This essay reviews the academic literature on the potential positive effects of tax havens on non-haven industrialized countries. It starts with briefly defining tax havens in section 2. In section 3, the essay outlines the traditional "negative" view on tax havens and the prevalence of this view in empirical literature. Section 4 contrasts the preceding section and investigates the emerging "positive" view on tax havens. The conclusion answers the research questions and summarises the most important findings.
The public image of tax havens is "traditionally" negative. Scandals in the past (e.g. Liechtenstein Affaire, Panama Papers) elucidated the role a tax haven may play for a variety of high net worth individuals and/or political figures as a secrecy-jurisdiction to facilitate illegal activities, such as the evasion of taxes and/or safe-keeping/hiding of illicit earnings. Non-governmental organizations (such as the Tax Justice Network and the Global Finance Integrity) denounced the spread of tax havens and published listings of havens they deem potentially harmful to the global economy. Academic literature also highlights how tax havens exacerbate harmful tax competition and allow multinational corporations to avoid taxes in developed and developing countries alike through tax planning, thus being of "parasitic" nature for the global economy.
Table of Contents
1. Introduction
1.1 Problem Statement
1.2 Objective of the Essay
1.3 Organisation of the research
2. Definition ofTax Haven
3. The Traditionally Negative View onTax Havens
3.1 Tax Planning
4. Can Tax Havens be Beneficial?
4.1 Keen (2001)
4.2 Hong and Smart (2010)
4.3 Chu, Lai and Cheng (2013)
4.4Desai et al.(2006)
4.5 Additional Literature
4. Conclusion
5. References
List of Abbreviations
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1. Introduction
1.1 Problem Statement
The public image of tax havens is “traditionally” negative. Scandals in the past (e.g. Liechtenstein Affaire, Panama Papers) elucidated the role a tax haven may play foravarietyof high net worth individuals and/or political figures as a secrecy-jurisdiction to facilitate illegal activities, such asthe evasion of taxes and/or safe-keeping/hiding of illicit earnings. Nongovernmental organizations (such as the Tax Justice Network and the Global Finance Integrity) denounced the spread of tax havens and published listings of havens they deem potentially harmful to the global economy (Taxjusticenetwork, 2019; Gfintergrity, 2020). Academic literature also highlights how tax havens exacerbate harmful tax competition (Slemrod& Wilson, 2009; Krautheimand Schmidt-Eisenlohr, 2011)and allow multinational corporations to avoid taxes in developed and developing countries alike through tax planning (Slemrod& Wilson, 2009), thus being of “parasitic” nature for the global economy.
1.2 Objective of the Essay
The influx of foreign capital to tax havens has risen drastically over the past decade (Alstads^ter, Johannesen & Zucman, 2017). High levels of offshore wealth - located in tax havens - translate into a reduction of taxable corporate earnings in non-haven countries, thus eroding the tax base. Additionally, the global average of corporate tax rateshas fallen from 49 to 24% between 1989 and 2018 (Zucman, 2019)in many industrialized countries -notable examples arethetax cuts and jobs actsin the USAthat reduced corporate taxes to21% from 35%.France is also planning to lower the corporate taxation from 33to 25% by 2022. Contrary to both observations, corporate tax revenues have inclined steadily and continuously in most industrialized countries, partially contradicting the notion thatthe existence oftax havens erodesthe tax bases of developed countries. The research questions, thus, are:
1. Are the deleterious effects tax havens have on non-haven economies exaggerated?
2. Cantax havens even have a positive effect on the economies of non-haven countries?
A stream of academic literature has so far investigated the potential benefits of tax havenson industrialized countries.Itstates that the before-mentioned negatives of tax havens do not inevitably leave high-tax, industrialized countries worse off. Dharmapalaand Hines(2009) concludethat if certain conditions are met, the existence of tax havens canraise social welfare by mitigating tax competition.
1.3 Organization of the Research
This essay reviews the academic literature on the potential positive effects of tax havens on non-haven industrialized countries. It starts with briefly defining tax havens in section 2. In section 3, the essay outlines the traditional “negative” view on tax havens and the prevalence of this view in empirical literature. Section 4 contrasts the preceding section and investigates the emerging “positive” view on tax havens. The conclusion answers the research questions and summarises the most important findings.
2. Definition ofTax Haven
Within the framework of the theory of optimal taxation, small open economies should eschew levying source-based taxes on foreign capital, realizing that the imposed burden would be shifted on to domestic workers (Gordon, 1986). Any efficient taxation should instead be imposed directly on to workers (ibid.), additionally luring in foreign capital due to a low effective tax rate on corporate income. This may not apply to countries that harbour locationspecific rents,e.g.resource endowments or agglomeration externalities (Dharmapala & Hines, 2009).
