5 Tax havens and developing countries

Tax havens harm both industrialised and developing countries, but the impact of the effects described in chapter 4 will be greatest in developing countries. This is partly because these countries are poor and thereby have a greater need to protect their national tax base, and partly because they generally have weaker institutions and thereby fewer opportunities for enforcing the laws and regulations they adopt. Tax treaties between tax havens and developing countries often contribute to a significant reduction in the tax base of the latter. In addition, certain effects of tax havens primarily make themselves felt in developing countries. While the existence of tax havens is likely to have had little impact on political institutions in rich nations, a number of indicators suggest that tax havens contribute to maintaining a vicious circle in developing countries whereby weak institutional capacity facilitates illegal capital flight, and tax evasion and capital flight in the next instance restrict the development of institutions. By the development of institutions, the Commission means all aspects from the legal system and law enforcement to the civil service and democratic governance in the broad sense.

5.1 Reduced tax revenues

Chapter 4 showed how tax havens increase opportunities for tax evasion. Tax evasion strategies which include the use of tax havens are difficult to identify, and competent and well-functioning tax authorities are required to prevent these opportunities from being exploited. A common feature of many developing countries is that they often lack resources, expertise and capacity for building up and developing an efficient civil service, so that the quality of the tax collection system is frequently found to be weaker in developing countries than in richer nations. As a result, developing countries often also have limited opportunities to pursue cross-border investigations, which demand both time and resources. The probability that tax evasion will be discovered by the tax authorities is accordingly lower in developing countries. These states also have more extensive corruption, which weakens the quality of the legal system at every level. This means that the consequences for taxpayers found to be evading tax are smaller. The willingness of taxpayers to pay what they owe may also be lower in poor countries than in most rich nations. This is the result partly of historical, political or cultural factors (Lieberman 2003) and partly of a lack of trust in the authorities because of their persistent misuse of public funds (Rothstein 2000).

Opportunities to utilise tax havens for economic crime, such as tax evasion, are not the same for all tax objects. Multinational companies, for instance, have greater opportunities to use tax havens to evade taxes than ordinary wage earners. Moreover, the problem of tax evasion will increase with the amount of income concentrated in a few hands. In many developing countries, only a few hundred or perhaps a few thousand taxpayers contribute the bulk of tax revenues. Less than one per cent of the population of Bangladesh, for instance, is registered as taxpayers. Only four per cent of these (in other words, less than 0.04 per cent of the population) pay 40 per cent of the taxes, while 50 per cent of the taxpayers (less than 0.5 per cent of the population) pay less than one per cent (Sarker and Kitamura 2006). In Tanzania, a country where the population exceeds 35 million, 286 companies contribute about 70 per cent of domestic tax revenue (Fjeldstad and Moore 2008). According to Baer (2002), 0.4 per cent of taxpayers in Kenya and Colombia account for 61 and 57 per cent of total domestic tax revenues respectively. The concentration of the tax base in a few hands, which are often rich in resources, makes countries more vulnerable to tax evasion through tax havens, and thereby contributes to the possibility that developing countries will experience a greater relative reduction in their tax revenues as a result of tax havens.

5.2 Tax treaties between tax havens and developing countries

An important feature of tax havens is that they have established tax treaties which assign the right to tax capital to the country in which a company is registered or an individual is domiciled, while the source country’s right to impose a withholding tax is sharply circumscribed or in some cases non-existent. Since developing countries are net recipients of investment from tax havens, these treaties lead to a reduction in their tax base.

One might ask why a number of developing countries voluntarily cede their right to tax in this way. The answer is probably that the tax havens occupy a very strong negotiating position in relation to the source countries. Secrecy legislation and low tax rates mean that tax havens attract mobile capital. A large proportion of foreign direct investment in developing countries is channelled through tax havens because the investors want to exploit the tax benefits and secrecy which such jurisdictions offer. Developing countries depend on the tax treaties to secure access to investment from the tax havens, direct investments which are sorely needed to generate domestic growth.

Although tax treaties with tax havens have been voluntarily entered into by two independent countries/jurisdictions, it is important to consider how far the unequal division of the tax base enshrined in these pacts can be defended.

Two conditions could potentially legitimise granting tax havens the right to tax companies registered there. One is that the companies are effectively managed from these countries, and the other is that a significant part of the value creation occurs there. However, neither of these conditions would appear to apply.

