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Photo: AFP
Photo: AFP

Fifty shades of black (money)

Despite increased scrutiny, tax havens such as Switzerland and Panama remain an important part of the global financial architecture

As a euphemism for undeclared income, or black money, as we like to call it in India, “Swiss bank accounts" had been a popular leitmotif of the anti-corruption movement of 2011. No one understood its resonance better than Narendra Modi, who promised to bring back such unaccounted wealth during the 2014 election campaign and said that once this wealth was recovered, it would be enough to make every poor person richer by Rs15,000-20,000. The furore over the recently released Panama Papers has revived memories of Modi’s election promise, on which progress has been patchy at best.

While it is true that not all of the undeclared wealth in the country is stashed abroad, tax havens such as Switzerland and Panama provide an attractive option to many companies and high-net-worth individuals in India as well as other countries to evade scrutiny from local authorities.

Consider the following facts. According to a 2004 National Bureau of Economic Research (NBER) paper by University of Michigan economist James R. Hines Jr, major tax havens have less than 1% of the world’s population (outside the US) and 2.3% of world GDP, but host 5.7% of the foreign employment and 8.4% of foreign property, plants and equipment of American companies.

A 2015 US Congressional Research Service report put the number of tax havens at 50. Most of these are small island countries and some are just separate jurisdictions within countries. According to the report, although there is no strict definition for tax havens, they have some common features: zero or low taxes, a limited information regime and the absence of regulatory requirements mandating substantial activity in that economy.

In a 2009 paper, Ronen Palan, a professor of political economy at the City University of London, wrote that the origins of tax havens may lie in the US. Faced with a revenue shortage, the governor of New Jersey agreed to a proposal by a New York lawyer to impose an incorporation tax on all companies based in New Jersey. The companies were promised lax incorporation laws and lower tax rates in return. Soon, the state of Delaware also followed suit. This has become the guiding principle for all tax havens in the world.

In an earlier paper, Palan listed various legal and regulatory changes in advanced countries that have laid the foundations of the modern-day tax haven network spread across the world. In a 1929 case, Egyptian Delta Land and Investment Co. Ltd. vs Todd, the UK’s House of Lords ruled that a company incorporated in Britain but conducted the bulk of its business abroad (Egypt, in this case) should be considered an ordinary resident of the latter country. This judgement opened the possibility for companies to register in Britain but avoid paying British taxes.

The judgement had ramifications beyond the country as it became relevant for the entire British Empire. Similarly, banking secrecy laws originated in Switzerland when Swiss bankers started offering secrecy to aristocrats for a fee during the French revolution. Later, the Swiss Supreme Court ruled that unless authorized, banks were bound to protect the secrecy of their customers.

The Swiss system was based on a numbered account requiring two bank officials to know the identity of the account holder. Luxembourg brought it down to one and Austria decided that nobody was to know the identity of the account holder.

A 2006 NBER paper by Dhammika Dharmapala and Hines Jr from the University of Michigan has examined the question of which countries become tax havens. The paper shows that relatively affluent island countries with smaller populations and small natural resource endowments are more likely to emerge as tax havens.

In the sample of 39 tax havens which the paper analysed, only eight had a population of more than 1 million. It also found that tax havens are more likely to have British legal origins and parliamentary systems using English as the official language, probably a result of the British ruling cited above. On the other hand, countries with French, Scandinavian and socialist origins are less likely to come under this category.

The most important determinant of whether or not a country can become a tax haven, as irony would have it, is governance. The paper says, “For a typical country with a population under one million, the likelihood of becoming a tax haven rises from 24 percent to 63 percent as governance quality improves from the level of Brazil to that of Portugal."

The authors’ calculations shows that tax havens had a governance index of 0.73 in a sample where the global mean was zero. The authors explain this by saying that tax rates tend to be generally higher in poorly governed (corrupt) countries to increase the rent-seeking capacity of officials.

The question then arises: what do tax havens gain by lowering their taxes?

Logically speaking, a lowering of taxes on foreign capital would act as a drain on a country’s fiscal resources, unless the volume of capital which flows in is so large that tax collections increase despite a lowering of tax rates. The 2005 paper by Hines Jr cited earlier has done an empirical exercise to ascertain these facts about tax havens. It suggests that tax havens seem to be gaining by their policies: tax haven countries had a higher rate of growth (3.3%) of GDP than non-tax haven countries (1.4%) during 1982-99, and they had broadly similar government spending levels relative to GDP. The latter statistic shows that lowering of tax rates might not be having an adverse effect on government resources.

The paper cites another piece of evidence on the gains of being a tax haven country: all countries that were tax havens in 1982 continued to remain so in 2002. The paper also argues that, contrary to the received wisdom of tax havens hurting other countries, they might be helping them by making foreign investment feasible in a country even with low profit expectations, which can be offset by lower tax liabilities facing an international company operating from a tax haven.

The latter is a contested claim in today’s world. In fact, large transnational corporations using tax havens to lower their overall tax liability has become a much bigger headache for countries than individuals secretly holding money in bank accounts.

