Response to Felix Salmon: Why We Should Care About Tax Havens

July 24th, 2012

Felix Salmon responded in a thoughtful post to a variety of news stories yesterday. This excerpt, referring to estimates of the total value of assets located in tax havens and secrecy jurisdictions, caught my eye:

 If you’re extremely wealthy and you come from one of the countries on the list here — Russia, Brazil, Mexico, Venezuela, Argentina, Indonesia, Nigeria, Malaysia, Ukraine, you get the picture — then obviously you’re going to keep a huge amount of money offshore, whether you made your money in a legal or in an illicit manner. And while some of the reason might well be tax avoidance, much of it is going to be simply the fear of expropriation and/or confiscation — again, be that legal or illicit. And since your investments are going to be global, it does make sense to park your money in jurisdictions which have proven themselves good at safeguarding individual wealth, as opposed to plundering it.

The total amount of wealth in the world is not an easy number to estimate, but it’s probably somewhere in the $250 trillion range. A lot of that wealth is financial, and a lot of financial wealth is held “offshore”, whatever that means these days. This new report says that roughly $25 trillion is held offshore by the wealthy, which just means that roughly $25 trillion is held offshore: after all, poor people by definition don’t have bank accounts in the Cayman Islands. That’s an interesting datapoint, but it’s not much more than that.

What’s unhelpful and sensationalist is to lead off your press release (and therefore lots of news articles) by saying that that amount “is equivalent to the size of the United States and Japanese economies combined”. That’s just a cheap way of comparing a stock with a flow, since GDP figures don’t measure wealth at all, but rather income.

I’m not going to comment on any particular estimate of the amount of money held in tax havens. There is a lot of money in offshore tax havens, and the problem is getting worse, not better. We should be concerned about the proliferation of very wealthy people all over the world putting a lot of money into bank accounts in tax havens for a lot of reasons. Here are three big ones:

A lot of that wealth is illicit. The UN Office on Drugs and Crime (UNODC) estimates (PDF) that $2.1 trillion – 3.6% of world GDP – was earned by organized crime in 2009. A lot of that money is sitting in tax havens not because the Cayman Islands or Luxembourg or the British Virgin Islands have stable, predictable banking systems (they do), but because the people who earned it sold $2.1 trillion worth of drugs or weapons, the proceeds of poaching, or whatnot, and a lot of people want to put them in jail. Following the money is the best way to put a kingpin in jail, and tax havens (or, as we often prefer to call them, secrecy jurisdictions), offer secrecy services to help prevent this. Law enforcement can’t effectively go after the real organized crime leaders, and instead end up playing wack-a-mole with lower-level criminals. In The Wire terms, they end up putting “dope on the table” instead of putting Avon Barksdale and Stringer Bell in prison.

If organized criminals did not have an easy path to banking secrecy, organized crime would not evaporate overnight. But in economic terms it would “raise the price” of illicit activity, possibly significantly. Transnational organized crime groups are sophisticated multinational businesses that cannot function at the scale they do today without access to the international financial system. You can’t stuff $1 billion under a mattress. And while the estimate from UNODC is a flow, not a stock, it doesn’t magically become legitimate wealth once the calendar year turns over. It eventually becomes a stock, and grows.

 Tax havens facilitate tax evasion. The $2.1 trillion number from the UNODC excludes tax evasion, a serious issue that is often under-reported. No good estimates exist for the total amount of tax evasion facilitated by tax havens, but we do have some useful anecdotes. Switzerland’s Wegelin & Co. were charged with hiding $1.2 billion in U.S. assets from the IRS. At some point in time, every cent of that was earned as income, and it is still earning income from dividends, interest, and capital gains. It should be taxed, and needs to be taxed under any equitable or efficient tax regime. And Wegelin wasn’t just passively receiving funds: they were actively undermining the U.S. tax system, including providing its customers with anonymous cash drops in Manhattan, at one point using a 5 year-old kid to deliver $150,000 in cash.

