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What Problems and Opportunities are Created by Tax Havens?

Dhammika Dharmapala∗

Prepared for Oxford Review of Economic Policy issue on “Business Taxation in a Globalised World” (Vol. 24 No. 4, Winter 2008)

Preliminary and incomplete: please do not cite without permission

∗ Department of Economics, University of Connecticut, email: dhammika.dharmapala@uconn.edu.

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1) Introduction

Tax havens have attracted increasing attention and scrutiny in recent years from

policymakers, as exemplified by the OECD’s initiatives to combat “harmful” tax practices

(OECD, 1998, 2000, 2004). The interest in tax havens reflects their disproportionate role in the

world economy, and in particular their centrality to many of the important current policy debates

in taxation, including international tax competition (Slemrod, 2004; Hines, 2006, 2007) and tax

avoidance activity by corporations (e.g. Desai and Dharmapala, 2006, 2008). This paper provides

an overview of the theoretical and empirical insights from a growing scholarly literature that

analyzes the consequences and determinants of the existence of tax haven countries.

The paper begins with an analysis of the characteristics of countries that tend to be

classified as tax havens. It focuses in particular on recent evidence (Dharmapala and Hines,

2006) that tax havens tend to have stronger governance institutions (i.e. better political and legal

systems and lower levels of corruption) than comparable nonhaven countries. The popular image

of tax havens is somewhat at variance with this picture, and emphasizes their role in facilitating

tax evasion by individuals. Recent estimates that have been widely influential in policy debates

suggest large revenue losses from haven-related evasion activities (e.g. Guttentag and Avi-

Yonah, 2006). This paper argues, however, that careful scrutiny of these estimates suggests that

they imply vast amounts of “hidden” wealth, and (if true) would have wide-ranging implications

(many of dubious credibility) for many economic phenomena far beyond the arena of taxation. It

appears more likely that evasion by individuals plays only a secondary role in generating tax

haven activity. Consistent with this view, some tentative evidence is presented in the paper

suggesting that the OECD’s recent initiative (promoting international information-sharing among

tax authorities) has had little impact on financial sector employment and wages in a

representative tax haven (Jersey).

The most important policy questions surrounding tax havens thus appear to relate to their

role in enabling tax planning by multinational corporations. Multinational corporations can use

tax havens to reduce or defer tax liabilities to other countries, through the strategic setting of

transfer prices (especially for intellectual property) and the strategic use of debt among affiliates.

It is often argued that tax havens erode the tax base of high-tax countries by attracting these

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types of corporate activities. This traditional “negative” view of tax havens has recently been

modeled formally by Slemrod and Wilson (2006). The evidence does show that tax havens host a

disproportionate fraction of the world’s foreign direct investment (FDI). However, according to

an emerging “positive” view of havens (e.g. Desai, Foley and Hines, 2006a, b; Hines, 2006,

2007; Hong and Smart, 2007), this need not necessarily imply that their existence makes high-tax

countries worse off. It is possible that havens enable high-tax countries to impose lower effective

tax rates on highly mobile firms, while taxing immobile firms more heavily. If differentiating

between mobile and immobile firms is difficult for informational or administrative reasons, the

existence of tax havens can enhance efficiency and even mitigate tax competition.

The latter view appears to be supported by the recent experience with corporate tax

revenues: despite substantial (and apparently increasing) FDI flows to tax havens, corporate tax

revenues in the US, UK and other capital-exporting countries has not fallen, but has actually

increased. Overall, while it is theoretically possible that the existence of tax havens could spur

harmful tax competition and lower global welfare, recent theoretical and empirical research has

tended to cast doubt on this view. The generally robust growth of corporate tax revenues in

major capital-exporting countries, despite substantial FDI flows to tax havens, suggests that the

concerns expressed about the deleterious effects of tax havens may be somewhat exaggerated.

Section 2 describes the characteristics of tax havens. Section 3 outlines how havens can

facilitate tax evasion by individuals and tax avoidance by corporations, and discusses recent

estimates of revenue losses from tax haven activity. Section 4 assesses the consequences of the

OECD initiative. Section 5 discusses the theoretical literature on the effects of tax havens on the

welfare of high-tax countries, and considers some relevant evidence. Section 6 concludes.

2) What are Tax Havens, and what are their Characteristics?

Although tax havens have attracted widespread interest (and a considerable amount of

opprobrium) in recent years, there is no standard definition of what this term means. Typically,

the term is applied to countries and territories that offer favorable tax regimes for foreign

investors. The elements of these favorable regimes include, first and foremost, low or zero

corporate tax rates. There are a variety of other elements common to tax havens, such as low or

zero withholding tax rates on foreign investors. Another common feature - bank secrecy laws -

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have attracted great attention, although they appear to be of declining significance (as discussed

in Section 3 below) due to growing international efforts to promote information-sharing among

the tax authorities of different countries. While the classification of countries based on these

criteria inevitably involves some degree of subjectivity, there are approximately 40 countries and

territories that appear in most published lists of tax havens. In this paper, the basic definition of

havens follows that in Dharmapala and Hines (2006; hereafter DH). DH begin with the list of

jurisdictions in Hines and Rice (1994, Appendix 2, p. 178), all of which also appear in Diamond

and Diamond (2002) and various other sources, and match these with countries and territories for

which current data on economic and other characteristics are available. This set of countries is

listed in Table 1 (under the heading: Tax havens (DH)).

What distinguishes this group of countries from the rest of the world? Even a casual

observer is likely to be aware that tax havens tend to be small and that many are islands. DH

provide quantitative measures of many other relevant characteristics, as illustrated in Figure 1.

Tax havens are on average substantially more affluent than are nonhavens. In addition to being

smaller in population size and more likely to be island countries (as expected), tax havens’

geographical characteristics lead them to be more intrinsically inclined towards economic

openness. In particular, they tend to be located in closer proximity to major capital exporters, and

have a larger fraction of their population located within 100 km of the coast.1 Havens also tend to

have a relatively sophisticated communications infrastructure, as measured by the number of

telephone lines per capita. They are also poorly endowed with natural resources: the value of

their subsoil assets per capita (as estimated in World Bank (2006)) is much smaller than that for

the typical nonhaven country.

