate adjustments are made, to determine the credit rating of the borrower ….”

If indeed implemented this would factually amount to a reversal of the burden of proof and MNEs, obviously including those never having adopted aggressive tax structures. MNEs having thus far based their intercompany loan agreements on the stand-alone rating of a local borrower, will face substantially increased difficulties in justifying the arm’s length nature of the applied interest rate.

For cash pooling agreements, the OECD formulated the default assumption of the low value-added nature of treasury functions even more explicitly; i.e., “In general, a cash pool leader performs no more than a co-ordination or agency function with the master account being a centralized point for a series of book entries to meet the pre-determined target balances for the pool members. Given such a low level of functionality, the cash pool leader’s remuneration as a service provider will generally be similarly limited.”

In other words, it will no longer be feasible, without compiling comprehensive analysis and justification, to allocate synergies realized from cash pooling at the level of a financial holding located in a low tax jurisdiction.

To be sure, the guidelines on financial transactions may only be in the discussion stage at this time. Many commentators have provided detailed and very sound arguments to the OECD (comments amounted to more than 800 pages), outlining that the proposed guidelines reflect an unduly negative view on the reliability of ensuring arm’s length pricing based on available market data and that there exist too many circumstances in which the simplified assumptions and the proposed rebuttable presumptions will not valid (for a summary of the relevant technical aspects, I recommend reading the comments submitted by NERA Economic Consulting, Public Comments – Part III, pp. 62ff.).

Looking back at the public discussion procedure on intangibles, however, one should not be too surprised if the OECD sticks rather close to its initial proposals when publishing the final guidelines. In any case, the discussion of the financial transactions further illustrates that BEPS is anything but a paper tiger and will have a tangible impact on the way MNEs structure their financial activities and the business operations.

There is a strong case to be made that BEPS will ultimately prove to be somewhat successful – measured by the goals set by the OECD in the beginning of the project. When viewed a little magnanimous, BEPS is reflecting an appropriate modernization of the arm’s length principle, as well as a targeted reform that effectively limits tax avoidance.

There is some good and some bad, but overall BEPS is at least no major calamity. On a technical level, there remain many unresolved issues and the OECD at times (the HTVI approach and rebuttable presumption for financial transactions) tends to be overzealous.

What I really do not see currently, however, is the need for any additional reforms or policies to counter tax avoidance. Resolving the unresolved technical issues will be more than enough. My impression is that advocates of going beyond BEPS, notably the EU, merely utilize the fight against tax avoidance as a fig leaf for their tax grabbing agenda. It is time to tear away this fig leaf and expose these advocates of higher taxes and anti-business policies for what they are.

Chapter 11 claims trading: New empirical evidence on how to win plans and influence people

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The influence, for good or ill, of hedge funds and other claims traders on the modern Chapter 11 plan process has been the subject of an intense, years-long debate. This column took up the issue nearly five years ago, citing evidence of a largely positive influence from hedge fund financing and other forms of participation in Chapter 11 reorganization cases.1 A recent empirical study confirms, as best it can, that bankruptcy claims trading and claims traders likely do not deserve the criticisms and suspicions to which they continue to be subjected. It also reveals how difficult it can be to examine subjects who do not particularly care to be examined.

In the first major empirical study of activity in the secondary market for both debt and equity claims against companies in Chapter 11,2 law professor Jared Ellias struggles to find objective evidence of elusive behavior. He takes a clever approach to measuring bond trading volume among the creditors of firms in Chapter 11 between July 2002 and July 2012 by hand-collecting data from FINRA’s Trade Reporting and Compliance Engine (TRACE). Though TRACE data is a comprehensive record of corporate bond trading activity, it identifies neither the issuer of the bonds nor the parties to the trades. A bit of public database correlation allowed for discovery of the issuer’s identities, but the traders remain anonymous.

Ellias finds very heavy trading (nearly 400,000 trades, more than seven per trading day on average) among the some 500 bonds issued by about 200 large firms in Chapter 11 from 2002 to 2012, along with a similarly heavy degree of trading in the equities of those companies. Indeed, bonds of issuers in Chapter 11 were among the most heavily traded on the corporate bond market, among both distressed bonds and bonds as a whole. This kind of churning produces one of the principal concerns with claims trading, i.e., that a constantly changing matrix of claimholders might disrupt the plan negotiation process that is the hallmark of Chapter 11 reorganization. In at least 60 percent of the sample cases, trading volume was sufficient to potentially alter the composition of 33 percent of non-priority bond debt claims, enough to upend the pre-filing balance of creditor interests and the entire plan negotiation process. This effect, however, depends on the details of the trading pattern and the traders involved.

A major limitation of this otherwise revealing study thus looms large from the outset.

Without knowing the identity of the traders of these bonds, we cannot know if the observed trading volume represents (1) consolidation sales from many small creditors to one or more larger creditors, (2) a series of serial trades involving the same stake sold multiple times, or (3) trades among largely passive investors on both the sell and buy side, the latter simply hoping to hold for a profit. Any of these would have minor implications for interrupting the negotiation process, as opposed to the contrary hypothesis of new, “activist” outside raiders buying claims, including potentially amassing a 33 percent blocking position to extract hostage value in the negotiating process. Ellias is forthright about acknowledging this key limitation.

He is more sanguine than might be warranted about ways in which the character of “activist” claims traders might be pinned down. The one victory that claims trading detractors have won in recent years is a rule requiring public disclosure of the identity of each member, along with the time of acquisition and nature of their equity and debt stakes in the debtor company, of any “group or committee that consists of or represents … multiple” claimants in a Chapter 11 case.3 Subsequent “material” changes in the composition of such a group (or any fact disclosed with respect to any member) must be disclosed in a supplemental filing. Seizing on this disclosure requirement, Ellias observes that the disclosed membership and claims position of these groups seem to remain fairly stable, with mostly early entry into the case and few supplemental disclosures.

But an additional observation reveals that “activist,” interrupter investors might buy into Chapter 11 more frequently than this study can discern. Only “groups” who “act in concert to advance their common interest” must be disclosed; that is, single investors (and their company affiliates and insiders) need not disclose their presence, much less the timing and nature of their stakes in the reorganizing debtor company. Even a modest sized hedge fund could muster the financial wherewithal to disrupt a Chapter 11 plan negotiation by buying a substantial bond stake, and such a single investor would be required to make no disclosure.

The lawyer for such a fund might file a notice of appearance, which Ellias also tracks, but only if the fund chose to intervene in the court proceedings, and Ellias tellingly finds nearly three times as many notices from attorneys representing single hedge funds than “ad hoc committees” or similar activist groups.

On the other hand, Ellias notes that traditional investors, like mutual funds, usually sell out of their positions long before a Chapter 11 is filed. Activist investors usually will have accumulated their positions in a distressed company well before a bankruptcy filing, so claims trading during bankruptcy is likely a lesser concern than trading before bankruptcy, which does not raise the principal concern of critics.

The study makes a significant contribution to our understanding of the volume – though, crucially, not the nature – of claims trading in Chapter 11 cases. Ellias concludes by noting in addition that the trading of claims not represented by bonds – private equity loans and loan-to-own strategies, for example – is another major missing element of this study. The more we know, the less we understand.

OECD Watch

Declaring “game over for CRS avoidance,” the OECD announced adoption of model disclosure rules for lawyers, accountants, financial advisors, banks, and other service providers. The report, Model Mandatory Disclosure Rules for CRS Avoidance Arrangements and Opaque Offshore Structure, fulfilled a request of the G7 and represents the latest in a disturbing trend whaereby tax collectors not only impose convoluted and burdensome rules in pursuit of diminishing returns, but also make it the obligation of the private sector to report why the results fail to match political expectations.

