ECAEF, XI.Gottfried von Haberler Conference, Vaduz, May 29, 2015
The Economics of Tax Competition
by Veronique de Rugy
Politicians and tax bureaucrats from high-tax nations have been persecuting jurisdictions that offer refuge for the world’s over-burdened taxpayers. For years now, they have tried to stop or hinder taxpayers’ ability to put their money in so-called tax havens. Blacklists and discriminatory tax laws are among the tools used to hinder economic transactions with these jurisdictions. High-tax nations also have enlisted international bureaucracies such as the European Commission,[1] the United Nations,[2] and the Organization for Economic Cooperation and Development[3] in a coordinated attack on low-tax jurisdictions.
From an economic perspective, this campaign is fundamentally misguided. Lower-tax jurisdictions facilitate the efficient allocation of capital through a process called tax competition. As noted in the New England Journal of International and Comparative Law, “Tax competition serves a…beneficial role. It forces greater fiscal responsibility and affords taxpayers the ability to enjoy more of what they earn. This in turn draws savings, investment, and skilled labor into the economy.”[4]
But economic efficiency is not the only reason tax competition should be preserved. It should be defended on a moral basis. Most notably, it encourages policies that promote economic well-being and offers a safe haven for people subject to persecution tax-grabbing governments.
- Tax Competition or the Power to Exit
There is no such thing as a neutral tax. Individuals react to taxes, always have and always will. There can be no neutral tax, that is, one that leaves the market exactly as it would be without the tax. All taxes create distortions as soon as they are implemented. Taxation, by nature, takes capital from private hands and prevents it from being used to serve the needs of producers and consumers in the productive sector of the economy. This is true regardless of the tax, and whether it is a flat tax, a sales tax or a lump-sum tax. In addition, the mere fact that government spends taxes alters the production patterns of the market.
As all taxes are ultimately borne by labor and capital, taxpayers tend to react to them at a larger scale when factors are mobile. Any coherent economic theory tells us that higher tax rates on productive effort and capital accumulation results in less of such activity and that is because taxes are not neutral. Factors tend to move marginally from where they are over-taxed to where they are less taxed or not taxed at all. More precisely, individuals do not only consider the amount of taxes they pay but also take into account the benefits they get from public expenditures, so each factor tends to move marginally from the place in which it gets the lowest - possibly negative- net benefit to the place in which it gets the highest net benefit.[5]
As a general rule, an individual dissatisfied with the tax system has four main options to react. First, he can try to change the tax system itself by participating to a tax limitation movement that takes place through the initiative process (citizen lawmaking), or by lobbying the government for loopholes for a given group of taxpayers. However, not every country allows its taxpayers to use the initiative process and the cost of organizing collective tax revolts is often high enough that it is a not a very commonly used solution.
Second, he can evade taxes by exiting to the underground economy. Third, he can avoid taxes by sending his capital abroad where the tax burden is lighter by using legal options provide by the law.
Finally, a taxpayer can exit from the level of government responsible for the tax. It usually involves moving out of a given country to go to another one. The more a factor suffers from tax discrimination, the more it tends to escape to another place.
Tax competition occurs when people can benefit from better tax policy in other jurisdictions by shifting where they work, save, shop, or invest. Or even where they live. The growing mobility of capital of the last three decades has meant that governments around the world have had to compete with one another in a way that they have never had to before. It also means that they are extremely vulnerable to the threat that taxpayers – or their money – might exit to go where taxes are lower.
It is that competition that helps keep governments from increasing taxes too much. It makes them more efficient and more receptive to the need to decrease taxes. The ability for taxpayers to exit and the tax competition it induces are the true liberalizing force in the world economy.
- Why it tax competition under assault?
In the last three decades, globalization has undermined the power of high tax countries quite drastically by decreasing the cost of moving capital around. Building on technological advances, we have witnessed a rapid increase in the volume of transactions transcending national borders.
For a while the tax competition between countries led to a reduction in tax rates both on capital but also on labor. Top personal income tax rates averaged more than 67 percent back in 1980, but thanks in large part to tax competition, the average top tax rate on individuals has fallen to about 41 percent.Corporate tax rates also have dropped dramatically, from an average of around 48 percent (this data is not as easy to pin down) in 1980 to 25 percent today.[6] And we now have more than 30 flat tax nations today, compared to just 3 in 1980.[7]
Unfortunately, it didn’t last. Politicians in most countries don’t like being constrained by tax competition. In addition, as fiscal challenges brought on by overspending became more pressing, lawmakers were faced with two choices: restrain spending, and in particular reform their bloated social transfer programs (like Social Security, Medicare and Medicaid in the United States) or increasing taxes.
