Tax havens and the Panama Papers

Jim Stewart: This blog is about tax havens: their growth; functions, characteristics, and how they might be defined. A related blog tomorrow considers in greater detail the role of Mossack Fonseca (the Panama firm at the centre of the leak), whether Ireland is a tax haven, and some of the effects and policy issues arising from publication of the Panama Papers.

The Panama Papers, consisting of 11.5 million documents, is the largest ever leak of confidential documents . Apart from the contents there is considerable interest in who leaked this information and why. It is likely to have involved considerable expertise – all communications were encrypted. The data was leaked over a 12 month period, with the latest data relating to Spring 2016, without discovery, and there was no payment.

This was achieved despite previous leaks. The Guardian newspaper has reported that Mossack Fonseca “previously suffered a smaller leak from its branch office in Luxembourg. German tax authorities bought the data for around €1m (£800,000) and in February 2015 carried out a series of raids across the country on more than 100 people suspected of dodging taxes”.

The Panama Papers relate to just one firm, and hence represent a small fraction of income and asset management that takes place in tax havens / low tax jurisdictions. The leak has drawn world wide attention to tax havens and their role.

The growth of tax havens / low tax centres 

Developing tax havens and sectors with tax haven type features, such as offshore financial centres, is widely seen as a means to economic success, especially for small, peripheral countries (population under 1 million). As a result one estimate is that 8% ($7,600 billion) of the global financial wealth of households is held offshore (Zucman, The Hidden Wealth of Nations: The Scourge of Tax Havens, 2015 p. 53), and the global loss in tax is estimated to be $200 billion of which $78 billion is lost in Europe (Zucman, p. 52-53).

Other sources have suggested a much larger figure of global wealth held offshore of $21,000 to $32,000 billion, with a resulting estimated tax revenue loss of $189 billion. This latter estimate depends on strong assumptions about the relationship between bank deposits and total financial net worth. This study assumes that a “conservative” estimate is that total financial net worth is 3 times bank deposits. This wealth has become increasingly concentrated so that most of the assets of the wealthy are held through tax havens.

Functions

The two main functions of tax havens are exploiting differences in tax and regulatory systems (tax and regulatory arbitrage). This is facilitated by secrecy in terms of transactions taking place and beneficial ownership.  Not surprisingly avoidance of tax and/or regulation and secrecy are often associated with illegal activities.

Tax havens operate as conduits. Assets do not stay in tax havens but are used mostly in developed economies. Assets located in tax havens are large and may be a multiple of a countries GDP. Most world Foreign Direct Investment (FDI) flows through countries that appear on lists of tax havens, such as Luxembourg and the Netherlands. Hence tax havens and financial centres are closely connected.  One of the reasons why Ireland is sometimes classified as a tax haven is due to the size of the IFSC (with assets  of €2300 billion or 16 times GNP in 2013).

Competition between tax havens, low tax regimes and offshore financial centres, ensures  costs, regulation and tax regimes are as all as favorable as possible for inward investment. For example, policy documents in relation to a tax regime in Ireland known as a ‘Knowledge Development Box’ states the need to “enhance further the competitiveness of Ireland’s overall corporate tax regime” and ensure a “best in class offering”.

How to define a tax haven

A tax haven has several distinctive features (1)  low or no tax; (2) ease of incorporation; (3) secrecy; (4) a well established infrastructure providing banking, legal, company formation and secretarial services ; and (5) a large offshore financial  centre.

These features are present in many countries that would not be generally considered to be tax havens. For example Shaxson argues that the city of London “is at the centre of the most important part of the global offshore system” (Nicholas Shaxson, Treasure Islands, p. 15) with many of the attributes of a tax haven (Shaxson, p. 247-252). Ease of incorporation and secrecy in relation to beneficial owners are key attributes.

What countries are tax havens?

Tax havens are difficult to define precisely, and those that are defined as a tax haven may lobby intensively to be redesignated.  Hence as Shaxson (p. 8) notes, it is very difficult to agree on the definition of a tax haven,  as illustrated in the following example.

The OECD was requested in 1996 to develop measures to counter “the distorting effects of
harmful tax competition”. A Report issued by the OECD (2000) identified 35 ‘jurisdictions’ which met the tax haven criteria (p. 17). That is: no or nominal taxes; lack of effective exchange of information; lack of transparency; no substantial activities.

Some countries were omitted from the OECD list because they made an “advance commitment” to eliminate harmful tax practices.

Tax havens were subsequently classified by the OECD into cooperative tax havens that agree to remove harmful tax practices (35 countries) and uncooperative tax havens (3 countries). No tax haven is currently regarded as uncooperative. In its most recent Progress Report the OECD (2012) state that all countries have “substantially implemented the internationally agreed tax standard”, with one exception (Nauru) which has agreed to implement the standard but have not yet done so.

Hence there is no country that meets the four OECD criteria of being a tax haven, and only
one country that the OECD consider to have a harmful tax practice.

At the same time  numerous lists of tax havens have been produced.  For example, the U.S. Government Accounting Office, (2008, p. 12‐13) lists 50 countries including Ireland, Luxembourg and Switzerland, as tax havens, and more recently the report by the U.S. Senate Permanent Subcommittee on Investigations (2013, p. 3) groups Ireland, with Bermuda and the Cayman Islands as tax havens.

The U.S. based Citizens for Justice in a 2016 report rank Ireland in the top 10 tax havens (along with Luxembourg, the Netherlands and Switzerland) in terms of U.S. corporate profits. This latter reports the effective tax rate on U.S. subsidiaries in Ireland, using I.R.S. data for 2012 at 2%.

Given the multiple aspects of tax havens and the difficulty of agreement on what a tax haven is, the Tax Justice Network focus on “secrecy“ as a key element and publish what is termed a secrecy index - a combination of secrecy with global financial services exports. The top six countries ranked by secrecy are:- Switzerland, Hong Kong, USA, Singapore Cayman Islands , and Luxembourg. Panama is ranked 13, UK 15, Bermuda 34 and Ireland is ranked 37.

The EU has recently announced that member states have agreed to establish a “joint” list of tax havens. The EU had previously published a list of 30 “uncooperative” tax havens in June 2015. This list was derived from lists that appeared in at least 10 member states lists of tax havens, and includes island states that are probably too poor (Niue, Nauru) to provide the necessary paperwork to avoid being defined as a tax haven, but excludes countries that many would regard as tax havens such as, Luxembourg and Jersey.

Despite the release of extensive evidence showing the use of offshore tax planning strategies involving Panama, prosecutions  may still be difficult.

Providing lists of tax havens, cooperative or not, and which are partly determined by political influence, is not a solution to tax evasion and harmful tax avoidance.

A related blog tomorow considers in greater detail the role of Mossack Fonseca (the Panama firm at the centre of the leak), whether Ireland is a tax haven, and some of the effects and policy issues arising from the publication of the Panama Papers.

Prof. James Stewart is a member of TASC's Economists' Network

This is Part 1 of a series on the Panama Papers. Part 2 is available to read here.