Thursday, June 18, 2009

Tax havens: macro-relevant?

"Tax distortions are likely to have encouraged excessive leveraging and other financial market problems evident in the crisis." These are the opening words of the executive summary of the IMF's new report on Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy, published earlier this week. "These effects" the summary continues "have been little explored, but are potentially macro-relevant."

Indeed they are macro-relevant (aside: where did this ugly term come from?), but why did it take so long for the penny to drop at the IMF of all places? This blogger started his economics career in the late 1970s looking at the impact of Europe's Common Agricultural Policy on the agricultural economies of Africa. The evidence was overwhelming: fiscal subsidies in the European markets wreaked havoc as far afield as Bamako, Kampala and Algiers as excess product in Europe was dumped onto their markets, often masquerading as food aid.

Years later, working in Jersey, I analysed the impact of unlimited mortgage interest tax reliefs on the residential housing market and beyond any shadow of doubt it could be seen that these reliefs stimulated demand (inducing inflationary pressures) and encouraged households to borrow to the max. As the IMF concludes in this new report: "The risks in distorting a market so central to financial stability reinforce long-standing efficiency and equity arguments for more neutral taxation." No shit, Sherlock.

But working in Jersey for well over a decade also highlighted another fiscal distortion which lies at the heart of the current crisis, and this is something that the IMF, and Financial Stability Forum, and Uncle Tom Cobley and all should have grasped decades ago: the ways in which banks, hedge funds, multinational trading companies develop and market complex financial instruments are shaped to a significant extent by the opportunities to engage in regulatory and tax arbitrage. In other words, the opportunities to use tax havens to create tax avoidance structures creates market distortions which are not easily identifiable since the structures are typically complex and highly opaque.

My colleague Sol Picciotto explored this issue in his recent Financial Times article:

"Since large multinantionals are as much financial as business entities, they have freedom to devise complex financial structures - financial institutions, such as banks, even more so: recent separate surveys by the US Government Accountability Office and the Tax Justice Network, the larger user of tax havens in every country surveyed was a bank. Tax authorities have enormous problems puzzling out these structures. If they can, it is often hard to characterise them as shams."

And Sol explores this issue further using hedge funds as an example:

"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 to their investors. The funds' location in a secrecy jurisdiction facilitates tax avoidance and is an open invitation to evasion."

It is hard to exaggerate the extent to which tax arbitrage has shaped cross-border trade and investment flows. Tax policy plays a significant part in shaping debt-equity ratios, favouring debt over equity finance. The majority of securitised debt obligations were issued in tax havens in order to secure favourable tax treatment to reduce the cost of financing sub-prime loans. The ability of banks and their clients to use tax havens to take advantage of their low or zero rates, has created a huge market bias favouring financial transactions over long-term investment in genuine business enterprises. For example, the IMF report says:

"Divergences in national tax rates, bases, and practices create substantial opportunities for international tax arbitrage, further increasing opacity and reinforcing tax biases to debt."

In summary, distortions in tax systems, and above all the ability of banks, multinationals and wealthy investors to use tax havens for avoidance and evasion purposes, has encouraged the accumulation of excess liquidity for use in what are largely speculative financial transactions. The need to disguise the transactions to deter serious investigation of tax avoidance structures has contributed to the complexity and opacity that prevented regulators, credit rating agencies, auditors, financial journalists, and others, from effectively doing their jobs as gate-keepers of public interest.

The IMF added this, rather timidly:

"Recent progress on ‘tax havens’ addresses issues of evasion but not fundamental ones of tax avoidance. Measures to address the latter that are both politically acceptable and technically coherent are hard to identify, but need to be explored further."

Why bow down to the politically acceptable before you've even started? Why not try and push the envelope a little? That is our approach, at least.

We're rather glad to see that the IMF is twigging on to our concerns. Now how about creating an international body to sort out the mess: perhaps it could be called the International Tax Organisation.


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