Tax havens and development. Professor Guttorm Schjelderup Norwegian Commission on Capital Flight from Developing Countries

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1 Tax havens and development Professor Norwegian Commission on Capital Flight from Developing Countries

2 Mandate Assess the magnitude of illicit capital flows and the consequences thereof from a development perspective Put forward measures that can curb the harmful effects tax havens may have on development Provide recommendations that can be used as operational guidelines for Norfund, the Norwegian Investment Fund for Developing Countries Unanimous Commission 2

3 Illicit capital flows Illicit capital flows from developing countries are estimated at USD billion Even the lowest estimate exceeds the net legal inflow to poor countries Corresponds roughly to ten times the development assistance given Rich people hide capital in tax havens corresponding to US GDP Totalled USD billion in 2004 Rich people in developing countries constitute 20% of this number (overrepresented) Only 5% of rich people who place deposits in tax havens declare deposits 3

4 What sets tax havens apart (i): Ring-fenced tax system One set of laws for local firms that entails high taxation and normal regulation One set of laws for companies that conduct and manage their business in other states with zero tax conditions, lax (or no) regulation, and secrecy (foreign investor legislation) Business concept is to earn income on registration and administration fees The foreign investor legislation is so damaging that it is forbidden to use by domestic (tax haven) firms 4

5 What sets tax havens apart (ii): Legal system Tax havens Ring-fenced tax system Absence of information of any kind No obligation to deliver accounts (or no auditing and control) No preservation of records Legislation favours foreign investor (escape clauses and opportunity to move funds if third party inquires) Normal states No ring-fencing Public registers and information available Mandatory auditing and controls Record keeping requirements Balanced legislation (interests of society, minority owners etc) No exceptions granted, legislation generally enforced, substantial penalties Information Exceptions exchange and lax (if tax any) treaties do not eliminate these harmful structures enforcement of regulation 5

6 What sets tax havens apart (iii): Artificial structures Either this is the largest building in the world or the largest tax scam (US President Barack Obama, Jan. 5, 2008, debate in Manchester, N.H)..about Ugland House, a small building in Cayman Islands, where companies are registered and supposedly conduct their business (among them Coca Cola and Intel Corp.) No real activity is going on! Side/Page 6

7 What sets tax havens apart (iv): artificial structures British Virgin Islands (BVI) inhabitants/ registered companies; 43 companies pr. capita. Some BVI residents are nominated board members and directors of hundreds (and in some cases even thousands) of companies Illustrative of the lack of activity of substance. These companies are not the real beneficial owners (or residents) they live elsewhere! Tax havens are tiny with huge amounts of capital flowing through them. It is not profitable for them to enforce regulation, keep accounts, do random audits etc as long as they do not tax capital 7

8 Tax havens and economic development: Seven ways in which tax havens hamper development 1. Tax havens encroach heavily on the sovereignty of other countries 2. Tax havens harm the efficiency of financial markets 3. Tax havens undermine national tax systems and increase the costs of taxation 4. Tax havens reduce the efficiency of resource allocation 5. Tax havens make it more profitable to engage in economic crime 6. Tax havens hurt private income too 7. Tax havens hurt institutional quality (bureaucracy at large) and economic growth The negative impact of these factors may be an insurmountable hindrance to economic development in 8 poor countries

9 1.Tax havens encroach on the sovereignty of other nations It is generally acknowledged in international tax law that income is subject to taxation in the country where it originates (source principle of taxation) and that owners/residents should be taxed where they reside (residence principle) Tax havens grant tax residency to firms that operate in other states and are managed and owned by individuals residing in other states, and they block all information about these firms and owners. By doing so tax havens steal other countries tax bases 9

10 1.Tax havens encroach on the sovereignty of other nations The abusive legislation of tax havens means that they are attractive as a station for investments. This gives them a strong bargaining position towards poor countries in need of capital And tax havens exploit this position by signing tax treaties with poor countries where poor countries give away some or all of their taxing rights in exchange for capital (the most important tax base for them) Tax treaties are meant to alleviate double taxation but taxes are not paid anywhere under these 10 circumstances

