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Friday, December 19, 2008

The Moral Defense of Tax Havens

The following is abridged from a speech delivered at “Evenings at FEE” in June 2006.

My job this evening is to present a moral defense of tax havens. To do so I need to explain why tax competition is important, to clarify why it depends on tax havens, and to demonstrate the valuable role tax havens play in the global economy.

Let me first define what a tax haven is and examine the international controversy behind this issue. A tax haven is any jurisdiction, anywhere in the world, that has preferential rules for foreign investors. A country that presents itself as a tax haven does not believe it has any obligation to help enforce the tax laws of other countries. Here is a simple stereotype of a tax haven: you take your money, you bring it to Switzerland, you deposit it in a Swiss bank account, and the Swiss authorities, by law and by their constitution, will not report the transaction to your home country’s tax authorities. That is a tax haven.

Tax havens play an important role in the global economy because of tax competition. Globalization has increased the mobility of the two main factors of production: capital and labor. Today the lower costs of technology and communication make it extremely easy for capital to cross national borders. Just a couple of clicks of your mouse, and capital can be in a different jurisdiction. Even labor is becoming increasingly mobile and crosses national borders in order to seek a better environment with a lower aggregate tax burden and more reasonable marginal tax rates. Three historical episodes over the last 25 years clearly demonstrate that tax competition imposes a significant constraint on the ability of politicians to tax and to spend.

In the 1980s both Margaret Thatcher and Ronald Reagan took office in miserable economic times. Both inherited very high tax rates. In the United States the top tax rate was 70 percent (our top tax rate today is 35 percent). In the United Kingdom the top tax rate was 83 percent. By the time you factored in capital gains taxes, corporate taxes, and death taxes, the effective marginal tax rate in many cases was over 95 percent. Both Reagan and Thatcher radically slashed tax rates. In the United States the top tax rate went down to 28 percent and in Britain, down to 40 percent.

It is most interesting that the Thatcher and Reagan tax cuts forced industrialized nations to cut their respective income-tax rates. Why? Because a lot of the world’s capital started shifting to the United States and Britain. This told the politicians in other countries that they better cut their tax rates as well. Here is a simple analogy: imagine there is only one gas station in a town. It can charge high prices. It can offer shoddy service. It can maintain inconvenient hours. If that’s the only gas station in town, you just have to accept it. But what happens when five gas stations open in that same town? All of a sudden you, the consumer, become king. The gas stations have to maintain market prices; they have to hustle to get your business; and they have to offer good service. The same principle applies to governments in the matter of taxation.

Twenty years ago Ireland was a true economic basket case, with 17 percent unemployment, a 50 percent corporate tax rate, a 65 percent top income-tax rate, a 50 percent capital gains tax, and a huge government that consumed over 50 percent of the country’s GDP. Their biggest export was their own people.

Ireland finally decided, “we’d better go on a new path,” and dramatically cut tax rates. Income tax went from 65 to 40 percent; the capital gains tax from 50 to 20 percent; the corporate tax all the way from 50 to 12.5 percent. It is no mystery and no surprise, or at least it shouldn’t be to people in this audience, that Ireland boomed. It has risen from the proverbial sick man of Europe to the Celtic Tiger. Ireland is now the secondwealthiest nation in the European Union.

Just as country after country lowered income-tax rates following the Reagan-Thatcher reforms in the 1980s, we witnessed almost the same level of corporate tax rate reduction following the Irish boom in the 1990s. If you read the actual reports in the international tax press, in almost every single case it’s all about “we’d better cut our tax rates because we’re losing business to countries that are lowering their tax rates.” As a matter of fact, there has been so much tax competition motivated by corporate tax reduction in Europe that every single European country, even socialist welfare states like France and Sweden, now has a lower corporate tax rate than the United States.

The third example of tax competition is the flat-tax revolution in Eastern Europe. In 1994 a 32-year-old Prime Minister, Mart Laar, under the influence of Milton Friedman’s ideas, adopted a flat tax in Estonia. It worked so well that Latvia implemented a flat tax the next year, and Lithuania the year after that. The rapid economic success of the three Baltic countries and the growing tax competition stimulated Russia to also put into place a flat income tax. Today the former Evil Empire has a 13 percent flat tax!

What happened next? Ukraine, Serbia, Slovakia, Romania, Georgia, and, just this year, Kyrgyzstan implemented the flat tax due to tax competition.

Capital: The Key to Growth

Tax havens are the sharp point at the end of the spear of tax competition because the most damaging taxes are those on capital. Every single economic theory agrees that capital formation is the key to long-run growth and higher living standards. In other words, you have to set aside some seed corn today in order to have higher production and output tomorrow.

But what happens if you save and invest? Historically in most developed countries, that’s what gets you the very highest tax burden! Politicians, when it suits their purposes, understand the role of taxes in the economy perfectly well: the more you tax something, the less you get of it. But politicians obviously fail to understand this when it comes to saving and investing. For example, in the United States between the capital gains tax, the corporate income tax, the personal income tax, and the death tax, a single dollar of income that is saved and invested can be taxed as many as four times. Even if the rates are low, by the time you cycle a dollar of income through the tax code four different times, your effective marginal tax rate can be very high.

