ORMAT
Tax Havens:
Their Limitations and Effectiveness at Attracting Foreign Direct Investment in Developing Countries
by
Martha Rogers
William Gentry, Advisor
A thesis submitted in partial fulfillment
of the requirements for the
Degree of Bachelor of Arts with Honors
in Economics
WILLIAMS COLLEGE
Williamstown, Massachusetts
7 May 2007
Rogers
Abstract
This paper employs a theoretical approach to analyze the effectiveness of tax havens at attracting foreign direct investment (FDI) in developing countries. Tax havens are designed to stimulate investment but, often times, induce more tax evasion from domestic taxes by foreign firms then they do physical re-allocation. Three models are developed to analyze the existence of tax competition, firm choice, and government choice. The first model allows tax competition between two comparable countries and demonstrates the importance of fixed costs, and other country characteristics, in investment decisions. Moreover, tax competition between comparable jurisdictions can lead to the setting of sub-optimal tax rates. The second model highlights a firm’s decision to invest in a developing country. The level of investment in the home country is highly dependent on a haven’s ability to induce profit shifting and tax evasion from home-country taxes. The last model examines the policy choice of a developing country’s government given knowledge of the firm’s decision process. The analysis on government choice demonstrates that a tax haven strategy is not always the most effective policy choice. Case studies of tax policy strategies in developing countries demonstrate the importance of the investment climate and the limits of tax havens in attracting FDI. Overall, the models presented provide the basic elements for analyzing government policy choice and the opportunity to enhance government revenue and promote FDI and the importance of considering factors a country’s tax policy.
Table of Contents
1. Introduction………………………………………………………1
2. Tax Havens: An Overview……………………………………….3
3. Corporate Income Taxation of Multinationals……………………6
4. Literature Review………………………………………………..10
5. Tax Competition Model …………………………………………23
6. Firm Choice Model……………………………………...... 41
7. Government Choice Model………………………………………55
8. The Celtic Tiger………………………………………………….71
9. Prospects for Africa……………………………………………...75
10. Conclusion………………………………………………………82
References…………………………………………………………..87
Table of Exhibits
Figure 1: Worldwide Location of Tax Havens…………………………………4
Figure 2: Investment Push under the Solow Growth Model…………………...6
Figure 3: Tax Competition with Symmetric, Low Fixed Costs…………...…...31
Figure 4: Tax Competition with Asymmetric Fixed Costs……………………..33
Figure 5: Tax Competition with Symmetric, High Fixed Costs………………..36
Figure 6: Capital Choice with Different Marginal Products of Capital………...45
Figure 7: Effects of Evasion and Taxation on User Cost………………………49
Table 1: Corporate Tax Rates of the SADC……………………………………79
Rogers
1. Introduction
Tax havens are small, often developing, countries that offer favorable tax policies to attract commercial activity. The mobility of capital has increased over the last twenty years thereby expanding the role of tax havens and their impact on the international allocation of capital and the potential to enforce international tax laws.[1] A critical dilemma for understanding the impact of tax havens is whether they re-allocate physical capital or merely facilitate tax evasion. A tax haven could be made worse off if a policy designed to attract capital investment only induces financial transactions. A government’s ability to adopt the most effective incentive policy is vital for promoting growth within the country. Furthermore, the drive to attract foreign direct investment (FDI) has the potential to lead to harmful tax competition across comparable countries. The development of applicable models that evaluate firm and government decisions provides one with a deeper understanding of these tensions.
An important sub-division of the literature on tax havens is their potential to promote FDI within developing countries. Foreign investment, however, is limited by other country-specific factors such as an uneducated workforce, poor infrastructure, large risk of expropriation, and corruption. If these hurdles could be overcome, the payoffs of increased FDI in developing countries would be extremely high. FDI creates additional jobs, accelerates growth, and connects the domestic economy with the international market. The influx of foreign investment that results from reduced corporate tax rates has the potential to increase the welfare of every individual residing within the tax haven.
