The Role of Tax Havens in Global Finance

When we think of “tax havens,” images such as palm trees with sand lodged between toe crevices or small countries teeming with corporate offices may come to mind, or dark laundromats where illicit wealth from illegal activities like extortion, fraud, bribery and human trafficking is washed clean before being reinvested back into global financial markets may also come to mind.

Legality

Tax havens provide individuals and corporations alike with anonymity, reduced taxes and lax regulations in an effort to decrease their overall tax burden. Furthermore, tax havens offer services like investment management, professional advice and wealth storage – offering peace of mind as they reduce overall taxable burden.

Individuals and firms use tax havens to avoid income, capital gains and wealth taxes by shifting profits to them via various mechanisms. The Panama Papers revealed how wealthy individuals and companies from around the world used Mossack Fonseca’s offshore accounts in Switzerland for stashing assets offshore.

Tax havens provide an effective means of concealing assets from governments, leading to a race-to-the-bottom in corporate tax rates and altering official GDP statistics by concealing foreign investments into local firms.

Researchers have noted that an indicator of tax haven status is an increase in GDP-per-capita rankings alone; such countries’ headline economic statistics are artificially inflate by BEPS flows they facilitate. Others contend this metric fails because it fails to include oil and gas producing nations.

Transparency

Tax havens may conjure images of balmy island nations with lax financial deposit regulations and an antipathy toward foreign authorities, with little in the way of taxes or reporting rules for non-residents looking to stash wealth there. While these classic tax havens still exist today, their number has greatly expanded as numerous jurisdictions now offer themselves as potential locations to stash wealth with minimal or no taxes and flexible bank reporting requirements for non-residents.

Secrecy may provide advantages to individuals and businesses, yet governments lose out by not receiving valuable tax revenue for infrastructure development and public services. According to estimates by Gabriel Zucman and James Henry, global individual income tax losses caused by offshore finance centers total up to $200 billion annually.

Transparency measures may help address these challenges, as demonstrated in our hand-collected subsidiary data set. Increased transparency from staggered signing of bilateral tax information exchange agreements (TIEAs) between home and tax haven countries is associated with an approximate 2.5% increase in firm value.

Profit Shifting

Profit shifting by companies, individuals and investors hurts developing countries by undercutting economic growth. Furthermore, this practice contributes to financial instability as evidenced by the global 2008 crisis.

Tax haven operations involve creating one or more legal entities within a tax haven country and attributing any income earned outside to those entities as a means of evading paying taxes in their home countries. Such activities can help accumulate personal wealth at lower rates while shifting business profits elsewhere.

We present an empirical model combining standard gravity controls and firm fixed effects to estimate the trade propensity of firms with affiliates located both in tax havens and non-havens. The findings from this model reveal that service trade with haven affiliates tends to favor imports over exports, possibly reflecting profit shifting by affiliates. It further supports evidence suggesting offshore finance opens are negatively related to GDP per capita in some countries.

Competition

Tax havens compete with other global finance institutions on many fronts. Individuals looking to hide wealth from taxes may find shelter there; however, an increase in international agreements like TIEAs and MLATs may soon lessen tax havens’ competitive edge by making it harder to conceal information regarding foreign assets.

By employing simple gravity models and firm fixed effects, we demonstrate that service trade between haven affiliates and non-haven affiliates with comparable size, distance and other standard trade determinants is six times larger – most likely driven by profit shifting.

These results are derived from estimates of capital flows to and from tax havens compiled using estimates generated from global national accounts data, corporate records and BEPS tools (Zucman 2017). They suggest that many of the world’s largest offshore financial centers (OFCs) serve as conduits through which much wealth moves while any leftover monies may be stashed away in sink OFCs with lax or opaque regulations.