If you look at all the tax-reform plans that are out there, what is the common theme? They all propose taxation of economic activity at a low rate and only one time. There is no double taxation of capital at all: no capital gains tax, no double tax on dividends, and no death tax. Economists understand that all the forms of double taxation in the current system are punitive and self-destructive because they are literally destroying people’s incentive to provide that seed corn for future economic growth. Public choice economics clearly explains that politicians have an incentive to divide people in order to maximize votes, to expand budgets in an attempt to buy votes, and to appease more interest groups. Even those who understand the lessons of economics and the role of taxation cannot resist the temptation to implement tax policies that common sense should tell them are destructive for the economic health of a country.

How can we counteract this powerful political influence? This is where tax havens play a very valuable role in providing a safe refuge and protecting capital from being double, triple, and quadruple taxed. As I explained before, many countries in Europe abolished or reduced double taxation solely for the purpose of trying to keep capital from escaping to Switzerland, Luxembourg, New York, and the Cayman Islands. By the way, the United States is also a tax haven, just not for Americans. Foreigners can invest money here with no taxation of interest or capital gains, and without being reported to their home governments. Unfortunately U.S. citizens do not get the same treatment.

In other words, tax havens not only stimulate economic reforms to lower taxes around the world, but also play an important role in reducing the level of double taxation of savings and investment.

This is the economic case for tax havens, but there is also a moral one. Here in the United States we complain about our government wasting a lot of money. And it does. We complain about tax rates being too high. And they are. But we are still pretty lucky. We live in a society where your chances of being actually oppressed are small. For most of the world that is not the case.

Most people do not have the freedoms we take for granted. Many are subject to religious, ethnic, or racial persecution; many to economic abuse. Imagine, for example, that you are an ethnic Chinese entrepreneur in Indonesia. The Indonesian government unofficially approves of, or at least doesn’t discourage, periodic rioting against you because you belong to the wealthy segment of a population and also happen to be an ethnic minority. Under such circumstances would you keep your money in an Indonesian bank or transfer it instead to the United States, Singapore, or Hong Kong? I think the answer is obvious: you would not keep it in an Indonesian bank. Let us also remember that in 1934 Switzerland deliberately strengthened their tax-haven secrecy rules and thus became the best refuge for the Jews persecuted by Hitler.

Now let’s imagine two Argentinean families in the 1990s. One kept their money in a local bank, the other in Miami. As you remember, in 1998 the incompetent Argentinean government caused a complete economic disaster: the currency collapsed, and more than half the wealth of the population vanished. If you were the lawabiding Argentinean, trusting your government and keeping your money in a local bank, your life savings had an involuntary “haircut.” On the other hand, the family who banked offshore in Miami weathered that storm because they chose not to trust their incompetent government.

What about those who live in Colombia, Venezuela, or Mexico, where tens of thousands of kidnappings happen every year? How do kidnappers target their victims? There are documented cases of the kidnapping gangs bribing the corrupt tax authorities for information about people with financial means. I side with all the Latin American families who refuse to keep their money in a local bank and try to maintain a very low profile so nobody can obtain information about their financial status. They do so not necessarily to dodge taxes, but to protect their children.

In other words, for most of the world tax havens mean much more than just “tax cheats.” It is about the ability of individuals to protect their fundamental human right: not to passively wait for slaughter, like a fatted calf, until the government decides either officially or unofficially that time has come to persecute, mistreat, or abuse them.

Whether for Jews in the 1930s or for ethnic Chinese in Indonesia today, tax havens have played and continue to play an extremely valuable role in protecting people from oppressive governments.

Today there is a real-world political battle going on. We are confronted with two alternatives: to fix the tax system or to create a global network of tax police. The high-tax governments of the world understand that tax competition is a threat to their redistributive policies. They are working through international bureaucracies like the Organization for Economic Cooperation and Development (OECD), the European Commission, and the United Nations to try to stamp out tax havens.

We, as advocates of the free market, argue that tax havens put pressure on governments to lower marginal tax rates, reduce or eliminate double taxation of savings and investment, and stimulate continuous economic growth.

But I would go one step further. In the grand scheme of things, the issue of tax havens involves much more than tax competition alone. It involves a moral imperative. Whether providing a refuge from government incompetence and corruption or from persecution and oppression, tax havens play a critical role in protecting life, liberty, and property.

Daniel J. Mitchell has been the leading international voice in the fight to preserve tax competition, financial privacy, and fiscal sovereignty. His audiences have included the Business Roundtable, the National Federation of Independent Business, the Swiss Bankers Association, and the Bermuda International Business Association. He has appeared on CBS, NBC, ABC, CNN, CNBC, and C-SPAN.

A prolific writer, Dan is the author of The Flat Tax: Freedom, Fairness, Jobs, and Growth and of numerous articles published in the Wall Street Journal, Washington Times, New York Times, Forbes, Offshore Investment, and Investor’s Business Daily, among others.

Dan Mitchell holds a Ph.D. in economics from George Mason University. He serves as the McKenna Senior Fellow at the Heritage Foundation and is the founder of the Center for Freedom and Prosperity.