Crackdown on tax competition will hinder trade and development

If we look at the performance of high-tax Western countries – which includes, amongst others, every EU country, plus the US – it is grim. These are the countries which, despite their high levels of taxation, are building up huge debts. These countries also regulate their financial systems heavily, often through bodies which have huge discretion, and yet they have recently suffered the worst financial crisis since the World War II. You would think that it would be this model – the corporatist model of high taxes and extensive regulation – that would be coming under scrutiny. However, like small children who wish to shift the blame, the EU is focusing its attention on International Financial Centres (IFCs).

IFCs are not entirely immune from the financial crisis. Cypriot banks, for example, managed to channel huge amounts of Russian capital into investment projects that did not pay off in other parts of the EU. But, as we look more closely at the Cypriot problem, we see the finger prints of the EU’s extensive system of government intervention all over that crisis too. The ECB has been supporting the governments and banking systems of countries in crisis – including Greece, which is closely connected to Cyprus – thus throwing fuel on the fire. Also, Cypriot banks were subject to the same failed capital regulations as banks in other EU countries – indeed, they were well capitalised by Basel standards. Not only that, Cypriot banks failed partly because they were over-concentrated in Greek assets and Greece is not an IFC.

Cyprus does, though, provide us with some lessons on how to deal with a crisis. If one of the advantages of IFCs is that they are immune from the regulatory overkill of other countries, then those who invest through IFCs must bear the risks. The flip side of the absence of supposed regulatory protection must be market discipline. We must ensure that investors through banks in IFCs lose their money if the bank goes under and that banks are structured so that assets and liabilities can be quickly understand and a winding-up procedure take place.

So, the Cyprus crisis has no general lessons for our understanding of the success or otherwise of IFCs. What we do know, however, is that those countries that are the most vocal in criticising IFCs have nothing to crow about. Non-IFCs and regulators had a very bad crisis; IFCs, hedge funds and other offshore investment vehicles had a very good crisis.

Just as offshore centres came into being as a result of incompetent regulatory and tax policy from the US government in the 1960s and 1970s, these centres are just as important today in ensuring the free flow of international capital. The nature of our corporation tax systems is such that investors can be taxed several times over on the same profits. Companies can be taxed when they make profits; investment funds can be taxed on their returns; and investors in funds can be taxed by their home tax authorities. In addition, capital gains tax systems often end up taxing companies when their share price rises as a result of the retention of profits or the anticipation of future profits even though extra tax is levied on those profits when they accrue.

If government reformed their corporation tax systems so that they were coherent and focused on the shareholder rather than on the activities of companies themselves, there would be much less need for IFCs.

IFCs also ensure that businesses and consumers can avoid pointless regulation whilst facilitating free trade in financial services. An insurer regulated in France does not need to buy reinsurance from firms that are, themselves, heavily regulated. The insurer can look after itself and, insofar as regulation helps consumers at all, the French insurance regulation should look after the company’s customers. Just as IFCs help individuals and companies to overcome costly duplication and double taxation, the same is true in the area of regulation.

Opponents of IFCs argue, however, that such regulatory competition leads to a ‘race to the bottom’, forcing governments to adopt light-touch regulation to prevent firms taking their business elsewhere. Similar arguments are applied to taxation, with the existence of IFCs said to make it harder for governments to maintain revenues from taxes levied at high rates. The behaviour of multi-national corporations is a major focus, since such firms find it relatively easy to relocate or adopt accounting procedures that take maximum advantage of variations in tax and regulation between different administrations. This is certainly the case with ‘footloose’ companies in the financial sector, which rely less on physical capital than other businesses. The large size of the financial sector makes the economies of the UK and its overseas territories particularly sensitive to the impact of competition from and between IFCs.

Fortunately, there are major economic benefits from such competition. There are very strong incentives for politicians to increase public spending (and hence taxes) in order to gain the support of powerful special interest groups and raise their chances of re-election. Partly as a result, most Western governments now confiscate around two-fifths of people’s earnings. And with such high tax rates many wealth-creating economic activities are no longer viable. Indeed, long-term studies suggest that every 1 per cent added to the level of taxation (as a share of GDP) tends reduce economic growth by about 0.15 per cent a year. Accordingly, a 10 per cent increase would decrease average growth rates by around 1.5 per cent a year. High rates of taxation therefore have a very significant and negative long-term impact on living standards.

Lower levels of overall economic output mean fewer resources are available to spend on areas such as health and education. Arguments that high tax rates are necessary to fund essential public services are therefore deeply flawed. High-tax, high-spend policies are entirely counterproductive since their negative effect on economic output inevitably results in lower public spending in the long term. While state spending may absorb a larger share of the economy under the high-tax approach, the overall size of the economy will be much smaller, limiting the resources available to government.  

This is one reason why the existence of IFCs is so important. They act as a deterrent to predatory politicians who wish to raise tax rates to highly damaging levels. Policymakers know that if they set tax rates are too high, business activity will shift to lower tax jurisdictions. The point at which tax increases no longer result in additional revenue to governments is therefore shifted downwards by competition from IFCs, and this means tax rates will tend to be closer to the optimal rate for economic growth.

Downward pressure on taxes and regulation is not just beneficial for wealthy economies such as the UK; it also helps developing countries. By reducing the fiscal and regulatory barriers to entrepreneurial activity, IFCs increase the opportunities for trade between rich and poor countries - a mutually beneficial process that raises living standards and reduces poverty.  

Nevertheless, there have been huge campaigns waged recently against IFCs. The latest is the ‘If’ campaign being run by a group of charities which claim that if only companies stopped dodging taxes, there would be enough food for everyone. Often, of course, companies avoid tax by using IFCs combined with transfer pricing to ensure that no profits are paid on the gains from intellectual property. Development charities simply do not understand that the real problems facing poor countries is not that businesses don’t pay enough tax in poor countries but that there is simply insufficient business activity. This is normally because the conditions for a thriving business economy – the rule of law, enforcement of contracts, absence of corruption and so on – do not exist. There are ways of ensuring that a company operating in a poor country makes a tax contribution regardless of its profits – for example, through land-use taxes. However, developing countries will be most effective in raising the condition of their people when they create the right conditions for business and not by using business profits as a tax milch cow. Indeed, under-developed countries could learn much from IFCs in terms of how to create the right business environment.

The importance of IFCs to the process of economic development, both as exemplars and facilitators, is a major reason why policymakers must resist calls to crackdown competition in tax and regulation. As well as diverting attention from the real causes of poverty, a crackdown on IFCs would hinder the trade and entrepreneurship that drive higher living standards. Moreover, if rules are tightened, the multinationals which are such a focus of anti-IFC campaigns are likely to benefit at the expense of small, local businesses. Large firms can afford to employ expensive tax lawyers and accountants in order to navigate their way through complex new rules, whereas their smaller competitors would face disproportionate compliance costs. It would be a tragedy if well-meaning development campaigners helped bring about policies that actually increased poverty by hindering international trade and suffocating small businesses.

This article originally appeared in the IFC Economic Report.

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