Building on its Action 1 Report, the Inclusive Framework on BEPS released the Interim Report on the Tax Challenges Arising from Digitalization. It sets out their plan to “work towards a consensus-based solution by 2020.” Notably, the report found that there was no consensus on the need for interim measures. Perhaps indicating a future point of major contention, the report also warned that blockchain technology “could present new transparency risks which if unchecked may undermine progress over the last decade to tackle offshore tax evasion.” Saint Lucia, Bahrain, the United Arab Emirates, and the Former Yugoslav Republic of Macedonia also joined the Inclusive Framework and brought its membership to 117.

At the July G20 meeting, French finance minister Bruno Lemaire stated that EU countries want common rules for digital taxation by the end of 2018 or beginning of 2019. The post-summit communique states that the G20 remains “committed to work together to seek a consensus-based solution to address the impacts of the digitalization of the economy on the international tax system by 2020.” In the OECD Secretary-General Report to the G20, digitalization was called “one [of] the most urgent issues in the international tax agenda,” and reiterated that crypto-currencies “pose risks to the gains made on tax transparency in the last decade.” The report promised an update in June 2019 and a final report for 2020.

Automatic Country-by-Country (CbC) exchanges began in June between the 72 signatories of the CbC Multilateral Competent, EU member states, and signatories to bilateral competent authority agreements for exchanges under Double Tax Conventions or Tax Information Exchange Agreements. Before that, the OECD released the first CbC peer reviews, boasting that “practically all countries that serve as headquarters to the large MNEs [multinational enterprises] covered by the initiative have introduced new reporting obligations compliant with transparency requirements.” Later, they provided additional interpretative guidance on the implementation of CbC reporting, answering questions on “the treatment of dividends received and the number of employees to be reported in cases where an MNE uses proportional consolidation in preparing its consolidated financial statements,” among other things.

Then in September, tax officials from 21 jurisdictions met in Yangzhou, China for a joint workshop organized by the OECD and Chinese State Administration of Taxes to consider lessons to date from the implementation of CbC reporting. Results from the workshop will be incorporated into future BEPS work, including a review of the CbC reporting minimum standard. One notable concern is that the workshop represents the first attempt to weaponize the trove of data provided by CbC reporting in the never-ending fight between tax collectors and economic producers.

The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosions and Profit Shifting entered into force on July 1 after the deposit of the fifth instrument of ratification by Slovenia. Slovenia joined the Republic of Austria, the Isle of Man, Jersey, and Poland as having ratified the treaty, and it will begin to have an effect for existing tax treaties for these jurisdictions in 2019. The Convention allows jurisdictions to transpose results from the BEPS project into their existing bilateral tax treaties. Additional new signatories include Kazakhstan, Peru, the United Arab Emirates, Estonia, Ukraine, and Saudi Arabia as the 84th to join.

Beyond BEPS, Serbia, Bosnia and Herzegovina, Cabo Verde, and Swaziland joined the Global Forum on Transparency and Exchange of Information for Tax Purposes, bringing it to 153 jurisdictions. The Global Forum also published (second round) peer review reports grading jurisdictions on compliance with the standard for exchange of information on request.

Estonia, France, Monaco, New Zealand, Guernsey, and San Marino were given overall ratings of Compliant. The Bahamas, Belgium, Hungary, Indonesia, Japan, the Philippines, and the United States were rated Largely Compliant. Ghana and Kazakhstan were rated Partially Compliant. A supplementary report also upgraded Jamaica to Largely Complaint from its 2017 rating of Partially Compliant.

Paraguay signed the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, becoming the 119th jurisdiction to do so. The OECD further announced new sets of bilateral exchange relationships under the Common Reporting Standard Multilateral Competent Authority Agreement, including activations by Panama for the first time. It also published the second edition of the Common Reporting Standard Implementation Handbook.
New economic surveys were released for Tunisia, Ireland, Israel, Poland, Costa Rica, Greece, Turkey, Korea, Lithuania, Canada. Tunisia’s taxes were observed to be high, but it was encouraged to focus on “tax justice” by increasing tax inspections to fight evasion in an apparent failure to recognize that high taxes and evasion go hand in hand. Ireland was said to have high regulator barriers to entrepreneurship, and Brexit was declared a “serious risk” to its economic outlook. Israel’s economy was acknowledged as performing strongly, but the nation was said to have “weak public spending on education and infrastructure.”

Poland was recognized for a strong economy and a relatively low tax burden. Unfortunately, it was encouraged to produce “higher tax revenues” to meet planned spending by “increasing environmentally related taxes and giving a stronger role to the progressive personal income tax.” Turkey was credited with a fast-growing economy despite adverse shocks that have weakened confidence in the rule of law. And in Costa Rica, efforts to increase tax collection have not reduced the budget deficit. This should come as little surprise given the strong historical evidence that spending restraint is the preferable strategy for eliminating red ink.

Unfortunately, three OECD reports exemplified the organization’s obsession with raising taxes by examining the use of taxes on personal savings and wealth as a means for “reducing inequalities and bringing about more inclusive growth,” and the advancement of carbon taxes.

Taxation of Household Savings examines the different approaches that countries take to taxing household savings and concludes that “while countries do not necessarily need to tax savings more … there may also be opportunities for many countries to increase progressivity in their taxation of savings.”

Similarly, The Role and Design of Net Wealth Taxes looks at the historical use of wealth taxes in OECD countries, as well as current trends, and “argues that there is a strong case for addressing wealth inequality through the tax system.” It concludes that “there are limited arguments for having a net wealth tax on top of broad-based personal capital income taxes and well-designed inheritance and gift taxes. However, there are stronger arguments for having a net wealth tax in the absence of broad-based capital income tax and taxes on wealth transfers.”

Effective Carbon Rates 2018: Pricing Carbon Emissions Through Taxes and Emissions Trading extols the virtues of carbon taxation and gleefully reports “there are signs that carbon pricing is gaining momentum.” Nevertheless, the top line message is that “governments need to raise carbon prices much fast if they are to meet their commitments on cutting emissions.”
The 2018 OECD Forum held in May, under the theme “What Brings Us Together,” focused on what it described as three interconnected issues: international cooperation, inclusive growth, and digitalization. As usual, the issue of inclusive growth provided opportunity to push a variety of leftwing causes, primarily those obsessing about inequality and gender issues. And in July, more than 70 participants from 20 European and Central Asian countries met in Tbilisi, Georgia, for a regional event on Developments in International Tax Co-operation: Fighting Tax Evasion and Avoidance. Among other things, it provided yet another opportunity to perpetuate the conflation of legal tax avoidance and illegal evasion that has been at the heart of the OECD’s anti-tax competition work.

The US as the world’s newest IFC and its impact on the Caribbean

During the last decade or so, the status of the U.S. as a superpower has enabled it to increasingly obtain market share from other countries by ignoring its failure to meet international standards while using its control of international organizations and groups, such as the OECD, the G7, the G20, FATF, and the Financial Stability Board, to sanction smaller jurisdictions with which it competes. In the last few years the the United States has consolidated its position as the world’s newest international financial center (IFC).

