Tax havens and market turmoil, Part 3 - what to do
We start with a kind of debate that has emerged in the Financial Times between two of Britain's leading economic commentators (and FT columnists), Martin Wolf and John Kay.
Kay argues that regulation is not the answer, because it does not work: history has shown us that regulators cannot successfully second-guess the decisions of huge institutions staffed by better paid and more motivated people than themselves, who will find ways to escape regulation. The right approach, he argues, is to "insulate the real economy from consequences of financial instability."
Wolf find's Kay's position
"both attractive and unrealistic. . . . governments cannot credibly promise to wash their hands of a financial breakdown. . . greater regulation is, alas, inescapable, even if doomed to be imperfect."
There is a way to slice right through these arguments.
Instead of looking at whether and what to regulate, we should be looking at the context in which regulation takes place. And that means looking at -- you guessed it -- tax havens and tax competition. To be more precise, we should talk about tax and regulatory havens and tax and regulatory competition.
The world, to date, has taken tax havens as a given, and given them a free pass. We seek to overturn that long-standing global consensus.
What role have tax havens played in the current crisis? Let's start with the submission that we made to the UK House of Commons Treasury Committee inquiry into Offshore Financial Centres earlier this year, substantially prepared by Richard Murphy. Tax havens, he says,
"deliberately set out to undermine the impact of legislation passed in other jurisdictions. . . These are deliberate acts of economic aggression targeted at sovereign states. . . . In the last decade new and highly abusive forms of offshore company and trust have developed. These evolutions have been little documented and much less understood, but have allowed both companies and trusts to float free of almost any regulatory control. . .
The offshore world is designed to make things appear other than they are, and by and large succeeds in doing so. This, in a nutshell, is the threat that they pose to the world."
This is the first part of our case. The facts are unambiguous. We are just describing, in plain terms, what tax havens seek to do. Undermining other nations' laws, whether on tax, financial regulation, criminal legislation, or whatnot - this is their meal ticket, and indeed their very raison d'être. It follows automatically that if we want regulation to work, then we need to remove the obstacles that are deliberately put in its place. Which means taking on the offshore world.
There is another reason we don't agree with John Kay. He is, in effect, saying this: getting regulation to work is too difficult, so we shouldn't try. This is a bit like arguing that drug smuggling is too hard to crack down on, so we should give up. (OK: to be fair, Kay also argues that regulation not only will not work, but can even be counter-productive. But, as Jim Stewart's article illustrates, the context for regulation, not regulation itself, that is the problem. So our argument stands.)
Let's consider some other things that tax havens do, that are relevant to the current market crisis. First, numerous players and observers of the crisis have remarked that opacity is at the heart of the crisis. John Plender said this today:
"What makes the management of this crisis so difficult is the opacity of the modern financial system."
Nobody can be sure about their counterparties' market positions in terms of assets, risks, and so on. Amid all this uncertainty, everyone's afraid to lend to, or trade with, other parties, and in this climate of opacity and mutual mistrust the financial system has become gummed up. Better transparency is essential, people are (belatedly) saying - but how to achieve it?
First, as an aside in the context of opacity and transparency, Professor Ronen Palan and Dr Anastasia Nesvetailova of Birmingham University, in a separate Treasury Committee submission (reproduced in the same document as TJN's,) said this:
"Opacity (benefits) those who are, as one of the directors of Enron is reputedly quipped: ‘the smarter man in the room’. The small investor, by definition if not the stupidest in the room, at least the one least equipped to handle complex and rapidly changing information. Opacity is used and abused in effect to shift risk from big financial institutions to society at large."
This is quite true. In this context, it seems reasonable to say, in response to Kay, that it is not only desirable to regulate (and to enjoy a context in which regulation can work), but it is indeed a democratic imperative that governments responsible to their citzens should do so.
Opacity has several dimensions -- some which are applicable on a case-by-case basis, some systemic, and some a mixture of the two. Tax havens are core to each dimension, in the context of the current crisis.
