Tag Archives: tax competition

Five political lessons of the #PanamaPapers

1.) The size of the problem and why they cheat:
The Panama Papers are hard to quantify given the complexity and size of information. However, they reveal fascinating insights into the reasons for evading and avoiding taxation. This has deeper implications for the overall size of the problem. Some economists like Gabriel Zucman (@gabriel_zucman) estimate the size of informal/ illegal assets held in tax havens close to 10 percent of all global wealth. This is a ballpark estimate and hinges on many assumptions. For instance, as an economist Zucman is mainly concerned about the economic reasons of tax evasion, i.e. not to pay taxation. But there is a political story to it: Many prominent politicians, business people, celebrities need to conceal their true wealth levels. And they do so for other reasons than tax evasion (social pressure, political regulations/ corruption and higher morality standards applied to politicians). This leads to much more under-reporting, and so arguably the issue at stake is even larger.

2.) International Relations and who is to blame:
Panama and similar tax havens can only operate in the shadow of its big brother: the U.S., the UK etc (see a previous blog post). No tiny tax haven can survive and attract money without the legal backing of a large and sovereign state. Otherwise financial investors would fear the lack of legal security in these countries and would avoid them. (The exceptions are larger, sovereign tax havens such as Switzerland.) Hence, the problem is on the international level not only isolated in tax havens themselves. Larger, sovereign countries profit from smaller tax havens in a symbiotic relationship. After all, the money rarely stays in Panama or Guernsey Island, it flows back to the financial centers.

3.) What will the public think?
The real political problem goes far beyond the material damage in lost tax income. If people think other people don’t pay taxes they are also more likely to cheat! Unfair tax behavior leads to large scale erosion in the legitimacy to pay taxes. And tax compliance in recent years already took a serious hit in many countries. For instance, here is data on two different waves of the World Value Survey. The question asked is whether it is justifiable to cheat on paying taxes. The average over a group of 50 plus countries has considerably increased over the period, i.e. people become more cynical about paying taxes.
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4.) Populist response?
If both the current and past presidents of Argentina are involved in these practices, as the PanamaPapers imply, what will the Argentine public make of this? Beyond Argentina, what happens if people see their politicians cheating? Once the public thinks that all types of politicians, irrespective of their ideology, background or political program, are involved in illegal practices the reaction is likely populist, anti-elitist. Paradoxically, this could mean that anti-government ideologies piggy-bag on these scandals. Isn’t the real problem big, bureaucratic government trying to steal our money? A Leviathan so big and yet so incompetent in levying taxes deserves to be cheated on. Of course, such an argument is like saying I robbed a bank, because the security guards seemed so weak. Yet, the inconsistency is not easy to observe for everyone. Political cynicism might well play into the hands of those who produce the problem of tax evasion in the first place (The Trumps etc. of this world).

5.) Football is the perfect micro cosmos to study problems of global political economy
As if further evidence was needed, FIFA’s involvement in the PanamaPapers shows how much one can learn from the world of football for the larger issues of regulating capitalism. FIFA does not need to avoid taxes, it needs to avoid transparency. Especially, when it needs to exchange bribes. Again, this implies that the issue is much larger than we think. In this sense studying FIFA is not only interesting for those who are fanatic about football.

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Blog on Tax Haven now on LSE’s Europp Blog

My recent blog post is now also at LSE’s Europp Blog.

http://bit.ly/11seDNy

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On Cyprus, Tax Havens, and the EU

How the European Union creates Tax Havens, and Why this Matters for Understanding Cyprus

Tax Havens are not randomly distributed in this world. Rather, tax havens live in symbiotic relationship traditionally with a nearby larger country that has a huge financial sector: the Caribbean islands for the U.S., the Channel Islands for the U.K., or Liechtenstein for Switzerland. The small country has a regime that attracts huge inflows of capital with zero levels of income taxation. Since this foreign capital cannot really be invested in these small countries, or else rates of return would go down, it flows immediately on to a larger financial market where profits and returns are made.

Who can become a tax haven and who not? It turns out that not all countries have the structural conditions to easily specialize on the trade. Two major factors are the size of the country and the predictability of its legal framework. Let’s first turn to the size argument. It is well established in the literature on tax competition, that smaller countries are more likely to gain from competition. The reason is that if you are small, or very small in the case of some tax havens, it does not really affect your domestic tax base very much if you lower the tax rate to zero. The domestic tax base is minuscule compared to the tax base attracted from other countries. Tax havens can live with zero tax rates, because they make their money with licenses, indirect taxes and other types of revenues.

More important for an understanding of the Cyprus crisis is the second issue, the predictability of the legal framework. Private firms are concerned about the so-called hold-up problem. They don’t trust any type of government, since investors are afraid of future expropriations. In the economics literature, this is a well-known problem of credible commitment: How can governments of prospective tax havens assure private investors that they won’t violate property rights, once the investors have made their decision to invest?

There are no easy solutions to this problem, but a certain type of semi-sovereignty can act as a commitment device. Like Ulysses binding himself to the mast, some countries give up having a legal framework of their own but fully subscribe to a foreign countries framework. Many of the Caribbean Islands are either still overseas territories of former colonial powers or have semi-dependent status. Guernsey and Jersey don’t have to provide a credible legal framework since they are directly connected to the British legal system. Liechtenstein and Switzerland share an economic and currency union. These types of semi-sovereignty are an effective solution to the hold-up problem. Private investors know that, say, Guernsey, cannot and will not easily expropriate foreign investors. This makes such countries enormously popular destinations for huge inflows of capital.

In the European Union (EU), the problem does not stop here. If we apply the same logic we see that the EU has generated additional tax havens. To be fair not all tax havens are the same, but countries like Cyprus, maybe Latvia, and even Ireland share structural characteristics: they are small, and until recently they had a problematic track record of legal predictability, and in a larger perspective, prudent macroeconomic management. However, these countries have seen a tremendous inflow of foreign capital with EU accession. And not any type of capital flows but those suspicious ones that flow in and in many instances directly out again.

Why is that? Well many factors may play a role here. For instance, political transition has stabilized in many Eastern European countries and made them economically attractive destinations for capital inflows. Yet, in most cases the real boost comes with the adoption of the acquis communautaire, i.e. the legal framework of the EU, and eventually EU membership. Similar to Guernsey borrowing legal safety from the UK, Cyprus or Latvia borrow legal guarantees from member states with a better track record in avoiding explicit expropriation or expropriation by stealth such as high inflation.

The EU creates this problem arguably without intention. Capital flows to poorer countries are welcome, catching up will benefit also the older member states. But this is not true for any type of capital flows. To avoid these, the EU first needs to acknowledge that an unintended consequence of its enlargement strategy was to create excessive flows of certain types of capital. Second, it needs to build up a framework that differentiates between types of capital flows, monitors them carefully, and sanctions them way before a new Cyprus needs to receive a bail-out. Third, so far manly the countries of destination of capital flows have been punished, hence the EU needs to think much more about the countries of origins.

 

Literature:

Dharmapala, D., & Hines, J. R. (2007). ‘Which Countries Become Tax Havens?’ American Law & Economics Association Annual Meetings, No. 48.

Genschel, P., Kemmerling, A., & Seils, E. (2011). ‘Accelerating Downhill: How the EU shapes corporate tax competition in the Single Market.’ Journal of Common Market Studies, 1-22. For the working paper version see here.

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