Friday, October 17, 2008

Tax Havens, Economic Aggression and the Race to the Bottom

Bruno Gurtner, the Swiss economist who chairs our global Board of Directors, has just delivered a paper on tax competition at a conference organised by the Instituto de Investigaciones Economicas in Mexico. In his paper, which you can download here, Bruno warns that:

" . . .the aggressive practices of tax havens (and the financial and legal specialists who operate from such places) demonstrates the emergence of a beggar-thy-neighbour culture in international relations. Left unchecked this tendency towards economic aggression will stimulate a race to the bottom affecting both tax and regulation."

We have previously blogged why TJN rejects the entire notion of tax and regulatory competition, see here and here for example, but the following sections from Bruno's paper, which he jointly wrote with John Christensen, summarise the key arguments:

"First, tax competition undermines democracy. This kind of “competition” between countries creates external pressure that undermine the right of electorates to decide whether they want to live in a high-tax or low-tax economy, or how to organize the relative weights of different forms of taxation within the economy. It prevents government from providing the tax systems their electorates vote for, and even threatens the viability of tax regimes and nation states."

This threat will become more evident if the current financial market crisis leads to global depression. We have seen plenty of evidence of how business people use their political influence to secure endless tax breaks - Barack Obama's recent interlude with Joe the Plumber appears to be yet another staged event to push for more tax breaks - and the pressure is remorseless, despite the evidence that tax breaks do not encourage innovation or entrepreneurship.

But in addition to undermining democracy, argues Bruno, tax breaks harm free and fair markets:

" . . tax incentives distort markets. These investment incentives are discriminatory in so far as they provide a significant financial advantage to external investors and put local businesses at a financial disadvantage. This financial advantage is further compounded by the ability of transnational companies to make full use of offshore tax vehicles, thereby undermining the integrity and equity of tax structures and creating a free-rider economy."

Most economists tend to ignore the free-rider problem (now why is that, we ask ourselves), but the issue is important and business is very aggressive in its attitude towards tax: arguing, falsely, that tax is a business cost to be minimised, rather than a distribution from profits. [Note to politicians: change company law to require that tax payments should be treated in the same way as dividends - the other major distribution from profits - i.e. company directors have a legal obligation to maximise all distributions from profits].

And finally, says Bruno:

"tax competition results in the tax burden being shifted from capital (a highly mobile factor of production) towards immobile factors such as labour. The relative tax burden on corporations has fallen, while the tax burden on labour and spending has risen. This shift in relative costs leads to a reduction in demand for labour, hampering job creation, whilst also increasing post-tax earnings to capital. Income inequality – one of the great economic challenges of our age – has increased sharply as a consequence. A good overview about the distributive effects of tax competition is given in a forthcoming paper byPeter Diesch (University of Montreal). Domestic wealth and income inequality has increased in the majority of developed countries and to a even greater extent in developing countries."

These already unacceptable inequalities will undoubtedly worsen in the coming three years as the impact of this massive transfer of the tax charge from owners of capital to consumers and workers reveals itself with startling clarity. Many governments will struggle to fund essential services and rising social security costs. We expect that unemployment, crime rates, family breakdown and domestic violence will increase markedly as the inevitable outcome of tax competition translates into human tragedy.

But there's more, because Bruno also addresses our concerns about how tax havens have been at the forefront of regulatory competition, using their legislative powers to undermine regulation elsewhere:

". . the light-touch regulatory practices (of the tax havens) have catalysed the emergence of a huge shadow banking system. Structured Investment Vehicles (SIVs) have been created by banks as artificial structures off the banks balance sheets, frequently for the purposes of raising capital offshore through an apparently separate entity that enjoyed a higher credit rating than its parent company and could therefore borrow on the wholesale financial markets at preferable terms.

Competition between tax havens is fierce, and their regulators have therefore tended to be particularly lax in regulating shadow banks and hedge funds. Recently European jurisdictions, notably the Channel Islands, Ireland and Luxembourg have been “streamlining” regulation, to attract funds (Stewart, in Tax Justice Focus vol 4, no.2, 2008). In 2008, Jersey authorised the launch of entirely unregulated hedge funds."

Bruno's paper is a work in progress, which will be submitted for journal publication in due course, but the issues are highly topical and their relevance will become increasingly clear in the coming years. Nov 21 update: new version of the paper available here.

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