The first dimension is straightforward secrecy. Tax havens allow investors to hide things. Once the dust settled in the Enron affair, it was clear that its hundreds of tax haven subsidiaries, and the veil of secrecy laid over each, were core to the opaque accounting that lay behind its frauds.
The next dimension is complexity.
And tax havens generate complexity, in spades. They provide companies with powerful incentives to festoon their financial affairs all around the world, pushing them into places where there is no economic substance to their activities, and then allowing them to use accounting rules that enable them to keep their activities melded into one big set of accounts, that cannot be unpicked. Complex structures are artificially sliced and diced between multiple jurisdictions, adding to the mess. Cocoon each part in secrecy, bathe them in lax regulation, and you have impenetrable complexity and opacity, where it would otherwise not have been.
That is not all. Tax havens love to call themselves "well regulated" - and in some cases they may be right, from a narrow technical perspective. This is a confidence trick. What they do is that they make sure that the regulation happens "elsewhere" - and that "elsewhere" is, as a result of the regulated activities falling between the stools of different jurisdictions, effectively "nowhere." The tax havens can then wash their hands of responsibility, and say they are clean. As our treasury submission put it:
"An example might be where a person resident but not domiciled in the UK creates a trust in a tax haven such as the British Virgin Islands that in turn owns a company incorporated in the Isle of Man that has a bank account in Jersey and directors in Cayman. The income of that company and trust are retained within the company. This sort of structure is costly, but that is a price of being ‘nowhere’."
How can there be any transparency if that which you are looking for or seeking to regulate exists "nowhere"?
But there is more. Let's return to the submission by Palan and Nesvetailova. What else do tax havens do? They make investors uncertain about who owns what.
"There is a link between offshore finance and financial stability. We believe that this connection lies in the financial cycle and more specifically in the maintenance of illusion of liquidity. The moment the mood in the market turns sour, as happened in August 2007, this creates an added dimension of fear as no one can be sure who will honour debts of what are legally speaking, separate entities. . .
Financial actors are perfectly aware of these manipulations, which includes ambiguities in asset ownership and distribution and responsibility for risk. Such ambiguities are used largely for tax purposes as a way of transferring profit-making financial activities to zero or near-zero jurisdictions and/or to obtain higher rating for ‘innovative’ financial instrument from the rating agencies. But as we will see, in the case of tax havens/OFCs one can kill two (or even more) birds in one go: tax avoidance and evasion schemes can easily be used for other purposes as well. Offshore entities can be used, for instance, with great ease for the purpose of isolating ownership of offshore financial vehicles from their onshore parents in order to obtain higher credit rating from the rating agencies. This exactly what happened and eventually precipitated the current financial crisis."
Their work, they acknowledge, builds on Richard Murphy's research into the failed British bank Northern Rock, and its offshore Jersey-based "shadow company", Granite, which had 50 billion pounds of debt and no employees.
"Confusion arose as to whether (Granite) was onshore or offshore. In practice it included elements of both. And, when Northern Rock was nationalised the House of Commons held late night debates on whether this meant that Granite was also nationalised."
(Richard Murphy, who exposed the Northern Rock/Granite sham, wrote about this here and here. The complexity, and legal and philosophical gymnastics, are shocking.) This confusion is replicated across the system. This kind of thing is not exactly going to inspire confidence in investors uncertain about the financial state of their peers. It is integral to the current crisis. And the offshore world is the creator of the confusion. As Palan and Nesvetailova rightly remark:
"the link between the type of offshore financial centres (OFCs) commonly known as tax havens and financial instability has not been widely researched and is not well understood."
