Tax havens and the flow of money: Incentives matter

The leakage of the Panama papers has brought the issue of tax havens into the spotlight. Revelations that the rich and powerful feature in these papers is no surprise. There has been the expected outcry against the unfair advantages that tax havens confer on the wealthy and calls to legislate against tax avoidance more vigorously are only to be expected. It might thus be illuminating to briefly understand why tax havens exist and how businesses and individuals respond as it illustrates how people react to incentives.

There is no fully satisfactory definition of tax havens but as long as different countries (or jurisdictions) tax the same (or similar) entity differently, scope for profitable arbitrage exists. A country with lower tax rates will attract more business and money will flow from high tax regimes to low tax regimes. Similarly, if individuals can transfer their income or wealth abroad to attract lower rates of taxation, they have an incentive to do so.

But why would countries or states offer lower rates of taxation? The most common reason is that many countries actively chose a low tax both corporate and individual strategy, to attract investment. Singapore is a case in point. At least part of its development can be attributed to its business friendly taxation laws. Together with strong privacy laws on banking, it has become one of the most sophisticated financial centres of the world. Stringent banking laws regarding privacy is a common feature of most tax havens and it is certainly true of the so called ‘big 7’ including Hong Kong, Ireland, Lebanon, Liberia, Panama and Switzerland, such laws help funnel illegal money as well as legal earnings.

Indeed, the ‘big 7’ while otherwise very diverse entities, share the common feature of low taxation and strict confidentiality in banking transactions. It is no coincidence that most of the outflows have been from high tax economies or unstable economies. The confidentiality laws have also led to an enormous flow of black money though precise estimates differ.

The existence of tax havens or any kind of preferential tax treatment, does not simply arise from countries using this as a strategy to grow. Businesses gain from this and one need not be an expert in political economy to understand that money and influence can lead to legislation favouring the powerful. Thus, contrary to the conventional wisdom of the power of the relatively poor median voter, political influence is usually successful via organised lobby groups and the rich have a clear advantage in forming such lobby groups. This may at least partly explain why developed countries continue to allow tax havens even though the average voter is against them.

Would it be a good idea if politicians listened to populist sentiments and clamped down on individuals and corporations from taking advantage of tax havens? To answer this, one needs to understand the efficiency equity debate. While tax havens prevent billions of pounds of income from being taxed, if people were prevented from investing in low tax areas, incentives to invest would go down. People respond to incentives, the high tax regime in many parts of the Western world post reconstruction, led to creative ways of tax avoidance and the shifting of firms to low tax areas. Indeed, differential tax rates have been around since taxation was introduced and often for legitimate reasons as we have discussed. Thus, when discussing regulation, it would be useful to understand that every regulation will have an unintended effect. And any gains in revenue will be accompanied by losses in investment and more creative ways of evading tax.

Some common sense legislation to create transparency in ownership of assets is likely to have beneficial effects, but for every loophole closed more creative ways to avoid taxation will be found. It is indeed arguable that lower and simpler taxation rates may even voluntarily lead to a reversal of the flow of money that goes to the so called tax havens.

Siddhartha Bandyopadhyay

Department of Economics

University of Birmingham