European-American University™

Fair play and tax avoidance
by Kathleen Lucia, EAU Vice-President

Offshore financial centers give the world’s taxpayers real and increasingly accessible consumer choice. If individuals think that their governments deliver poor value for tax money, they can move their wealth elsewhere. Uncontrolled capital movement leaves governments fearful and dangerous.
 
For more than a decade, offshore financial centers have been under sustained attack from the international institutions that represent the world’s developed economies, particularly the Paris-based Organization for Economic Co-operation and Development (OECD). Since 1998 small independent territories have been forced to accept costly and burdensome regulation or become pariah states facing severe economic sanctions.

Control is at the heart of the issue. The OECD’s rationale is that offshore centers give individuals the opportunity to dodge tax liabilities in their home jurisdictions to the extent that high-spending developed countries (which the vast majority of OECD member states are) face the erosion of their tax base. And, with it, comes the erosion of their power to manage and control socio-economic activity. The OECD’s richest and most powerful members see information as the key to this problem: they are working to limit the financial privacy of individuals as much as possible through global regulation.

The project is to ensure that sovereign territories share with each other their citizens’ financial information so that taxes can be exacted from them by their home territories. To do this, global information exchange is vital. It is the only way to overcome the barrier of state sovereignty and the freedom of sovereign jurisdictions to make and enforce banking confidentiality laws.

Earlier this year, the OECD trumpeted the signing of two new agreements to exchange of information on individuals’ tax status (incidentally, between Guernsey and the Netherlands and between the Isle of Man and Ireland), bringing to 14 the number of such agreements signed over 12 months to date. Paolo Ciocca, Chair of the OECD’s Committee on Fiscal Affairs, said: “The trend towards greater transparency and tax co-operation continues as more and more countries and jurisdictions implement the OECD standards. Recent events have put international tax evasion in the spotlight, demonstrating the pressing need for action to tackle tax compliance issues in an increasingly borderless world. These agreements will better equip their signatories to address all forms of tax abuses.”

For many they come at a high cost. Small states with small populations rarely have the human resources to implement the international standards imposed by the developed states. It has been particularly difficult for the 40 or so territories singled out by the OECD at the turn of the century as “unco-operative”. These at first resisted the contravention of their sovereignty and the, for them, massive costs of meeting the OECD’s demands. Only three of these territories now remain on the blacklist – all of them small but, significantly, rich European states: Monaco, Andorra and Liechtenstein, all of which have the financial muscle and expertise to fight their corner effectively. Yet most of the others have come to some accommodation with the OECD and have found ways to survive and do business almost as usual.

Places for shady people?
So how justified are their big, rich “onshore” neighbours in their extreme prejudice? The novelist W Somerset Maugham famously described Monaco as “a sunny place for shady people”. And certainly the OECD, at least, believes that description to be apt today. But offshore financial centers (OFCs) stand accused of more than mere “tax abuses”. For good measure, the OECD has blackened their reputation with charges of:
 
 
But OFCs are not just small, remote islands. Anyone who invests outside his or her own jurisdiction is investing “offshore”. An offshore financial center is one that trades heavily in financial services, even when there is no large domestic market for those services. The world is full of tax havens – the UK can be a tax haven for non-domiciled individuals, for example, and some states in the United States are tax havens for those who simply use them as places in which to register their business. OFCs sell convenient services relatively cheaply to foreigners looking to protect their wealth from high taxation in their home territories. They tend to specialise in sophisticated tax planning, offer low or zero tax rates to individuals and companies and maintain high confidentiality. For increasing numbers of individuals and businesses and despite the OECD’s efforts so far, OFCs remain tax havens – an escape from the tax hell that is some developed countries. But governments that run high tax regimes argue that, as well as eroding their tax base, OFCs:


Too much freedom
In support of this campaign the OECD also accuses offshore centers of threatening global financial stability by failing properly to regulate the activities of the banks, insurers and investment managers they host. This, it is argued, raises the risk of a serious financial default or collapse that could spread to the whole global financial system. And if that is not bad enough, the high level of confidentiality in OFCs’ dealings attracts serious and dangerous criminality by being money laundries for drug runners, gun runners, fraudsters, robbers and terrorists.

But none of this really stacks up. To take the last point first, it was never in the interests of OFCs to gain a reputation for aiding and abetting international criminals, it simply is not good for business. All are happy to do what any financial center can to block criminality and limit reputational risk. And the biggest financial crime scandal since the South Sea Bubble – Enron – originated onshore in New York.

The global financial instability threat could hardly be lamer, either, in that the three global financial crises of the past decade: the collapse of the Thai baht and of the hedge fund Long Term Capital Management, the Russian debt default and, latterly, the US sub-prime loans meltdown and today’s credit crunch all had their roots in systemic failures onshore, not off.

What has really panicked high spending governments is the rapid growth of OFCs from the mid-1990s when increasingly robust and efficient information technology started to make it ever quicker and easier for more and more people to move money around the globe. Most reasonably affluent individuals can now vote with their feet on a government’s tax policies. And they are, in droves.

