31/07/18

You won’t find a free lunch by clamping down on tax havens

(City A.M.)-- If you take your economic cues from shadow chancellor John McDonnell, chances are you are not a fan of so-called “tax havens”.

The Labour MP has a long history in denouncing offshore financial activity. Following the Panama Papers revelations in 2016, he called for Britain to impose a “withholding tax” to ensure that HMRC took its share of company profits before firms moved them on to low-tax jurisdictions. Over the weekend he was at it again, promising to track down rich companies to fund his party’s projects.

The Labour stance on this reflects an increasingly common conventional “wisdom”: that the primary effect of companies profit-shifting to places with super-low taxes on capital is to starve advanced economies of needed revenue. Tax havens are seen as “unfair” competition, siphoning off resources that could be invested in higher-quality public services.

It is of little surprise that a party promising to “end austerity” sees a pot of gold to plunder. But new research shows that there’s no fiscal free lunch where “clamping down” on tax havens is concerned.

Few economists would doubt, of course, that tax competition from havens lowers corporate revenues here. But the total economic effects are not limited to the public finances. We must also consider both the impact on investment incentives from the lower effective corporate tax rates, and what the companies do with the extra funds.

Research from Duke University economist Juan Carlos Suarez Serrato shows that trying to eliminate profit shifting can reduce company-level investment worldwide and shift what investment does occur overseas.

He examines what happened in 1996 when the US repealed part of its tax code that allowed US multinational companies to shift profits to affiliates in Puerto Rico.

This break had effectively reduced corporate tax rates by 10 percentage points for firms affected. This was a big tax expenditure in the US code, affecting up to 16.1 per cent of all investment for publicly-listed firms, and reducing US tax revenues by over $230bn.

McDonnell, no doubt, would have unthinkingly sought its elimination too, had he been in charge of US economic policy at the time.

But repealing this exemption had a major impact on the affected firms, and hence the broader US economy. Investment among companies affected by the repeal fell a massive 23 per cent relative to firms not affected, with US employment by them falling by 9.1 per cent.

The composition of investment changed significantly too, with the share abroad jumping sharply and domestic investment falling by a much larger 38 per cent.

More than that, these impacts were unsurprisingly geographically concentrated where the firms operated. Even 15 years after the change to the tax law, areas that were home to the major firms affected saw a combination of slower employment, income, and home value growth, and became more dependent on transfers from the government.

Limiting profit-shifting had clear trade-offs, and potentially very detrimental effects for certain regions.

Is this a slam-dunk in the argument over tax havens? Of course not. Few would be surprised that the lower effective tax rates from the carve-out enhanced investment activity for firms affected. Nevertheless, it may still have been the right thing to do to eliminate this provision, and raise revenues in a less-distortionary way, enabling broader lower tax rates elsewhere.

Serrato’s research also doesn’t touch on the other advantages tax havens can bring – but they exist. For example, offshore financial centres can play a key role in facilitating investment in developing countries from advanced economies, with investors safe in the knowledge that their funds can be protected from arbitrary and intrusive government.

It should not surprise us that the economic convergence seen since 1980, with rapid rates of growth in much of the developing world, has coincided with a liberal environment of capital mobility.

Many mutual and pension funds too are able to fetch much higher returns through investing through these centres.

But the real point here is that the downsides of unilaterally clamping down on tax havens are rarely acknowledged in political debate, least of all by those thirsty for tax revenues. Never mind that UK tax revenues as a share of economic activity are at a 49-year high. The populist impulse of the day encourages our leaders to talk tough and be outraged by what they perceive as lost funds for public services.

The great economist Thomas Sowell once remarked that, where policy is concerned, “there are no solutions, there are only trade-offs”.

Whether Labour likes it or not, this is as true for tax havens as anything else. It might look as if there’s money sitting waiting to be spent on MPs’ pet schemes. But overall investment levels and workers in particular regions may suffer if it is taken.