Traditionally investors have come to the U.S. because the U.S. has been the world’s largest economy. Its currency has been the most stable and has been clearly the reserve currency and the currency used for much of the world’s trade. The U.S. political system has been considered strong and the U.S. has had peaceful transfers of power. Hence, in 2018, an estimated 20 percent of the world’s offshore financial assets are in the U.S.1

This article discusses the politics of international regulatory initiatives followed by U.S. federal and state initiatives to attract foreign investment, including a section on regulatory arbitrage, in particular entity transparency, anonymous foreign investment in U.S. real estate, and automatic exchange of information. Finally, the article discusses the impact on small jurisdictions in the Caribbean. Some potential solutions are offered for rectifying the problem of the lack of a level playing field in international financial regulatory initiatives.

Federal and state incentives

Non-resident aliens have been traditionally exempt from tax on U.S. bank deposit interest. IRC §871 (h) and (i) exempts from U.S. tax the interest paid to NRAs by persons carrying on the banking business, savings institutions and insurance companies. CDs, open account time deposits, and multiple maturity time deposits are all exempt. A similar exemption applies with respect to estate taxes.

Many U.S. states offer single-member LLCs, whereby an individual can open an LLC to do foreign activities, generating non-sourced U.S. income and avoid U.S. and state taxation. By default, the IRS will treat a single-member limited liability company (SMLLC) as what it calls a disregarded entity. This means that the IRS will not look at an SMLLC as an entity separate from its single owner for the purpose of filing tax returns. Instead, just as it would do with a sole proprietorship, the IRS will disregard the SMLLC, and the owner will pay taxes for the business as part of his or her own personal tax returns. In 2016, the U.S. Treasury issued final regulations that require certain foreign-owned U.S. companies, known as limited liability companies, or LLCs, to disclose their owners to the IRS.

The list of U.S. states offering captive insurance include Alabama, Arizona, Arkansas, Colorado, Connecticut, Delaware, Florida, Hawaii, Illinois, Kentucky, Maine, Nevada, New Jersey, New York, North Carolina, Oklahoma, Oregon, Rhode Island, South Dakota, Tennessee, Utah, and Vermont. A captive insurance company is essentially a new subsidiary that is created by a parent company to underwrite the insurance needs of its operating subsidiaries. The basic idea of a captive is to bring in-house the purchasing of insurance that was previously done from unrelated commercial insurance companies, and retain the underwriting profits for the benefit of shareholders. For most tax purposes, there is little difference between an offshore captive (one formed outside the United States) or a domestic one, since the vast bulk of captives make the election under Tax Code § 953(d) to be treated as a domestic company. Thirty-seven states in the U.S. offer themselves as a captive domicile.

Under the EB-5 U.S. immigration program, for an investment as low as $500,000, entrepreneurs (and their spouses and unmarried children under 21) are eligible to apply for a green card (permanent residence) if they: make the necessary investment in a commercial enterprise in the United States; and plan to create or preserve 10 permanent full-time jobs for qualified U.S. workers. The program has resulted in a series of fraudulent projects, investigations, and scams.

Regulatory arbitrage

In recent years, the U.S. unilaterally and through international organizations and groups has raised transparency and gatekeeper requirements without taking any significant measures itself. In 2006 and 2016, FATF found the U.S. non-compliant with corporate transparency and gatekeeper requirements. In 2012, FATF raised standards further. Meanwhile, the G7 and G20 have similarly had initiatives against the abuse of entities.

On July 16, 2018, the OECD Global Forum on Transparency and Exchange of Information for Tax Purposes issued a second-round evaluation of the U.S., updating the first-round evaluation from 2011, and downgrading U.S. ratings in four areas, including beneficial ownership, the availability of banking information, and exchange of information on request.

The U.S. has not yet reciprocated on the exchange of information under the FATCA IGAs although the U.S. promised in 2011-13 to do so. In the FATCA IGAs the U.S. agrees to develop a multilateral regime on exchange of information. While many countries became early adherents to the OECD’s Common Reporting Standard (CRS) on March 19, 2014, the U.S. has taken the position that it did not have authority to sign. Four years later there is no sign the U.S. is interested in joining the CRS.2

Fueled apparently by the potential to anonymously invest, significant foreign investment is made each year in U.S. real estate, especially luxury homes. U.S. Treasury’s Financial Crimes Enforcement Network (FinCEN) has issued Geographic Targeting orders (GTO) that temporarily require certain U.S. title insurance companies to identify the natural persons behind companies used to pay “all cash” for high-end residential real estate in the certain jurisdictions, such as Borough of Manhattan in New York City, New York, and Miami-Dade County, Florida, Los Angeles, the San Francisco region, and San Diego in California, and San Antonio, Texas. FinCEN has required the information reporting on all-cash purchases Under the EB-5 U.S. immigration program, for an investment as low as $500,000.00, entrepreneurs (and their spouses and unmarried children under 21) are eligible to apply for a green card – i.e., those without bank financing – that may be conducted by individuals trying to hide their assets and identity by purchasing residential properties through limited liability companies or other opaque structures. FinCEN is requiring certain title insurance companies to identify and report the true owner. The GTOs are only authorized for 180 days. It seems likely the U.S. government will continue to use this tool. Other countries, such as the U.K., have a law requiring beneficial ownership information of foreign investment in real estate.

Impact on small jurisdictions in the Caribbean

The fact that U.S. and states continue to develop various incentives to attract international financial services in the way of tax incentives, regulatory arbitrage, and customized products while simultaneously failing to adhere to international regulatory standards means that small jurisdictions have trouble competing. For instance, small jurisdictions in the Caribbean have pressure to have public registers and the ever changing “fair tax” requirements of the EU Tax Haven Initiative. They are regularly evaluated by FATF, the OECD, and the Financial Services Forum with the risk of being black listed if they do not meet the standards. Even though the U.S. does not remedy the above-mentioned non-compliant ratings, international organizations do not dare put the U.S. on a blacklist. The U.S. is the largest financial contributor to both the OECD and FATF.

Unless the international organizations and informal implement the regimes with a level playing field they profess to have, small jurisdictions will continue to lose business to the U.S. Two initiatives that may help redress the disproportionate balance of power is to have FATF and OECD evaluate not just the U.S., but selected states that have strong international financial sectors, such as Delaware, Montana, South Dakota, and Wyoming. After all, states have their own blacklists. When foreign governments have complained about the state black lists, the U.S. Treasury has said it does not have authority to interfere. Alternatively, neutral bodies, such as the Society of Trust and Estate Practitioners, should do their own evaluations of the states, so that governments worldwide will be able to evaluate whether there is a level playing field in the international initiatives and use such information against states that do not comply.


1 Tax Justice Network, Financial Secrecy Index, Narrative Report on USA (2018), available at
2 For additional discussion of these regulatory arbitrage issues with the U.S., see Bruce Zagaris, International Tax Enforcement Cooperation in the Trump Administration, TAX NOTES INT’L 1013 (Sept. 3, 2018).

Taking on tokenization

Cryptocurrency coins

You cannot avoid it. Everywhere you turn, people are talking about cryptocurrency, investing in cryptocurrency, debating the future of cryptocurrency. You cannot walk down the street without hearing the words “Bitcoin,” “Ethereum,“ or “mining.“ And that is not just while walking down Wall Street, that is while walking down residential streets of Oklahoma.

Now entire conferences are being held on cryptocurrency and all its opportunities and challenges. Specialists are popping up everywhere. Despite all the grumbling over the last few years about the bitcoin bubble, the use of cryptocurrencies and related blockchain technologies is growing at an incredible pace.

Just when a lot of the industry is finally comfortable with the idea of funds investing in various cryptocurrencies, more curveballs are being thrown, the latest being around tokenization.