According to an Oxfam report released last month, the share of tax havens in American corporate profits has increased from less than 5% to more than 20% between 1984 and 2012. Developing countries might be suffering even more, suggest some studies, such as this one published in the Monthly Review in 2010. The paper cites an example of a Zambian company selling copper to its subsidiary in Mauritius at €2,000 per tonne; the subsidiary resells it at €6,000 per tonne. The margin of €4,000 per tonne is completely exempted from taxes in Zambia.

There are many other ways in which companies can avoid paying taxes in a high-tax-rate country. The most common is using transfer pricing by selling cheap and buying dear among different arms of a multinational corporation to lower incomes and avoid taxes in a high-tax country.

Although many countries use an arm’s length price principle—one where transaction prices between unrelated companies are taken as benchmarks to prevent transfer pricing for evading taxes—finding arm’s length equivalents for all transactions, especially those involving intangibles such as royalties and patents, is often difficult.

Another way is to use higher equity for investments in low-tax countries and higher debt for those in high-tax ones. This allows companies to lower tax liability on profits and increase credits on interest paid. To be sure, there are more sophisticated methods used for such purposes, some of which are briefly explained in the US Congressional Research Service report cited above.

India is no stranger to such tax evasion methods. For many years, Mauritius has been the single largest source of foreign investment into India, and a substantial part of it is estimated to be a result of round-tripping or rerouting of funds to avoid paying taxes in India. While the recently enacted treaty with Mauritius to tax capital gains on shares might help tax some of this income, the bulk of it is still likely to escape taxation, given the fact that instruments such as debentures constitute around 90% of equity trading in India.

To be sure, major countries are gradually coming together to enforce strict disclosure and information-sharing requirements on tax havens to discourage tax evasion and avoidance. The Organisation for Economic Co-operation and Development (OECD) has come up with a list of commitments that all tax havens must comply with and, depending on whether or not countries comply with, accept or refuse these, they are classified into white, grey and black lists.

In 2009, the last of the black list tax havens were moved to the grey list. Increasing concerns about offshore funds being used for terror activities has also led to greater scrutiny and vigilance on such activities.

While the process is subject to fluctuations arising out of the political will of incumbent regimes in important countries—in the US, George Bush withdrew the Bill Clinton administration’s support for efforts to combat harmful tax competition—at its core, it carries a fundamental contradiction, argues Palan in his paper.

He writes, “In prostituting their sovereign rights, tax havens provide important legal platforms for globalizing financial and, increasingly, other types of services. Thus, a virtual world of a state system can exist beside the ‘real’ state system, feeding on its juridical and political infrastructure. The two are not adversarial; they merely present the complex face of the processes we call globalization."

Nonetheless, tax havens are no longer seen as benign entities in a post-crisis world where governments are struggling to find resources to reduce public debt and maintain existing levels of public spending. A recent letter signed by 300 economists called on world leaders to put an end to tax havens, arguing that these enclaves serve “no useful economic purpose". The economists also noted that tax evasion was directly harming poor economies such as Malawi.

“In Malawi, it’s impossible to get a full picture of the scale of tax dodging," the economists wrote. “However, Oxfam calculated that the lost tax revenue from the money revealed to be held by Malawians in HSBC accounts in Geneva in last year’s Swissleaks scandal could pay the salaries of 800 nurses for one year."

“As the Panama papers and other recent exposés have revealed, the secrecy provided by tax havens fuels corruption and undermines countries’ ability to collect their fair share of taxes. While all countries are hit by tax dodging, poor countries are proportionately the biggest losers, missing out on at least $170 billion of taxes annually as a result. As economists, we have very different views on the desirable levels of taxation, be they direct or indirect, personal or corporate. But we are agreed that territories allowing assets to be hidden in shell companies or which encourage profits to be booked by companies that do no business there, are distorting the working of the global economy. By hiding illicit activities and allowing rich individuals and multinational corporations to operate by different rules, they also threaten the rule of law that is a vital ingredient for economic success."

Despite increased awareness of tax havens in recent years and greater recognition of the problems they pose for the world, the battle against tax havens is not likely to be an easy one. Even as the old tax havens shed some of their secrecy and have begun to lose their charm to tax evaders of the world, some of the largest economies of the world, such as the UK and the US, seem to be gaining favour as the destination of choice for such individuals and companies.

An 8 May Financial Times report called the US the “new Switzerland", pointing out how American states such as South Dakota, which has guaranteed secrecy for family trusts, have become magnets for offshore wealth.

A more recent report in the same publication suggests that the UK’s record may be even worse, with tax authorities in the country failing to show the same zeal as their US counterparts in investigating and prosecuting known tax dodgers.

The report shows how banks operating from the city of London offer various means to their customers to evade taxes in countries ranging from the US to Kazakhstan by offering them innovative services to evade local government authorities. For instance, to avoid any paper trail of banking records, customers are offered nameless prepaid cards, which are refinanced through coded messages rather than through formal instructions.

Similarly, banks help customers set up shell companies in tax havens such as the Virgin Islands, where its ownership can be kept secret.

The economists who signed the above-cited letter recognize the enormity of the problem, and they invoke 18th century economist Adam Smith to press for action against tax evasion.

“Taking on the tax havens will not be easy; there are powerful vested interests that benefit from the status quo," they write. “But it was Adam Smith who said that the rich ‘should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion’. There is no economic justification for allowing the continuation of tax havens which turn that statement on its head."

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