The positive production externalities that can result from tax havens can easily be offset by the high cost of becoming a tax haven. Globalization has increased competition amongst countries and resulted in lower corporate tax rates alongside higher levels of government spending: “When firms have a choice of locations, governments are forced to offer an attractive combination of good public services (schools, infrastructure, legal systems, etc.) and levy taxes no higher than necessary to pay for these” (Baldwin 2000). Competing governments are forced to spend money improving their investment climate but the simultaneous reduction in corporate tax rates lowers government revenue. The lower the corporate tax rate within a host country also heightens administrative fees because of the increased incentive for multinationals to evade domestic taxes: “tax havens lead to the wasteful expenditure of resources, both by firms in their participation in havens and by governments in their attempts to enforce their tax codes” (Slemrod and Wilson 2006). As noted earlier, tax havens are not always successful at attracting capital investment and are frequently used as subsidiaries solely to facilitate profit shifting and tax evasion.
The remainder of this paper attempts to address some of the key questions and problems arising with the implementation of a tax haven policy in developing countries. The paper proceeds with a description of tax havens and their worldwide implementation, an outline of corporate taxation policies for multinationals, a literature review, and then the development of three models. These models attempt to highlight some of the prominent questions about tax havens. The first model addresses tax competition between two developing countries each trying to attract FDI. After that, the second model investigates firm choice and when a firm will invest capital in a haven. The third model includes government choice and shows when it is optimal for a government to become a tax haven.
ORMAT 2. Tax Havens: An Overview
A tax haven, as defined by the OECD, is “a jurisdiction that imposes no or only nominal taxes itself and offers itself as a place to be used by non-residents to escape tax in their country of residence” (Slemrod and Wilson 2006). Multi-nationals are attracted to tax havens because they offer low tax rates on interest earnings and physical investment which lowers the effective over-all tax burden faced by the firm. The Institute for Fiscal Studies provides a second definition of tax havens in its reports, “What Has Been the Tax Competition Experience of the Last 20 Years,” where tax havens are viewed as, “the phenomenon that countries lower their corporate income taxes in order to attract the real activities of firms” (Griffith and Klemm 2004). This second definition highlights the ability for tax havens to attract foreign production. For developing countries, tax havens are most beneficial if they are able to increase physical investment within the country. On the other hand, the first definition demonstrates how tax havens can lower the effective tax rate on multinationals that engage in domestic corporate tax evasion through tax havens.
There are roughly forty major tax havens that exist in the international economy. Their average population is under one million individuals and, combined, they make up just 1.2% of the world’s population (James R. Hines and Rise 1994). Furthermore, their share of the world GDP is 3 percent and they account for only 4.2 percent of all plants, property and equipment (James R. Hines and Rise 1994). Figure 1 highlights the major tax havens as identified by James Hines and Eric Rice where tax havens are represented by bold dots.[2] This map emphasizes the high density of tax havens amongst small island nations in the Caribbean and the relatively small country size of tax havens throughout the world.[3]
The map shows the limited existence of tax havens in developing countries throughout Latin America and Africa.[4] With the exception of Liberia, no tax havens exist in Western or sub-Saharan Africa. The lack of tax havens could be a result of inefficient policy decisions amongst these governments. These larger developing countries could also have exogenous factors that make tax policy an inefficient means of competing for firm activity. These countries must carefully weigh the costs and benefits of becoming a haven before they change any tax policies.
Theoretically, a tax haven policy has the potential to stimulate an investment “push” that raises a country’s ability to combat poverty and increases the growth rate of the economy. The large influx of foreign direct investment into the tax haven drives this investment spurt and raises the capital level beyond some cutoff point so that the country jumps to a higher savings curve (see Figure 2). Figure 2 depicts a standard Solow-type growth model where a country invests until it equilibrates saving and investment levels. Foreign investment raises the level of capital in the host country beyond and the country moves to the higher savings curve,, and the equilibrium level of capital is now . This new steady-state level represents a more prosperous country that has undergone more substantial growth. If tax havens could create a similar investment “push” in more impoverished countries the result would be high growth rates that ultimately increase the standard of living.
