The Impact Of Tax Havens On The Economy Finance Essay

The offshore economy is a consequence of the globalization. Its emergence is known as a new economic environment where tax and regulations are relatively lax. As countries are getting closer and borders are blurred, the flow in and out of capital and money, mostly as Foreign Direct Investment, has caused critical changes to the contemporary economy. This essay will examine the impact of the tax havens, which are one of the most important aspects of the offshore economy (beside Offshore finance, Export processing Zones and E- Commerce) including their evolution, the successes and failures in their operation and their impact upon the global economy.

Haven is defined as a place of sanctuary, a place of safety and thus implies that it is an area within which someone or something is protected from an enemy. For many in business the enemy is government taxes, which have a direct impact on profits and the financial structures of a business. Thus, tax havens are a geographical area within which a business can find ‘sanctuary’ from taxes or enjoy lower levels of taxation than in other parts of the world. Because of the attraction to investors of lower taxes the areas become somewhere that can offer a competitive environment to attract investment away from other countries and into their own. This is spread across both personal and corporate tax environments. However, it should be noted that tax havens are designed for people or businesses to avoid tax in their own country and are a serious risks to the income of governments. For example, the Trade Union Congress researchers found that ‘Tax avoidance by wealthy UK residents through tax havens costs UK tax payers at least £4 billion a year’ (TUC 2009), while the IMF in 2000 found that assets of $4.6 trillion are passing through the balance sheets of tax havens (Offshore Financial Centers”, International Monetary Fund background paper, June 23, 2000). The TUC went on in a later report to criticise the UK government review of tax havens (the Foot review) and declare that ‘The PM and Chancellor have made it clear that they want to ‘outlaw’ tax havens and the evasion and avoidance they promote. But this progress report suggests that this leisurely review is more focused on helping tax havens through their current financial difficulty than addressing the serious threat they pose to the global economy… The Treasury needs to get a grip of this Review and decide whether it is flowing with or against the grain of world opinion which has turned so decisively against tax havens since the G20′(‘Interim

report of Foot review of tax havens is deeply disappointing, says TUC,’ TUC 2009). The fact that tax haven have seriously harmed the ability of governments to collect tax revenues means that in the aftermath of the 2008 financial crisis the role and future of tax havens has become a central problem in the global economy. This essay will now look at how tax havens have developed.

Ronen Palen (1992) identifies tax havens as a means for small countries and states to compete with the developed states of the world economy and has routes through which money can be ‘laundered’, with a third of all multinational corporations’ Foreign Direct Investment (FDI) transactions carried out through tax havens. Palan notes how there are two principal geo-political poles. The first is centred on those areas with close links to the City of London, and the other is centred in Europe and consists of the Benelux countries.

For Palan (1992) tax havens are those states that can ‘write/modify its own laws with the aim of making specific offers on the ‘tax/financial aspects to attract/encourage/pave the way for target clients’ to invest money in the countries.

The definition of tax havens is quite general and covers a number of methods that help persons and corporations to avoid tax. At present there are over 70 tax havens in the world; and many of these are weak or small countries (microstates). Hines (Which countries become tax havens, 2006), noted that in general the havens are small countries with a population of less than one million and are using low tax policies as a part of their developmental strategy.

Palan (1992) draws a distinction between a ‘Preferential tax regime’ and a ‘tax haven’. For example, the UK and US are two countries considered as tax havens by many countries because they apply a no taxation strategy on some specific sources of income. However, ‘tax havens are not their key strategy, and the policies are limited means of taxation reduction aimed at attracting more foreign capital’.

The history of tax havens can be traced back to Ancient Greece, but their main role has developed as the industrial revolution and the modern economy has developed. Their main emergence came in the late 19th C to 1930s. Tax havens were established

gradually. As Palan (1992) noted, tax havens were born from the three main centres of financial development of the global economy; the US, UK and Switzerland.

In the late of 19th Century, the two large states of the US – New Jersey and Delaware, were desperately in need of new funds. Thus, the states established new financial structures to encourage the attraction of finance and issued policies establishing benefits to attract companies such as ‘offshore company’ status that could be activated in less than a day since its establishment. The aim of the states was to attract companies and funds through low taxation and liberal incorporation laws, which were still rare and restricted in main economic regions of Germany and England. For those reasons, New Jersey had successfully encouraged a number of headquarters/ businesses to switch to the states. Today, New Jersey and Delaware are not seen as the tax havens in the general definition, but are recognised as the birthplace of tax havens.