Tax havens also differ substantially from nonhavens in their legal origins (the historical

source of a country’s system of commercial law, as classified by La Porta et al. (1999)) and

political institutions. As shown in Figure 2, havens are more likely to have British legal origins

and less likely to have French legal origins than is the typical country. Havens are also more

1 Proximity to major capital exporters is measured by Gallup, Sachs and Mellinger (1999) as the distance by air from the closest of New York, Tokyo or Rotterdam. The coastal population measure is also constructed by Gallup, Sachs and Mellinger (1999).

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likely to use English as an official language and to have parliamentary rather than Presidential

political systems. They are somewhat more likely to be dependent territories, rather than

sovereign states (as reflected in a lower rate of membership in the United Nations (UN). These

differences mostly persist when attention is restricted only to haven and nonhaven countries with

small populations (below one million).2

DH (2006) focus in particular on an overall measure of governance institutions created by

the World Bank (Kauffmann, Kraay and Mastruzzi, 2005). This governance index measures

several different dimensions of governance quality, including political stability, the absence of

official corruption, respect for the rule of law, government effectiveness and democracy. The

index is normalized to have a mean of zero across all countries and a standard deviation of one,

with higher values indicating stronger governance institutions. DH (2006) find that tax havens

score substantially better on this measure relative to comparable nonhaven countries. Moreover,

tests using a variety of statistical approaches show that this relationship is highly robust, and

suggest that a causal interpretation (i.e. that countries with stronger governance tend to become

tax havens) may be reasonable.

DH (2006) interpret these results within the framework of the standard result in the

theory of optimal taxation that a small open economy should not levy any source-based tax on

foreign investors (Gordon, 1986). The burden of such a tax would be shifted entirely to domestic

workers in the form of lower wages as investors demand higher pretax rates of return, so a more

straightforward and efficient means to raise revenue would be to tax workers directly. In the real

world, this conclusion may not apply to countries that enjoy significant location-specific rents,

for instance through natural resource endowments or agglomeration externalities in capital

formation. More generally, however, this theoretical framework suggests that the real puzzle is

not why some countries become tax havens, but rather why so many small countries do not (for

instance, of 75 countries and territories with populations less than a million in the DH dataset,

only 31 are tax havens). DH (2006) argue that only countries with good governance are able to

credibly set low tax rates; those small countries that are not tax havens would generally not reap

any benefits from seeking to become havens, as stated policies would count for little with foreign

2 An exception is UN membership, which is slightly higher for small havens than for small nonhavens (DH, 2006).

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investors in the absence of a strong institutional framework.3 Moreover, becoming a tax haven

appears to a successful economic development strategy for those countries that are able to make

this choice: Hines (2005) finds that tax havens experienced higher rates of economic growth over

the period 1982-1999 than did comparable nonhavens.4

3) Individual and Corporate Uses of Tax Havens

In February 2008, an international scandal relating to tax evasion unfolded after

Germany’s tax authorities purchased data from a former employee of a Liechtenstein bank.5 This

information on German individuals with Liechtenstein bank accounts led to the prosecution of

prominent German citizens for tax evasion, and to a focus on the role played by Liechtenstein

and other tax havens in facilitating evasion. This scandal exemplifies the image of tax havens in

the popular mind, which emphasises the use of tax havens by individuals for the purpose of

illegally evading home country taxes. The mechanism underlying this type of evasion is

straightforward. Virtually all countries with income tax systems impose residence-based taxes on

the interest, dividends and capital gains earned by their residents abroad. The bank secrecy laws

of tax havens create the opportunity to evade these taxes. Foreign individuals can locate assets in

tax havens, thereby earning interest, dividends and capital gains. If they fail to report this income

to their home country, bank secrecy provides them with the assurance that the source country

(the tax haven where the income is earned) will not provide information on this income to the

home country.

3 Some limited but intriguing supporting evidence for this view is that inbound foreign direct investment (FDI) appears to be much more sensitive to corporate tax rates in countries with stronger governance institutions (DH, 2006).

4 Slemrod (2008) views tax havens within a broader context of practices that involve the “commercialization” of state sovereignty, a concept that also encompasses involvement in facilitating money laundering activities, and the issuance of stamps designed to appeal to foreign collectors. Slemrod (2008) finds that better governance is related not only to being a tax haven, but also to “pandering” stamp issuance (though not to involvement in facilitating money laundering). He suggests a more general interpretation, arguing that better governance leads not only to greater policy credibility but also to a greater capacity to undertake welfare-enhancing government activities.

5 See e.g. “Steuerskandal erfasst Europa und die USA” Der Spiegel Online (26 February 2008), available at http://www.spiegel.de/wirtschaft/0,1518,538014,00.html. The scandal also spread to the UK – see “UK in Liechtenstein Tax Data Deal” BBC Online (24 February 2008) at http://news.bbc.co.uk/2/hi/business/7261830.stm.

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However, corporations also locate large amounts of investment in tax havens. For

instance, about a quarter of US firms’ foreign direct investment (FDI) is located in tax havens (as

defined in DH (2006)), and the corresponding number for UK firms’ FDI is similar.6

Presumably, this is not because these firms are seeking to evade home country corporate taxes.

However dedicated corporate managers may be to the maximization of after-tax shareholder

value, they will surely not risk prosecution on behalf of their shareholders. Rather, corporations

use tax havens for legal tax avoidance and tax planning activities. Thus, the policy questions

raised by corporate uses of havens may be very different from those relating to individual uses.

