The Issue with Tax Havens

Tax havens are receiving more attention than they perhaps like these days, and rightly so. These jurisdictions are parasites in the global economic system, exploiting the gap between global capital flows and national legislation. What’s more: they facilitate a transfer of wealth from the global south to the global north, providing a structural impediment to development and poverty eradication.

What are tax havens?

UK Uncut, a protest movement against tax avoidance/evasion and austerity cuts, closed Topshop's flagship store on Oxford Street to raise awareness of the company's owner's tax avoidance schemes. The movement has staged similar protests against other tax avoiders, including Vodafone and Boots. Photo credit: Flickr/yurri

First: what kind of places am I talking about? Tax havens are states that write their laws purposely to enable outsiders to get around regulatory constraints or taxation in other states. In simple terms, this means that they enable companies and people to avoid (technically legal) or evade (illegal) the regulation or tax burden of the country in which they live or operate.

There are many ways in which tax havens do this, but two features are prominent. The first is that of secrecy. Tax havens typically have strong banking secrecy laws (think of Switzerland) and rarely exchange information with authorities in other countries. In fact, many tax havens ensure they are unable to do so even when under pressure – they simply do not collect basic information such as corporate ownership or accounts. As a result, many refer to tax havens as secrecy jurisdictions.

The second feature is something called ring-fencing. That is: one set of rules for residents (typically a normal system of taxation) and another for non-residents (which enjoy low or nil taxes and/or lax regulation). In practical terms, this means that companies and people based in other countries can enjoy low or nil tax rates without having any other link to the jurisdiction than a nominal post box address and an offshore account.

Needless to say, this combination of secrecy, low taxes and lax regulation is a powerful concoction for attracting international capital. But why is it so harmful?

It’s all in the accounting…

When people hear of tax havens, they often think of millionaires hiding their wealth from the taxman. This is indeed an important part of the problem. The Tax Justice Network, an organisation promoting transparency in international finance, estimates the annual tax loss to states from hidden assets to be around US$250 billion globally. However, another source of capital flight to tax havens may account for significantly more than that: the accounting concept known as transfer pricing.

Consider this: The typical corporate tax rate in the developed world, the main target markets of most multinational corporations, is around 28%. Yet a study by the Obama administration found that US multinationals paid only 2.3% tax on foreign income in 2004. How is that possible?

Click for an interactive description of Google's tax avoidance strategy. Facsimile: BusinessWeek.

Click for an interactive description of Google's tax avoidance strategy – which has been approved by US tax authorities. Facsimile: BusinessWeek.

By using various techniques, corporations can shift profits from states with a high tax rate to ones with a low tax rate, such as tax havens. Many of these techniques are technically legal if morally questionable. For example, Bloomberg recently ran a story on how Google reduced its non-US tax bill to just 2.4% by navigating loopholes in the tax legislation and creating accounting trails through Ireland and the Netherlands, both tax havens. But many techniques are not even technically legal.

Here’s how corporations can abuse transfer pricing to shift profits to a low-tax jurisdiction. First, they can simply over price internal transactions between subsidiaries. This increases costs in one subsidiary (reducing taxable profit) and increases income in another subsidiary (increasing taxable profit). For example, one investigation found that ballpoint pens were being sold from one subsidiary to another at more than US$8,000 a piece. Most examples of abuse are subtler, but the effect is the same: the overall tax burden is reduced by fraudulently shifting taxable profits from one jurisdiction to another.

Another way of illegally reducing the tax burden is by fraudulently billing intra-company services. It is easy to understand why this is an attractive technique: it is virtually impossible to determine how much value a service, such as consulting, provided to the final product. The problem is of course not where such services have been provided and priced on an arm’s-length basis. The problem, or fraud, arises when no such services have been provided, were overpriced or the services were provided by employees in another subsidiary – and yet profits have been shifted to a low-tax jurisdiction. The secrecy provisions of tax havens and the lack of transparent accounting makes it very difficult to uncover such fraud. Intra-company loans can be used with similar effects (as interest is tax-deductible, an intra-company loan shifts profits from one subsidiary to another).

