It's the tax exemptions, stupid!

The IMF is showing advanced symptoms of abandoning its one-sided economic doctrine enshrined in the Washington Consensus. Among the signs is the recent comment by IMF managing director Dominique Strauss-Kahn that the era of the Washington Consensus is over, and that from now on more, not less state, will be a feature of the economic equation. As unfettered freedom for international capital flows becomes less fashionable, we can expect that capital controls will soon be added to the mix of IMF’s policy prescriptions provided to indebted nations.

However, an astonishingly large splinter remains in the eye of recent IMF research. As we argued quite recently, the fiscal side of macro-economic imbalances and the financial crisis was largely glossed over in the recent IMF-paper on "What Caused the Global Financial Crisis - Evidence on the Drivers of Financial Imbalances 1999 – 2007”. Mysteriously, an earlier IMF paper on the impact of tax policies on debt and other financial crisis-related issues seems to have been largely side-lined since its publication at the height of the crisis in 2009.

A more recent IMF working paper on the relationship between capital flows on boom and bust cycles in New EU Member States’ economic growth initially raised our hopes that fiscal policy might be given more of the attention that it surely deserves. The abstract explains that the focus of the analysis has been laid on the sector-specific destination of the capital flows, and not on their form (portfolio and/or FDI and/or greenfield vs. merger and acquisitions). It nevertheless promised to look at the fiscal side of the story:

“Applying data from EU New Member States, it is found that capital flows into real estate have a greater impact on swings in GDP than other sectors, irrespective of a country's exchange rate or fiscal policy.”

Did the researchers attempt to examine how tax exemptions for foreign investments might have acted as an independent variable impacting on growth? The evidence from this paper suggests not:

“Although stylized facts indicate that strong fiscal policy during the boom years helped provide a buffer for the crisis, the regression results indicate that fiscal policy did not have a significant direct impact on GDP growth and therefore did not appear to add in a significant manner to the overheating pressures experienced during the boom.”

This means that the only fiscal variable used in their analysis was the deficit or surplus of a nation’s state budget expressed as a percentage of GDP. Yet again, the IMF appears to have ignored the issue of whether tax exemptions and incentives for foreign capital investment played a part in boom and bust economic cycles.

We don’t necessarily call for the total cessation of tax exemptions as the panacea for financial and economic crisis. However, it is worrying that this potential root cause of macro-economic distortions remains largely ignored by IMF staff (apart from in the case of FDI and small Caribbean islands).

The kind of tax exemption now usually granted by most rich nations on returns for non-resident absentee owners (portfolio investments) is the number one root cause for international (harmful) tax competition. It forces down the quality of public education, health care and infrastructure and invites massive tax evasion by the wealthiest. It allows an all-powerful financial sector to become a politically dominant force in many nations. And it may well have played a key role in the recent international financial crisis. Yet no international body gives this matter the degree of attention it deserves.

Why is this?

At TJN we are advocating automatic information exchange to remedy this. It would help even if national policies would not change concerning the tax exemption of non-resident investments. And it is heartening to see the recent initiatives by the European Union’s political leaders to start developing such a multilateral system of automatic information exchange (here and here).

Wouldn’t it be nice if the IMF stopped turning a blind eye to this subject?