Well said. Much more research into this -- forensic research is now needed, urgently. Take a look, for example, at the bankruptcy filing of Lehman Brothers. It starts like this:
"Lehman Brothers Holdings Inc., a Delaware corporation . . . "
Delaware, as we have pointed out, is the nasty little tax haven that is rotting the United States from the inside: the product of lobbying and tax and regulatory competition between U.S. states which saw Delaware as the clear victor in the race to the bottom, underbidding its competitors on regulatory laxity at every opportunity. Half the Fortune 500 companies are incorporated there. Take a look at this example of the kind of thing that Delaware has to offer. What other financial disasters will Delaware lie behind?
Let's now step back a bit, and return to Martin Wolf:
"In deregulated financial systems crises are inevitable, like earthquakes on a fault zone. Only timing is uncertain."
That is surely true. But, once again, that is not to say that regulation cannot work. Not at all. Regulation must be geared to looking at the way that economic cycles happen, and managing them and addressing their outcomes.
So here's something else to consider. As the real effects of this financial crisis spread through the rest of the economic system, and more banks and companies go to the wall (as seems likely), it will emerge that alongside all the excessive risk-taking and so on, it will turn out that plenty of criminal activity has been taking place, which nobody paid too much attention to while the going was good. The offshore world is a hothouse for trans-national crime - and, once again, societies have a democratic imperative to rein it in. Regulation is essential.
Oh, and then there's this. As we've noted many times before, tax havens are at the core of processes of international competition on tax and regulation - both of which are driving tax rates on capital down. They are also, in many cases, magnifying the incentives for (tax-deductible) leverage. As we remarked earlier, in a discussion of private equity companies:
"Private equity firms load the companies they buy with debt – typically “lent” by a subsidiary of the company based in a tax haven: it will therefore pay little or no tax on its subsidiary’s interest income, and the borrowing company will write its interest costs off against tax. The net result is that the company as a whole cuts its tax bill. Typically private equity companies use very high “leverage” rates – just 20% from the wealthy private equity owners, and 80% in borrowings. This financial engineering is just that: it does absolutely nothing to improve the efficiency, innovation, or overall quality of the business in question. What it does is abuse our tax system and our democracy: in effect, the rest of us pay their taxes for them."
This blog is long enough already, but we have a couple more things to say. First, while we think that regulation is essential, and can work in many useful ways, another thing needs to happen. The climate of accepting tax havens as a given, and tolerance for offshore monkey business, has to end.
Newspaper editors need to prohibit phrases like "financial innovation" when used as a catch-all term. This term means two things: first, useful things like using clever tricks to provide better services for customers; and second, the bad things: using clever tricks to get around the regulations of democratic nation states. Always consider, and specify what you are talking about. (see our offshore dictionary for some more examples.)
We also need to start thinking in new ways. We need new codes of conduct on taxation, as soft guidelines for companies, governments, individuals, and their agents, to follow. We need to wrest the language and culture of taxation away from the tax avoidance industries, which have for so long held a near-monopoly on them. We need country-by-country reporting - it would constitute a revolution in international transparency.
And there is another powerful insight from our Treasury submission which we must not forget. We distinguish between tax havens (the jurisdictions) and the offshore financial centres (OFCs, the commercial communities located there) and note that the OFCs have all the power, because they can play the tax havens off against one another to get what they want. We must bear this in mind when considering regulatory responses.
We'll leave the last word with John Gapper, musing on the troubles of American Insurance Group (AIG).
"In presentations to investors this year, it emphasised how thoroughly its AIG Financial Products arm assessed the risks of insuring CDOs. It ran all the data and decided that, in the worst case, it risked losing $2.4bn on the portfolio. Well, $24bn of write-downs later – a mere 10 times its maximum estimate – the company has burned through its equity, spread financial chaos to all corners of the earth and humiliated the US Treasury. The job of insurance companies is to guard others against catastrophes, not cause them.
Call me a spoilsport, but I do not believe that AIG or any other capital markets institution should be allowed to play like that with my money (I am a US taxpayer) in future. If this means going back to basics, and redesigning the global regulatory system so that a renegade insurance company is denied the chance to blow up the world’s banks again, so be it. Regulation cannot solve everything but enough is enough."