Thursday, July 10, 2008


One of the most interesting discussions among the economists and policy experts is a debate about the role of tax havens and offshore destinations that compete with other nations in the areas of taxes, regulation and investor protection. The opponents of tax havens believe that tax havens cause an enormous damage to the economies on the other side of the world since (in their opinion), tax havens are the fundamental reason for the lack of reinvestment and capital flight in onshore economies. The real reason why tax havens are prosecuted by governments is that governement agents seek the highest possible utility from tax revenues in the form of rent-seeking that would yield more power and revenue.

Taxes and Regulation

There are two reasons for high tax rates. One is that in case of high government spending, the structure of tax rates must be high enough to avoid excessive deficit spending that could impair domestic macroeconomic stability. First, the real threat to macroeconomic stability is not deficit but the size of government spending. Also, excessive deficit spending is a threat to domestic macroeconomic stability because of the so called crowding-out effect where high government spending crowds out investment in the private sector. The net outcome is higher interest rate that arises from an increased scarcity of investment that is caused by budget deficit and high government spending. Second, the basic assertion of the Laffer curve is that high tax rates produce a bulk of negative effect. For example, when Sweden had the highest marginal tax rate in the world excessing 80 percent, the net result had been a decreasing tax revenue and when marginal tax rate were reduced, tax revenue soared. However, the real aim of tax rate reduction is not the growth of government revenue but welfare and the right of taxpayers to use the disposable income they earn. Empirical evidence suggests that prudent macroeconomic discipline such as principles of low tax burden, limited spending and adherence of price stability by the central bank result in the improvement of conditions for economic growth and stabilization process regardless of asymmetric shocks. What about regulation? Government regulate for two reasons. First, to remove the negative effects of market imperfections and second, to insure public goods. However, predatory tax rates, the growth of tax burden and the regulation of the private sector are designed seek monopoly rents in an unregulated way. While sound regulation can certainly offset the sideblocks of negative externalities such as free-riding, excessive regulation is hampering the growth of real productivity which is essential to the standard of living and the quality of life.

Tax Havens

Dan Mitchell recently explained (link) the positive role of tax havens in a global economy. From a basic perspective, minimal tax burden in tax havens is a liberalizing force in the world economy since, given capital mobility and the fluidity of knowledge, destinations with higher corporate and personal income tax burden have no choice but to reduce tax rates on productive behavior. Flat tax revolution, that was initiated by Estonia in early 1990s, also helped reduce corporate tax rates in continental Europe and Scandinavia. Given the lack of data, there are hardly any empirical studies researching the impact of tax rate reductions on tax revenue. When Swedish economy faced an onerous macroeconomic instability marred by high inflation, low output growth, declining productivity growth and a sudden dramatic increase in the interest rate (to 500 percent overnight) by Riksbank, top marginal tax rate was 84 percent. Consequently, economic growth decline and public spending grew and shrank into deficit, pushing the real interest rate up, as explained by crowding-out effect (link). When the economy is on the line of potential output, expansionary fiscal policy boosted money demand which, in turn, induced the increase in the real and nominal interest rate. As a consequence, Swedish economy faced a declining investment. Firstly, because corporate tax rate was excessive and secondly, because crowding-out effect took place. Regarding tax havens, supply-side economic and tax policies induced the trend of lowering tax rates on all sources of productivity ranging from investment, savings and entrepreneurship to labor supply. Concerning regulation, high corporate tax rate and excessive regulation usually go hand in hand since the regulation of the private sector is mostly an implicit insurance against the loss of control and - hence - the loss of tax revenue that is needed to finance government spending.
Empirical observation

I took a closer view on the comparative analysis of tax havens and onshore jurisdictions that impose higher mandatory tax rates on corporate and personal income tax as well as more excessive regulation. I downloaded the data from World Bank's Governance (link) and used a correlation analysis tool to analyze related motions of corporate tax rate, the rule of law and regulatory quality on each of these variables. An important note is that it depends on what is meant by 'regulatory quality' since World Bank oftenly criticizes tax havens. Concerning governance, tax havens scored lower than Germany and Austria - countries with high and almost punitive corporate tax rate. Despite a shaddy and imperialist fiscal agression on Liechtenstein, Germany still enjoys an enormously high score on the rule of law and regulation. However, I did not take a detailed look at methodological details even though I can say that there are extreme bias towards what regulatory quality really is.

This chart, for instance, shows a log-linear relationship between corporate income tax and regulatory quality. Considering trend line - estimated by a polynomial of second degree, countries with higher corporate income tax also have sounder regulation. But, if you take a closer look, it can be seen that trend line declines slightly in the area where there is a high concentration of countries (France, Spain, Belgium, Germany...). From WB's data, a curious reasearcher would conclude that higher taxes are good and tax havens have a tighter regulatory quality. However, the relationship in the chart is intuitive since R-square is 0,0436 which means that the variation of the independent variable explains only 4,36 of the variation of the dependent variable.

This chart(log-linearization of the relationship between corporate tax rate and the rule of law) shows that countries with high corporate income tax rate also have comparatively decreased rule of law. Again, it all depends on what is meant under the rule of law. For example, if offshore services are legally recognized in Cayman Islands, and if World Bank's governance methodology treats that as irresponsible, then Caymans will receive a lower score on the rule of law. As you can see, Iceland has the highest rule of law and a modest corporate tax rate (16 percent down from 18 percent). Interestingly, Netherlands Antilles are a tax haven more in terms of regulation and information disclosure than in terms of taxes since 34 percent corporate tax rate seems to be highly sensitive to the rule of law. In fact, many so-called tax havens have a higher rule of law than continental countries. For instance, Cayman Islands have a higher rule of law than Spain, Singapore has a higher rule of law than Germany, Belgium and France etc.

As a conclusion, tax havens are the force of liberalization in the global economy and when surveys (such as WB's) are conducted, it's good to review the methodology and measurement of particular indicators. There are bias everywhere.

Rok Spruk is an economist.

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