However, ifa small open economy cannot offer any location-specific rents, one channel tolure incapital, inspired by Gordon's findings (1986), might be creating a tax environment that offers foreign entities the possibility of reducing tax burdens in their home countries . Following Hines' (2005) results, tax havens experienced higher growth rates compared to non-havens between 1982-1999, demonstrating the success the establishment of a low-tax environment may pose for the respective countries' development.
Desai et al. (2006, p. 6) summarised shared characteristics of tax havens as “(...) low-tax foreign countries that offer advanced communication facilities, promote themselves as offshore financial centres, and frequently feature legislation promoting business or bank secrecy”.
In an attempt to specify the term tax haven, a further starting point can be the Harmful Tax Practices Initiatives (OECD, 1998). The multilateral organisation published a catalogue of criteria qualifying a country as a tax haven:Tax havens offernooranominal tax on the relevant income; they lack an effective exchange of information and transparency and do not require company activities to be substantial.
Respectively, the OECD also issued a blacklist of non-cooperative countries or territories. This list is updated annually, and the countries fluctuate repeatedly. As of 2020, only North Korea remains listed. This is in sharp contrast to other listings, such as the frequently cited list by Dharmapala and Hines (2009) that accountsfor 49 different tax havens, of which Switzerland, the Netherlands, Luxembourg and Ireland are referred to by many (Zucman, 2019; ITEP, 2017; TJN, 2020) as belonging to the biggest - in terms of financial importance - existing tax havens today. It should be mentioned that the OECD's blacklist is directed at combating money laundering, terrorist financing and individual tax evasion, meaning the OECD initiative does not combat or only insufficiently combatscorporate tax planning (Dharmapala & Hines, 2009). Fittingly, any positive effects uncovered by academic literature focalize the role tax havens play as facilitators of tax planning. Before the potential beneficial role of tax havens is reviewed, the essay briefly recapitulates the traditional negative view of tax havens and discusses the term tax planning.
3. The Traditionally Negative View on Tax Havens
The “traditional” negative view focalizes the adverse effects the existence of tax havens may have on the economic and political development of non-haven countries. Torvik (2009) stresses that tax havens will negate the development of sound and strong institutions, further exacerbating the problem of money laundering by corrupt politicians, e.g. dictators. Schwarz (2011) supports this argument, finding that money laundering and tax havens are closely associated. Hebous and Lipatov (2011) underline how dictators make the decision in their personal utility optimum to shift bribes to tax havens. Both also find a strong association between the activities of multinational corporations (MNC) in very corrupt nations and in tax havens (ibid.). Boyce and Ndikumana investigate the problem of capital flight from numerous African states. They argue that the capital flight drastically exceeds the stock of debt African countries have accumulated, thus making Africa a “net creditor to the rest of the world” (Boyce and Ndikumana, 2012, p. 1). Moreover, they argue that the existence of tax havens exacerbates this effect, enabling and spurring capital flight, and, consequently, retarding the pursuit of development. Slemrod and Wilson (2009) model the parasitic nature of tax havens on the economies of non-haven countries. They state that tax havens prevent the efficacy in resource expenditure in both haven and non-haven countries. Tax havens expend the development of “concealment services” to enable corporate tax planning, whilst non-haven countries expend on the enforcement to combat tax avoidance. The authors argue that tax havens intensify harmful tax competition, driving corporate tax rates to lower levels than non-haven countries would otherwise set, provoking, in the view of some commentators, a “race to the bottom”. In turn, tax bases are eroded, thus lowering the share of public investments.
Furthermore, Al stadsver, Johannesen and Zucman (2017) find that, when accounting for offshore wealth in measuring the wealth concentration, or rather the wealth inequality, inequality measurements increase substantially.
The research on the negative impacts of harmful tax competition, profit shifting, and, by extension, tax havens, shows that itis a fruitful field. However, the focus of this paper is on what critics of tax havens may consider to be the underbelly of tax haven research, meaning the benefits tax havens offer to the global economic system. Prior to reviewing the beneficial role tax havens may play, tax planning will be discussed. This helps to understand the view the advocates of tax havens hold.
3.1 Tax Planning
T0rsl0v, Wier and Zucman (2018) estimate that 40 % of the profits made by MNCs in high-tax countries end up being booked in tax havens. They also argue that the high profits booked by multinationals are largely dependent on the opportunity to shift said profits into low-tax environments (ibid.). Maffini (2009) underlines that the marginal effective tax rates for multinational corporations with affiliates in tax havens will be 1 % lower than for companies without any affiliates in tax havens. In the long run, additional tax haven affiliates reduce tax liabilities over all assets by as much as 7.4 % (ibid.). Multinationals lessen their tax burden by utilising tax havens in their respective tax-planning strategies.