More and more investment managers are launching tokenized asset funds. While the industry is still settling on its terminology, this can mean a few things:

  • Funds are letting investors come in with in-kind subscriptions of cryptocurrency.
  • Investment managers are having their funds issue share classes denominated in cryptocurrency and represented by blockchain tokens.
  • Secondary markets are being formed for these tokenized share classes.

What are the issues and what are parties looking for?

Investment managers and investors are leading the charge. Managers want to be able to invest in cryptocurrency or tokenized entities and offer tokenized classes. Many asset managers and family offices that have invested in cryptocurrencies have expressed interest in using their cryptocurrency to invest and to hold tokenized assets.

There are more than a few issues/questions that naturally arise here:

  • How is know-your-customer (KYC) performed on the token holder?
  • How is ownership substantiated?
  • How is the secondary market monitored so no anti-money laundering laws are broken?
  • How is KYC performed on purchasers participating in the secondary market?
  • Volumes can be high, so how can the industry keep up?
  • How is liquidity dealt with?
  • How do auditors gain comfort with ownership?
  • How do fiduciaries gain comfort with the issues above?

None of these issues are insurmountable but some require thinking outside of the box. And these “out of the box” ideas also need to be offered in an efficient way to keep up with volume and mitigate risk. Adding body count will not suffice. A technology-based solution is required.

Graphic showing stacks of cryptopcurrency coins

How can these issues be solved?

Having KYC performed on token holders is not an impossible task. In fact, it is not very different from regular KYC on an investor. The primary concern is over ownership and control of the wallet used to subscribe to the token. This can be proven by several methods, such as using microtransactions while in communication with the potential investor. A secondary concern is the source of funds that are coming from the wallet. To gain assurance that the source is legitimate, a risk-based approach is used. A combination of wallet behavior analytics with token history tracking can be used to ensure the cryptocurrency being used is not sourced from a previous exchange theft or known illicit source.

From a fund administrator perspective, one of the concerns with a tokenized share class is the potential high volume of investor transactions. To accommodate this, a change in behavior is needed by all parties. It is not efficient for KYC to be a manual task anymore, especially with all the additional regulatory demands and the volume of transactions expected.

GRADA offers a centralized KYC platform whereby the onus is on the would-be investor to complete the KYC as required by the administrator. The GRADA platform then verifies and validates these documents and answers. GRADA electronically validates many documents with the issuer – including passports and certificates of incorporation. GRADA also uses advanced analytics to confirm other aspects of KYC so that administrators can gain comfort in the existence and residence of new investors.

When a fund or asset is tokenized, a special smart contract created by GRADA is used that not only sets parameters that must be met before purchasing (such as a minimum value or being a qualified investor), it also ensures that secondary transfers cannot take place unless these conditions are also met.

The Titan Platform by AdvancedAIS is an all-in-one, cloud-based portfolio accounting, multi-currency (including cryptocurrencies) general ledger, and transfer agency/income allocation platform that has been built from the ground up by seasoned fund administration accountants.

By combining these two SaaS (Software-as-a-Service) platforms, Titan and GRADA can tokenize a share class or asset while ensuring KYC is verified both on the token holder and anyone who purchases the token on a secondary market. The smart contract used for tokenizing the class/asset interfaces with the platforms to confirm that all the requirements to hold that token by an investor are met.

Advanced Alternative Investment Systems Ltd The Titan Platform, by Advanced Alternative Investment Systems Ltd is a leading-edge cloud-based portfolio accounting, partnership accounting, and transfer agency solution.  Titan offers its clients security, scalability and significant ease of use over comparable hedge fund platforms.   Global Risk  and Data  Authority Limited  GRADA provides a full KYC and AML solution for tokenized funds and assets via its GRADA Oracle technology.  The GRADA Oracle ensures that all token holders at both the initial tokenization event and on subsequent transfers have proper KYC and AML as required by most regulatory authorities.For example, if a fund’s investment parameters include ensuring KYC is complete, excluding U.S. citizens, allowing only “qualified investors” and having a minimum equivalent to US$250,000, then these parameters are written in to the contract. When a transaction occurs, the smart contract calls the GRADA platform. The GRADA platform assesses the parameters against the data from both the seller and buyer and returns a result indicating whether the transaction can proceed or not. If the transaction proceeds, the smart contract writes it to the blockchain. Once confirmed in the blockchain, GRADA pushes the transaction details into Titan along with any required investor information or related KYC documentation.

The required integration of this process is made easier by both platforms sharing the same DNA. The Titan Platform was originally architected by Peter McKiernan, co-founder of AdvancedAIS, 12 years ago. He is both a chartered accountant and software architect and a few years ago, he saw a need in the finance industry for a centralized KYC and risk analytics system. Using a similar architecture to the Titan Platform, he then designed GRADA.


Although the mention of “tokenization” has many service providers grinding their teeth and seeing things in terms of additional risk, we disagree and are excited about the new opportunities created.

We believe the use of tokenized funds and smart contracts is going to open up a whole new world. For example, historically, private equity (PE) managers would go about sourcing funds first, and then look for deals to invest in. With the use of smart contracts, PE managers can market the deal to investors first, noting that they need a certain total of investment before the deal can proceed. This can all be built into a smart contract. In this way, investors are assured that should the total capital raise not be successful, their money will be returned. This will turn the PE deal raising process upside down. And that is just one example of the various opportunities that will arise due to the use of smart contracts.

While gathering feedback about how the industry would feel about working with our platforms on crypto and tokenization, we had a lot of interest from various parties and a ton of idea generation of how to create this ecosystem that would benefit anyone involved in the crypto industry.

For instance, we saw a need for liquidity for token holders and while talking to a market maker out of Chicago, we got them comfortable with how GRADA and Titan would eliminate risk and they offered to provide this liquidity. We were also talking to an exchange in Canada and again, once we explained to them how our technology mitigates risk, they offered to act as a crypto exchange.

It is an exciting and fast-changing industry. Many service providers are just wrapping their heads around understanding it, identifying the associated risks and figuring out where they fit into the landscape. The companies that can get there first are going to do well.

Technology and privacy – Is the GDPR already out of date?


Nothing challenges the effectiveness of privacy laws like technological innovation. As the volume of data being generated about individuals increases, technology is making it easier than ever for data to be captured and analyzed, making that data ever more valuable.

Unfortunately, technology also introduces new and previously unknown threats. As such, how companies collect, process and protect the personal data of their customers, staff and suppliers has become a key challenge.

The General Data Protection Regulation (GDPR), which came into effect on May 25, 2018, is the European Union’s legislative response to this challenge. Drafted to be “technology neutral,” the GDPR is intended to give individuals better control over their personal data and establish a single set of data protection rules across the EU, thereby making it simpler and cheaper for organizations to do business. So far, so sensible. Unfortunately, technology always runs ahead of the law and the GDPR is already starting to show some of its limitations as the law clashes with newer technologies.

Blockchain technology

Blockchain – or distributed ledger technology – replaces the centralized transaction database with a decentralized, distributed digital ledger where each and every transaction flowing through it is independently verified against other ledgers maintained by different parties, in different locations. In this way, the record of any single transaction cannot be altered without changing all subsequent transactions or “blocks” that are chained together across the entire distributed ledger. It is this immutability that ensures the reliability of the information stored on the chain.

The GDPR gives data subjects the right to request that their personal data is either rectified or deleted altogether. For blockchain projects that involve the storage of personal data, these legal rights do not mix well with the new technology. Drafted on the assumption that there will always be centralized services controlling access rights to the user’s data, the GDPR fails to take into account how a permissionless blockchain works. Ultimately, this may mean that blockchain technology cannot be used for the processing of personal data without potentially falling foul of the GDPR.

