Tax competition

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Dr. Ann Phillips, USAID/PPC,  Melissa Brown, USAID/PPC, Dr. Dennis Wood, IRIS Center.

BULLETIN ISSUE 21

Introduction

 

Globalization has heightened competition among firms and countries for management, labor, capital and other resources. While markets for capital, other factors of production and products have become global, tax structures remain national. Some countries have responded to globalization by broadening their tax base and reducing their tax rates, a strategy designed to improve investment incentives while maintaining (or even improving) revenues. Other countries have reacted differently, solidifying or designing “no tax” or minimum tax havens or tax holidays and lower tax rates on the profits and investment gains of foreign firms to attract economic activity. Governments in these countries, in essence, have a tax expenditure policy with respect to the rest of the world. They forego taxable funds they could collect to increase money inflow and associated business activity beyond that likely under a normal tax regime. No-tax or low-tax jurisdictions are sometimes referred to as “tax havens” or “harmful preferential tax regimes.” Taxation also plays a key role in the choice of “offshore centers” to place funds.

These unique tax regimes impact international and domestic companies, countries and governments differently. For example, multinational corporations and international investors can funnel investment, business activity and profits through no- or low-tax jurisdictions to lower their tax rates relative to countries that do not provide special tax benefits. Some wealthy individuals and their banks or brokerage firms arrange offshore accounts to evade taxes. These distinctive tax regimes also have different impacts on country development. Experts disagree, however, on whether and the extent to which the impact of tax competition policy is positive for economic growth. Some claim severe forms of tax competition deprive developed and developing countries of tax revenue, foster wasteful expenditures by investors to conceal their economic activity, and enable undesirable covert activities. In an era of liberalized global capital movement, harmful tax competition regimes and tax havens become open-ended entitlements for those who can access them. Others argue that low-income nations with low tax rates (as well as nearby countries with standard tax rates) benefit from increased investment and economic activity. Nevertheless, differences in national tax systems can create fiscal pressures on governments. For example, low-tax governments are frequently pressured to improve tax incentives by multinational corporations. Also, competition between governments can result in a race toward the bottom (zero tax rates).

There are direct interactions between a country’s tax competition policy and the other institutional arrangements that create its investment climate. Developing countries lose investment funds to tax havens both because taxes can be evaded but also because they have poor investment climates. Nevertheless, while tax benefits may attract foreign investment to the tax haven jurisdiction, an otherwise poor investment climate may cause capital flight that overwhelms those benefits. Even illicit money (from drug trafficking, proceeds from transfer pricing, or corruption) seeking a legitimate business purpose may move outside a tax haven country if its investment climate is too deficient. Likewise, a sound investment climate frequently attracts investment without the benefit of an aggressive tax competition policy.

Finally, certain tax competition policies in combination with banking, commerce and secrecy laws and practices in both western and non-western countries influence the flow of dirty money—illegally earned, moved and utilized—from criminal, corrupt, and commercial processes. Laundered through offshore financial centers or through many other ways, it flows to other legitimate banks where it can be used in legal commerce or, as 9/11 showed, in terrorist enterprises. This money has significant, but differential, impacts on developing and developed countries.

Opposition to tax competition

 

The OECD’s Project on Harmful Tax Practices: The 2004 Progress Report (Centre for Tax Policy and Administration, Organisation for Economic Co-Operation and Development) Since 1998, the OECD has worked to reform global tax practices to eliminate tax competition (i.e., tax havens). This report details improvements in regulatory and informational transparency in banking sectors in both OECD and non-OECD countries. In addition, the report comments favorably on the development of an international framework to address  allegedly harmful tax practices. The OECD recommends that the international community monitor potential tax havens, provide technical assistance to cooperative nations, create dialogue with non-OECD member countries, and consider the application of an international framework.  

Tax Havens: Releasing the Hidden Billions for Poverty Eradication (Oxfam, GB Policy Paper (2000)) Oxfam claims that the existence of low-tax jurisdictions hurts all nations and developing countries in particular through, 1) loss of tax revenue, 2) unfair competitive advantages for large transnational companies who can funnel profits through low-tax jurisdictions, 3) implied threats by companies to relocate if governments raise tax rates, 4) increased ability of corrupt elites in poor nations to launder money, and 5) unstable influences on global financial markets as global capital flows through rapid surges and reversals. Based on this analysis, Oxfam recommends a multilateral approach that forces international investors and multinational corporations to comply with an international framework for tax standards.