Evaluating individuals’ use of havens is complicated by the wider context of

understanding foreign portfolio investment (FPI).7 As a general matter, FPI is worthy of

encouragement. Economists have long argued that there are substantial gains available to

investors from international portfolio diversification, which provides insurance against economic

risks that are specific to the investor’s home country (French and Poterba, 1991). Historically,

investors have failed to achieve these gains from diversification, partly because of capital

controls and a lack of information about foreign assets, but also for other reasons that are not

fully understood by researchers. This “home bias” phenomenon (i.e. that investors tend to place

too much of their portfolios in home country stocks) appears to be eroding over time.8 Given the

sophisticated financial infrastructure of the more successful havens, it might be the case that they

have many nontax advantages as vehicles for global diversification. However, if investors evade

home country taxes on their tax haven investment returns, then there may be efficiency costs that

must be weighed against the obvious benefits of FPI. For instance, the potential for evasion may

create an incentive for investors to locate too much of their portfolios abroad.9 Evasion also

6 This is apparent, for instance, in Figures 7 and 9 – see the discussion in Section 5 below.

7 FPI refers to cross-border investment by individuals (or by institutions such as pension funds on behalf of individuals), as distinct from FDI, which is carried out by multinational firms.

8 For the US, Dharmapala (2008) calculates that in 2004 US investors held only 12% of their equity portfolios in foreign stocks. However, from 2004 to 2005, increases in holdings of foreign stocks represented 43% of the total increase in holdings of equity.

9 However, if the home bias is caused by an irrational aversion to foreign assets, then there may be a case for subsidizing foreign investment; lax enforcement of home country taxes on foreign-source income may be one way to implement such a subsidy.

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raises issues of fairness and “tax morale”, as home country revenue is eroded and confidence in

the tax system is undermined.

The importance of the costs associated with individuals’ use of tax havens depends

crucially on how much tax evasion occurs through havens.10 Given the illegality of evasion, this

is obviously inherently difficult to quantify. However, some estimates have recently been

proposed, suggesting that significant amounts of revenue are lost by countries such as the US as

a result of tax evasion through havens. A representative example is provided by Guttentag and

Avi-Yonah (2006), who begin with an estimate (based on data from the Boston Consulting

Group) of the value of assets held overseas by US individuals. They assume that offshore assets

earn a 10% annual rate of return (apparently risk-free), and compute a revenue loss to the US of

$50 billion a year.

As this and similar estimates have been widely influential in policy debates, it is worth

considering their implications in some detail. It should be noted at the outset that a 10% return

appears optimistic, especially for interest income. If all of the $50 billion loss were generated by

hidden assets that were invested in bank deposits or other debt instruments, then a more

reasonable return might be 2%, which (assuming that all of the interest, if reported, would have

been taxed at the top marginal rate of 35%) implies $7.5 trillion of hidden assets. On the other

hand, if all of the hidden assets are invested in equities, then it may be reasonable to use their

assumption of a 10% return, though with the caveat that it does not necessarily account

adequately for risk.11 However, the appropriate tax rate would then be the effective tax rate on

equity returns (currently 15% on dividends and realized capital gains for a top-bracket taxpayer).

It is standard (e.g. Poterba, 2004) to use an effective capital gains tax rate of about a quarter of

the statutory rate to account for the deferral advantage enjoyed by taxpayers because capital

gains taxes are imposed only upon the sale of an asset. Assuming that one third of equity returns

10 Rose and Spiegel (2007) argue that portfolio investment in offshore financial centres (OFCs) is substantially motivated by tax evasion. However, this conclusion rests essentially on a regression of OFC status on tax haven status (see Table 2, p. 1319), and does not take into account the potential simultaneity of countries’ choices to become OFCs and tax havens.

11 For instance, when evaders’ hidden assets fall in value, the evaders are effectively making a contribution to the home country treasury because they are unable to deduct their losses.

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are paid out as dividends (probably a conservative assumption) implies an effective tax rate on

equity returns of under 8%; thus, the implied value of assets hidden in tax havens by US

taxpayers would amount to about $6 trillion.

The $50 billion revenue loss estimate thus implies hidden overseas assets of $6-7.5

trillion, depending on the composition of those assets. By way of comparison, the US Treasury

reports $4.6 trillion of US portfolio investments held overseas in 2005 (in all countries, not only

in tax havens; $3.3 trillion is in the form of equity and the rest in the form of debt). These data

are from the Treasury International Capital (TIC) system, the most authoritative and

comprehensive source of information on the portfolio holdings of foreign securities by US

investors.12 TIC data are based on responses to periodic surveys from a defined panel of banks,

other financial institutions, securities brokers and dealers. It is rather unlikely that investors

would seek to evade taxes on investments reported under the TIC system. Many of the banks and

other financial institutions that are surveyed routinely report their investors’ taxable income to

the US tax authorities. Other US institutions and entities can also be compelled to provide

information to the US government. Moreover, most of the assets reported in the TIC data are

located in countries with information-sharing arrangements and tax treaties with the US. The $6-

7.5 trillion of hidden assets must therefore be held in tax havens through non-US entities, and

therefore constitute an additional stock of assets (beyond the visible assets reported through

TIC). To put this additional wealth in context, the aggregate stock market capitalization of

publicly-traded US firms in 2005 was $17 trillion.13

The implications of the foregoing argument are quite far-reaching. It implies that nearly

two thirds of all US FPI is hidden from the authorities, and conversely that US FPI is more than

two and a half times as large as one might suspect on the basis of official figures. This has

widespread ramifications for a variety of economic issues extending far beyond the arena of

taxation. For instance, it would suggest that US households are in aggregate considerably

wealthier than currently believed. The home bias would be much less pronounced than currently

12 These data are available at www.treas.gov/tic/ and are described in more detail in Desai and Dharmapala (2007).

13 This is obtained from the World Bank’s World Development Indicators (WDI), available at http://econ.worldbank.org.

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thought. Depending on how this stock of hidden wealth has changed over time, the savings rate

of US households may not be approximately zero (or even negative), as currently believed.

Before we revise our (generally well-attested) beliefs about this wide range of economic

phenomena, it may be worth exercising some degree of caution about these large estimates of

revenue losses from evasion.