Typically, the tax regime for foreigners in tax havens requires that foreign companies do not use the local currency or have local employees other than local representatives at senior executive or boardroom level. See the detailed presentation in chapter 3 above. From a business management perspective, such rules make it impossible to conduct production or other types of operation on any scale in a tax haven if one also wants to obtain the tax benefits accorded to foreigners. It is therefore clear that very little of the value creation by companies registered in tax havens takes place there.

There is also every reason to believe that the companies are not generally run from the tax havens. Where business management is concerned, the importance of maintaining an overview of operations in a company through local knowledge of the markets in which it invests is well known. This means that chief executives in rich countries are located together with parts of the company’s activities (either staff functions or staff and operational functions). In tax havens, it is common for a few people to be nominated as the chief executive for hundreds of companies. The same individuals also serve as directors of these companies. The companies they administer are located in different countries with different cultures and cover a very wide range of business activities. From that perspective, they demand different kinds of technical and economic expertise, and no single person covers such a variety of qualifications. Another indication that the effective management of the companies is not conducted from the tax havens is that full-scale board meetings are seldom held there, as is the case for companies and group in other countries. Such structures indicate that the local representatives are passive front persons. This can be illustrated by looking at direct investments from Mauritius to India. No less than 38 per cent of direct investment to India in 2006-08 came from Mauritius. This capital was primarily channelled through companies prohibited by Mauritian law from having local employees. This means that the capital in reality is administered by people who do not live in Mauritius.

Conditions such as those outlined above raise questions of principle about what requirements should be set for a company to be regarded as domiciled in a country. The Commission is aware that such requirements have been defined in the legal field. In its view, however, these cater for the establishment of harmful structures in tax havens. The Commission takes the view that the assignment of the right to tax should be based on the real economic substance.

The domiciliary state principle has traditionally been justified with reference to the strong ties which typically exist between the country of domicile and the taxpayer. If a personal taxpayer pays tax in the country where they are domiciled, they will also benefit from the range of public services financed by the tax. This justification disappears in the case of legal entities only registered in a jurisdiction. A characteristic of tax havens is precisely that a minimal connection exists between the taxpayer and the jurisdiction. In such circumstances, principles of fairness suggest that the right to tax should rest with the source country.

5.3 Effects of reduced tax revenues 1

The consequences of a decline in tax revenues for developing countries are more serious than for rich countries, in the sense that tax revenues in developing countries are already generally low. Weak public finances are one of the principal challenges in a number of developing countries. Tax revenues in low-income countries averaged about 13 per cent of GDP in 2000 (Baunsgaard and Keen 2005), or less than half the average of 36 per cent for OECD members (OECD 2007). The basis for the calculation is also smaller, since per capita GDP is much smaller than for the OECD countries. A substantial share of the operating budget in many developing countries is financed by development assistance, and this proportion can reach 40-50 per cent in certain African countries. These figures show that substantial weaknesses exist in the fiscal base for many developing countries. According to the IMF, tax revenues corresponding to 15 per cent of GDP represent a “reasonable” minimum level for low-income countries in order to ensure the funding of basic state functions such as law and order, health and education (IMF 2005). Many developing countries lie far below this level. A study by Fox and Gurley (2005) found that as many as 44 of the 168 countries covered had tax revenues lower than 15 per cent of GDP during the 1990s. Eighteen of these nations were in sub-Saharan Africa.

Rich countries have, by and large, responded to the tax-haven challenge by modifying their tax systems towards heavier taxation on less mobile tax objects and lighter on mobile tax objects. Compared with more developed states, however, developing countries would find it more difficult to collect alternative taxes – on wage earners, for example. Low economic activity also means that few alternative tax objects exist. Insufficient institutional capacity and extensive informal sectors reinforce the challenges related to effective tax collection. The potential for replacing the loss of tax objects is accordingly limited. Responses to the loss of income as a result of tax havens must therefore largely take the form of a reduction in economic activity by the public sector, which is already very low.

One might think that reduced government revenues resulting from the use of tax havens would be partly offset by higher post-tax private incomes, and that the reduction in the tax level in developing countries might thereby encourage positive development of the business sector, with a consequent contribution to higher economic growth. As discussed in Appendix 1, however, tax havens are also likely to have a negative effect on private incomes. This is because tax havens make unproductive activity more attractive, which means that fewer resources are employed in productive operations. Viewed in isolation, that tends to reduce incomes and leads in the next instance to lower demand for productive entrepreneurs. This makes it even less profitable to pursue productive commercial activity. Overall, the decline in private economic activity is typically larger than the tax savings made by the private sector from the use of tax havens (this multiplier effect is considered in more detail in section 5.4). In other words, the effect of the tax havens on developing countries is not only lower revenues for the public sector but probably also a decline in private sector incomes. There is no contrast between private and public sectors here – the tax havens are a disadvantage for both.