Lawmakers aren’t known to do the right thing without being forced to. As a result, if possible, they would rather not limit spending or engage in the fundamental entitlement reforms that would be necessary to put their government finances back on a healthy fiscal track. It means that raising taxes is always an appealing option. However, when tax competition exists, lawmakers are afraid that jobs and investment would escape to lower-tax jurisdictions.
It is this understanding that tax competition makes it hard to engage in class-warfare tax policy which led to 15 years campaign to replace tax competition with some sort of tax cartel. The goal was to impose rules on the entire world that will make it hard for taxpayers to benefit from better tax policy in another jurisdiction. That’s a form of tax harmonization which has for end goal to extract as much money from taxpayers as possible without enduring as much consequences as it should otherwise.
Another reason behind the attack on tax competition is an ideology that embraces an all-too-comprehensive “Haig-Simmons” definition of income. Under the Haig-Simons tax base, saving and investment incomes are subjected to double taxation. Chris Edwards at the Cato Institute has a good explanation of the “Haig-Simons” approach to taxation. He writes:
To maximize growth, we should “tax the fruit of the tree, but not the tree itself.” That is, we should tax the flow of consumption produced by capital assets, not the capital that will provide for future consumption. A Haig-Simons tax base—which includes capital gains—taxes the tree itself. Why does a Haig-Simons tax base garner support if it is impractical and anti-growth? It appears to be because the liberal idea of “fairness” includes heavy taxation of high earners. Since high earners save more than others, they would be taxed heavily under a Haig-Simons tax base. …Today, many economists favor shifting from an income to a consumption tax base… Under a consumption tax base, savings would not be double-taxed, and capital gains would not face separate taxation because the cashflow from realized gains would be taxed when consumed. With regard to “fairness,” a Haig-Simons tax base penalizes frugal people and rewards the spendthrift. That’s because earnings are taxed a second time when saved, while immediate consumption does not face a further tax. That makes no sense because it is frugal people—savers—who are the benefactors of the economy since their funds get invested in the new businesses and new capital equipment that generates growth.[8]
This ideology also assumes that all tax planning is bad. Even though legally and in theory there is a difference between evasion and avoidance, the framework for taxation of international income adopted by high tax countries policy officials is now slyly conflated avoidance with evasion. The Economists’ terms for this view is Capital Export neutrality is a pure product of the myth of tax neutrality and of the misunderstanding of the nature of economic activity.[9] CEN advocates are often true believers in the need for some sort of information exchange systems between countries to prevent a taxpayer to export its capital when over-taxed.
- What is the status of the fight?
Since 1998, acting on behalf of European high-tax nations the Organization for Economic Cooperation and Development has been seeking to undermine tax competition to create an international tax cartel.[10] These efforts to "harmonize" all taxes around the world first took place through a set of tax harmonization requirements. The justification used by the OECD and other harmonizers is that tax rate differentials between countries alter the allocation of resources and as such is harming high tax nations. As a consequence, low tax policies and preferential tax treatment of foreign income aimed at attracting foreign capital constitute harmful tax practices and should disappear.
At the time, the OECD designated 41 non-member countries and territories as “tax havens” guilty of unfair tax competition. These countries were asked to discontinue promptly their allegedly unfair practices if they did not want to face severe sanctions imposed by OECD member countries. The goal was to pressure low-tax countries into raising their rates to the levels of high-tax European nations.
Thankfully, officials in the United States expressed resistance and skepticism to measures that would visibly infringe on national sovereignty and the right of each country to have the tax regime of its choice and to pay the consequence or to get rewarded for this choice.
It forced the OECD to change its approach and move to harmonize taxes indirectly under the curtain of information exchange. Soon, the European Union joined the fight for harmonization. In March 2001, it introduced the ill-conceived European Savings Tax Directive, a plan to tax non-residents' savings and to implement for “automatic” information sharing between countries and demanded “the removal of banking secrecy practices.”[11] But it wasn’t limited EU countries and was expanded to include to non-EU countries such as the United States, Switzerland, Liechtenstein, Monaco, Andorra, San Martino and all the territories in the Caribbean.
Finally, the United Nations joined the movement calling for the creation of an International Tax Organization (ITO), global taxes, and tax harmonization.[12]
Unfortunately, after years of abuses and bullying the statists have been making tremendous progresses. For instance, all targeted jurisdictions have agreed to sign tax information exchange agreements, hence weakening their human rights laws on financial privacy.