It may seem that a naively optimistic view of human nature is required to believe that

evasion is not widespread when the theoretical opportunity for it clearly exists. However, a

limited prevalence of evasion would be consistent with the tax compliance experience in the

domestic setting. In circumstances where taxpayers have some discretion over the reporting of

domestic-source income (e.g. among the self-employed), there tends to be a significant amount

of evasion, but far less than might be expected on the basis of probabilities of audit and expected

sanctions (e.g. Andreoni, Erard and Feinstein, 1998). In other words, taxpayers seem to comply

to a greater degree than is consistent with the principles of Homo Economicus. It would not be

entirely surprising if this tendency extends to the international setting. Thus, it appears unlikely

that income tax evasion through havens is as big a problem as has sometimes been claimed. To

be sure, large estimates of tax revenue losses due to haven-related evasion are not beyond the

realm of possibility. However, believing them would require us to also revise our beliefs about a

wide range of other economic phenomena; such inferences do not seem warranted, given the

very limited data on evasion.14 It should also be remembered that in countries such as the UK

and Germany that impose a value-added tax (VAT) in addition to an income tax, income tax

evasion should result in higher VAT revenues – of course, there are differences in timing and in

rates, but to some degree, what governments lose on the swings they gain on the roundabouts.

If individual evasion is not as widespread as has been thought, then the primary policy

questions relating to tax havens concern their use by multinational corporations (MNCs). MNCs

can use havens to reduce or defer their tax liabilities to other governments. Understanding how

14 Even if the $50 billion revenue loss estimate is thought to be credible, it should be viewed in the context of the total revenues collected by the US Federal government (over $2.5 trillion in 2005, based on data from the US Bureau of Economic Analysis, available at http://www.bea.gov). It should also be remembered that in countries such as the UK and Germany that impose a value-added tax (VAT) in addition to an income tax, income tax evasion should result in higher current or future VAT revenues. There are of course differences between the taxes in terms of timing and rate structure, but, to some degree, what governments lose on the swings they gain on the roundabouts.

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they can do this requires a brief digression on how governments tax the foreign income of their

resident corporations. Most (nonhaven) governments insist on taxing economic activity that takes

place within their borders, whether undertaken by domestic or foreign firms. There are two

alternative approaches to taxing the foreign-source income generated by a country’s resident

corporations. A “worldwide” system (used for instance by the US, the UK and Japan) taxes this

foreign income. However, to avoid the “double taxation” that would result from the overlapping

claims of the source and residence countries, a foreign tax credit (FTC) is allowed for taxes paid

to foreign governments.15 On the other hand, a “territorial” system (used by most other capital

exporting countries, such as Germany and the Netherlands) exempts foreign-source income from

home country taxation.16

For MNCs resident in territorial countries, there is an obvious advantage to being able to

reallocate income from the home country (or some other high-tax country) to a tax haven. This

incentive would not exist under a pure worldwide system. In practice, however, worldwide

systems are not pure – for instance, the US permits the deferral of US taxation of foreign income

until that income is “repatriated” to the US. Repatriation consists of the payment of a dividend

by the foreign subsidiary to the US MNC. Delaying the payment of these dividends by retaining

earnings abroad can thus confer a substantial deferral advantage on the MNC by significantly

reducing the present value of its US tax liability (Hines, 1994). Moreover, the reallocation of

income to a tax haven affiliate can magnify this deferral advantage (because the immediate

source-based tax paid to the tax haven government is low or zero).

Thus, MNCs based in countries with either territorial or worldwide tax systems have

incentives to use tax havens to reduce or defer their tax liabilities. The major mechanisms for

achieving this aim involve transfer pricing and the use of debt among affiliates. When affiliates

of the same MNC trade goods or services among themselves, they must choose prices for these

transactions. The prices used inevitably affect the allocation of the MNCs’ income across

different jurisdictions. Governments generally insist that firms use “arm’s-length” prices (those

15 Note, however, that the FTC is limited to the home country tax liability on the foreign income.

16 The exemption pertains to “active” income generated by the firm’s normal business operations. Generally, “passive” income from firms’ cash holdings or portfolio investments is taxed by the home country.

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that would be used by unrelated parties engaging in market transactions). However, for certain

transactions, arm’s-length markets are thin or nonexistent. A particularly important example in

practice is intellectual property: affiliates of the same MNC can, to a significant degree, choose

where to locate research and development activity in order to ensure that royalty payments from

other affiliates flow towards lower-tax jurisdictions.17 MNCs can also choose to have affiliates in

tax havens lend to affiliates in high-tax countries (i.e. locate debt in high-tax jurisdictions, while

holding fixed the aggregate capital structure of the MNC’s family of affiliates). This practice

(known as “interest stripping” or “earnings stripping”) directs interest payments to low-tax

countries, while generating interest deductions in high-tax countries. Governments seek to

restrict this practice through “thin capitalization” rules (imposing some restrictions on capital

structure), but apparently with less than complete success.

Thus, there are strong incentives for MNCs to use tax havens for international tax

planning. Empirical research (as surveyed for instance in Devereux (2007)) shows that MNCs

are highly responsive to these tax incentives. For instance, Hines and Rice (1994) and a

substantial subsequent literature find a large elasticity of US FDI holdings and of US affiliates’

profits with respect to foreign countries’ corporate tax rates. Desai, Foley and Hines (2004) find

evidence consistent with MNCs locating debt in higher-tax countries (despite the thin

capitalization rules noted above). The overall result is that (as noted above) a vastly

disproportionate amount of the world’s FDI is located in tax havens. This situation has not gone

unnoticed in policy debates (e.g. Sullivan, 2004); Section 5 below addresses the question of how

it might best be evaluated from a normative standpoint.

4) The OECD Initiative and its Consequences for Tax Havens

Concern about the use of tax havens to erode the tax bases of higher-tax countries has

prompted a major effort by the Organisation for Economic Cooperation and Development

(OECD) to combat tax havens (OECD, 1998, 2000, 2004; Hines, 2006). The OECD in 1998

introduced what was originally known as its Harmful Tax Competition initiative (OECD, 1998),

17 Consistent with the importance of this strategy, Desai, Foley and Hines (2006a) find that US MNCs with extensive trade among affiliates and greater focus on research and development are more likely to establish affiliates in tax havens.