Unfair tax competition
The OECD has now softened its position on the global instability claim and is now fairly satisfied with progress on anti-money laundering measures, but remains no less strident in attack on “harmful tax practices” and “unfair tax competition”. The organization says that it accepts the right of sovereign territories to form their own fiscal policies and set their own tax rates. The logical alternative is, after all, one world tax authority. The only option, then, is global information exchange. To this end, in summer 2005 the European Union implemented the Savings Tax Directive, an agreement between the Member States and their dependent territories ― 39 countries worldwide ― automatically to exchange information about any customers who earn savings income in one EU State, but live in another. The individual saver’s name, address, bank or investment house, savings income received and over how long a period must be supplied first to the tax authority of the country where the money is held, then to the tax authority of the saver’s home territory. In some jurisdictions, though, customers who do not agree to the passing of information to their home tax authority have the option to pay a withholding tax instead, which, by 2011 will be levied at 35 per cent.

In the United States, the US Patriot Act gives the US Secretary of the Treasury the right to impose sanctions on any jurisdiction that he determines is complicit in money laundering. The US also uses its extra territorial jurisdiction over foreign banks to coerce their co-operation in law enforcement. These powers can apply to any bank that operates dollar accounts, or has correspondent arrangements with US banks, even where there is no physical presence in the US.

The OECD-sponsored Global Forum on Tax, last year issued the following statement: “In today’s increasingly borderless world, countries are working more closely together to prevent abuses of the global financial system in a wide range of areas, including taxation. The Global Forum on Taxation... seeks to improve transparency and to establish effective exchange of information so that countries can ensure compliance with their national tax laws. The Global Forum is working towards a level playing field in these areas so that activities do not simply migrate from countries that engage in effective exchange of information to those that do not. In working towards a level playing field, the Global Forum seeks to ensure the implementation of high standards of transparency and information exchange in a way that is fair, equitable and permits fair competition between all countries, large and small, OECD and non-OECD”.
 
The level playing field
But what is a level playing field in this context and is it possible? William Vlcek, lecturer in international politics at the Institute of Commonwealth Studies, University of London, thinks not. In a paper, A Level Playing Field and the Space for Small States, presented last year at the International Studies Association 48th Annual Convention in Chicago, he concludes that a level playing field in the global political economy is “a mirage with more substance for some states than for others”.

This could be the real killer blow to small OFCs. Vlcek sums up thus: “In the end, levelling the playing field does not create a space for a competition among equals. Rather it provides a situation for other factors to exercise dominance (economies of scale, superior financing, etc.) and establishes a barrier to the participation of smaller jurisdictions. It protects the already established players from the competition that could be introduced by the emergence of new players.

“The level playing field then is a mirage, possessing far less substance for the small economic players than it does for their larger, better financed competitors.”

In his paper he argues that the targets of the OECD project are small territories most of which have resident populations of less than 1.5 million people. Their limited resources and small scope for other forms of economic development makes the financial services industry perfect for them. They have developed legal structures for business and finance within which to establish an OFC and are thereby able to collect rents from the regulatory arbitrage opportunities arising from differences in taxation, regulation and corporate governance between them and other jurisdictions. But regulations for data collection and retention by financial institutions imposed in the name of a “level playing field” places an administrative burden on small jurisdictions that is potentially crippling. Equally, similar problems face smaller firms in larger states. And these onerous regulatory requirements may be disproportionate to their effectiveness in achieving the desired outcomes, anyway, in view of the outstanding success of Singapore and Hong Kong, which so far remain outside the OECD’s sphere of influence.

Neither do tax incentives alone attract foreign direct investment, Vlcek points out. Tax incentives cannot make up for serious deficiencies in a country's economic environment. But when other factors–such as infrastructure, transport costs, political and economic stability–are more or less equal, the taxes in one location can affect the choices of investors based elsewhere.
 
State sovereignty challenged
While small states argue that the OECD project contravenes the non-intervention principle of state sovereignty and the freedom of a sovereign jurisdiction to create and enforce local legal structures and tax administrations, they also argue strongly that:
 
 
Vlcek argues that efforts to create a level playing field are not aimed at redressing an imbalance, but at establishing common rules of play. The assumption is that if all are following the same global rules for ‘acceptable’ conduct, competition will be ‘fair’. Yet, even in sports competitions, a level playing field does not guarantee equity or fairness.

“Think”, he says, “about the relative status of Manchester United and the New York Yankees as representative professional sports franchises. Both are well-funded organizations able to use their economic position to maintain their dominance by acquiring the best available players. They are analogous to the large states, competing against less well-endowed smaller organizations. Consequently, they possess an economic advantage that has translated into a competitive advantage that overwhelms the level circumstances of the playing field. It is true that they do not win every match or game, however, over the long term of many seasons they have consistently remained at or near the top of their league table”.

Forcing a global level playing field, in whatever market sector, gives the OECD states a competitive advantage to maintain their market position and to continue to dominate the economic initiatives of smaller states, he says, and describes the OECD project as a form of protectionism.

“Unable to convince citizens to honestly make their contributions for the public good, governments are seeking ways to identify the recalcitrant domestic free riders. Extraterritorial attempts to apply domestic laws have not been successful, consequently OECD member states must ‘gang up’ in order to force co-operation”.

Will this coercion work? At present, individuals who feel they are not getting value for money from their government’s tax regime have a genuine form of redress and OFCs provide a popular service in which they continue to innovate as the regulatory burden grows. The real solution is for governments either to spend less of their citizens’ money or offer excellent value for tax take in the projects they pursue. The OECD’s pursuit of “fairness” in tax competition looks wrongheaded and wasteful.