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Do Tax Havens Flourish

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  • This PDF is a selection from a published volumefrom the National Bureau of Economic Research

    Volume Title: Tax Policy and the Economy, Volume19

    Volume Author/Editor: James M. Poterba, editor

    Volume Publisher: MIT Press

    Volume ISBN: 0-262-16236-9

    Volume URL: http://www.nber.org/books/pote05-1

    Conference Date: October 7, 2004

    Publication Date: September 2005

    Title: Do Tax Havens Flourish?

    Author: James R. Hines Jr.

    URL: http://www.nber.org/chapters/c0165

  • Do Tax Havens Flourish?

    James R. Hines Jr., University of Michigan and NBER

    Executive Summary

    Tax haven countries offer foreign investors low tax rates and other taxfeatures designed to attract investment and thereby stimulate eco-nomic activity. Major tax havens have less than 1 percent of theworld's population (outside the United States) and 2.3 percent of worldgross domestic product (GDP), but they host 5.7 percent of the foreignemployment and 8.4 percent of foreign property, plant, and equipmentof American firms. Per capita real GDP in tax haven countries grew atan average annual rate of 3.3 percent between 1982 and 1999, whichcompares favorably to the world average of 1.4 percent. Tax havengovernments appear to be adequately funded: their average 25 percentratio of government to GDP exceeds the 20 percent ratio for the worldas a whole, though the small populations and relative affluence ofthese countries would normally be associated with even larger govern-ments. Whether the economic prosperity of tax haven countries comesat the expense of higher tax countries is unclear. Recent research sug-gests that tax haven activity stimulates investment in nearby high-taxcountries.

    1. Introduction

    Countries design their tax systems to fit circumstances and opportu-nities; as a consequence, tax regimes exhibit considerable diversity.Countries known as tax havens offer very low tax rates and other taxfeatures that make them particularly attractive to foreign investors.Rising volumes of international investment contribute to the grow-ing importance of tax havens, which in turn has exposed tax havenactivities to greater scrutiny and has prompted a number of policyresponses in higher-tax countries.

  • 66 Hines

    The purposes of this paper are to review the use of tax havens by in-ternational businesses and to evaluate the effect of their tax systems oneconomic outcomes in tax haven countries and elsewhere. Countriesoffer low tax rates in the belief that, by doing so, they attract greater in-vestment and economic activity than would otherwise have been forth-coming. The extent to which this expectation is fulfilled certainlyvaries, though there are spectacular examples of tax haven countries,such as Ireland, that have enjoyed very rapid economic growth ratescoinciding with dramatic inflows of foreign investment. The empiricalevidence presented in section 4 confirms that Ireland's experience,while extreme, is not anomalous because tax haven countries as agroup exhibited 3.3 percent annual per capita gross domestic product(GDP) growth from 1982-1999, whereas the world averaged just 1.4percent annual GDP growth over the same period. While national eco-nomic statistics, particularly those describing the performance of smalltax havens, must always be treated with some caution, the availableindicators consistently show that tax haven economies outperformthe economies of other countries. Controlling for country size, initialwealth, and other observable variables does not change the conclusionthat the period of globalization has been favorable for the economies ofcountries with very low tax rates.

    The policy of offering investors very low tax rates is potentiallycostly to tax haven governments if doing so reduces tax collectionsthat might otherwise have been used to fund worthwhile governmentexpenditures. It is far from clear, however, that tax haven countriesface significant tradeoffs of this nature. Governments have at their dis-posal many tax instruments, including personal income taxes, propertytaxes, consumption or sales taxes, excise taxes, and others, that can beused to finance desired expenditures. Furthermore, even very low ratesof direct taxation of business investment may yield significant tax reve-nues if economic activity expands in response, producing wealth andexpenditure that augment tax bases. As an empirical matter, the publicsectors of tax haven countries are of comparable size to that of othercountries, though there is evidence that they may be somewhat smallerthan would otherwise have been predicted on the basis of their popu-lations and affluence.