On a positive note, Cato Institute’s Dan Mitchell has explained that the European Union has had to temporarily temper its exhaustive tax grabbing desires. The EU Savings Tax Directive was watered down, subjected to many loopholes and only applies to EU members, their overseas territories and Andorra, Lichtenstein, Monaco, San Marino and Switzerland.[13] Also, while the UN regularly floats “grandiose schemes of an international tax organization,” it has continued to play a minor role.
But the EU’s relative ineffectiveness and the UN’s total ineffectiveness is just a small silver lining to a large dark cloud. That’s because the OECD’s campaign to weaken financial privacy and undermine tax competition has been so successful, largely because the Obama Administration joined with high-tax European nations to push for bad policy using the G-20.
That being said, the fight isn’t over and we have to remain vigilant. Politicians and tax bureaucrats continue to be viscerally hostile to jurisdictions that offer refuge for the world’s over-burdened taxpayers. Laws often are enacted to hinder economic transactions with these so-called tax havens, but these national efforts are just the tip of the iceberg.
- What happens next?
The US Treasury has opened a new front in its war against offshore jurisdictions. Thanks to the Foreign Account Tax Compliance Act (FATCA), Americans with legitimate bank accounts outside the country, and foreigners working in the United States, have begun receiving letters from their banks in around the world, informing them that their account information is being turned over to the US tax authority.
Under new treaties with the United States, some 100,000 foreign financial institutions in more than 100 countries must report to the Treasury on the accounts of any so-called “US persons” — a US citizen, or anyone with an immigrant’s “green card” or a US work permit.
Leaving aside the tremendous impact on the financial privacy of millions of people who haven’t done anything wrong, this arrangement represents a heavy burden on foreign financial institutions who have to do the reporting. What’s more, financial institutions not reporting to Treasury would be hit with a 30 percent withholding tax on the bank’s US earnings.
Considering the downsides, some financial institutions are already stopping accepting accounts from certain clients because of the tougher regulations. Dan Mitchell recently told the US Global Tax Limited Law firm “I know that foreign nationals who live in the US, some of them have had their bank accounts back in Europe shut down,” said Dan Mitchell, a tax reform expert at the Cato Institute.
In addition, this is only increasing the speed at which Americans living abroad are resigning themselves to give up their U.S. citizenship. With the IRS chasing their accounts to force them to pay US taxes, in 2013 some 3,000 people gave up US nationality, and a record number of 3,415 Americans did so in 2014.[14]
But a financial privacy evisceration party isn’t complete without the OECD joining in. In July 2014, released itsglobal standard for automatic exchange of information.[15] Its goal is to explicitly but an end to bank secrecy in tax matters, meaning financial privacy. The OECD website explains:
TheStandard for Automatic Exchange of Financial Account Information in Tax Matterscalls on governments to obtain detailed account information from their financial institutions and exchange that information automatically with other jurisdictions on an annual basis.[16] The standard was endorsed byG20 Finance Ministers in February 2014 and approved by the OECD Council.[17]
As the Heritage Foundation’s David Burton noted back in July 2014, “It is one thing to exchange financial account information with Western countries that generally respect privacy and are allied with the United States. It is an entirely different matter to exchange sensitive financial information about American citizens or corporations with countries that do not respect Western privacy norms, have systematic problems with corruption or are antagonistic to the United States. States that fall into one of these problematic categories but areparticipating in the OECD automatic exchange of information initiativeinclude Colombia, China and Russia.”[18]
The standard provides for governments to annually and automatically exchange financial account information—such as balances, interest, dividends and proceeds from sales of financial assets—that are reported to governments by financial institutions and cover accounts held by individuals and entities, including businesses, trusts and foundations. Banks, broker-dealers, investment funds and insurance companies are required to report. Needless to say these are information that we shouldn’t want to put in the hands of corrupted governments.
Finally, the OECD is also targeting multinationals and has launched a new scheme to boost tax burden on business. In 2013,it just published a studyon “Action Plan On Base Erosion and Profit Shifting” that lays the groundwork for a radical rewrite of business taxation.
The underlying assumption in this BEPS report is that governments are not seizing enough revenue from multinational companies. The OECD makes the case, as it did with individuals, that it is illegitimate for businesses to legally shift economic activity to jurisdictions that have more favorable tax laws. This is remarkably scary considering that if a government do not like legal tax avoidance it can change it business tax policy without resorting to an international organization bureaucracy to impose useless rules on everyone.