Interestingly, blockchain technology provides its own potential solution to this problem by allowing personal data to be kept off the various ledgers altogether. It does this by replacing the personal data with an encrypted reference to it – a “hash.” These hashes, or digital fingerprints, prove that the data exists, but without the data itself appearing on the chain.

Problem solved? Unfortunately not. The GDPR draws an unhelpful distinction between pseudonymized and anonymized data. Pseudonymization occurs where personal data is subjected to technological measures (like hashing or encryption) so that it no longer directly identifies an individual without the use of additional information. Anonymization on the other hand, results from processing personal data in order to irreversibly prevent identification. As such, anonymized personal data falls outside the scope of the GDPR, whereas pseudonymized data – including hashed data – does not.

Unlawful algorithms

Social media sites and search engines specialize in algorithms that allow them to target advertisements at users. However, the way those algorithms work makes all the difference and reveals an unintended consequence of the GDPR’s drafting.

Take the example of Bob. Bob decides to buy a new car by doing all of his research using an internet search engine. He then posts details of his new purchase on social media. The algorithms for Bob’s social media site correctly profile Bob as someone who is likely to buy car products or access car-related services in the future. Bob will therefore start to see targeted adverts on his social media page. Following his hours of online research for a new car, the algorithms used by his chosen search engine reach the same conclusion and Bob will also start to see some of those same adverts each time he goes online. While the resulting adverts Bob receives may be the same, the way the algorithms achieve this result is very different.

Social media algorithms target adverts by knowing who you are, whereas search engines target adverts by knowing what you are searching for. The who versus what dichotomy is therefore critical under the GDPR. Social media sites know which adverts to show Bob because they analyze his profile and hold personal data about him. The algorithms for most search engines, on the other hand, look only at what Bob searched for. The only data those engines need to target their advertising to Bob is to know that somebody in a particular geographic area used the search term “new car.” The engines have no idea that it was Bob searching for a new car, just that someone did. Search engines can therefore ignore personal data and still achieve the same algorithmic precision, social media sites cannot.

Should Bob be required to give his consent to this use of his data before it is used in this way? Under the GDPR, arguably yes, but only for the way the social media site uses his data. Bob has no ability to stop his chosen search engine using the data it holds because that data is not considered “personal data.”

Artificial intelligence

Artificial intelligence relies on machine learning, but for machines to learn, they need to crunch data, and lots of it. The GDPR makes it more difficult for those machines to get the data in the first place and once they have the data, rights granted to data subjects under the GDPR could also make it difficult for companies to reap the full benefits of machine learning.

The volume of data available for machine learning is not a problem, but under the GDPR, using that data lawfully often will be. This is because those developing machine learning will often be data processors rather than data controllers. Data processors are not permitted to decide for themselves how personal data is used, they can only use the data as directed to do so by the data controller and with the consent of the data subject.

Assuming consent is obtained and the machines learn from the data they consume, the output those machines then generate may also be restricted by the GDPR. This is because data subjects have a right under the GDPR not to be subject to a decision based solely on automated processing if that decision significantly affects the data subject. In other words, much of the ability to allow machines to make automated decisions will be linked to how those decisions affect our lives. Automated decisions about our shopping habits will probably be fine but automated decisions which determine a career promotion or mortgage application are likely to be challenged in the future.


With the GDPR now in force, not only is the long arm of EU data protection law reaching beyond the EU’s borders, potentially it is also impacting our use of new technologies.

Technology will not stop to adjust to the new laws, which means legal frameworks like the GDPR need to remain flexible enough to strike a balance between technological progress and the protection of individual privacy.


Massive deficits and tax cuts: Good for US growth or harmful in the long-run?

Graphic showing scissors cutting the 'T' in TAX in half

The election of Donald Trump in November 2016 was not just a public referendum on American social values, but on fiscal policy as well. The Obama-era stimulus package consisted primarily of increased deficit spending without much divergence from what is considered normal tax policy when attempting to propel the economy out of recession. The result was one of the most sluggish, albeit longest, expansions in U.S. history. The slow expansion of the Obama administration became a key pillar to then Republican presidential candidate Donald Trump’s campaign, as he promised to deliver record economic growth through a series of aggressive personal and corporate income tax cuts. In December 2017, Trump fulfilled his promise to lower taxes as Congress passed the Tax Cuts and Jobs Act less than one year after he took office.

The total outstanding public debt was already $19.8 trillion when Donald Trump became the 45th President of the United States. Since then, it grew to $21.2 trillion, according to Federal Reserve Economic Data (FRED) published by the Federal Reserve Bank of St Louis. Although U.S. debt continues to grow, it grew at a quarterly average of 1.3 percent, a 35 percent decrease when compared to the U.S. historical average. At the same time, U.S. GDP also grew at a quarterly rate of 1.3 percent. That means that the U.S. debt to GDP ratio has remained constant so far during the Trump presidency.

This is in sharp contrast to the post-recession Obama presidency, which saw large increases in the U.S. debt to GDP ratio. During that time, GDP grew at a quarterly rate of 0.9 percent, but debt levels rose at twice that rate. The Obama-era stimulus was justified as a means to help the economy bounce back from the worst downturn since the Great recession. By 2012, the idea of secular stagnation as first introduced by economist Alvin Hansen was re-introduced by Lawrence Summers prompting more government stimulus. Secular stagnation is the idea that the private economy is prone to sluggish growth caused by insufficient demand, unless stimulated by extraordinary public actions via monetary and fiscal policies.

But, did it work?

Despite these extraordinary public actions –record deficit spending and the Federal Reserve unprecedented decision to keep short-term nominal interest rates at the zero lower bound for a prolonged period after the recession – economic growth remained low by historical standards (some readers will argue that the unusually large deficits worked because growth could have been lower).

It is obvious to most economists that structural factors have contributed to an increase in the propensity to save relative to investment demand resulting in lower real interest rates and lower economic growth. Most experts argue that some government deficits can lift aggregate demand and therefore boost a sluggish economy. However, fewer experts consider that although deficit spending can work to stimulate growth in the short-run, prolonged deficit spending leads to debt accumulation, which impairs growth.

This is because too much debt lifts expectations of a government debt crisis. Consistent with Japan’s experience, new research1 suggests that the fear of a public debt crisis lowers economic growth. As public debt accumulates, the growth rate of output declines persistently, while the yield on government bonds decreases. This is because a debt crisis raises expectations of a large-scale capital levy. Attempts to stimulate economic growth via larger deficits can result in declining economic growth and long-term interest rates.

In economies plagued by low growth, attempts to stimulate growth with large increases in government borrowing can result in higher debt to GDP ratios, which in turn will harm economic growth. These facts leave policymakers with an increasingly challenging task.

Why persistently higher deficits are a terrible idea

Besides the fact that politicians, like most of us, may find it hard to “live within their means,” economists have long believed that running a deficit could be a powerful tool, at least in the short run, because higher government spending raises aggregate demand to boost economic activity.

The initial popularity of using deficit spending to increase output was based on the belief that the market economy is unable to sustain aggregate demand at a level consistent with full-employment output.

Standard Keynesian theory has argued that an increase in government spending has a multiplier effect. The multiplier effect refers to the increase in income arising from any new injection of spending. As for the size of the multiplier, the experts are divided. Some experts2 argue that the multiplier is around 0.8 while others3 estimate the multiplier to be closer to 1.5.