A second creator of tax havens is the British Courts. While the US states were know for the liberal financial laws, the British Courts should be credited with the “technique of virtual residencies”. By creating the ability of companies to have a financial identity but not actually be situated in the UK, the corporations could avoid paying tax on much of their income (Palan, 1992).

In 1929, it formally established the rule that if companied registered in Britain but it doesn’t conduct any trading then it wouldn’t be claimed against for tax. Thus, companies are encouraged to incorporate in Britain with free taxation.

Last but not least, the Swiss bank was a significant factor in the creation of tax havens. The Swiss bank system has been famous for its secrecy. The Bank Act in 1934 demonstrated that it had: “absolute silence in respect to a professional secret”, and this strengthened the idea that Swiss Banks were a place where companies could deposit funds and finances without tax authorities having access to the financial details of the transactions. Any companies, businesses, investors, even secret groups had the right to be protected perfectly from anyone trying to access information. Once they have protection of the Swiss banks, no one, including governments could violate

that privacy. The main point of this is that companies and individuals could ‘hide’ their finances within the Swiss Banking system and prevent tax authorities from gaining the financial information they need to request tax payments on those profits (Palan, 1992).

These are seen as the inventors of tax havens. That they were trying to deliberately set up ‘tax havens’ is in question, but the reality is that the policies they established brought about the financial conditions for tax havens to exist.

The development of tax havens from WWI to early 1960s saw them become vital elements in the growth of the global economy. These are some of the countries who considered themselves as the first formal tax havens in the space of 1920s, 1930s. Once tax havens were established and certain states could attract vital funds from the global financial world it was inevitable that others would copy the system and create conditions that competed with existing tax havens (Baker, 2005, Henry, 2003).

Liechtenstein- situated between Austria and Switzerland enacted its own Civil Code in 1924 and established new tax conditions that offered favourable benefits to investors and corporations. Luxembourg on 31st July 1929, applied a new law in which holding companies were exempt from income tax. The idea that a state could attract large sums of investment and finances through the manipulation of tax structures in a state was now formally established as a way to profit from the global economy (Palan 1992)

From the 1960s to 1990s the global economy saw the heyday of tax havens. New laws of the Bank of England, which were established in 1957, declared that transactions that took place in the UK, even though its holders were not residing in the UK, could be recorded/credited for tax reductions. Thus, those activities could be considered as offshore transactions and benefit from the tax haven status. Those advantages lead to the development of London as a major financial centre of the world attracting funds from across the globe and later developing its expansion into the Euromarket (Palan, 1992). In 1964, British Banks successfully established a cooperative relationship with three of the World’s largest Banks – City Bank, Chase Manhattan, and the Bank of

American. Thus, Britain through the manipulation of the global tax system and the creation of London as a tax haven managed to raise its development to new heights and compete on equal terms with the largest banks in the world (Palan, 1992).

It was inevitable that other states would follow the example of the US, Swiss and UK and numerous areas now became tax havens. In the Cayman Islands tax policies encouraging financial actors around the world to base themselves there soon made it the fourth largest financial centre in the world. Singapore became the “fastest growing private sector in the world” and attraction of investment through beneficial tax conditions quickly became a central policy for many states to attract new finances and keep them through increasingly more favourable tax incentives (Baker 2005, Henry, 2003).

However, the multitude of new tax havens brought problems as well as benefits to the global economy. For example, in the Norfolk Islands, which was the first Pacific tax haven, the Australian government tried to block its development as it was seen as only benefiting international business and did little for national citizens. Despite the problems by 1990, there were nearly 100 tax havens in the world, both self-defined and internationally recognized and became the main stream of international lending. Almost one third of FDI was routed through Tax havens and recognised as the main route for carrying out international business whilst avoiding the payment of tax.

It is undeniable that tax avoidance through tax havens has greatly influenced and modified the way the world economy has developed. It created a new environment that challenged most of the traditional rules. The major economic powers such as the US, UK and France gradually saw their control of the tax havens reduced and, ironically, while they were the largest and most active players in creating tax havens and their expansion, they also found themselves heading the international reaction to control them (Baker 2005, Henry, 2003).