5.4 The paradox of plenty: natural resources, rent-seeking and tax havens

On average, countries rich in natural resources have experienced lower growth than other states over the past 40 years. Often termed the paradox of plenty, this phenomenon is described in detail in Appendix 1. Two principal reasons explain why studying the paradox of plenty is important for analysing the impact of tax havens. One is that income from natural resources can give rise to many of the same mechanisms as tax havens – particularly to economic changes motivated by the desire to redistribute existing income to one’s own benefit rather than to create new income. The second is that tax havens make it easier for the power elite to conceal that income from resources is not being used in the best interests of the broad population. Tax havens are a contributory factor in making income from resources negative rather than positive for a country’s economy.

If, for example, a country’s resource wealth is measured by the proportion of GDP represented by the export of natural resources, a negative correlation exists between resource wealth and economic expansion. Natural riches accordingly appear to coincide with low economic growth – while resource poverty is correlated with high economic growth. Such a correlation does not necessarily mean that resource wealth is the true reason for low economic progress. A number of other explanations for such a correlation can be conceived. However, new research which seeks to take account of other possible reasons for the correlation shows that rich natural resources do actually appear to be a cause of poverty (Mehlum, Moene and Torvik, 2006a). The reason for this paradox is that a large proportion of society’s resources in countries with a wealth of natural resources are devoted to activities which primarily seek to redistribute income to the individual’s own benefit. Such activities are often termed “rent-seeking” in the economic literature, because players seek to obtain the economic rent 2 from natural resources.

However, rich natural resources are not a curse for all countries. Where societies have well-functioning political institutions, research shows that no negative correlation exists between resource wealth and poverty. Resource income appears to make a positive contribution to growth in countries with little corruption, well-functioning legal systems, good protection of property rights and a high probability that the public sector will fulfill its contractual obligations. Another interesting finding from recent research is that the paradox of plenty does not apply to democratic countries with a parliamentary system, while countries with a presidential form of government have a negative correlation between rich natural resources and economic growth. It is unclear why presidential government seems to have a less beneficial effect than parliamentarism when a country derives income from natural resources. Some commentators maintain that, viewed in isolation, a president in a presidential system has great power but that this is balanced by the fact that decisions in the popularly elected bodies are taken under a separation of powers. A central element in the US constitution, for example, establishes a division of power – often termed “checks and balances” – in the presidential system.

Recent research suggests that many other countries with a presidential form of government have not gone as far in implementing the necessary mechanisms which ensure a balance of power (see Appendix 1). In a number of countries with substantial earnings from natural resources, particularly in Africa, the presidential mode of government gives one person or a small group of people great political might. Abuse of power can more easily occur in such countries, and resource income can be applied for purposes which benefit the power elite rather than the population.

The most important lesson to be drawn from the paradox of plenty is that revenues which fall to a great extent into the lap of the political and economic players in a country can have unfavourable economic consequences. That is because resources are wasted on securing this income through rent-seeking. As with some forms of natural resources, tax havens provide players in the economy with opportunities to obtain earnings without creating any supplementary value. Rent-seeking leads to the reorientation of society’s resources away from productive value creation. A particularly important effect of this reorientation is that tax havens influence how some private entrepreneurs choose to use their talents. Tax havens make it relatively more profitable for them to devote their abilities to increasing the profitability of their own business through tax evasion rather than through efficient operation. A private-sector distortion of talent along these lines is not offset by other beneficial socio-economic effects, because the socio-economic calculation must take account of the fact that tax saved for the private entrepreneur represents a reduction in government revenue. Once again, the damaging effects can be stronger in developing countries because power is more concentrated there and because entrepreneurs and expertise are scarcer resources. Misuse of such talents will accordingly have greater consequences in developing countries.

