Why Are So Many Tax Havens Islands? The View from Economics

September 15th, 2014

We often think of tax havens as tropical islands or tiny nations nestled in the mountains. We know most of them are geographically and demographically small. Very small. Given their huge reputations, just how small they are just might surprise you.

Ireland, which is well known for its emerald hills and low tax rates, is about the same size as South Carolina. Luxembourg, a tax haven nestled in Western Europe between France and Germany, is about 2,500 square kilometers, or about a third of size of Rhode Island. Bermuda, a group of islands off the coast of South Carolina, is just over 50 square kilometers. That’s about one third of the size of Washington, DC. Singapore has about the same land mass as El Paso, Texas. Hong Kong is about the same size as Suffolk, Virginia. The notorious Cayman Islands have the same land mass as Shreveport, Louisiana.

These statistics might be surprising. How can nations so small garner such strongly negative reactions in the international community? Any why are so many tax havens so small? Is it coincidence? Or is there something else going on?

Economists have studied this question and their literature offers one strong hypothesis for why small countries tend to have an incentive to lower their tax rates compared to larger countries.

In a series of papers in the mid-80s to early 90s, Bucovetsky, Wilson, Zodrow, and Mieszkowski (among others)  laid out the rationale for this phenomenon in the basic model of asymmetric tax competition. Under this framework, tax competition is defined as “non-cooperative tax setting by independent governments, under which each government’s policy choices influence the allocation of a mobile tax base.” That is, under tax competition, governments do not cooperate in setting tax rates. When one government raises (or lowers) taxes, we expect that action to have an effect on the location decisions of individuals’ and businesses’ for capital allocation. That is, people can and will choose to move their money in response to changes in tax rates.

Suppose we are in a world of only two nations: a large nation (Largenia) and a small nation (Tinyland). The residents of each nation are equally rich, but there are many more residents in Largenia than in Tinyland. As a result, Largenia’s economy is much bigger in absolute terms. Both nations can tax their citizens in one of two simplified ways. They can tax their earnings as they work (labor tax) or they can tax their earnings on their assets (a capital tax).

If capital is mobile, then Tinyland has a clear incentive to keep its capital taxes low. Specifically, if Tinyland raises its capital taxes even a little above Largenia’s, then its residents will transmit all of their capital abroad. Labor, while also mobile, is not so responsive.

We are left with a lower capital tax rate in Tinyland, which allows the nation to subsume a great deal of capital from Largenia. As a result, Tinyland winds up with more capital per capita than Largenia, which allows the nation and its residents to spend more on public and private goods. The conclusion of this model is that small nations have a strong incentive to lower their taxes and become tax havens.

The tax competition literature focuses on source-based taxes—which are taxes on capital located within a country’s boundaries—rather than resident-based taxes—which are imposed on residents of a nation, regardless of where their capital is located. In part, this evolution has occurred because of the difficulty policymakers have in taxing worldwide income.

Many of these papers conclude that the result of these phenomena is that taxes are below their efficient level; they are too low. As such, governments will under-supply public goods, which are goods enjoyed by everyone, such as public parks and national defense. Bucovetsky and Wilson (1991) even go so far as to conclude that it is “the absence of residence-based taxes on capital income, not taxes on wage income, which is responsible for the under-provision of public goods.” That is, in order to maintain an efficient level of taxation and government-supplied goods, we must tax capital where it is earned, not where it is located.

The world’s ability to do that, in turn, depends on its ability to increase transparency in the global financial system. And that’s where we come in.

Written by Ann Hollingshead

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