By the end of 1990s, it was recognized that tax havens had as many negative impacts on the global economy as they had positive ones. International organisations designed to help develop the global economy, such as the OECD, now declared that tax havens

were the centre of a “harmful tax competition” that threatened the development of free trade and open markets. The European Union and the US now also became centres of influence on the global economy to find ways to control and limit the impact of tax havens. However, how genuine this call for control of tax havens by the US is has to be questioned as the administrations of both Clinton and Bush did little to effectively control their growth. While Bush and Clinton seemed to be against the out of control development of tax havens, Obama in the other hand has some interest in it. At same time there is growing pressure on tax haven issues and the debate on them is deepening and spreading. The G20 summit in London suggests a number of proposals to re write / rebuild/ re structure tax havens regulations (Shah, 2009).

It is clear that tax havens have now become a major player in the economic world. They have grown rapidly and there are about 70 formally recognized tax havens in the world.

Although OECD is doing its best to re regulate tax havens, there are still many difficulties remaining. The financial crisis last 2008 weakened the big financial centers like UK, Western EU and US. However, the centres in Hong Kong, Singapore and China seemed to still be thriving. Thus, the tension in tax havens debates is likely to continue.

In the age of global capital, offshore investment has become a normal way of international business. It helps areas attract a large number of international banks, businesses and investors. On the other hand, it has also attracted harsh criticism, mainly on its ability to protect and encourage those carrying out illegitimate activities, for example such criminal trades as drugs, arms trafficking and terrorism, where the tax havens offer a means to illegally launder money and financially support their activities. However, many would claim that tax havens still bring more benefits to state and society, than negative impacts. Thus, the question here is whether the legitimacy of the offshore investment tax havens should still exist and if yes, what should be its boundaries and limitations (Shah, 2009)?

There are many elements of the offshore investment world, from E- commerce (online markets, casinos, etc), to flags of convenience (special offers on those who register their ships with particular countries), Export processing zones, offshore financers and Tax havens. However, the tax haven is a major concern. The offshore economy is known for its systemic lack of rules and regulations, with the advantages of tax reductions and tax avoidance. On the surface the tax havens themselves are important means for businesses and banks to conduct their trade, but it is also clear that their greatest advantages lies in actions that are very dangerously near to criminal claims of money laundering and tax evasion.

Tax havens are countries with very clear tax and investment benefits such as little or no income or corporate tax, strong bank secrecy laws, good telecommunication links with global markets and public presentation as a tax haven. In a similar vein, tax havens have constructed their national legislation to clearly give incentives for big business to move from highly taxed countries to the tax havens. For example, Monaco has retained its low taxation environment since the last century to purely attract foreign investment, while small states in Caribbean have used low taxation as the major key to their developmental strategy.

However, there are still many different characteristics of tax havens. Most tax havens normally modify their rules and law in order to encourage and attract foreign investors. They concentrate on reducing barriers to new businesses, offering strict privacy in regard to their business conduct and ensuring that the tax haven is both a low tax environment and a place to legally restrict the financial information that outside countries, governments and organizations can request access to. Tax havens also prevent its investors/clients from avoiding double taxation problems and confidently carry out their international business without paying large amounts of tax. The Bahamas Investment Authority demonstrated why the tax haven is necessary and legitimate as it declared them ‘a paradise for many reasons: no personal, corporate or income tax, provide easy access to great world markets’ and are highly secure’ (Financial times, cited by Ronen)

Tax havens are “small financial resorts” which are basically the “booking centers” for the huge financial systems in London, Tokyo and New York. They have the ability to write their own laws in relation to tax and financial issues in order to attract investors and large businesses from all over the world.

In some views, tax havens are also known as “the parking lot” or “transit lounge” for those companies using “this kind of service”. Critics claim that Tax havens countries demonstrate a complete lack of interest or concern about the nature of companies and investors who register in their territory. Their only concern is the “parking fee” they receive for their services and it is this lack of concern for the consequences of allowing financial actors a free ‘reign’ to conduct their business in the haven that troubles many people. In addition, the tax havens further harm their reputation by offering the companies who register in territory an unprecedented level of secrecy in both their tax and business matters. This is in itself a situation that now threatens the security of the globe in the age of the ‘war of terrorism’ where tax havens guarantee terrorism organisations a base from which they can safeguard their financial dealings (ATO talks tough on tax havens. Australasian Business Intelligence | January 6, 2003.