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which was subsequently renamed the Harmful Tax Practices initiative. The initiative was

intended to discourage the use of preferential tax regimes for foreign investors and to encourage

effective information exchange among the tax authorities of different countries. As part of the

initiative, the OECD (2000, p. 17) produced a list of 35 countries and territories that it deemed to

be tax havens. In addition, another six countries (listed in Hishikawa (2002, fn. 72, p. 397)) that

otherwise satisfied the OECD’s tax haven criteria were not included on the list because they

provided “advance commitments” to eliminate allegedly harmful tax practices. The complete set

of 41 OECD-designated havens is listed in Table 1 (under the heading “Tax haven (OECD)”). In

the years since, most of these havens have agreed to improve the transparency of their tax

systems and to facilitate information exchange.18

Thus, the OECD initiative appears to have been successful, in the sense of persuading

most havens to agree to information-sharing arrangements. However, the practical impact of

these agreements remains uncertain. For instance, the commitments of many tax haven countries

to exchange information and improve the transparency of their tax systems are often contingent

on similar practices by OECD member countries. More generally, the extent of information-

sharing in practice is unclear. Moreover, evidence on the impact of the OECD initiative is

severely limited. Kudrle (2008) examines total foreign portfolio investment (as reported by the

Bank for International Settlements) in the Cayman Islands and in a broader set of tax haven

countries. His time-series analysis finds no significant impact of the OECD initiative; he

concludes that it was ineffective because the information-sharing provisions were too weak.

However, Kudrle (2008) does not use a control group of countries to account for possible shocks

that affected FPI in haven and nonhaven countries alike. More generally, any analysis based on

reported investment data is vulnerable to the criticism that evasion occurs primarily through asset

holdings that are unreported not just to tax authorities but also to statistical agencies.

To circumvent these difficulties, an alternative approach is to consider other variables

that are less likely to be subject to misreporting. Examples include the levels of employment and

18 OECD (2004) lists five recalcitrant tax havens that had failed to make such commitments as of 2004 – see Table 1. The preferential regimes identified by the OECD have also generally been abolished or modified to remove the features that the OECD found objectionable.

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wages in the financial sectors of tax haven countries. The International Labour Organisation

(ILO) reports data on employment and wage levels by industry for a large sample of countries.19

Unfortunately, the coverage of smaller countries (including most tax havens) is very limited,

rendering a cross-country longitudinal study of the impact of the OECD initiative difficult.

Instead, without any pretence of econometric rigour, we report the data for the Bailiwick of

Jersey, using employment and wages in the financial sector of the UK as a control. Figure 3

reports employment levels in the financial sectors of the two countries for the period 1997-2005.

The most notable feature is that the two series follow a very similar trend. There is a slowdown

in employment in Jersey around the time of the initial announcement of the OECD initiative in

1998, but this is mirrored in the UK. Similarly, there is a decline around 2001-2002 (after Jersey

was named as a haven in OECD (2000, p. 17) and the information-sharing agreements began to

take shape), but this pattern is also shared by the UK.

A negative effect of the OECD initiative on investment in tax havens may manifest itself

not in a quantity effect (on employment levels) but a price effect (on the wages of workers in the

financial sector). The basic conclusions, however, are similar when examining the average wage

(measured in pounds per week) in Jersey’s financial sector. There is a general upward trend that

does not appear to be interrupted by the OECD initiative; if anything, wages in Jersey seem to

increase faster over this period than in the UK financial sector. Thus, this evidence (limited

though it undoubtedly is) does not suggest any impact of the OECD initiative on tax haven

activity. One may conclude (as Kudrle (2008) does) that this implies that evasion via tax havens

was a significant problem before the initiative, and that the OECD’s measures were insufficient

to address it. As we have seen, however, this view commits us to believing in the existence of

vast amounts of hidden wealth, and to various related implications of dubious credibility. An

alternative conclusion from this evidence is that evasion via havens was not a very important

problem before the OECD initiative, and that hence the OECD measures had little effect. This

could perhaps be because most tax haven activity involves corporate tax planning (which was not

targeted by the OECD measures), rather than individual evasion.

19 These data are available at http://laborsta.ilo.org/.

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5) The Consequences of Tax Havens for High-Tax Countries

The foregoing arguments suggest that individual evasion is not as important a problem as

has been claimed. However, the various forms of corporate tax planning outlined in Section 3

may nonetheless constitute a significant policy problem for high-tax countries. This point of

view has been given a rigorous formal exposition by Slemrod and Wilson (2006). They develop

a model of tax competition in which tax havens are viewed as being “parasitic” on the tax bases

of nonhavens. In their framework, firms based in nonhaven countries can choose to purchase

“concealment services” from havens, thereby avoiding (or evading) home country taxes. In

addition to the resource costs incurred by havens in providing concealment services, tax

avoidance also induces nonhavens to expend additional resources on enforcement. In the

equilibrium of this model, small countries endogenously choose to become tax havens.20 The

existence of havens intensifies tax competition, forcing nonhaven countries to set lower tax rates

than they otherwise would, and thereby reducing the supply of public goods. These welfare

losses can be ameliorated in their model by the elimination of tax havens.

Slemrod and Wilson (2006) present a rigorous statement of a set of conditions under

which the existence of tax havens spurs harmful tax competition and lowers global welfare. It is

certainly a logical possibility that these conditions hold in the real world. However, their

equilibrium entails that the (small and relatively powerless) havens impose significant welfare

costs on the populations of larger and more powerful countries. Thus, this perspective requires a

belief in a political (and indeed military) equilibrium in which major powers tolerate substantial

harm inflicted on them by small “parasite” countries and territories. However, many prominent

tax havens (such as Bermuda and the Cayman Islands) are British dependent territories; they

enjoy a substantial degree of fiscal autonomy, but it is difficult to believe that in practice they do

not face any constraints in pursuing policies that are harmful to the UK. Even tax havens that are

independent sovereign entities (such as the Bahamas) are acutely vulnerable to economic,

political (and indeed military) pressure from major powers. Even without exerting any pressure

on havens, nonhaven capital exporters could eliminate the use of havens by their corporations by

20 This prediction is of course consistent with the evidence on population size shown in Figure 1.

16

the simple expedient of changing the source rules for corporate income, or imposing immediate

worldwide taxation.