Most experts also seem to agree that the multiplier effect can be substantially larger than one when the zero lower bound on the nominal interest rate binds. The key reason is that a persistent increase in government spending raises labor demand, this translates into higher expected inflation, hence into a negative real interest rate (given a zero nominal interest rate), inducing a substitution from future consumption into current consumption to raise the level of output4.

However, household expectations over the central bank actions also matter. Government stimulus tends to raise the inflation rate. The size of the government multiplier will depend on consumers’ expectations over monetary policy. If the nominal interest rate is at its lower bound, a rise in inflation rate lowers the real interest rate, and consumers have an incentive to consume and invest. On the other hand, if the central bank were expected to react to a rise in the inflation rate in a manner that results in a higher real interest rate, then consumers would reduce their expenditures and save. This latter scenario would reduce the size of the government multiplier5.

Regardless of the size of the multiplier, new research6 finds that large increases in government spending – wasteful or not – are not welfare enhancing. Using data from the U.S. Great Recession, the authors find that the optimal increase in (useful) spending is around 1.5 percent of GDP. Any larger spending stimulus decreases welfare. Any government waste is welfare-detrimental even with a large output or employment gap.

The Trump administration deficit-financed tax cut experiment

That brings us to the current administration, seemingly not aware of recent massive debt accumulation or simply choosing to ignore it to focus on campaign promises. The Trump tax cuts were met with a lot of resistance. For one, the tax cuts would raise government debt and higher government debt can impair growth. Another reason experts gave for opposing the tax cuts is the fact that for individuals, a share of the increase in disposable income resulting from tax cuts could end up saved thus resulting in a lesser bang for each buck.

However, Post World War II U.S. data suggest that personal income tax cuts lead to a fall in tax revenues while corporate income tax cuts have little impact on tax revenues. This is because although personal income tax cuts have a small positive impact on consumption, investment and employment, it is cuts to the corporate income tax that lead to large increases in investment resulting in a substantially larger growth effects7.

Finally, other economic research8 also shows that deficit-financed tax cuts outperform deficit spending – deficits resulting from spending increases without tax cuts – in improving GDP. Deficit-financed tax cuts deliver up to five dollars of additional GDP per one dollar of decline in government revenue caused by the tax cuts. Deficit-financed tax cuts stimulate investment and output significantly, with the effect peaking three to five years after the policy change.

Although private consumption does not change significantly in response to tax cuts private investment does9. Tax cuts, especially corporate tax cuts have the potential to grow the economy, but their benefit depends on how they are structured. For tax changes to promote growth, changes should encourage new economic activity (rather than providing a windfall for previous investments) and reduce economic distortions.

Rightly so, deficit hawks feared that if deficit-financed tax cuts failed to raise growth, low growth would lead to more debt and a higher debt to GDP ratio. So far, growth has kept up with debt, thus holding the debt to GDP ratio constant. Only time will tell if President Trump’s tax cuts were the “shot in the arm” that the U.S. economy needed. One thing is certain: the current administration’s new experiment will greatly inform the policy debate.

Orphe P Divounguy is the chief economist at the Illinois Policy Institute. He also heads the Quantitative Policy Group.


1 Keiichiro Kobayashi & Kozo Ueda, 2017. “Secular Stagnation and Low Interest Rates under the Fear of a Government Debt Crisis,” CIGS Working Paper Series 17-012E, The Canon Institute for Global Studies.
2 Barro, R.J., 1981. Output effects of government purchases. J. Polit. Econ. 89 (6), 1086–1121.
3 Ramey, V.A., 2011. Identifying government spending shocks: It’s all in the timing. Quart. J. Econ. 126 (1), 51–102.
4 Christiano, L., Eichenbaum, M., Rebelo, S., 2011. When is the government spending multiplier large? J. Polit. Econ. 119 (1), 78–121.
5 Yangyang Ji, Wei Xiao. 2016. “Government spending multipliers and the zero lower bound” Journal of Macroeconomics, 48, 87-100
6 Florin Bilbiie, Tommaso Monacelli, Roberto Perotti. 2017. “Is Government spending at the Zero Lower Bound desirable”. Forthcoming, American Economic Journal: Macroeconomics
online version:
7 Mertens, Karel, and Morten O. Ravn. 2013. “The Dynamic Effects of Personal and Corporate Income Tax Changes in the United States.” American Economic Review, 103 (4): 1212-47.
8 Mountford, A. and Uhlig, H. (2009). “What are the effects of fiscal policy shocks?” Journal of Applied Econometrics, 24: 960–992. doi:10.1002/jae.1079
9 Blanchard O and Perotti R. 2002. “An empirical characterization of the dynamic effects of changes in government spending and taxes on output.” Quarterly Journal of Economics. 117(4): 1329–1368

Wealth management step by step

Writing on blackboard: Estate Planning, with a circle of sub-categories around it

With a focus on promoting the Cayman Islands as a leading jurisdiction for private clients, wealth management, and the administration of trust and estates, the Cayman Islands Branch of the Society of Trusts and Estates Practitioners continues to work hard to promote and highlight the breadth of expertise and wealth planning solutions available in the jurisdiction – with great success.

Following on from the very positive response to its Inaugural International Wealth Structuring Forum, held at the Kimpton Seafire Hotel in January 2018, STEP Cayman will again host its Cayman Islands conference there on Jan. 31 and Feb. 1, 2019. Having enjoyed an impressive number of attendees last year, of both onshore and offshore origin, the forum is already acknowledged as the leading private client conference in the Cayman Islands and expected to again be well attended by locals and international guests.


STEP, a global network of professionals who specialize in family inheritance and succession planning, has a significant membership base in the Cayman Islands comprising lawyers, accountants, fiduciaries and other wealth structuring specialists. From that membership base, and via STEP’s global network, more than 250 people attended the 2018 Forum. In addition to receiving cutting-edge guidance, delegates are attracted by the extensive networking opportunities among fellow experts from the wealth management industry and the chance to hear (and question) respected speakers with a wide range of experience.

The content, format and speakers

The 2019 Forum will retain the same two-day format for the 2019 Forum which will occur on the final two days of the working week. The agenda for the forum has now been finalized, with the speakers addressing new enticing topics, including how trustees are responding to the growing demand to hold digital assets, notable developments in trust litigation, a review of the success of Cayman’s introduction of its Foundation Companies Law and the challenges faced by international financial centers which might well now include the United States of America. Deep dives into recent case law affecting trustees and beneficiaries alike, including the judgments in important trusts law cases such as Mezhprom v Pugachev and Investec v Glenalla will be undertaken, and issues as to the confidentiality of trust documentation and the proper litigation of family disputes will be explored in break-out sessions. A mock court application and wealth structuring tips for families from the People’s Republic of China and philanthropists round out the agenda.

To guide delegates through the multitude of topics, there is an impressive array of domestic and internationally renowned speakers. These will include the Minister of Financial Services and Home Affairs Tara Rivers, who will provide an opening address, keynote speakers Justice of the Grand Court Ian Kawaley and Mary Duke, as well as highly regarded experts from the U.K., Switzerland, China and the USA. Speakers from local law firms and from on-island trust companies join them.

Promoting Cayman

Thanks to the ongoing efforts by STEP Cayman, and the support of sponsors, the forum is now a key component of the international private wealth calendar and the jurisdiction’s wider marketing efforts. Promoting Cayman as a jurisdiction of choice via the forum has been successful to date, and STEP Cayman continues to work on expanding the substance of the event in an effort to attract an even greater range of delegates to the island. It is already anticipated that the delegate numbers for the second year of the Forum will exceed those of 2018 and it will therefore be important for potential delegates to reserve their space as soon as possible to ensure attendance.