Tax havens, however, are not universally successful at stimulating investment within a country. The debate around whether or not tax havens invite evasion or capital investment depends, in part, on the home-country’s tax system. The following section outlines both the territorial and residential tax regimes and describes the effects that these policies have on a multinational’s investment decision.
3. Corporate Income Taxation of Multinationals
In order to better understand the models presented one first needs to understand the different methods of taxing multinationals. Home countries have the option of adopting either a territorial or residential based tax system. Under the territorial system international firms are only subject to their host country’s taxes. Countries such as France, Germany, and Belgium currently use a territorial system and Germany will be used to illustrate territorial corporate taxation policies. Suppose a German firm establishes production in Country A. Under the territorial system, the German firm would pay Country A’s corporate tax rate to Country A for all profits earned in Country A and no taxes to Germany on these profits. A territorial system is advantageous for attracting firm headquarters because it simplifies the process of outsourcing production. On the other hand, territorial systems can induce profit shifting as firms attempt to increase reported profits in low-tax subsidiaries and reduce reported profits in high-tax subsidiaries.
Conversely, the residential system makes domestic firms subject to their home country tax rate, regardless of where production occurs. To avoid double taxation, a country operating with a residential system usually offers deductions or tax credits to firms. The residential system reduces the attractiveness of tax havens since multinationals’ profits are subject to domestic taxes. Countries such as the United States, United Kingdom, and Japan have all adopted a residential tax system.
The tax credit system is illustrated using the United States’ residential system as an example. The United States’ corporate tax rate is around 35 percent and the host country’s rate will be arbitrarily set at 10 percent. Ignoring foreign currency issues, if an American firm invests $100 abroad then the U.S firm will owe $10 in taxes to the foreign government and $25 to the United States. The American firm pays no taxes to the United States if it invests in a country with a corporate tax rate larger than 35 percent.
In the United States, foreign tax credits are based on a policy of worldwide averaging. This policy enables firms to average the tax rates of all their international investments calculating its U.S tax liability and its foreign tax credits. Suppose an American firm earns $100 each in two foreign countries, Country A and Country B, where Country A’s corporate tax rate is 10 percent and Country B’s corporate tax rate is 40 percent, respectively. The firm pays $10 to Country A, $40 to Country B, has a foreign tax credit of $50, and owes $20 to the United States. As illustrated above, worldwide averaging enables firms to receive foreign tax credits even when they invest in countries where the corporate tax rate is higher than the rate in the United States.
Another policy choice under the residential system is whether or not the home country offers tax sparing. James Hines offers a clear and concise definition of tax sparing: “’Tax sparing’ is the practice by which capital exporting countries amend their taxation of foreign source income to allow firms to retain the advantages of tax reductions by host countries”(James R. Hines 1998). Often times, countries establish bilateral treaties that enable firms to claim foreign tax credits on international profits that would have been paid to the home government in the absence of tax abatements. To illustrate tax sparing, consider Japan that has a residential system comparable to the United States and a corporate tax rate of 30 percent but offers tax sparing with certain low-income countries. Assume the Japanese firm invests $100 in Thailand who also has a corporate tax rate of 30 percent. Under the tax sparing agreement, however, Thailand offers a tax reduction of 10 percent to Japanese firms. Consequently, the Japanese firm will pay $20 to the Thai government but will still receive $30 worth of foreign tax credits and will owe no money to the Japanese government. Tax sparing enables firms operating within a residential tax system to benefit from tax incentives in certain developing countries.
Both of the above mentioned tax systems have loopholes that create the opportunity for firms to engage in tax evasion. Under the residential system, foreign income is often not taxed domestically until it is repatriated. Thus, firms can continuously re-invest foreign income abroad in order to reduce the present value of their foreign income. Similarly, the policy of worldwide averaging motivates the continual investment by firms in low-tax countries in order to compensate for foreign investments made in high-tax countries.
Transfer pricing is a third form of tax evasion that is present in both residential and territorial tax systems. Under transfer pricing, two related companies sell assets to one another so as to increase reported profits in the low-tax country and reduce profits in the high-tax country. Legally, these intermediary goods are supposed to be sold at arms-length prices but these operations are hard to monitor and prices are usually highly inflated or deflated.