The IRS has collected $5 billion from the 2009 Swiss tax amnesty, and more is still coming in. That is derived from just one portion of the funds in one tax haven. You could make quite an impact in the U.S. deficit by taking a chunk out of tax evasion and maintaining the reduction over a long period of time. Treasury generally estimates that tax evasion and avoidance (a separate issue) facilitated by tax havens costs the United States $100 billion per year.

Developing countries get hit hard, especially by corrupt officials. We have revenue problems right now in the developed world. Italy, Spain, and Greece all struggling to collect revenue, which is contributing to the Eurocrisis. But in the developing world, the problem is infinitely worse. A billion dollars of lost tax revenue in the United States may mean that a bridge doesn’t get repaired, fewer teachers or police officers are hired, or an important research grant does not get handed out. But in many countries, it means that basic services like ground-level health care, education, or sanitation can’t happen. There’s a lot of stories out there about why developing countries experience poor economic growth, but one of the biggest is the inability for a state to independently establish itself as an entity capable of doing the basic things necessary for a modern economy.

Tax havens not only facilitate tax evasion, but they also provide the path of least resistance for corrupt officials to siphon off huge amounts of money into their offshore bank accounts. This also undermines the state’s ability to govern, causes capital to flee away from economies that desperately need it, and generally undermines society. While there’s a lot that some of these countries can do domestically to clamp down on corruption, effectively curtailing it becomes very difficult when it is easy to hide money offshore.

Banking secrecy is an issue that we need to expend more effort addressing. I didn’t even get into problems like undermining regulatory authority or facilitating massive corporate tax avoidance. I’m sure that a lot of people have accounts in offshore jurisdictions for perfectly legitimate reasons, like fear of expropriation or confiscation. Those people would do just as well having accounts in actual financial centers – London, New York, Tokyo, etc – without taking much away from those legitimate reasons. There are very few legitimate reasons to seek the secrecy provided by offshore tax havens. The problem isn’t just tax avoidance.

This is why I believe that the expropriation argument is a red herring – there’s no reason why offshore tax havens like the Cayman Islands or Switzerland are any better at providing this service than a normal financial center in a country with less banking secrecy. If offshore tax havens stopped existing, the legitimate money being protected from expropriation would simple shift to other banks in other jurisdictions without much change, while the illegitimate money would have a harder time finding a home without risk of discovery by law enforcement and tax authorities.

Update: Salmon posted another interesting post this morning on the subject. The general thrust of his argument is that offshore tax avoidance/evasion is generally not a problem for the United States, relative to other nations. An excerpt:

As far as US individuals are concerned, no one has yet demonstrated to me that there’s some kind of pandemic of rich people opening offshore accounts. In England, where I come from, it’s reasonably commonplace for individuals to have bank accounts in Jersey. And in Germany, likewise, lots of middle-class families keep money in Luxembourg or Liechtenstein. But in the US, by contrast, I see no day-to-day indication that offshore accounts are a remotely common tax-avoidance strategy.

Insofar as there is a problem, it seems to me, the problem is with tax collection and enforcement, rather than with the complexity of US tax legislation. Yes, the US tax code is ridiculously complex, and riddled with loopholes which ought to be abolished. But I think it’s actually pretty good when it comes to individuals’ offshore assets. And it’s only going to get better as Fatca comes in to force.

The U.S. has done more than a lot of countries, through FATCA and otherwise, to clamp down on offshore tax evasion. However, progress is still very slow. Most of Treasury’s efforts have been directed at banks in Switzerland, but the problem is much more global. Banking secrecy in tax havens undermine a lot of U.S. policy goals other than just revenue collection, like some of those mentioned above. Its true that the U.S. has a lot of reach in the world economy to go out and put pressure on banks in some jurisdictions. Banking secrecy and tax havens are still harmful to the United States. The world economy is weaker because of the global opaque financial system, because countries a lot weaker than the United States are significantly impacted by the volume of money fleeing their country for the untaxed safety of places like Jersey and Luxembourg.

Written by EJ Fagan

Follow @FinTrCo