Further information about the 2019 STEP Cayman Forum is available online at and further enquiries can be directed to [email protected].

Can U.S. regulators do fintech?

In a recent speech, Commissioner Hester Peirce from the U.S. Securities and Exchange Commission (SEC) admonished financial regulators against behaving like “helicopter parents,” treating innovators like children constantly in need of adult supervision. “If we do not become more comfortable with risk,” Peirce warned, “our helicoptering may so burden fintech innovations that they begin to lumber along at a regulatory pace.”

Commissioner Peirce’s skepticism of regulatory proliferation is unusual among U.S. financial watchdogs. Her dissent from the SEC’s July decision not to authorize a bitcoin exchange-traded fund (ETF) earned her the nickname “Crypto Mom” and the Twitter fandom of 19,000 cryptocurrency enthusiasts. At a time when regulators’ attitude to financial innovation is suspicious tolerance at best and Luddite hostility at worst, Peirce’s openness to new ways of doing things, and her call for humility from officials, is refreshing.

Her colleagues are slow to catch up. Cryptocurrency markets in the United States remain shrouded by regulatory uncertainty as we celebrate the tenth anniversary of the invention of Bitcoin. The pressure on policymakers has subsided as market valuations declined and consumer appetite for new cryptocurrency issues became less voracious. But it will resume if the technology proves to have staying power.

The costs of regulatory fragmentation

Regulators have shown greater willingness to revise their rulebooks for other financial innovations. At the end of July, the Treasury released a much anticipated report with its recommendations for nonbank and fintech firms. This segment of the market has grown rapidly since the financial crisis, as risk management software improved, and as regulation made certain forms of lending costly and bureaucratic for deposit-taking institutions. A study published by the U.S. National Bureau of Economic Research last year found that 60 percent of the growth in nonbank market share was explained by increased bank regulation after the financial crisis. Another 30 percent was explained by better technology. At the end of 2017, online lender Quicken Loans surpassed Wells Fargo as America’s largest mortgage originator.

Yet, for a long time, the U.S. regulatory structure has not kept up with developments in the private sector. States have historically been the primary regulators for nonbank lenders such as Quicken and Lending Club. This may have made sense in a previous era when most marketplace lenders were local in scope. Yet, even then, states often used their prerogative to protect local incumbents from competition by non-state lenders and new firms. The National Banking Act of 1864 partly helped overcome state protectionism by creating an alternative federal charter for banks. But nonbank lenders could not use this charter.

As financial regulation at both the federal and state levels has expanded, and as technology has created economies of scale in marketplace lending, state-by-state licensing has become an onerous burden. A recent report by the U.S. Government Accountability Office reported annual licensing costs for nonbank lenders at between $1 million and $30 million. Costs of recordkeeping and complying with regular examinations come in addition to that. Plainly, state-level regulation is no longer competitive.

That is why the Office of the Comptroller of the Currency (OCC)’s announcement – shortly after the release of the Treasury report – that it would begin to accept national bank charter applications from fintech lenders was a momentous development. This charter will allow lenders that do not take deposits to eschew the fragmented state-by-state licensing regime and apply instead for a single, nationwide license.

The OCC charter will not usher in a free-market nirvana. Chartered institutions will be subject to significant disclosures of their business plan, capitalization, liquidity position, and community lending activities at the time of application, as well as in ongoing periodic examinations. But a federal charter will give nonbank lenders an outside option from the redundant state-based framework which presently makes scaling up needlessly costly. As venture capitalist Jay Reinemann from Propel Venture Partners put it to me at a conference in September, “a plethora of options is good … different firms are going to want different things.”

Can data make all of us richer?

Licensing is not the only area where regulation is slowly evolving to accommodate promising financial innovation. The Treasury report devoted much attention to the use of data to make financial services provision cheaper, more personalized, and more competitive. The U.K. has led the way among developed countries in seeking to facilitate third-party access to banks’ consumer data in a bid to make it easier for customers to find out about new products from a wider range of providers. So-called “open banking” would, in the minds of its proponents, make possible in the financial services industry the diversity and choice we currently enjoy on

Internet marketplaces.

A crucial way in which consumer data can be productively deployed is the calibration of loan interest rates. Risk-based pricing is the cornerstone of credit markets, allowing financial institutions to efficiently allocate scarce capital, and fomenting competition between lenders.

Innovation that ushers in more accurate loan pricing can expand loan volumes and lower interest rates, making consumers better off and increasing economic activity. A recent Federal Reserve paper found that Lending Club’s proprietary credit-pricing model predicts borrower default better than the long-standing Fair Isaac (FICO) score. Lending Club can thereby extend more and better-priced loans than some of its older competitors.

However, government regulation can chill innovation in credit pricing because providers are wary of falling foul of anti-discrimination laws. The fight against differences in the price of credit based solely on the race, age or gender of the borrower has informed U.S. public policy since the 1970s. But regulators and courts have sometimes given these statutes a broad interpretation, judging lenders not on the intent or design of their policies but on the impact of their lending on different communities.

Customized lending vs. discrimination

It may be that certain practices that are not overtly discriminatory end up allocating credit on different terms to people of different races. On the other hand, what superficially might look like discrimination can be driven by legitimate business factors.

For example, if a lender offers two prospective borrowers of different races a similar loan on different terms, one might conclude that the lender was discriminating, in violation of the law. However, if the two borrowers also have different incomes, then differential pricing is not gratuitous discrimination but rather an adjustment of interest rates on the basis of default probability, since borrower income is a predictor of loan default. Asian Americans, for example, have higher median household income than other ethnic groups. If they get better loan terms than whites on average, that may have little to do with discrimination and instead be the product of third factors that also correlate with race.

The promise of financial technology is to customize risk-based pricing in a way that not only makes credit markets more efficient, but also mitigates the injustice of generalization – whereby diligent borrowers face higher prices because some of their group traits (income, occupation, housing status) correlate with a higher default probability. By using data-rich aggregation techniques, fintech lenders can better account for individual characteristics and rely less on group characteristics.

When regulators push the envelope

Yet, this beneficial innovation can only happen in an environment where lenders have the assurance that new practices will not put them on the wrong side of regulators. The Bureau of Consumer Financial Protection, one of the most activist post-crisis watchdogs, set a dangerous precedent by assessing fair lending compliance by auto dealers on the basis of aggregate statistical analysis that used borrower last names and ZIP codes as the primary variables. Both economists and industry participants regarded such “enforcement by proxy” as flawed, because it failed to account for relevant factors like borrower income and lender market power.

Recently, there have been signs of a more constructive stance. The Bureau has changed direction under the Trump administration, vowing no longer “to push the envelope” in a bid to expand its regulatory remit. In September, the agency proposed a trial disclosure program to encourage innovation. Modeled after so-called “sandbox” programs implemented, among others, in Arizona and Britain, this initiative will exempt qualifying firms from specific registration and disclosure requirements as they try out new products and business models.

Sandboxes are an attempt to increase certainty among innovators and reduce the fixed costs of regulatory compliance. Coupled with broad safe harbor provisions, sandboxes could perceptibly increase the scope for innovation in U.S. consumer financial services.

Implications for finance in America – and beyond

Time will tell if this modest trend toward regulatory forbearance can effectively promote new ideas by financial incumbents and startups. With U.S. financial services among the most heavily regulated industries in the world, whose rulebook grew by 27,000 new mandates after the 2008 crash, the road to make finance dynamic and competitive will doubtless be a long one. But U.S. credit and capital markets represent tens of trillions of dollars in value, so the consumer gains – and associated profits – from effective cost-cutting innovation are huge.

