This article, and all other articles in this feature, is an extract from IEA Current Controversies 67: ‘All at Sea: The Misguided War on Offshore Financial Centres’, written for the Institute of Economic Affairs by Jamie Whyte (March 2019). Jamie Whyte is a journalist. He has previously been a Director of Research at the Institute of Economic Affairs, leader of the ACT Party of New Zealand, a management consultant with Oliver Wyman and the Boston Consultant Group, and a philosophy lecturer at Cambridge University, where he also gained his PhD.
The war on tax havens is an inherently dirty business. Most tax havens are stable democracies, with the rule-of-law and tax regimes that are superior to the inefficient systems that have become the norm in Western countries. The UK and EU have no proper justification for interfering in their affairs.
In May 2018, the UK parliament passed a law requiring Overseas Territories to publish the names of the ‘beneficial owners’ of firms registered in them. The law enjoyed cross-party support and was advertised as an attempt to combat financial crime. But, since these countries had already entered into data sharing agreements with the British authorities, including the police and Her Majesty’s Revenue and Customs, this is implausible.
A more likely explanation is that British politicians were trying to discourage British citizens from registering companies in OFCs. Newspapers and campaigning organisations have taken to vilifying companies that reduce their tax bills by incorporating in low tax regimes and, by extension, vilifying the owners who benefit from it. This is the idea that has caught on. Someone named on an Overseas Territory’s register of beneficial owners will be a prima facie ‘tax cheat’ and face the commercial and social risks attendant on that status. The new law will thereby increase the cost of registering a company in an overseas territory. And what costs more happens less.
It is not only the British government that seeks to discourage the use of ‘tax havens’. The European Commission has waged a campaign against them, creating blacklists of ‘non-cooperative tax regimes’. Even without the associated legal sanctions, European firms might be expected to avoid the reputational damage that comes from registering companies in blacklisted countries. The OECD has also consistently campaigned against low corporate tax rates since publishing an influential report on the topic in 1998.
No one should be surprised that politicians in ‘non-tax haven’ countries want to discourage their citizens from registering companies in tax havens. Not only do they fear a loss of tax revenues they would otherwise receive but the competition puts pressure on them to cut their own corporate tax rates. As capital has become more mobile over recent decades, corporate tax rates have fallen all around the Western world. Governments miss out not only on taxing companies registered in tax havens, but they must also tax companies registered domestically at a lower rate.
Though understandable, the war on tax havens is unfortunate. The simple reason is that by pushing corporate tax rates down, tax havens do other countries a service.
Corporate tax is an inefficient tax, with much greater deadweight costs than most other taxes. The optimal corporate tax rate is zero.
But this is not the only reason to object to the war on tax havens. More important, perhaps, is the fact that the war is conducted by violating important principles of liberal democracy. It undermines national sovereignty, privacy rights, and the rule of law.
Before getting to these matters, however, we must understand tax competition and why tax havens create it only in corporate taxation.
Tax Competition and Tax Havens
Discussions of tax competition usually begin with Tiebout (1959), which introduced the idea within the academic literature. Tiebout argues that the difficulty of arriving at optimal government spending through voting systems is avoided when taxpayers can ‘vote with their feet’. Imagine that governments spend on only one good – policing, let’s say. Some spend a lot on policing and tax a lot to fund it. Others spend little on policing and hence tax little. Some may spend nothing. If people can move between these fiscal jurisdictions at no cost, they will locate themselves in the one that best fits their preference for tax-funded spending on police. Some will gravitate towards jurisdictions with a lot of police and high taxes, while others will prefer fewer police and lower taxes. Tax jurisdictions will be populated by citizens with a shared fiscal preference.
Adding other kinds of spending does not change the general point. Provided there are enough jurisdictions with enough variation in the combinations of spending and provided people can move between them at no cost, communities will self-select on the basis of their shared preference for the package where they live.
That’s a simplification. Being able to move at no cost is not the only condition for perfect Tieboutian fiscal community formation. Another is an absence of ‘leakage’. If I can get the benefit of government spending in another fiscal area without contributing to it, I won’t move to the higher tax area, even when its trade-off between tax and government services suits me better than the one I am taxed in. I will free-ride on those taxed in the leaky fiscal area. Another condition for perfect tax competition is perfect knowledge of the available options.
These conditions are met imperfectly at best. Moving is expensive; the benefits of government spending often leak across tax borders (for example, Belgium arguably benefits from French tax-funded spending on nuclear weapons); and people don’t know exactly what options are available and what the effects of moving would be.
According to Nick Shaxson, author of the (2011) Treasure Islands: Tax Havens and the Men Who Stole the World, the fact that the conditions for the formation of fiscal communities are not met … basically kills Tiebout’s model stone dead’.[i]
Mr Shaxson is confused. Tiebout’s theory says that if certain conditions hold, then fiscal communities will form. You cannot refute this theory by showing that these conditions do not hold. Newton’s laws of motion describe what happens in a vacuum. We do not live in a vacuum. That does not refute Newton’s laws. Add in friction, and we get what Newton’s laws tell us to expect (at least, for super-atomic objects travelling at nowhere near the speed of light). More generally, the claim that if p then q is not refuted by not-p. If John were a dog, he would have four legs. This is not refuted by the fact that John is not a dog.
