A spectre haunts the world’s governments. They fear that the combination of economic liberalization with modern information technology poses a threat to their capacity to raise taxes.
– The Financial Times, July 19, 2000
Globalization is making it harder for governments to overtax, because it is increasingly easy for taxpayers to shift their productive activities to lower tax environments. This is what is known as tax competition. But not everyone favors this development, particularly, international bureaucracies. The Organization for Economic Co-operation and Development (OECD), a Paris-based organization with 30 member nations from the industrialized world, has urged an end to “harmful tax competition.” The European Union also has an anti-tax competition project, and its “savings tax directive” may be the most dangerous of all tax harmonization initiatives. Last but not least, the United Nations has proposed an “International Tax Organization,” which would be responsible for dictating global tax policy.
All of these schemes are misguided. They would harm the world economy and reduce global commerce. If successful, the EU and OECD campaigns will result in a tax cartel by eliminating or substantially reducing competition between nations. An “OPEC for politicians” would have adverse consequences for world taxpayers. Moreover, the EU and OECD proposals threaten national sovereignty, financial privacy, technological development, and the rule of law.
Policy makers should resist tax harmonization. Instead, they should take advantage of globalization by reforming tax systems and reducing marginal tax rates. Such policies not only would boost long-term growth, but also dramatically reduce both the incentives and opportunities to evade taxes.
What is tax competition?
Competition exists when rivals offer similar or better products at better prices. In the business world, competition leads to innovation, lower prices, and better service. Competition serves the same role in the public policy arena. In this case, the taxpayer is the consumer and governments must learn not to overtax lest they drive economic activity away.
The EU and OECD campaigns to eliminate tax competition and financial privacy are, at their core, a response to globalization. As one European bureaucrat stated, “differences in national tax systems are becoming increasingly evident and are therefore having an increasing influence on economic decisions concerning, for example, investment, savings, employment and consumption.” As the world economy becomes more integrated and technology improves, it is becoming much easier to avoid excessive taxation. Vito Tanzi, a former senior economist with the International Monetary Fund (IMF) economist, noted:
“Today, individuals may be able to choose among many countries in deciding where to work, to shop, to invest their financial capital, to allocate the production activities of the enterprises they control and so on. In these decisions, they take into account the impact of taxes, especially as long as the tax systems of different countries diverge as much as they do today.”
The Attraction of Lower Tax Rates
Ample evidence exists that economic activity is drawn to low-tax regimes. This insight is particularly relevant to international investment flows since, as Professor Mason Gaffney, an expert from the University of California in Riverside observed,
“Arbitrage in capital markets causes rates of return to converge; but it is the net rates of return after taxes that tend to converge, not gross rates of return, so that businesses in jurisdictions with high taxes must offer and generate correspondingly higher gross rates of return on capital, to continue to attract investment.”
Consider the example of an investor looking at two potential business opportunities. In Country A, a project might generate a 10 percent return, while in Country B, a similar investment is expected to yield a 7 percent return. On paper, this would suggest the investor would take advantage of the opportunity in Country A. But what if Country A has a 50 percent tax and Country B has no tax? In that case, the investor will choose to invest in the project in Country B. This choice is made because the actual after-tax return in Country A falls to 5 percent, less than the 7 percent after-tax profit that could be earned in Country B.
This does not mean, of course, that all investment will flow to low-tax nations. It does mean that investors will steer away from projects in Country A unless the expected pre-tax return is sufficiently large to compensate for the tax burden. In non-economic terms, this means that where there are two equally attractive projects, investors will choose the project that is subject to lower tax rates.
THe benefits of tax Competition
Government officials who fear tax competition are like the owner of a town’s only gas station who has to deal with a bunch of competitors after years of being able to charge high prices while offering poor service. The residents of the town are like the world’s taxpayers. The competition is lowering the price of gas and auto repairs and making their lives better.