Around 60% of world trade takes place between subsidiaries of the same company, illustrating the potential of transfer pricing as a means of (illegally) reducing the corporate tax burden. In his 2005 book Capitalism’s Achilles Heel, Raymond Baker estimated that transfer pricing abuse accounts for up to 2/3 of all illicit cross-border capital flows – or US$700–1,000 billion annually. More recently, Global Financial Integrity, a think-tank promoting policies to curtail illicit cross-border capital flows, estimated that in 2008, illicit capital outflows from developing countries alone was nearly US$1.3 trillion. More than half of this related to trade mispricing. On top of that comes tax avoidance – which while technically legal by definition avoids following the spirit of the law. While these estimates must be taken with a pinch of salt (as any estimate of underground activities), the actual tax paid by multinational corporations serve as another indicator that the issue is anything but trivial.

Blue collar criminals like tax havens, too

Tax havens are not just attractive to white-collar criminals, however: they also attract criminals of the more traditional kind. A recent report by Global Financial Integrity estimated the global illicit flow of goods, guns, people and natural resources at US$650 billion annually. By far the largest part of this relates to drugs (US$320 billion) and counterfeiting (US$250 billion), with humans (US$31.6 billion) coming in third. In sharp contrast to tax evasion (the proceeds of which, astonishingly, are not covered by international definitions of money-laundering), however, great efforts are put in to prohibit the proceeds from these illegal activities entering the financial system.

These efforts are undermined by tax havens. Their secrecy provisions enable criminals to transfer proceeds with relative ease and low risk of detection. Even where regulatory authorities operate, chances are their resources are going to be overwhelmed by the sheer volume of capital going through their jurisdiction. As a result, only a small amount of criminal flows are detected, even where procedures to uncover such flows are in place. As such, tax havens can provide a relatively comfortable hiding place for the wealth of criminal tycoons and a comfortable cover for transactions within large criminal networks.

The bigger issues

If the estimates currently available reflect the underlying reality, this has serious consequences for all of us. If governments cannot tax the wealthy, they need to tax the middle class and poor harder, or cut welfare services. If governments cannot tax multinational corporations, they need to tax small and medium-sized businesses harder, or cut welfare services. The result is a two-tier tax system: One for the wealthy and multinational corporations, and another for the rest of us – a system for which none of us has voted and which undermines the credibility of the tax system. And if the activities of international crime are facilitated, this threatens our ability to fight crime.

But perhaps even more seriously for those concerned with global issues: tax havens represent a structural impediment for development and poverty eradication in the global south. The illicit capital outflows from developing countries, dominated by transfer mispricing, are perhaps as much as ten times larger than development aid inflows, a 2009 report commissioned by the Norwegian Ministry of Foreign Affairs found. A substantial part of these outflows end up in the developed world – Christian Aid estimates the illicit capital inflow from transfer mispricing to the US and the EU alone to be around GB£300 billion annually. Further, developing countries generally do not have a large middle-class tax base to fall back on – making the difficulties of taxing multinational corporations all the more pressing.

While it is fashionable these days to blame poor countries’ failure to catch up with the economic performance of the developed world on governance, corruption and other apparently national issues, this suggests impediments to development are not purely, or even mainly, national. Indeed, developing countries’ ability to catch up economically is undermined by a large, illicit shadow financial system that facilitates a transfer of capital from the global south to the global north. If we are serious about the development of poorer countries, therefore, we must both uncover this shadow system by ensuring more transparency in the accounting of multinational corporations and address the structural bias inherent in the current system.

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2 comments

  1. Bastian

    Vidar, this is a great post. Especially so as it sheds light- in clear and understandable language – on a problem whose magnitude I and probably most others (including policy makers) have never really managed to grasp. Question is: what to do about it?

  2. Vidar

    Thanks, Bastian!

    Your question is of course hugely important. I was going to include a section about it but decided it would be stretching readers’ patience in what is already quite a long post. I intend to write a separate post about it, but step one is raising awareness and calling for transparency (for example, country-by-country reporting and automatic tax information exchange). The big states have too strong a vested interest in the current system to change it in anything but the margins unless there is a strong demand from domestic constituents. This, in turn, can only come about from exposing the scope and effects of the issue.

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