On the whole, it appears more reasonable to believe that the world’s major economies

benefit from the existence of tax havens. This claim may appear to be at odds with the OECD

initiative described in Section 4, where many of the largest economies engaged in multilateral

action to curb the activities of tax havens. It should be remembered, however, that the OECD

initiative focused on the use by individuals of havens for tax evasion, and on related issues of

information-sharing. It was not aimed at corporate uses of havens.21 How might corporate tax

haven activities beneficial for the MNCs’ home countries? A number of models (Keen, 2001;

Desai, Foley and Hines, 2006a, b; Hong and Smart, 2007) have specified conditions under which

such benefits may be generated. The rest of this section summarizes this “positive” view of

havens, and considers some relevant evidence (see also Hines (2006, 2007)).

Keen’s (2001) model is not explicitly motivated by the question of tax havens, but rather

by preferential tax regimes for foreign investors or specific sectors (which were also targeted by

the OECD initiative). In a simple model of tax competition, Keen introduces the assumption that

capital may be heterogeneous in its mobility across borders. If preferential regimes (i.e. lower tax

rates for more mobile forms of capital) are not allowed, then countries are constrained to

compete by setting a single tax rate for all forms of capital. This will result in a needlessly low

rate on immobile capital. On the other hand, when preferential regimes are permitted, countries

can set high tax rates on immobile capital, while competing only over tax rates imposed on

mobile capital. Preferential regimes can thus mitigate tax competition by restricting its effects to

a subset of the tax base. This intuition extends quite readily to the analysis of the role of tax

havens, as discussed below.

Hong and Smart (2007) develop a general equilibrium model of a small open economy in

which the corporate tax serves to both tax the returns to inbound FDI and to tax the rents earned

by domestic entrepreneurs. As in Gordon (1986), the burden of the former is entirely shifted to

domestic workers in the form of lower wages. Despite this, the optimal corporate tax rate will 21 The OECD initiative initially included provisions directed at corporate activities, but this element was soon dropped – see Kudrle (2008, p. 7).

17

generally be positive when the government wishes to redistribute from domestic entrepreneurs to

domestic workers.22 In this setting, the existence of tax havens can increase the welfare of

nonhaven countries. Tax planning by MNCs (e.g. sourcing income in the tax haven through

interest stripping) lowers their effective tax rate and makes them more willing to invest in the

nonhaven for any given statutory tax rate. This directly makes domestic workers better off. It

also increases the optimal corporate tax rate, enabling more redistribution from domestic

entrepreneurs to domestic workers (without driving away FDI). The key to their result that the

existence of tax havens raises welfare is that the government cannot discriminate between

(immobile) domestic entrepreneurs and foreign investors in setting the corporate tax rate.

Desai, Foley and Hines (2006a) analyze the determinants of US MNCs’ choice of

whether to establish affiliates in tax havens. They find that the scale of a MNC’s foreign

operations is a crucial factor in driving the establishment of affiliates in havens. They exploit

exogenous variation in the scale of operations in foreign nonhavens by using foreign countries’

economic growth rates as an instrument. To explain their findings, Desai, Foley and Hines

(2006b) develop a model in which there are complementarities between investment in havens

and investment in neighboring nonhaven countries. On the one hand, investment in nonhaven

countries spurs demand for tax haven operations in order to reduce tax liabilities on the income

from the former. On the other hand, the presence of a tax haven enables tax planning that lowers

the cost of investing in neighboring nonhavens. Thus, the existence of havens can stimulate

investment in nonhavens.

The insights from this literature that are most relevant for analyzing the role of tax havens

can be illustrated using a simple example. Assume that there are two symmetric countries (A and

B). A is home to an immobile firm A1 and a mobile firm A2 (each of which generates net

income of 50 through domestic operations), and B is home to an immobile firm B1 and a mobile

firm B2 (each of which generates net income of 50 through domestic operations). There are two

corporate tax policies available to each government – a rate of 50% and a rate of zero (neither of

22 Slemrod and Wilson (2006) also model small open economies. They derive positive optimal corporate tax rates through a different route. Specifically, taxes on wages can be evaded, at some resource cost. Thus, governments prefer (up to a point) to tax workers indirectly by imposing taxes on capital rather than to tax them directly and thus incur these costs of evasion.

18

which can discriminate between the two firms). It is assumed that this is tax imposed on a

territorial basis (i.e. it applies to all domestic income, but exempts foreign-source income). The

marginal cost of public funds in each country is 1.2, reflecting the notion that alternative sources

of revenue impose deadweight costs.

It is assumed that immobile firms are nonstrategic. Mobile firms choose the location of

their operations in order to maximize after-tax profits. Each country maximizes a payoff that is

the sum of revenue collected (multiplied by 1.2) and the after-tax profits generated within its

borders (whether by domestic or foreign firms). Equivalently, a country’s payoff ca be defined as

the (pretax) profits generated within its borders (whether by domestic or foreign firms), plus the

social benefits (0.2 per dollar) of the revenue transferred from firms to the government. The

profits generated can be viewed as a proxy for the amount of capital employed within the

domestic economy, and hence for the wages of domestic workers (which are obviously higher

when more capital is employed domestically).

The payoffs in the case where tax havens do not exist are shown in Figure 5. If both

countries set the same tax rate, firms do not choose to move from their original locations, even if

they are mobile. If B sets a zero rate while A sets a 50% rate, then A2 will (costlessly) move its

real operations to B. This raises B’s payoff by the extra 50 of profits that A2 generates in B. The

dominant strategy equilibrium is for each country to set a zero rate, even though this is Pareto-

inferior to the outcome where both set their rates at 50%.