For offshore jurisdictions, the changing regulatory winds in the United States present an opportunity, as well as a challenge. Offshore financial centers have historically functioned as small-scale laboratories of innovation, where favorable tax and regulatory policies encouraged the location of multinational affiliates and investment funds. America’s newly-found tolerance for experimentation, if it does materialize, would place competitive pressure on smaller jurisdictions such as the Cayman Islands.

Yet it is unlikely, much as one would like it, that U.S. financial regulators will soon adopt an across-the-board presumption in favor of permissionless innovation. Particularly for more headline-grabbing technologies like cryptocurrencies, policy uncertainty will probably remain a feature of the business landscape for some time, with a statistically significant impact on cryptocurrency prices. This is where smaller markets like Cayman can offer a more welcoming environment, as the recent EOS initial coin offering – at $4.2 billion, the world’s largest so far – illustrates.

Commissioner Peirce beseeched her colleagues at the SEC and elsewhere to relent from “helicoptering” and embrace “free-range parenting.”

It is as yet unclear whether U.S. regulators will heed Peirce’s call, but it applies just as forcefully to any other jurisdiction eager to harness the benefits of financial innovation.

Swiss review of corporate taxation: a typical Swiss consensus story

Swiss Flag

For the first time in its history, Switzerland will review its corporate taxation not for internal reasons but in response to international pressure.

Switzerland has agreed to comply with international company tax standards by the end of 2018. The rules developed by the Organization for Economic Co-operation and Development (OECD) require, among other things, the abolition of special tax status for foreign companies.

Last December, the European Union (EU) placed Switzerland on the “Grey List” of countries that have not yet taken the necessary measures to comply with the new standards. If Switzerland does not quickly adapt its legislation, the country could end up on next year’s black list of jurisdictions considered uncooperative by the EU.

Unlike the previous reform in 2008, when the main objective was to lower the taxation of small and medium-sized enterprises in the country, this revision is primarily needed to comply with international standards.

Some Swiss cantons had set up tax packages for foreign companies to attract employment and capital. These packages were sometimes extremely advantageous, a privilege reserved only for these foreign companies and not Swiss companies.

This had led a number of companies to set up in Switzerland to avoid tax costs. Under increasing international pressure, Switzerland was called upon to reform its tax system so that all companies would be treated equally.

Switzerland could simply abolish these tax lump sums, but this would lead to the departure of many international companies and a significant tax and job loss. It was therefore decided to reform corporate taxation to reduce the tax burden and introduce a single system for all.

However, Switzerland is a federation and it has been decided to maintain tax competition between the cantons. Although distorted by fiscal equalization, a system for distributing wealth between rich and poor cantons, tax competition makes it possible to have very different taxation from one canton to another and has given a very good incentives for self-discipline in the keeping of state accounts.

In order to maintain this competition, it was decided to establish a “tax toolbox.” This describes “instruments” that cantons can use to reduce the usual corporate taxation. We will look at some of these tools to increase Switzerland’s tax attractiveness.

For example, there is the “patent box,” which allows significant tax deductions for all research and development expenses. The aim of this box is to encourage innovative companies that create future jobs.

Another instrument that is the subject of debate is “notional interests.” These are fictitious interests that a company can deduct under certain conditions. The idea is to reward highly capitalized companies on the same basis as those that get into debt and can deduct interest from the debt.

In the toolbox, there is also the “step-up,” which allows special-status companies to cushion the impact of ordinary taxation over five years. This complex mechanism consists of a tax reassessment of the company’s goodwill followed by a tax amortization of this goodwill over a period of 10 years. This amortization would ideally reduce the tax burden to the same level as an auxiliary company.

Sack full of money, with tax written on the side.

A first refusal by the Swiss population

For those who know Switzerland, such a revision takes an extremely long time. In fact, this third review of corporate taxation (RIE3) began in 2014.

The legislative proposals and drafts have been renegotiated several times to reach a consensus between the different parties. In 2017, the revision was proposed to the population but, to everyone’s surprise, a referendum conducted by the extreme left and right had succeeded.

The reasons for the opposition ranged from refusing to comply with international pressure and the affront to the autonomy of the cantons (right) to refusing to offer so many tax rebates to companies (left). Despite the consensus reached in Bern by the major Swiss parties, the population refused this compromise. By a narrow majority, the Swiss population has unusually stood up against political establishment.

The previous reform, the Federal Council predicted hundreds of millions of tax losses and it was billions. The left said that the right tends to obtain tax rebates and lie about the consequences.

The right does not deny a deficient estimate of RIE II’s losses, but it counterattacks by pointing to the gains. The 2nd reform was, on balance, a success, as net revenues increased significantly.

In any case, the reform was rejected in 2017 and the challenge now is to find a consensus with the left to put it ahead of international sanctions as soon as possible.

The merger of pension with taxation revision

It is therefore in 2019 that the second proposal for the revision of company taxation will take place. This revision remains very close to that of 2017 but includes a revision for the collective pension system known as “old age and survivors’ insurance.”

This merger of two very different problems, corporate taxation and the pension system, comes from the fact that the two reforms were rejected by the people for different and sometimes opposing reasons.

The politicians therefore decided to group the two solutions together to cancel the objections. Since everyone is partially satisfied, no party really dares to oppose the tax and pension project fused together.

It will therefore be the “last chance review” for the political world. At least that is what they called their proposal, which combines several different changes.

The two Chambers have decided to introduce social compensation into the initial tax plan: 2 billion Swiss francs ($2 billion) will have to be paid into the solidarity pension system. This means that insured persons’ contributions will increase by 0.15 percent, as will employers’ contributions. The Confederation’s contribution to the pension system will also increase gradually, depending on the effects of the tax reform on public authorities.

In summary, since the corporate tax review is likely to reduce tax revenues by $2 billion and was rejected by the people in 2017, it was decided to compensate for this loss by increasing taxes for the pension system.

Where does the legislative process stand today?

This new bill, which merges the review of corporate taxation and the pension system, was accepted by both chambers at the end of September 2018.

As provided by law, the population has the possibility to hold a referendum to oppose a law passed by parliament. A subject as essential as this revision is very likely to provoke a referendum again.

The Greens and far-left circles have already stated that they are ready to collect signatures to oppose it. Consequently, the validation of this project will not take place until June 2019 and the debates are likely to be very intense again.

The problem that this revision will encounter for the population’s vote is that it does not respect the “unity of matter.” In other words it forces a vote on several unrelated matters and is therefore in violation of the basic principles of the rule of law.

“The unity of matter” is precisely present to avoid such a montage on the part of politicians. The complex combination of two subjects as different as pensions and corporate taxation will have to be explained to the people and politicians will have the difficult task of justifying their actions.

Another problem is that the Swiss are very conservative and view the reforms with great skepticism. Many political actors, generally regional or municipal, see this revision as a major upheaval that could lead to significant tax losses but above all to uncertainty.

A new refusal would necessarily trigger a reaction from the OECD as well as possible international sanctions against Switzerland, mainly from the European Union.

This revision should therefore also be understood in the context of a conflictual relationship between Switzerland and the European Union. The Confederation is in the process of renegotiating bilateral agreements, following the population’s decision to limit immigration and therefore to oppose the agreements on the free movement of persons that have been signed with the European Union.

Swiss politicians are therefore forced to introduce legal changes to avoid further difficulties and maintain their overall trade relations with foreign countries while maintaining a competitive tax system.

The fact that the tax proposal is called the “faint hope package” is an indication of the pressure behind such a review.