11 11 2. Tax havens harm the efficiency of financial markets The financial crisis has shown us that financial institutions and private firms hide debt and assets in tax havens Stock exchange and insider trading; tax havens enable investors with inside information to disguise their identity Tax havens create information asymmetries between parties that hamper the efficiency of financial markets Increases the risk premium in financial markets Difficult to battle tax haven firms in court due to information asymmetries

12 3. Tax havens undermine national tax systems and increase the costs of taxation Tax havens make it harder to tax capital (unfair tax competition) Capital is the most important tax base in most developing countries Tanzania; The returns from only 286 enterprises contribute to 70% of national tax revenue As a consequence, tax revenue in poor countries falls and/or taxes are levied at a too high rate (to compensate) on the few remaining tax bases This hampers growth 12

13 4. Tax havens reduce the efficiency of resource allocation Tax havens increase the (private) after-tax return on projects that can easily use tax haven services Consequently, capital is allocated away from projects with a high return beforetax (which is what matters for growth), to projects with a high return aftertax Tax havens thus increase the difference in magnitude between after- and before-tax return and thus weaken growth. 13

14 7. Tax havens hurt institutional quality Empirical research: Institutional quality is very important for growth (public bureaucracy, process of law and democracy etc.) Improved institutional quality can increase national income sevenfold Tax havens make it attractive to steal resources from society (since the booty can be hidden) Tax havens provide the ruling elite with incentives to weaken their own countries institutional quality in order to facilitate theft from society 14

15 Tearing down institutions (i) Stealing taxpayers money means less investments in institutional quality Mobutu Sese Seko (former president of Congo, ) Stole annually approx % of the national budget in the 70s Money hidden in tax havens Income pr. capita in 1992 was half of what it was in 1960 Sani Abacha (former president of Nigeria); Stole at least 3 billion USD Zardari (president of Pakistan): 500 million USD (lowest estimate) Suharto-family (Indonesia); billion USD (interval estimate) 15

16 Tearing down institutions (ii) Extensive rainforests in the Philippines, Indonesia and Malaysia provided an opportunity for politicians to enrich themselves Research shows how the income from the rainforests contributed to the conscious destruction of state institutions in South-East Asia by politicians Research also shows that developing countries rich in oil deposits have become less democratic 16

17 Tearing down institutions (iii) Tax havens do not only offer a place to hide money thereby providing incentives to tear down public bureaucracy at large and the process of law. Tax havens may even affect (negatively) the way countries are governed!

18 Tearing down institutions (iii) There are 27 African countries south of the Sahara At the time of independence only five of these had a presidency, the rest were parliamentary democracies In 2009 all of the 27 countries had converted to presidency except for three (Mauritius, South-Africa and Botswana) There is a long list of presidents in these new states who have stolen from society (Mobutu Sese Seko, Sani Abacha etc) 18

19 Tearing down institutions (iv): The Paradox of wealth: On average resource endowments lead to lower growth 8 Growth Økonomisk vekst But there is country variation in the sample Some countries do really well! What distinguishes them? 0 0,0 0,1 0,2 0,3 0,4 0,5 0,6-2 y = -8,9817x + 2, Naturressurseksport/BNP Export of natural resources/bnp

20 Tearing down institutions (iv): Annual growth And the countries with good institutions are all parliamentary democracies Presidencies in many poor countries gather power in few hands with weak balances and checks Countries with good institutions Countries with bad institutions Natural resource exports/gdp

21 Concluding remarks on institutions and tax havens Tax havens means that the ruling elite in poor countries do not have to face the full consequences of their actions, since stolen assets cannot be recovered easily (and they have nowhere to flee) If we get rid of tax havens, the ruling elite will have to face their own actions (and countrymen). In the long run this will reduce crime and theft from society and lead to better and more stable institutions a prerequisite for growth and a better world

22 Some of the Commission s proposals 22 International proposals: - Initiate international convention on transparency in international activity National proposals: - More legal tools to combat manipulated transfer pricing - Those who facilitate tax haven registration should register their activities - Set up a competence center in international tax and public finance - Multinationals annual accounts o Must show where they have affiliates (and affiliates of affiliates) o Must show how much they pay in tax in percentage of taxable income National development policy Help poor countries develop its revenue side The Norwegian Investment Fund for Developing Countries has a development perspective and should not invest through tax havens