Combine Tiebout’s theory with facts about the presence of its conditions for fiscal community formation, and the theory does alright. For example, in the US, people often move into districts with high local taxes and high spending on schools when they have children and then move out when their children leave school (see Fischel 2006).
Tiebout’s theory faces other objections regarding the incentives of fiscal rule-makers, but these need not detain us.[ii] The question here is not whether Tiebout’s theory of fiscal community formation is true but whether tax havens create tax competition and whether it is something to be welcomed or regretted and, potentially, stopped.
Anti-tax competition campaigners, such as the Tax Justice Network, mean to show that tax competition is harmful. Because Tiebout’s theory suggests it is beneficial, allowing people to live under their preferred trade-off between taxation and the provision of tax-funded goods, they are hostile to Tiebout’s theory. But my argument does not depend on it. I need only the reality of international competition in corporation tax rates and the net harm caused by corporation tax. Tieboutian fiscal communities are surplus to my requirements.
Nevertheless, Tiebout makes an important contribution to understanding international corporate tax competition: namely, the significance of jurisdictional switching costs. Migrating is expensive. The migrant must find new housing, a new job, and a new school for his children. He must learn the customs of his new country. And he leaves his friends and family behind. Few will be willing to bear these costs for the sake of reducing the rate of personal income tax they pay. The lack of international income tax competition is therefore no surprise. The fact that every country in the world imposes severe restrictions on immigration makes it even less surprising. The same goes for consumption taxes, land taxes, sin taxes and poll taxes.
OFCs Are a Threat to Corporate Tax Revenues
But not corporate taxes. Since the 1970s, the legal restrictions on the registration of companies and on moving capital across national borders have been markedly reduced. And the cost of registering a company in a low-tax jurisdiction is extremely low. Indeed, when the cost is spread across many thousands of shareholders, it is close to zero for each of them. So, we see what we might expect to see: namely, company registrations flowing from high corporate tax jurisdictions to low or no tax jurisdictions, and vast quantities of capital flowing through them, from investors to the ultimate destination of their investment (see Zuluaga 2018).
Of course, low corporate tax rates are not the only consideration. The owners of companies also seek legal certainty and the efficient administration of their company’s legal affairs. Again, we see what we should expect. Offshore financial centres (OFCs) typically display a strong commitment to the rule of law. And they host networks of professional services firms – lawyers, trustee companies and funds administrators – that supply high quality administrative services.
OFCs that impose no tax on company profits are not, of course, competing for the tax revenues of the companies they attract. Rather, they benefit from the economic activity attendant on the registration of so many companies and trusts in them. A large portion of their small populations earn a living from work that comes directly or indirectly from the provision of financial services.
This explains why tax havens are small countries. In a large country, only a tiny percentage of the population could earn a living from the services supplied in OFCs. A politician offering to distribute 25 per cent of all company profits to the population will win more votes than one offering to preserve jobs in the (relatively small) trustee and funds administration sectors (see below).
Although OFCs are not competing for corporate tax revenues, their success in competing for company registration threatens the corporate tax revenues of non-OFCs. To discourage companies from shifting offshore, they reduce their own corporate tax rates. Not to zero, of course – which would defeat the purpose – but to a level at which (they figure) the tax revenue lost from the lower rate is more than offset by the revenue gained from companies and their profits being retained or gained domestically.[iii]
Thus, corporate tax rates have fallen all around the world since the 1970s, when the international movement of capital started to become easier. For example, between 1979 and 2018, the UK corporate tax rate has fallen from 52 per cent to 19 per cent. Over the same period, the rate has fallen from 50 per cent to 33 per cent in France; from 40 per cent to 21 per cent in the US; and from 46 per cent to 26 per cent in Australia.[iv]
Politicians outside tax havens are reluctant corporate tax-cutters and, thus, reluctant contestants in tax competition. Ending such competition would suit them better than winning it. Hence their war on the tax havens that provide the competition. And hence the abandonment of principles that UK and EU politicians would normally claim to support – the sovereignty of third countries in tax policy, the right of law-abiding citizens to keep their financial affairs private and the rule of law.
[iv] These are ‘statutory rates’, not effective rates, either average or marginal. Effective rates are usually lower than statutory rates because the way profit is measured for tax purposes allows some profit to be exempted from taxation. But this observation, though important in many contexts, is irrelevant here. Over the past 30 years, effective corporate tax rates have fallen along with statutory rates.
Jamie Whyte is a journalist who was previously Director of Research at the IEA. He holds a Ph.D. from Cambridge University and is former leader of the ACT Party of New Zealand. No Company.