Tax havens are the right developmental strategy for the small and weak states. However, it is claimed that the goal of these countries is to “draw rent surpluses from the income that otherwise would accrue to larger states”(Hampton 1996, cited by Palan)

Tax havens are seen as an abuse of rules and codes of sovereignty (Palan 1998) and at the same time encourages tax evasion and money laundering (Hines and Rice 1994, cited by Palan) Palan argues that: ‘The conditions that gave rise to the commercial use of sovereignty as perfected by tax havens cannot be dismissed either as legitimate responses to an unreasonable sure in taxation and regulation in the post war era. On the contrary, they go to the heart of the continuing process of state formation in a period of intensified capital mobility’.

Palan (1992) categorized tax havens into four types:

Countries who don’t charge income tax and only require license fees to foreign businesses. (Bermuda)

Countries with low taxation policies (Jersey)

Countries who levy tax on internal taxable activities only. (Hong Kong)

Countries who provide special tax offer to specific types of businesses (Channel islands)

Although the calculation of money through tax havens are various, some assume half of the world’ stock passes through tax havens, others believe that one fifth of private wealth is invested offshore (Cassard 1994, cited by Palan).

One main reason leading to this growth of tax havens is the imposition of increased regulation in industrialized countries. (Financial Stability Forum 2000,11 cited by Palan) Banking, insurance and ship registrations are the most three important factors in offshore business, thus they are also the target subjects of heavy tax regulation. In regard to this situation, many states then offer the low tax or even zero taxation to attract foreign businesses to their countries.

The most serious attack against tax havens is the possibility that they ‘undermine democracy’. Shah (2009, p.1) notes that ‘companies also pour lots of money into shaping a global system that they will hope to benefit from. If the right balance can’t be achieved, not only will attempts to evade taxation and other measures undermine capitalism (which they claim they support) they will also undermine democracy (for even responsible governments may find it hard to meet the needs of their population)’. Shah continues in explaining that tax is the ‘lifeblood’ of a countries economy and without it the consequences are extremely dangerous, for example, a government without an efficient revenue system cannot hope to successfully ‘govern’ the country. Shah explains that developing countries lose $160 billion a year through tax evasion in 2008, which was over three times the figure for 2000, demonstrating a

rapidly growing problem. Even these figures are suspect as the core base for this is tax avoidance and being able to calculate actually how much tax is secretly avoided is extremely difficult, so figures are only seen as conservative estimates (Shah, 2009, p.2). Shah points to even more graphic evidence of the damage that tax havens cause as he cites evidence from Christian Aid which says ” illegal, trade related tax evasion alone will be responsible for some 5.6 millions deaths of young children in the developing world between 2000 and 2015. Half are already dead”. Shah (2009, p.3) is clear in his reasons for protesting against tax havens as he finds they:

• Secret bank accounts and offshore trusts encourage wealthy individuals and companies to escape paying taxes

• The ability of transnational corporations to structure their trade and investment flows through paper subsidiaries in tax havens provides them with a significant tax advantage over their nationally based competitors.

• Banking secrecy and trust services provided by global financial institutions operating offshore provide a secure cover for laundering the proceeds of political corruption, fraud, embezzlement, illicit arms trading, and the global drug trade.

• The offshore economy has contributed to the rising incidence of financial market instability that can destroy livelihoods in poor countries.

Thus, tax havens are purely constructed to allow ‘multinational companies, rich individuals, corrupt leaders, criminals and terrorists to keep their wealth away from the prying eyes of national tax authorities. In the words of one tax expert, “I have never come across any reason for people to set up an offshore trust [in a tax haven] other than to avoid tax’

(Shah, 2009. P.4). Basically then, tax havens cannot be justified as legitimate aspects of the global economy. They are based on giving financial actors unfair advantages and in a world moving towards open and free markets they offer many barriers to competitors who ‘play the game’ and pay all their required taxes.