Tax planning involves the separation of production and outputsales from capital-financing activities between affiliates to lower the overall tax burden. Tax planning essentially lowers the marginal cost of capital. The methods vary and essentially exploit legal loopholes in national and international tax laws. Major techniques for tax planning may include:
- Transfer pricing: Enables multinational corporations to reallocate profits by simply over-or understating the prices of intra-group traded goods and/or services. Clausing (1998) examines the relationship between effective tax rates and intra-firm trade. She found the relationship to be strong, indicating that transfer pricing is incentivised by the existence of low-tax jurisdictions, i.e. tax havens where reallocated profits are subject to a lower effective tax rate.
- Utilisation of conduit holding companies: Conduit companies are created as linkages in a financial transaction train, wherein the conduit exploits tax treaties between two countries. This method of tax avoidance is better known as “treaty shopping” and normally involves a tax haven. Weyzig (2012) studies the structural determinants of FDI diversion via the Netherlands (also a tax haven) and finds that the tax treaties are centric at determining whether capital is to be routed through the Netherlands.
- Thin capitalisation: Herein, a multinational corporation will adjust the debt-equity ratio between its affiliates. Affiliates in high-tax countries will ideally be financed by loans - in most cases, accruing interest is tax-deductible - from an affiliate situated in a low- tax jurisdiction. Additionally, the latter will then have to pay less taxes on its interest earnings received from the high-tax affiliate. Feld, Heckemeyer and Overesch (2011) determine a positive semi-elastic relationship between reported pre-tax profit and the opportunity of tax arbitrage, indicating that conduits in tax havens are instrumentalised for tax arbitrage.
Tax planning generally aims at locating profits in low-tax jurisdictions. Naturally, tax planning will continue to exist if corporate tax rates differ between jurisdictions. The widespread view, for most, is that tax planning, and, by extension, tax havens, hinders the development as it erodes the tax bases (see chapter 3).
4. Can Tax Havens be Beneficial?
In Germany, the corporate tax rate was slashed in 2008 from 25to 15% (Deutscher Bundestag, 2018), while the corporate tax revenue has been on the rise almost consecutively since 2009 (Statista, 2020). Before the Tax Cuts and Jobs Act was enacted in the USA in 2017, the corporate tax revenue had also been on a continuous rise since 2009 (Statista,2020)1.This trend also applies to the UK and several other European countries (Statista,2020).This signifies that there is not much evidence of a general decline in the corporate tax revenue, partially discounting the argument of tax base erosion induced by tax havens. Alstads^ter et al. (2017) also find that the stock of offshore wealth remained equal for the past decade at 10 % of the global Gross Domestic Product (GDP), underscoring the unchanged prominence of tax havens; but also showing that tax havens have not gained further offshore wealth or rather prominence relative to the global GDP.
Conversely, one might ask if corporate tax revenues are higher if all countries pledge to universalise corporate tax rates or when simply changing the source rules for corporate income. Notwithstanding current public debates on equalising the effective corporate tax rate, it is not beyond reason to believe that the world's major economies may benefit from the existence of tax havens. Keen (2001), Hong and Smart (2010), Chu, Lai and Cheng (2013), Desai, Foley and Hines (2006) make the argument that tax havens serve a positive function for high-tax developed nations. They argue particularly that tax-planning activities - incentivised by low- tax jurisdictions - can have positive effects on the welfare in high-tax countries, in contrast to a situation in which tax-planning possibilities are disabled by eliminating tax competition, i.e. universalising tax rates on capital, thus making tax havens useless for corporations.
4.1 Keen (2001)
Keen (2001) scrutinises tax competition and assumes that capital is heterogeneous in its mobility. Furthermore, he defines preferential tax regimes that offer low tax rates to mobile capital. In this, Keen's preferential regimes may be regarded as analogous to tax havens. He argues that if preferential regimes are disallowed, the constraint on tax competition would result in a low tax rate for all forms of capital, i.e. immobile capital would also be taxed at a low rate. Thus, preferential regimes allow countries to alleviate tax competition by setting higher rates on immobile capital whilst only competing for mobile capital. This means that preferential tax regimes soothe the effects of tax competition by inducing the high taxation of immobile firms.
4.2 Hong and Smart (2010)
Hong and Smart acknowledge revenue losses high-tax countries suffer because of tax planning and tax competition. At the same time, they argue that real investment effects may counteract, even dominate, the base erosion effect. Additionally, if corporate taxes are not too high to begin with, increasing international tax planning can lead to a rising optimal corporate tax rate.
The authors create a general equilibrium model inspired by Gordon (1986) to analyse the impact of multinational tax planning on small open economies. Against the backdrop of Gordon's (1986; see chapter 2) findings of how small open economies should levy taxes, they argue that welfare-optimizing governments will want to levy a positive tax rate on mobile capital and a 0 % tax rate on perfectly mobile companies. However, since governments are not able to discriminate between foreign investors and domestic entrepreneurs when setting the corporate tax rate, tax rates will be set at a low non-optimum level as a means to lure in capital.
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1 After a sharp decline in the corporate tax revenue in 2018, revenues have increased and are predicted to overtake the level in 2017 by 2025 (Statista, February 18, 2020).
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