This is the central reason why tax competition is a good thing. A response by Switzerland to a 1998 OECD report noted, “competition in tax matters has positive effects. In particular, it discourages governments from adopting confiscatory regimes, which hamper entrepreneurial spirit and hurt the economy, and it avoids alignment of tax burdens at the highest level.” A British newspaper, The Independent, wrote that tax competition is only damaging
“…in the absurdist sense that any government that finds itself in competition with a lower-tax regime can condemn its competitor as ‘harmful.’ Accept this and you introduce an irresistible upward bias in international taxation. Bad news for the tax havens, for sure, but scarcely better for the citizens of some of the tax hells that we hear rather less about.”
The Wall Street Journal similarly opined that,
“Tax competition between states is a good thing. The power of individuals and companies to vote with their feet is one of the most potent weapons against overweening government. Any attempt to deprive them of places to run must surely be considered an attack on freedom and a threat to prosperity.”
Tax Competition Promotes Fiscal Responsibility
Economists like tax competition because the lower tax rates that result in turn reduce the penalties on productive behavior. Taxpayers have a more narrow perspective – they simply enjoy the prospect of keeping more of the money they earn. The Reagan tax rate reductions – and the tax cuts that followed around the world –demonstrate that tax competition has generated big savings already for taxpayers. Another compelling piece of evidence is the round of tax cuts that recently took place in Europe. It is likely that these tax cuts will induce other nations to propose competing tax rate reductions. This certainly has happened in the past. For instance:
· In response to the U.S. tax rate reductions in the 1980s, all but two OECD countries lowered their top marginal rate on personal income tax between 1986 and 1991.
· Rates of corporate income tax all over the world dropped by up to 50 percent after the Reagan and Thatcher tax rate reductions. Following the Reagan tax cuts, all but one European Union nation reduced corporate tax rates between 1985 and 1998.
Yet many government officials, particularly in Europe, do not like this competitive process. In effect they are losing their power to set tax rates. And as an IMF official observed in a recent publication, with the passage of time it will likely become even “more difficult and more costly for a country to maintain high taxes.”
what the EU and oecd want
Taxpayer mobility – the ability to “vote with one’s feet” – means that countries with high tax rates are likely to lose revenue. The only way to stop taxpayers from fleeing to lower tax environments, however, is to have all governments agree to maintain high tax rates – in effect, by establishing a tax cartel.
Tax harmonization can be achieved in two different ways. Explicit tax harmonization occurs when nations agree to set minimum tax rates or even decide to tax at the same rate. In the European Union, for instance, member nations must have a value-added tax (VAT) of at least 15 percent. If tax rates in all countries are explicitly harmonized, a taxpayer’s only option is the underground economy – which already accounts for one-fourth to one-third of GDP in many of Europe’s welfare states.
The other way to stop tax competition is implicit harmonization. This occurs when nations are able to tax their residents on the basis of worldwide income. In order to tax worldwide income, however, a country’s tax collectors must find out how much income residents earn in other nations. This is why “information exchange” is such an important part of the EU and OECD agendas. “Information exchange” is a very misleading term, incidentally, since it implies that both countries receive some benefit.
The EU and OECD claim that tax harmonization is not their goal, but it is the unavoidable result of their proposal. Consider, after all, the following statements from various OECD publications:
· Low-tax policies “unfairly erode the tax bases of other countries and distort the location of capital and services.”[1]
· “[T]ax should not be the dominant factor in making capital allocation decisions.”[2]
· “These actions induce potential distortions in the patterns of trade and investment and reduce global welfare.”[3]
· Tax competition is “re-shaping the desired level and mix of taxes and public spending.”[4]
· Tax competition “may hamper the application of progressive tax rates and the achievement of redistributive goals.”[5]
· “Harmful tax practices may exist when regimes are tailored to erode the tax base of other countries. This can occur when tax regimes attract investment or savings originating elsewhere.”[6]
Why tax harmonization is misguided
1) An Assault on Taxpayers
The EU and OECD argue that tax competition is a bad thing and that governments should work together to stop “harmful” tax practices. What this really would mean, however, is creating a cartel of high-tax nations that would impose its will on low-tax jurisdictions.
The issue was neatly summarized by an Australian economist, Terry Dwyer, who wrote, “If the concern is with whether a country’s tax regime induces economic activity to shift, than all tax competition is necessarily harmful. The only way to prevent tax-induced changes of investment location would be for all countries to adopt the same tax system and the same tax rates.”