    Tax havens are viewed with alarm in parts of the high-tax world.Concern is often expressed about foreign tax haven locations possiblydiverting economic activity away from countries with higher tax ratesand eroding tax bases that might otherwise be used to raise govern-

  • Do Tax Havens Flourish? 67

    ment revenue. These considerations are commonly thought to be mostacute in the case of nearby tax havens, i.e., those that might divertactivity from other countries within the same region or economicfederation. The evidence, however, suggests a different conclusion.Foreign tax haven activity and nearby investment in higher-tax coun-tries appear to be complementary: a 1 percent greater likelihood ofestablishing a tax haven affiliate is associated with percent greater in-vestment and sales in nearby non-haven countries. This pattern impliesthat the availability of nearby tax havens stimulates, rather thandiverts, economic activity within a region or federation.

    The empirical regularity that economic activity in high-tax countriesbenefits from the availability of nearby tax havens does not resolve theimpact of tax havens on the welfare of high-tax countries. Tax havenoperations may stimulate activity in nearby countries by facffitatingthe avoidance of taxes in that country, by facifitating the avoidance oftaxes elsewhere, or by reducing the cost of goods and services that areinputs to production or sales in high-tax countries. Tax avoidanceactivity carries mixed implications for governments of nearby coun-tries because it may erode tax bases and therefore tax collections,implying that the greater economic activity associated with nearby taxhavens might come at a high cost in terms of foregone governmentrevenues. Any evaluation of this effect relies, however, on careful con-sideration of the type of tax avoidance uses to which tax haven affifi-ates are put. In particular, it is possible that the use of tax havenoperations by multinational firms permits governments of high-taxcountries to refine their tax systems by subjecting multinational firmsto different effective tax rates than domestic firms.

    Section 2 of the paper reviews international taxation in practice andits implications for international investment and the tax policies incapital-importing countries. Section 3 considers American evidence ofthe extent to which investors concentrate their foreign investment andtax-avoidance activity in tax havens. Section 4 evaluates the economicexperience of tax havens over the period since 1982. Section 5 considersthe effect of foreign tax havens on the welfare of high-tax countries.Section 6 concludes.

    2. Tax Havens and International Taxation

    The investor appeal of tax haven operations is easy to understand.Countries that tax business activity at very low rates permit investors

  • 68 Hines

    to retain all, or most all, of locally earned pretax income. Investmentprojects of modest anticipated value, with expected pretax returns toolow to justify undertaking if the returns would be subject to taxation atnormal rates, might be deemed worthwhile if located in tax havensand therefore taxed lightly (if at all). Other considerations being equal,therefore, countries with lower tax rates should be expected to offer abroader range of attractive investment opportunities, and thereforedraw larger volumes of foreign investment, than do otherwise similarcountries with higher tax rates.

    Foreign investment is attracted to tax havens for reasons beyond theafter-tax return to local activities because multinational businesses canuse tax haven operations to facilitate avoidance of taxes that wouldotherwise be owed to governments of other countries. Foreign affiliatesof multinational firms typically have multiple business transactionswith each other and with their parent companies, providing opportu-nities for reallocating taxable income. Tax avoidance can take manyforms, including the use of financial arrangements, such as intrafirmlending, that locate taxable income in low-tax jurisdictions and taxdeductions in high-tax jurisdictions. In addition to the tax-motivateduse of intercompany loans, firms are often able to adjust the prices atwhich affiliates located in different countries sell goods and servicesto each other. Most governments require that firms use arm's lengthprices (prices that would be charged by mrelated parties transactingat arm's length) for transactions between related parties, in principlethereby limiting the scope of tax-motivated transfer price adjustments.In practice, however, the indeterminacy of appropriate arm's lengthprices for many goods and services, particularly those that are intangi-ble or for which comparable unrelated transactions are difficult to find,leaves room for considerable discretion. As a result, firms often findthat transactions with tax haven affifiates can be used to reallocateincome from high-tax locations to the tax haven affiliates themselvesor else to other low-tax foreign locations. This in turn increases theappeal of locating investment in foreign tax havens.

    There are two circumstances in which foreign investors will notbenefit from the opportunity to locate economic activity in very low-

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