Tax Evasion: Hidden Billions for Development (Bruno Gurtner, Swiss Coalition of Development Organizations, 2004) Bruno Gurtner claims that tax havens hurt average citizens and domestic business in several ways by, 1) shifting the tax base from mobile assets (e.g., capital) to immobile assets (e.g., salaries), 2) narrowing the tax base and forcing governments to reduce social service spending, 3) increasing the effects and costs of financial crimes such as tax evasion, and 4) shifting policy away from progressive taxation. Gurtner asserts that developing countries, in particular, lose funds to off-shore centers as rich elites use these jurisdictions to evade taxes. And even within off-shore jurisdictions, local citizens bear the tax burden because they do not receive the same tax breaks as wealthy non-residents. Gurtner notes that markets have globalized while tax policy has remained constrained by national boundaries. Accordingly, he advocates generally for global solutions to regulate the off-shore center industry. 

Support for tax competition

 

Oxfam’s Shoddy Attack on Low-Tax Jurisdictions (Daniel Mitchell, Center for Freedom and Prosperity Foundation, Prosperitas, August 2001) Mitchell claims that Oxfam’s calculations in its 2000 report are based on incorrect assumptions. In particular, Oxfam assumed that developing nations are losing returns of 20% on foreign direct investment and tax revenue equaling 35% of corporate earnings to “tax havens.” However, these numbers are inaccurate because tax rates and rates of return in developing nations are much lower. Mitchell encourages readers to look at “real world” results, where low-tax jurisdictions can be categorized as some of the most successful developing economies.

An OECD Proposal to Eliminate Tax Competition Would Mean Higher Taxes and Less Privacy (Daniel Mitchell, McKenna Senior Fellow in Political Economy, The Heritage Foundation, Backgrounder #1395, September 2000) Mitchell alleges various weaknesses in the OECD’s handling of tax competition issues. He claims that, 1) the OECD’s recommendations for uniform tax practices would, in effect, create a tax cartel, 2) the organization gives certain non-OECD nations the pejorative label of “tax havens” and “money launderers,” even though OECD countries support most of this activity and many low-tax jurisdictions readily assist with criminal investigations of laundering activity, 3) the OECD does not adequately address the impact of its recommendations on financial privacy concerns, and 4) the organization’s suggestions would diminish the ability of developing countries to attract skilled labor through tax incentives.

Economic Effects of Regional Tax Havens (Mihir Desi and C. Fritz Foley from Harvard University and James Hines, Jr. from University of Michigan (2004)) Desi and Foley studied corporations with regional affiliates in both tax haven and non-haven areas. They conclude that corporate use of tax haven affiliates promotes growth in non-haven affiliates within the same region.

The Case for International Tax Competition: A Caribbean Perspective (Carlyle Rogers (2002), Center for Freedom and Prosperity Foundation, Prosperitas, Vol. II, Issue II) Rogers criticizes the OECD strategy of blacklisting non-OECD members. He notes that the OECD has targeted small, developing, non-OECD countries, even though wealthy countries provide the majority of global wealth protection. Rogers argues that underdeveloped countries must use tax competition to promote economic development. He points out that developing nations lose tax revenue to wealthy nations through labor migration. Accordingly, tax competition helps poor nations make up for this loss of revenue.

Mixed responses to tax competition

 

Event: Tax Competition and Tax Avoidance: Implications for Global Development (2004) Two authors of the aforementioned 2000 Oxfam report organized this follow-up event to review literature and research by tax competition scholars. Each presentation is summarized in this program review. The organizers indicate that the global Tax Justice Network intends to update the Oxfam report in 2005. Two papers discussed at the event are included below.

             ▪ International Organisations, Blacklisting and Tax Haven Regulation (J.C. Sharman (2004), Government and International Relations, University of Sydney) Sharman claims that the OECD’s plan to blacklist low-tax nations damages the ability of such nations to attract capital, which encourages recalcitrant nations to reform their tax practices. However, a negative consequence of this technique is that OECD and similar organizations can label nations as “tax havens” indiscriminately. The author concludes that blacklisting is effective; however, this effectiveness is limited by credibility questions that result from the arbitrary selection of blacklisted countries.  

             ▪ Offshore Finance Centres, Multilateral Initiatives and Increasing Tax Competition (Gregory Rawlings (2004), Centre for Tax System Integrity, Regulatory Institutions Network, Research School of Social Sciences, The Australian National University) Rawlings concludes that actions by the OECD and other organizations have diminished the impact of offshore financial centers (OFCs). However, sophisticated OFCs continue to thrive because they have developed a loyal client base. Commentators concede that OFCs will continue, in part, because even OECD members refuse to meet the organization’s demands for tax reform.

Why Worry About Tax Expenditures? (The World Bank, PREM notes, Economic Policy, No. 77, January 2003) The World Bank defines “tax expenditures” as tax breaks that promote a particular policy. For instance, the tax deduction for charitable donations is a classic example of a tax break that provides a policy-oriented benefit. However, the author warns of the dangers of tax expenditures, namely that, 1) incentives may support actions that would have taken place anyway, 2) tax bases narrow, 3) the absence of ceilings and sunset clauses make cost/benefit analysis hard to calculate, 4) more complex tax laws are harder to enforce, and they are more costly, 5) expenditures lack transparency and are not subject to review through normal budgeting processes, and 6) the system is regressive, in that wealthy individuals tend to benefit from tax expenditures. The World Bank recommends that countries remedy these weaknesses by subjecting tax expenditures to the same scrutiny as direct spending programs. 