Creation of a tax cartel may be just the beginning. Advocates of the EU and OECD projects repeatedly stress the need for “global” action. Unfortunately, that next step may be a radical proposal to create a new international organization with worldwide enforcement powers. The U.K.-based Commonwealth Secretariat foresees the OECD’s actions as “the initial kernel of a ‘world tax organization.’” A recent United Nations report, which echoed the OECD’s attack on low-tax jurisdictions, also called for a world tax organization.[7]
2) An Attack on Free Trade and Global Commerce
In order to force the so-called tax havens to comply with its demands, the OECD report proposes that member nations subject low-tax regimes to severe and discriminatory financial protectionism. The EU is making similar threats, primarily targeting Switzerland. But heavy-handed restrictions on international capital flows would cripple the world economy. In effect, the anti-tax competition politicians would impose a financial blockade against targeted nations.
More specifically, the OECD suggests a panoply of fees, penalties, charges, restrictions, and other measures that could be implemented by member nations. In a remarkable twist, the OECD has even referred to these steps as “defensive measures” – sort of like Hitler’s defensive attack on Poland or Japan’s defensive attack on Pearl Harbor.
The French have gone even further, arguing that “the International Monetary Fund should oversee capital flows into these centers.” Their former President also talked about outlawing all financial transactions with low-tax regimes, and France’s former Finance Minister echoed this sentiment, stating that he is ready to “cease all financial relations of whatever type” with offending countries.” The British Manchester Guardian expressed a similar view, editorializing that, “Ultimate sanction may even be a ban on banking transactions between institutions in countries belonging to the OECD and banks in tax haven nations.”
These views are antithetical to the free flow of trade and commerce. Moreover, financial protectionism contradicts the OECD’s professed support for “the concept of free trade and investment across national frontiers.” Indeed, it is quite likely that the OECD’s agenda violate WTO obligations.[8]
Not surprisingly, several countries have pointed out this hypocrisy. Caribbean leaders have stated that “tax competition is just another form of free trade in a globalized world.” And Switzerland has noted that, “This results in unacceptable protection of countries with high levels of taxation, which is, moreover, contrary to the economic philosophy of the OECD.”
3) An Attack on Sovereignty
The EU and OECD proposals would substantively interfere with the right of sovereign nations to determine their own tax policies. High-tax nations are especially interested in forcing so-called tax havens to raise their tax rates and eliminate financial privacy. But as the former Vice President and Chief Economist of the U.S. Chamber of Commerce, Richard Rahn, noted, such a radical approach represents “financial imperialism.”
In effect, the EU and OECD seek to overturn 200 years of established international practice so that high-tax nations can impose taxes on assets and activities outside their own territory. Traditionally, governments have used a “territorial” or “source-based” rule for taxation, allowing them to tax all incomes and activities within their borders. And because this type of system was not concerned with economic activity in other nations, conflicts were non-existent.
The problem with a territorial system – at least from the perspective of the EU and OECD – is that it allows tax competition between nations. As such, even though it is a recognized rule that one country should not be compelled to collect taxes for the benefit of another country, the EU and OECD appear willing to discard tradition so that their member nations can grab more revenue.
4) An Attack on Third World Countries.
Most EU and OECD nations made the jump from poor, agriculture-dependent economies to industrial powers during the 1800s – a period when most did not impose income taxes of any kind. Today, poorer nations are being told they cannot adopt similar policies – a demand that one Canadian called an “infringement on their sovereignty by a group of rich white nations.” In a stunning display of arrogance, a senior OECD official reportedly has stated that the tax competition project was designed to “close down the islands in the sun.”
The OECD’s approach toward developing nations has been one-sided from the beginning. One European politician, for example, openly bragged, “This is like a military campaign.” Faced with rhetoric like this, it would be no exaggeration to state that the OECD’s tactics in this regard are like the modern-day equivalent of gunboat diplomacy.
The EU and OECD insist that they are merely trying to uphold internationally accepted standards, but there is no indication of what that means. Instead, according to The Financial Times, “The implication is that the OECD intends that certain rules and practices relating to tax matters, of the most powerful countries in the world, should be imposed internationally on other jurisdictions.” Stripped of diplomatic double-talk, this is simply, in the words of The Financial Times, an “attempt to bully tax havens into raising their tax rates.”
