Financial Times: How tax havens helped to conjure up the current crisis

Tax Justice Network has argued for years that the faults in the international tax system cause significant market distortions at micro and macro levels. Tax havens, in particular, divert investment and trade flows as capital seeks opportunities for tax and regulatory arbitrage. The Financial Times has published an opinion piece by Professor Sol Picciotto, senior adviser to TJN, in which he explains how tax havens have contributed to the current crisis.

We cannot, for copyright reasons, publish the entire text of the article, but here are selected extracts which explain the origins of the problem and the causes of decades of inaction by the appropriate authorities as they have tried to grapple with the contradictions between short term national interest and the longer term public interest in a world of globalised capital markets. Sol also lays out the key remedies proposed by TJN to tackle these distortions.

International tax co-ordination depends on treaties based on a model devised 80 years ago. To prevent double taxation, the treaties generally give governments the right to tax returns from an investment in the investor's country of residence. Business profits, meanwhile, are taxable in the "source" country where the activity takes place. But for most of the past century, international investment was dominated by multinational corporations, which could choose the location of their sources of funds and organise their affiliates' capital structures. This enabled them to devise techniques to ensure that they were not taxed unfairly, as they saw it, exploiting ambiguities in the concepts of residence and source using legal entities formed in convenient jurisdictions. Such methods were also pioneered, with rather less legitimacy, by wealthy people resentful of high income taxes.

This issue has lain unresolved for decades, during which a massive offshore infrastructure was created for the sole purpose of providing tax evasion and avoidance services. De-regulation of capital markets significantly boosted demand for these services:

The relaxation and final abandonment of exchange controls in the1970s led to the blossoming of "offshore" finance and a boom in tax havens. These depend on both outright tax evasion and the exploitation of grey areas by tax avoidance. Since large multinationals are as much financial as business entities, they have freedom to devise complex financial structures - financial institutions, such as banks, even more so.

Hedge funds are prime example of this freedom to devise complex financial structures which are driven, at least partly, by opportunities for tax arbitrage:

The tax authorities in the US and the UK have accepted a lax interpretation of residence and source rules, accepting that these funds are resident and their profits sourced offshore (mostly in the Cayman Islands) - even though they are effectively managed from London and New York. Not only are the funds' gains treated as realised in Cayman, and hence not taxable, but their distributions are not subject to withholding tax - a great benefit for their investors. The funds' location in a secrecy jurisdiction facilitates tax avoidance and is an open invitation to evasion.

The distorting effect of exploiting opportunities for tax avoidance and evasion has shaped investment decisions in perverse ways, encouraging speculative activity over productive activity. The situation is worsened by the lack of market transparency, which prevents analysts and regulators from detecting concentrations of risk:

For multinationals and rich investors the point is the same: returns on financial transactions are ultimately taxed at a low or zero rate, making them far more profitable than genuine business endeavours. This distortion of the tax system has greatly fuelled the excess of liquidity channelled into largely speculative financial transactions.The offshore secrecy system has been a main element of the opacity that has undermined corporate and financial regulation.

And where can we find the remedies to this harmful situation:

The remedies lie in fundamental reforms of international fiscal and financial regulatory co-operation, and their co-ordination. International tax co-operation requires a comprehensive, multilateral system for both obtaining and exchanging information for all tax purposes, with proper safeguards for taxpayers.

Requiring multinationalsto break down their accounting information by each country in which they do business would inject much-needed transparency into the system.

Reform should include a shift towards unitary taxation, which most international tax specialists recognise is long overdue. This would be preferable to the Obama administration's new proposals to tinker with US rules on tax deferral.

These reforms would make the international tax system more effective and fairer, and remove a major rationale for tax havens. They would produce large cost savings for business and perhaps even close down the departments in banks that conjure up wasteful and distorting tax-driven schemes.

Speaking at an event held at the London School of Economics last week, a marketing person from one of Britain's more prominent small island tax havens (sorry, the Chatham House Rule was - for no good reason - applied to this meeting, so we cannot attribute) pooh-poohed our proposition - see here - that tax havens have in any way contributed to the current crisis. We sensed that the majority of the audience were sceptical of this claim. Perhaps that spokesperson (you know who you are) would now like to come forward with a reasoned riposte to this opinion piece, which we will be happy to publish in full.