Now, imagine that a third country exists and functions as a tax haven. It imposes no taxes

on firms’ profits and facilitates their tax planning activities. In these circumstances, if A imposes

a 50% tax, then A2 has available the option of keeping its real operations in A, but sourcing all

of its profits in the tax haven (thus ensuring a zero effective rate). A1 (the immobile firm) is

assumed to be unable to use the tax haven, in much the same way that it cannot move its

operations to B. The new payoffs when a tax haven exists are shown in Figure 6. The Nash

equilibrium is now for each country to set its rate at 50%. Thus, tax competition is mitigated by

the presence of the tax haven, which results in welfare gains for both A and B. The existence of

havens thus enables nonhavens to sustain higher equilibrium tax rates. Of course, this will be of

little value to them unless there are some immobile firms that can be taxed. This underscores the

19

importance to the “positive” view of havens of the assumption of heterogeneity across firms in

their degree of mobility.23

The relevance of these alternative models of tax havens thus depends on factors such as

whether there are significant differences in the international mobility of different firms, and

whether governments can discriminate between firms on this basis in setting tax rates. These are

difficult issues to determine, but it is also possible to examine the testable implications of each

view. The standard “negative” view of tax havens, as formalized by Slemrod and Wilson (2006)

implies that increased tax haven activity would intensify international tax competition, and so be

associated with declining corporate tax revenues in major capital-exporting countries. In

particular, the rapid growth in international capital flows in recent years (a disproportionate

amount of which is located in tax havens) would be expected to have led to precipitous declines

in revenues from the corporate tax. In contrast, the “positive” view of havens suggests no

necessary decline in revenues: even though increased tax haven activity may reduce tax rates on

firms that use havens, it also enables more taxation of immobile domestic firms (Desai, 1999;

Hines, 2007).

The data on corporate tax revenues does not suggest any decline, precipitous or

otherwise. It is true that statutory corporate tax rates have tended to fall in recent decades.

However, this has been accompanied by base broadening, so that revenues have not fallen. In the

US, Figure 7 shows the pattern of FDI in tax havens over the period 1994-2006.24 A large

fraction of US FDI – about a quarter – is located in tax havens. This is obviously vastly

disproportionate relative to tax havens’ share of world population, and presumably reflects the

various opportunities for tax planning provided by havens (discussed in Section 3 above).

Moreover, there is a slight upward trend over this period. Nonetheless, the fraction of US Federal

23 Desai, Foley and Hines (2006a) find that in their sample of US MNCs, a significant fraction (about 40% in 1999) do not have affiliates in tax havens, despite the obvious potential benefits discussed in Section 3 above. This evidence suggests considerable heterogeneity in the mobility of firms, even among MNCs. This heterogeneity would be even greater, of course, if purely domestic firms were also considered.

24 The data on FDI and on US corporate tax revenues are from the US Bureau of Economic Analysis, and are available at http://www.bea.gov. In Figure 7, tax havens are defined as in DH (2006), while Figure 8 uses the OECD definition (see Table 1).

20

tax revenues derived from corporate taxes has increased over this period, especially since a

decline associated with the 2001-2002 economic downturn. The increased revenues are not due

to increases in the US statutory corporate tax rate (which has remained unchanged over this

period). There are various explanations for why US corporate tax revenues have increased (see

Auerbach (2006)); the very fact that they have increased, however, starkly contradicts the notion

that tax haven activity by MNCs has eroded the US corporate tax base.

This increase does not appear to be sensitive to the precise definition of tax havens. In

Figure 8, the definition of havens is restricted to those designated as such by the OECD (see

Table 1). As this list omits some important destinations for investment (such as Luxembourg,

Switzerland, Hong Kong and Singapore), the fraction of US FDI located in havens is

considerably lower under this definition (around 10%). Figure 8 also reports US corporate tax

revenue as a fraction of GDP (rather than total revenues). Nonetheless, the basic pattern is very

similar to that in Figure 7. Moreover, the robustness of corporate tax revenues in the face of

global economic integration is by no means confined to the US. Figure 9 shows a very similar

pattern for the UK (although data limitations restrict the period covered).25 The phenomenon also

appears more broadly across Europe (as discussed in de Mooij and Nicodeme (2007)).

It is of course possible to imagine a counterfactual world in which corporate tax revenues

would have grown even faster in the absence of tax havens. This, however, appears unlikely. For

instance, in the US, the recent increases shown in Figure 7 represent the reversal of a longer-term

decline going back to the early 1960’s (Auerbach, 2006). (which, incidentally, cannot easily be

attributed to tax havens). A counterfactual involving significantly higher growth in corporate tax

revenues than has actually occurred would represent a dramatic departure from past experience.

Thus, the generally robust growth of corporate tax revenues in major capital-exporting countries,

despite substantial FDI flows to tax havens, suggests that the concerns expressed about the

deleterious effects of tax havens may be somewhat exaggerated.

6) Conclusion [to be written]

25 The data on UK FDI is from the UK Office for National Statistics, available at http://www.statistics.gov.uk/. The data on UK corporate tax revenues are from the European Commission’s “Taxes in Europe” database, available at http://ec.europa.eu/taxation_customs/taxation/. Tax havens are defined as in DH (2006).

21

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Desai, M. A. and D. Dharmapala (2006) “Corporate Tax Avoidance and High Powered Incentives” Journal of Financial Economics, 79, 145-179.