5) An Attack on Privacy
Because it is impossible to tax worldwide income without knowing the worldwide assets and activities of taxpayers, destroying financial privacy is an integral element of the EU and OECD proposals. Their initiatives would give high-tax governments the right to obtain personal financial information about a resident’s investments in another jurisdiction. This is the policy of so-called “information exchange.” More specifically, tax collectors would have a right to inspect any bank account anywhere in the world – and the EU and OECD want to have that information automatically provided.
Information exchange is a drastic step, one that undermines the common law principle that bank secrecy is an implicit part of the contract between banker and client. Financial privacy historically has been viewed as an essential safeguard of the citizen against the power of dictatorship. Indeed, the famous Swiss laws regarding banking secrecy were significantly strengthened in 1934 after Adolf Hitler took control in Germany.
Bank secrecy laws do more than just protect privacy. They also provide systematic benefits to a country’s financial institutions. The OECD even admits that, “Customers would be unlikely to entrust their money and financial affairs to banks if the confidentiality of their dealings with banks could not be ensured.” As a result, bank secrecy laws can help stimulate a vibrant financial services industry.
Finally, privacy also makes it harder for criminals to select victims. Many citizens, particularly those from the developing world, want confidentiality to reduce the likelihood of kidnapping and other violent crimes. The ability to have private offshore accounts also enables people to protect themselves from financial instability and expropriation.
6) A Threat to Technology and Innovation
The desire to maintain tax revenue gives governments a reason to limit innovation and control new technologies. One of the most promising financial developments is the creation of “smart cards” – which are like pre-paid phone cards that can be used to make cash purchases. Unfortunately, those who back the EU and OECD proposals appear afraid that these stored-value cards will make it harder to collect taxes. More specifically, they do not like the fact that smart cards allow anonymous transactions.
Online banking is also a concern to tax collectors, largely because a country may find it difficult, if not impossible, to prohibit its citizens from setting up accounts with institutions from other locations beyond its borders. The expansion of e-commerce also causes headaches for government, since the Internet enables people to shop and do business where taxes are lower.
Consumers, of course, like innovative new products and services. As a result, the EU and OECD cannot make a direct attack on the high-tech sector. Instead, they resort to dire warnings about anonymous financial transactions. For example, one OECD official wrote that online banking was a dangerous development. Other critics have pointed to cyber-payment systems as a problem. There is a distinct danger that those who seek to forestall tax competition will interfere with innovation and technological development. The OECD, for instance, has suggested limiting “the types of on-line services or the amount of such transactions”
7) An Attack on the Rule of Law
The EU and OECD anti-tax competition projects violate established legal principles at home and abroad. They seek to blur and perhaps even eliminate the distinction between tax avoidance, which is lawful, and tax evasion, which is not. Yet as Learned Hand, a distinguished former American judge, stated, “There is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible…for nobody owes any public duty to pay more than the law demands.”
The EU and OECD proposals clearly advocate a substantial shift in the traditional practices governing international enforcement of tax laws. In large part, this is an inevitable consequence of trying to tax income earned in other countries. This creates all sorts of conflicts, particularly as EU and OECD nations try to tax capital gains, inheritances, and incomes that citizens earn in other jurisdictions.
Standard international practice – known as the “dual criminality” principle – is that one country should not expect another country to help investigate supposed wrong-doing unless the conduct being investigated would constitute a crime under the laws of both countries. Needless to say, since many “tax havens” do not tax income, capital gains, or inheritances, asking them to help enforce other nations’ laws in this regard would violate international norms.
More generally, as one expert explained, no country has the
“…legal right to investigate the activities of any person in any other country without first obtaining the consent and cooperation of the country in which the investigation is to be conducted. Even then, the investigation must be conducted under the law of the country in which the investigation is to take place, not under the laws of the country conducting the investigation.”
The dual criminality principle is an important safeguard against abusive government. The United States, for instance, would never consider (hopefully) helping China persecute escaped pro-democracy protestors or women fleeing that government’s forced-abortion policy. Why? Because those activities are not criminal offenses in the U.S. Yet if EU and OECD nations insist that this principle be abandoned in order to enforce oppressive tax laws, what is to stop other nations from demanding that dual criminality be suspended to enforce their laws.