Tax Expenditures: A Review and Analysis (Vice Chairman Jim Saxton (R-NJ), Joint Economic Committee (JEC), U.S. Congress, August 1999) This report does not discuss international tax competition per se. However, the former Chairman of the JEC argues that erroneous definitions of taxable funds prevent coherent debate on tax policy issues. Saxton claims that certain taxes, such as taxes on capital gains, amount to multiple taxation because the funds are previously taxed as income. Accordingly, Saxton argues that the U.S. government should not label exclusions for these taxes as “tax expenditures” or “tax subsidies.” Saxton’s argument is relevant to the issue of tax competition because it questions the definition of taxable funds and the right of jurisdictions to enforce multiple taxation.

The connection between tax competition and criminality

 

After Dirty Air, Dirty Money (The Nation, June 18, 2001) The Nation claims that the current administration has withdrawn efforts to diminish money laundering and tax evasion. The article sites various opinions on the administration’s motives. Some commentators believe that the government’s position reflects ideological support for free market principles generally. However, others claim that greed motivates the U.S. because the American economy benefits from inflows of dirty money. The Nation asserts that criminal financial flows can be eliminated if the U.S. provides leadership and support.

Dirty Money: Nourishing Poverty and Terrorism (A Brookings Center for Public Policy Education/Caux Roundtable, Remarks by Richard Newcomb, Director, Office of Foreign Assets Control, U.S. Treasury Department, and Robert Morgenthau, District Attorney, County of New York, June 5, 2002) The first speaker, Richard Newcomb, is responsible for investigating international financial flows that support terrorist activity. He claims that networks disguised as “charitable organizations” play a significant role in funding terrorism. The U.S. approaches this problem by either targeting or cooperating with legal entities, such as legally operating U.S. financial centers. These centers can provide valuable information to identify individuals, organizations, and sources that are connected to suspicious funds. The U.S. also seeks international cooperation and information sharing to identify criminal activity. The second speaker at the roundtable, Robert Morgenthau, has prosecuted financial crime cases in New York. He believes the relevant New York statute is better and broader that the U.S. Patriot Act because the New York law focuses on financial crime generally rather than terrorism per se. Morgenthau says that the U.S. government “winks” at financial crime for political reasons. International cases are particularly hard to prosecute because subpoenas must go through a mutual assistance treaty, which can take years. In response to an audience member’s statement that tax evasion is inevitable and even preferable in a free market, Morgenthau argues that the fairness of tax rates is a policy question, but the payment of those rates is a law enforcement question. He asserts that individuals and entities are required to pay applicable rates as they use legitimate political processes to advocate for changes in the tax code.

Dirty Money (Miriam Wasserman, Regional Review, Quarter 1, 2002, Federal Reserve Bank of Boston) With the passage of the Patriot Act, anti-money laundering regulations have expanded. However, the rate of globalization has simultaneously made money laundering more difficult to track. The author, Miriam Wasserman, characterizes money laundering as a cat-and-mouse game, where criminals search for new loopholes as authorities close existing gaps. She argues that the U.S. should continue efforts to balance tough regulations with financial costs to banks and privacy concerns for individuals. Regarding developing countries, the author details ways in which money laundering derails free market principles and hurts developing economies through, 1) promoting and funding large-scale corruption of institutions, 2) distributing money globally based on avoidance of controls rather than rates of return, and 3) crowding out legitimate business and weakening domestic manufacturing by providing artificially low prices through businesses that provide cover for money laundering schemes.

Dirty Money and Its Global Effects (Raymond Baker, International Policy Report, January 2003, The Center for International Policy’s Global Financial Flows Project) Raymond Baker defines “dirty money” as money that is illegally earned, moved or utilized from criminal, corrupt, or commercial processes. Baker asserts that the U.S. must target all dirty money to effectively fight terrorism and other crimes. Accordingly, he believes that the U.S. Patriot Act is too narrowly focused on financial flows that support terrorism. Regarding developing nations, Baker claims that dirty money flows out of such countries to their detriment. He cites Russia as an example, where between $200 and $500 billion flowed from the country into private accounts during the 1990’s. To remedy the problem of dirty money, Baker suggests that the U.S. create legislation incrementally that criminalizes all relevant activities including, 1) preventing U.S. banks from working with offshore centers, and 2) requiring financial centers to create additional safeguards that identify sources for suspicious funds. Baker asserts that the primary barrier to such legislation is the lack of political will.

Published by the PPC IDEAS Project at the IRIS Center

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