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Table 1: List of Tax Havens

Country or Territory Tax Haven (DH)

Tax Haven (OECD)

Country or Territory Tax Haven (DH)

Tax Haven (OECD)

Andorra* 1 1 Luxembourg 1 0 Anguilla 1 1 Macao 1 0 Antigua and Barbuda 1 1 Maldives 1 1 Aruba 0 1 Malta 1 1 Bahamas 1 1 Marshall Islands* 1 1 Bahrain 1 1 Mauritius 0 1 Barbados 1 1 Monaco* 1 1 Belize 1 1 Montserrat 1 1 Bermuda 1 1 Nauru 0 1 British Virgin Islands 1 1 Netherlands Antilles 1 1 Cayman Islands 1 1 Niue 0 1 Cook Islands 1 1 Panama 1 1 Cyprus 1 1 Saint Kitts and Nevis 1 1 Dominica 1 1 Saint Lucia 1 1 Gibraltar 1 1 Saint Vincent and the

Grenadines 1 1

Grenada 1 1 Samoa 0 1 Guernsey 1 1 San Marino 0 1 Hong Kong 1 0 Seychelles 0 1 Ireland 1 0 Singapore 1 0 Isle of Man 1 1 Switzerland 1 0 Jersey 1 1 Tonga 0 1 Jordan 1 0 Turks and Caicos Islands 1 1 Lebanon 1 0 Vanuatu 1 1 Liberia* 1 1 Virgin Islands (U.S.) 0 1 Liechtenstein* 1 1

Source: “Tax haven (DH)” refers to the definition of tax havens used in Dharmapala and Hines (2006), who begin with the list of jurisdictions in Hines and Rice (1994, Appendix 2, p. 178), all of which also appear in Diamond and Diamond (2002) and various other sources, and match these with countries and territories for which current data on economic and other characteristics are available. “Tax haven (OECD)” refers to the definition of tax havens in OECD (2000, p. 17), but includes an additional six countries (listed in Hishikawa (2002, fn. 72, p. 397)) that otherwise satisfied the OECD’s tax haven criteria but were not included on the list because they provided “advance commitments” to eliminate allegedly harmful tax practices. In each case, 1 = tax haven and 0 = nonhaven.

* Tax haven designated by the OECD (2004) as having failed to make commitments on information exchange.

25

Figure 1: General Characteristics of Tax Havens (Relative to Nonhavens)

0 0.2 0.4 0.6 0.8 1 1.2

Subsoil Assets pc

(Nonhavens=1)

Telephone Lines pc (Havens=1)

Coastal population (fraction)

Island (fraction)

Distance by air (Nonhavens=1)

Population (Nonhavens=1)

GDP pc (PPP; Havens=1)

Nonhavens

Havens

Source: Authors’ calculations, based on the dataset used in Dharmapala and Hines (2006). GDP per capita (in US$ in PPP terms), population and telephone lines per capita are all from the World Bank’s World Development Indicators (WDI), available at http://econ.worldbank.org, for 2004. Distance by air measures proximity to major capital exporters (constructed by Gallup, Sachs and Mellinger (1999) as the distance by air from the closest of New York, Tokyo or Rotterdam. Coastal population is the fraction of the population living within 100 km of the coast, also constructed by Gallup, Sachs and Mellinger (1999). Subsoil assets per capita are from World Bank (2006).

26

Figure 2: Institutional Characteristics of Tax Havens (Relative to Nonhavens)

-0.2 0 0.2 0.4 0.6 0.8 1

Governance Index

UN Member (fraction)

Parliamentary System (fraction)

English as an Official Language

(=1)

Ethnolinguistic

Fractionalization

French legal origin (fraction)

British legal origin (fraction)

Nonhavens

Havens

Source: Authors’ calculations, based on the dataset used in Dharmapala and Hines (2006). Legal origins and ethnolinguistic fractionalization are from La Porta et al. (1999). The use of English as an official language is from the Centre d’Etudes Prospectives et D’Informations Internationale (CEPII) dataset (available on Thierry Mayer’s website at: http://team.univ-paris1.fr/teamperso/mayer/data/data.htm)The World Bank’s Database of Political Institutions (Beck et al., 2001). UN membership is obtained from the United Nations Organization website, at http://www.un.org/Overview/unmember.html. The governance index (for 2004) is from Kauffmann, Kraay and Mastruzzi (2005).

27

Figure 3: Financial Sector Employment in Jersey and the UK, 1997-2005

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1997 1998 1999 2000 2001 2002 2003 2004 2005

UK (millions)

Jersey (tens of

thousands)

Source: Authors’ calculations, based on data from the International Labour Organsation (ILO), available at http://laborsta.ilo.org/. The UK financial sector data includes real estate and insurance.

Figure 4: Financial Sector Wages in Jersey and the UK, 1997-2005 (Pounds/Week)

0

100

200

300

400

500

600

700

800

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

UK

Jersey

Source: Authors’ calculations, based on data from the International Labour Organsation (ILO), available at http://laborsta.ilo.org/. The UK financial sector data includes real estate and insurance.

28

Figure 5: Payoff Matrix when there is no Tax Haven

Country B

Tax Rate: 50% Tax Rate: 0%

Country A Tax Rate: 50% 110, 110 55, 150

Tax Rate: 0% 150, 55 100, 100

Figure 6: Payoff Matrix when there is a Tax Haven

Country B

Tax Rate: 50% Tax Rate: 0%

Country A Tax Rate: 50% 105, 105 105, 100

Tax Rate: 0% 100, 105 100, 100

Figure 7: US Investment in Tax Havens and Corporate Tax Revenues, 1994-2006

0

5

10

15

20

25

30

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

% of US FDI in Tax

Havens

% of US Federal Tax

Revenue from

Corporate Taxes

Source: Authors’ calculations, based on data on FDI and US corporate tax revenues from the US Bureau of Economic Analysis, available at http://www.bea.gov. Tax havens are defined as in Dharmapala and Hines (2006). while Figure 8 uses the OECD definition (see Table 1).

29

Figure 8: US Investment in OECD-Designated Tax Havens and Corporate Tax Revenues, 1994-2006

0

2

4

6

8

10

121

99

4

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

% of US FDI in OECD-

designated Tax Havens

US Corporate Tax

Revenue as a % of US

GDP

Source: Authors’ calculations, based on data on FDI and US corporate tax revenues from the US Bureau of Economic Analysis, available at http://www.bea.gov. Tax havens are defined as in OECD (2000) – see Table 1.

Figure 9: UK Investment in Tax Havens and Corporate Tax Revenues, 1994-2006

Source: Authors’ calculations, based on data on UK FDI from the UK Office for National Statistics, available at http://www.statistics.gov.uk/ and on data on UK corporate tax revenues from the European Commission’s “Taxes in Europe” database, available at http://ec.europa.eu/taxation_customs/taxation/. Tax havens are defined as in Dharmapala and Hines (2006).