In addition to upending international tradition and practice, the EU and OECD proposals threaten basis civil liberties. Important legal principles, including the presumption of innocence, are being eroded. The operating presumption of the U.S. Department of Justice, for instance, is that any one with offshore bank accounts or other offshore financial structures is presumed probably guilty of money laundering. The Financial Action Task Force (FATF) shares the same view, assuming that anyone that wants financial privacy is a likely money launderer. One critic of this trend, speaking to a U.N. panel, remarked, “I do not feel comfortable with the notion of reversing the burden of proof in these cases. If we are going to tar someone as a criminal, I think it behooves us to prove that this person is a criminal beyond all reasonable doubt.”
The second legal principle under assault is the protection against unreasonable search and seizure without either court warrant or probable cause. The American Civil Liberties Union correctly notes that laws which allow government to invade financial privacy require “the reporting of personal financial information for law enforcement purposes without probable cause of a crime, and creates incentives for banks to spy on their customers.”
The Money Laundering Red Herring
Some argue that the EU and OECD proposals will make it easier to fight money laundering. Yet, money laundering is the opposite of tax evasion. Bill Gilmore, Professor of International Criminal Law at the University of Edinburgh, writes that money laundering and tax flight, “are activities with radically different purposes and practical outcomes.” The U.N. comes to the same conclusion, declaring,
“Tax evaders under-report the earnings of their legal enterprises, thereby paying less tax than they legally should. Criminals, by contrast, over-report the earnings of any legal enterprises they use for cover, therefore paying more tax than their legitimate front companies would normally be required.”
It is also worth noting that “dirty money” is not a problem unique to low-tax nations. Indeed, the U.N. reports that, “Money laundering can proceed very easily without bank secrecy; in fact, it may well be that launderers avoid it precisely because it acts as a red flag.” Indeed, according to a Brookings Institution expert, America is the “largest repository of ill-gotten gains in the world.”
The Crisis Is Too Much Revenue, Not Too Little
The EU and OECD initiatives supposedly exists to keep tax revenues from evaporating, but there is no evidence that the tax systems of the industrial countries are collapsing. A recent OECD publication even admitted that, “In 1998, OECD governments collected almost US$8 trillion in taxes: the equivalent of 37.2 percent of the aggregate GDP of their economies and the highest figure recorded since revenue data began being collected by the OECD.” Moreover, the OECD also acknowledged that, “There has been a continuing trend towards higher tax levels: from 29 percent of GDP in 1970, to 33 percent in 1980, to 36 percent in 1990 and more than 37 percent in 1998.” The EU nations face the heaviest tax burdens. According to OECD data, taxes consume about 43 percent of GDP in EU nations.
The Right and Wrong Ways to Deal with Tax Evasion
Supporters of the EU and OECD make one compelling argument. It is unfair, they say, for some people to avoid taxes while others are stuck carrying the load. For those who believe that the law should apply equally to all, this is an important issue. The key question, of course, is how this inequity can be solved. This is where the EU/OECD approach breaks down. Even if all low-tax jurisdictions surrender and join in a tax cartel, the desired result will not materialize.
Simply stated, more people will enter the underground economy if the tax burden climbs. In Europe, the underground economy already accounts for 13 percent to 15 percent of economic output, and in some countries, such as Greece and Italy, more than one-fourth of economic activity takes place underground. The biggest reason for the shadow economy, not surprisingly, is tax burden. This is why efforts to address tax avoidance and evasion through an international cartel is doomed to failure.
Fortunately, there is a right way to fight tax evasion. The answer is to cut tax rates and reform the tax system. The lower the tax rate, the lower the incentive to use either legal or illegal means to hide money. In other words, when tax rates are low, people are willing to report more income to the government. This is part of the reason why tax rate reductions often result in increased tax revenues. During the 1980s, for instance, upper-income taxpayers in the United States dramatically increased the amount of income they reported after Reagan’s sweeping tax rate reductions. As a result, according to the Internal Revenue Service, tax collections nearly doubled during the decade. The same thing happened, incidentally, following the Kennedy tax rate reductions in the 1960s. Revenues rose and the rich wound up paying more.
