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The Economic Case for Tax Havens

Today’s topic is why tax havens are good for the global economy.

We’re talking about this issue because politicians—especially those from high-tax nations such as France and Germany—are persecuting low-tax jurisdictions. They don’t like the fact that jobs and capital are shifting to places with better tax laws.

Working through international bureaucracies such as the Organization for Economic Cooperation and Development (OECD), the European Commission, and the United Nations, politicians from high-tax nations are trying to shut down tax havens in hopes of propping up their uncompetitive fiscal systems.

The OECD even put together a tax-haven blacklist and threatened these jurisdictions with financial protectionism if they didn’t agree to become vassal tax collectors for bigger nations. Some off-the-wall advocates of big government have even urged military attacks against tax havens.

In a previous article, we talked about the issue of tax competition, which occurs when politicians feel pressure to improve tax policy so the geese that lay the golden eggs won’t fly away.

Before getting into details, let’s define what it means to be a tax haven.

According to stereotypes, tax havens are little islands in the Caribbean—and indeed, some of the world’s premier offshore centers are Caribbean islands—but to be more accurate, a tax haven is any jurisdiction that satisfies two criteria.

First, it has tax laws that are attractive to global investors and entrepreneurs.

Second, it protects its fiscal sovereignty by choosing, in at least some cases, not to enforce the bad tax laws of other nations.

So which countries are havens?

The answer is going to surprise you. One of the world’s leading experts on offshore issues, Marshall Langer, wrote in Tax Notes International that the most important tax haven in the world is Manhattan. The second most important tax haven in the world is London. The United States and United Kingdom are havens because of attractive laws that enable foreigners to invest money and then not have to report that income to their tax police. That’s good for the US and UK economies, and it’s good, of course, for the foreign taxpayers.

By some counts, there are more than 70 tax havens in the world, ranging from big nations like the US to obscure, tiny jurisdictions such as Malia, which is an autonomous part of Spain on the coast of Morocco and Sark, a British-controlled island off the coast of France. In some cases, such as America, the tax-haven policies are designed to attract global capital and are only available to foreigners. In other cases, such as the Bahamas, the beneficial tax rules are open to everyone, both residents and nonresidents.

Let’s quickly run through four reasons why tax havens are good for the global economy.

Reason #1: Tax havens promote good policy around the world.

They do this by pressuring politicians in high-tax nations to lower tax rates because of tax competition. Tax havens are very valuable in this regard because politicians are less likely to be greedy when they know taxpayers have escape options.

Remarkably, even OECD economists understand that tax competition is a pro-growth force in the world economy. They’ve admitted that the ability to choose the location of economic activity offsets shortcomings in government budgeting processes, limiting a tendency to spend and tax excessively.

Another OECD study acknowledged that decentralization can make governments more accountable. It may also introduce competition across jurisdictions and thus raise public sector efficiency. These are astounding confessions, since the OECD is the bureaucracy that’s leading the attack against low-tax jurisdictions.

Tax havens have been especially helpful in convincing politicians to reduce the double taxation of saving and investment. Many nations have lowered or eliminated death taxes and wealth taxes because the politicians have finally figured out that oppressive tax laws simply lead taxpayers to move their money to havens such as Luxembourg or Panama.

From an economic perspective, these lower tax rates are critical because they reduce the tax bias against saving and investment. This encourages people to set aside more of today’s income to finance tomorrow’s growth. Even socialists agree that capital formation is the key to long-run prosperity and rising living standards.

Reason #2: Tax havens generate high living standards.

According to World Bank data, nine of the world’s 13 richest jurisdictions are tax havens. Academic researchers, not surprisingly, have confirmed that tax havens grow faster and create more prosperity for people. This is especially important in the developing world, where poor nations that become tax havens enjoy big increases in prosperity and big reductions in poverty.

Reason #3: Tax havens promote better governance.

One of the problems plaguing poor nations is the lack of sound institutions. Property rights, the rule of law, and sound money are the indispensible building blocks for wealth creation and economic growth. Well, two academics found that the desire to become a tax haven leads nations to improve their institutions for the simple reason that global investors don’t want to place their money in poorly governed jurisdictions. This is something that should be applauded, not persecuted.

Reason #4: Tax havens help high-tax nations enjoy more prosperity.

This seems like an odd result, but it actually makes a lot of sense. Most countries, even high-tax nations, generally have more favorable tax rules for inbound investment. This is because politicians figure that their own citizens are captive customers and can be overtaxed, but they understand that they have to compete for global investment, so there are better rules for foreigners.

What happens then is that citizens from high-tax nations often move their money to a neighboring tax haven. They then pretend that they’re foreigners and use the haven as a platform to invest back in their own country. This additional investment in the high-tax country which otherwise would not have taken place increases its prosperity.

Let’s close with a quote that captures the essence of the issue.

John McGuiness of Northwestern University Law School wrote that “Jurisdictional competition among sovereign nations is a primary mechanism for empowering the encompassing interest of a nation and reducing the ability of interest groups to take resources from the government. Leaders are therefore restrained from rewarding themselves, their supporters or influential special interest groups.”

Dan Mitchell is an economist and senior fellow at the Cato Institute. He’s a strong proponent of tax competition, financial privacy, and fiscal sovereignty. You can read his blog here.

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