A lecture presented to the One World One Wealth Conference by John De Val
The recent controversy about companies such as Starbucks, Amazon and Google avoiding UK taxes have made tax havens a high profile subject. Public opinion generally considers their use to avoid taxes as unethical. This note looks at whether such use gives rise to a situation which is unjust. But, first, some background.
What are tax havens and where are they? The term ‘tax haven’ is a bit of a misnomer, for these places don’t just offer an escape from tax. One useful definition is ‘a place that seeks to attract business by offering politically stable facilities to help people or entities to get around the rules, laws and regulations of jurisdictions elsewhere’. The whole point is to offer escape routes from the duties that come with living in and obtaining benefits from society – tax, responsible financial regulation, criminal laws, inheritance rules and so on. This is their core business. The special feature that concerns us here is that they offer very low or zero taxes.
There are about fifty tax havens in three main groups. First are the European havens e.g. Monaco, Switzerland, Luxembourg. Second, is a British zone centred on the City of London, which spans the world and is loosely shaped around Britain’s former empire. It includes places as diverse as the Channel Islands, the Cayman Islands and Hong Kong. Third is a zone of influence focused on the United States.
How important are tax havens? Various organisations, including the IMF, have had a stab at estimating their global significance. They suggest that more than one half of world trade passes, at least on paper, through tax havens. The global offshore system also played its part in the latest financial crisis. The combination of impenetrable complexity and offshore secrecy, ‘foxed’ regulators and fed the mutual distrust between market players that worsened the crisis. Trust is a vital ingredient in any healthy economic system and there is nothing like the offshore system to erode trust. It is no coincidence that so many of the great houses of financial trickery like Enron, or the empire of the fraudster Bernie Madoff, were so thoroughly entrenched offshore. When nobody can find out what a company’s true financial position is until the money has evaporated, bamboozling abounds.
But let us focus now on the issue of tax avoidance. First it is necessary to distinguish between tax avoidance and tax evasion. It is simply defined; tax avoidance is legal, tax evasion isn’t. But there is a large grey area in between.
How is tax avoided? Answer: By artificially manipulating paper trails of money across borders. For example, consider the humble banana. Each banana takes two routes into your fruit bowl. The first route involves a worker in, say, Honduras, employed by a multinational, who picks the bananas, which are packaged and shipped to Britain. The multinational sells the fruit to a big supermarket chain, which sells it to you. Simple.
The second route – the accountant’s paper trail – is more roundabout. When a Honduran banana is sold in Britain, where are the final profits generated, from a tax point of view? In Honduras? In the British supermarket? In the multinational’s US head office? How much do management expertise, the brand name, or insurance contribute to profits and costs? Nobody can say for sure. So the accountants are more or less free to make it up. They might, for example, advise the banana company to run its purchasing network from the Cayman Islands and run its financial services out of Luxembourg. The multinational might locate the company brand in Ireland; its shipping arm in the Isle of Man; ‘management expertise in Jersey and its insurance subsidiary in Bermuda.
So the Luxembourg financing subsidiary now lends money to the Honduras subsidiary and charges interest at, say, $20 million per year. The Honduran subsidiary deducts this sum from its local profits, cutting or wiping them out (and its tax bill). The Luxembourg subsidiary’s $20 million in extra income, however, is only taxed at Luxembourg’s ultra-low tax haven rate. With a wave of an accountant’s wand, a hefty tax bill has disappeared and capital has shifted offshore.
Big Banana has performed a common offshore trick known as transfer pricing or, more accurately, transfer mispricing. In this banana example, tax revenue has been drained out of a poor country into a rich one. And poor countries with under-paid tax officials always lose out to multinationals’ aggressive, highly paid accountants.
Does tax evasion through tax havens give rise to injustice? Let us look first at how the different interested parties see the issue.
Governments in countries who are tax havens will of course see nothing wrong in offering companies registered in their territory lower taxes on corporate profits. It provides them with a source of revenue which is likely to be far greater and more reliable than other alternatives such as tourism.
Governments who lose revenue from tax avoidance, such as UK, see the situation very differently. They argue that even large global corporations are dependent on the state in many different ways. Their property rights are defended by the state. They often depend upon publicly provided infrastructure such as road and rail and need a workforce educated by state-provided schools and universities, and kept healthy by the health service. Some of the banks they rely on were rescued by the taxpayer. So corporations have a moral obligation to pay all their taxes owed to the state not just the ones they cannot avoid.
Governments in the less-developed countries are, as already noted, particularly harmed when global companies located there avoid paying taxes on their profits. Collecting tax is difficult enough in poor countries and corporation taxes, particularly from large firms should in theory be much easier to collect.
Ordinary tax payers will not generally be sympathetic to the activities of tax avoiders. In order to replace the revenue lost through avoidance, governments will need either to raise more money from taxes or cut public expenditure or postpone the pain by increased borrowing. None of these are positive outcomes for the taxpayer and they will, and do, resent the apparent unfairness.
Full tax paying competitors of tax avoiders are entitled to feel particularly aggrieved. Tax avoiders will presumably enjoy lower costs which can be passed on in lower prices or they will be better able to spend more on advertising and/or research to give them a competitive edge
The tax avoiders’ defence is usually brutally simple. It is legal. If it is possible to so arrange your activities so that the payment of tax is minimised this is just another aspect of business efficiency. Don’t blame us. Blame the governments who designed the tax system. This argument can be somewhat disingenuous. Many of the loopholes that are made use of are there because of lobbying, either by the corporations themselves or by other offshore interests. A second argument is that taxes are far too high in most developed countries and stifle business and economic growth. The existence of tax havens provides a competitive spur for these countries to reduce taxation on businesses.
So where does all that leave us? How would an impartial observer assess whether the use of tax havens gives rise to injustice? Well, it all depends. This, of course, is a deeply unsatisfactory answer. Depends on what? At the risk of being over-simplistic, it depends to a great extent on whether, by avoiding tax, companies are hanging onto a share of wealth created not by them, but by others; in particular, a share of wealth which rightfully belongs to the community.
Much public outrage is primarily an emotional response rather than one based on facts. It is by no means obvious why a tax on profits is a just tax in the first place. Profit as measured by accountants is a mixed bag. It can reflect both the ability of a company to create wealth and the enjoyment of some benefit which it has done nothing to earn. For example, a business owning land which has appreciated in value because of infrastructure improvements arising from public investment will gain a competitive edge over other businesses not enjoying that advantage. Their profits are likely to reflect that advantage. But by how much is very difficult to ascertain from the outside and the company itself may not know. So a uniform rate of tax applied to the profits of all companies is a very blunt instrument and, for some companies whose profits reflect very little unearned benefit, may very well be unjust.
Corporation tax is not the only tax currently levied that when considered from the point of view of justice does not stand up very well to scrutiny. The current furore over tax avoidance has put the spotlight on companies avoiding tax but the spotlight should be on the taxation system itself. It is doubtful whether the closing of tax loopholes and greater transparency will provide a greater measure of justice while the underlying system for collecting public revenue has so many flaws. A move towards a system based on ownership rather than earnings would appear to have the potential for greater justice. If the existence of tax havens is a catalyst for a serious examination of such a possibility then perhaps tax havens have their uses – but not, hopefully, for long.