Wealth obtained from natural resources has particularly damaging side effects for a society when economic and political players have opportunities to conceal the proceeds of rent-seeking. Tax havens provide a relatively easy opportunity for such players to conceal income from natural resources. These jurisdictions thereby make it profitable to be a rent-seeker, which encourages more people to opt for rent-seeking and fewer to prefer productive activity. More rent-seekers and fewer productive entrepreneurs lead in the next instance to a decline in income for each productive entrepreneur. But a relative fall in earnings from productive activities makes it even more attractive to pursue rent-seeking. That leads to a further contraction in the number of productive entrepreneurs and thereby to a decline in the income of those involved in productive business activities. In turn, this means fewer people wish to pursue productive operations and more want to turn to rent-seeking and the like. In other words, the existence of tax havens helps to unleash a negative multiplier process. The reason this does not continue ad infinitum is that the income of rent-seekers also falls as their number increases and the proportion of productive players declines.

In other words, tax havens reinforce the mechanisms which underlie the paradox of plenty – they make it easier for corrupt politicians and destructive entrepreneurs to enrich themselves at the expense of society. As mentioned above, recent research shows that it is precisely countries with weak institutions and political systems which are affected by the paradox of plenty (see Appendix 1). Private entrepreneurs and politicians in this type of country have private incentives which do not accord with the most beneficial behaviour for society as a whole. The combination of weak institutions and tax havens give corrupt politicians and destructive entrepreneurs good opportunities to conceal the resource income they arrogate to themselves.

5.5 Tax havens and institutional quality

Potentially the most serious consequence of tax havens is that they can contribute to weakening the quality of institutions and the political system in developing countries. This is because tax havens help to give politicians in these countries a self-interest in weakening the existing institutions. The lack of effective enforcement bodies means that politicians can make greater use of the opportunities offered by tax havens to conceal the proceeds of economic crime and rent-seeking.

Tax havens represent a problem for politicians in countries with strong institutions and well-functioning political systems – they cause economic damage and limit government revenues. However, institutional and political changes can restrict these harmful effects. In well-functioning countries, it will therefore be natural to respond to the challenges represented by tax havens with specific measures which reduce their damaging impact. The opposite responses may occur in developing countries. Secrecy jurisdictions could represent not only a problem to politicians in countries with weak institutions and political systems but also an opportunity. Tax havens provide an opportunity to conceal the proceeds of corruption and illegal activities, or income which politicians have dishonestly acquired from development assistance, natural resources and the public purse. In this way, the growth of tax havens also provides political incentives to tear down rather than build up institutions and to weaken rather than strengthen the political system. Many examples exist of institutions supposed to prevent illegal money transfers being deliberately destroyed by governments, 3 and of people associated with such institutions being pressured to neglect their duty or even being killed.

An example of the way resource wealth can lead to a weakening of democratic mechanisms is documented by Ross (2001a). Ross shows that the presence of extensive rain forests in the Philippines, Indonesia and Malaysia contributed to the conscious destruction of state institutions by politicians. The rain forest assets gave many players big opportunities to enrich themselves – but, in order to do so, they had first to undermine the state institutions which were specifically intended to combat misuse and excessive exploitation. Rather than building institutions, the politicians were given incentives to destroy them. Ross (2001b) also finds that countries with large oil deposits become less democratic. In such nations, democracy can carry a cost for politicians because it prevents them from using large government revenues as they please. Income opportunities provided for politicians by tax havens weaken the incentives to introduce democratic reforms or even strengthen incentives to reduce democratic controls over those in power.

Collier and Hoeffler (2008) demonstrate how checks and balances (institutional rules which limit the abuse of and balance political power) promote growth. They find that countries where such rules are important – because of large government revenues from natural resources, for example – are precisely where the rules often get undermined by both politicians and the commercial players who bribe them. The analogy with tax havens is once again obvious. The growth of tax havens can give dishonest politicians incentives to reduce institutional rules which promote growth. It becomes in the politicians’ interest to invest in a social model where secrecy and opportunities for personal abuse of power are tolerated.

The impact which tax havens can have on institutional quality in poor countries may cause great damage. During the past decade, it has become clear that institutional quality is perhaps the most important driver for economic prosperity and growth. Acemoglu, Johnson and Robinson (2001) provide the best-known analysis of the effect of institutions on national income. They estimate that, if a country located initially in the 25 per cent percentile for institutional quality could improve its institutions so that it moved into the 75 per cent percentile, national income would be increased sevenfold. Few factors have such a strong impact on growth as improved institutions. This is precisely why the damaging effects of tax havens can be so great for developing countries – the tax havens contribute not only to preserving weak institutions, but also to making them worse.