Territorial Taxation: The Ideal Solution
Assuming tax burdens are reasonable and governments are behaving justly, there is a societal interest in minimizing tax evasion. The key question is how this goal can be achieved, particularly when dealing with cross-border economic activity. The EU and OECD act as if tax evasion has reached epidemic proportions and that their proposal is the only way to address this supposed crisis. This is a clever strategy, but it is also very misleading. There is another approach – a combination of territorial taxation and no more double taxation of income that is saved and invested – that is far more effective in terms of reducing tax evasion.
Unlike the “information exchange” schemes favored by the EU and OECD, a territorial system has no destructive side effects. Territorial taxation means that all countries would reserve the right to tax the income earned inside their borders, regardless of who earns the money, but they would not assert the right to tax income earned in other countries. As the following list indicates, a territorial system hinders government power and therefore is not in the interest of high-tax European governments:
· Tax competition – A territorial system promotes competition since investors and entrepreneurs can take advantage of lower tax rates by doing business in jurisdictions with pro-market tax systems. A worldwide system, by contrast, largely destroys competition since high-tax governments would have the right to export their tax burdens around the world. It would be as if a gas station charging $2.00 per gallon asserted the right to charge its old customers a 50 cents surcharge if they switched to a gas station that only charged $1.50 per gallon.
· Financial privacy – A territorial system is much more protective of financial privacy, especially since a withholding regime taxes capital income at the source (in other words, companies would pre-pay taxes on behalf of stockholders and bondholders, regardless of where they lived). This means people would not be forced to divulge their personal financial information to the government every year. By contrast, a system of information exchange necessarily means that at least two governments are privy to the most intimate financial details of a taxpayer’s life.
· Fiscal sovereignty – By definition, a territorial system does not create conflicts with other nations. Each country has the right to impose any and all taxes on any and all income earned inside its borders. Any income earned in other countries, however, is off limits.
· Tax reform – A territorial system is conducive to fundamental tax reform. A flat tax, for instance, only taxes income earned inside national borders. A worldwide tax system, by contrast, is an impediment to tax reform. Indeed, many high-tax countries favor “information exchange” because it allows them to double-tax income that is saved and invested, a misguided practice that every major tax reform plan seems to abolish.
Conclusion
Tax competition is a positive force in the global economy. It forces politicians to be more responsible, pushing tax rates down and allowing people to enjoy more of the money they earn. Unfortunately, some policymakers in high-tax nations have come up with a strategy to stop tax competition. Working through the EU and OECD, they are pushing plans to shut down so-called tax havens and create a cartel of high-tax nations. One of America’s top international lawyers, Bruce Zagaris, explained the dangers this would pose:
“The ferocious attack on the offshore jurisdictions by the OECD and EU tax initiatives, as well as parallel initiatives by national governments and international organizations, risk raising Americans’ tax bill on a variety of areas in the medium and long-term, and robbing the US Congress of its constitutional authority over revenue. The assault on bank secrecy and financial privacy and concomitant increases of exchange of tax information will further erode privacy in an era when both law enforcement, electronic commerce, and various information gatherers have dismantled much of the foundation of privacy law. The initiatives will further alienate many Americans on the need to support globalism, since the impact of the initiatives will fulfill their worst fears of the erosion of national sovereignty and the loss of individual rights to the rise of global government.”
Policymakers should reject the EU and OECD initiatives. They are bad for the world’s taxpayers; they will undermine national sovereignty; they will destroy financial privacy; they will hinder technological innovation; they will lead to protectionism; and they will sabotage the rule of law.
[1]OECD, “Towards Global Tax Co-operation,” p. 5.
[2]Ibid.
[3]OECD, “Harmful Tax Competition: An Emerging Global Issue,” p. 14.
[4]Ibid., p. 16.
[5]Ibid., p. 14.
[6]OECD, “Harmful Tax Practices,” April 13, 2000, at www.oecd.org/daf/fa/harm_tax/harmtax.htm.
[7] United Nations.
[8] Mark Warner.
