Anna Gibson, Research Associate, Re-Define
Consequently, clamping down on this capital flight would bring in hundreds of billions of dollars a year in tax revenue and contribute to sustainable public financing. This would also serve to minimise the chance of a sovereign debt crisis – an unnervingly plausible reality for some – by fomenting fiscal stability.
Secondly, while the need for government revenue is crucial in developed countries, it is even more indispensable to the developing world. Illicit capital flight from countries like South Africa, which loses almost 10% of its GDP every year through non-cooperative tax jurisdictions, corresponds to roughly ten times the amount of financial assistance received. It also outweighs inward FDI flows. Tackling this severe loss of government revenue is thus critical to low-income countries (LICs), as mobilising a country’s own domestic resources via taxation provides a sustainable alternative to external revenue sources, such as rent from natural resources, which are often volatile. This would then enable greater public revenue to provide basic services, generate employment, and revive growth through fiscal stimulus.
Moreover, establishing a broad-based system of taxation can also contribute to good financial governance practices: on the one hand, there is increased government accountability when public revenue relies more heavily on tax (as opposed to rent); on the other, citizens have more incentive to pressure their government to spend finances prudently when they are contributing to these finances themselves.
And thirdly, the operation of tax havens and other entities complicit with tax flight is predicated on an environment of secrecy, which has a detrimental impact on the stability of the financial system as a whole. The financial crisis has demonstrated that many financial institutions carried off-balance sheet liabilities, often registered in low tax secrecy jurisdictions, which foment distrust between corporations and enhances information asymmetry. As a result, this opacity undermines the international financial market, contributes to higher risk of collapse, and boosts borrowing costs for both rich and poor countries.
If stringent measures to deal with the operations of these secrecy jurisdictions are not taken, the nascent recovery of the global financial system may revert to crisis, as large MNCs continue to disguise their true inter and intra-firm financial transactions.
Tax flight is evidently a global problem, which requires a collective response transcending sovereign borders. What, then, is being done to tackle this predicament, and what remains to be done?
One of the key responses to tax flight by the EU has been the establishment of the EU Savings Tax Directive (EUSTD), an agreement by member states to automatically exchange information with each other about individuals who earn interest in one EU member state but reside in another. Yet this directive has been deficient in several ways.
Firstly, the EUSTD does nothing for developing countries – its ambit extends only to Europe. Furthermore, this focus on European tax havens alone undoubtedly fails to address the illicit tax practices that pervade the rest of the globe. This failure is particularly surprising given our era of liberalised trade and capital regimes, where the transfer of wealth can be just as easily made to the Cayman Islands or Singapore instead.
Nonetheless, the scope of the EUSTD is inadequate, even for Europe. On every $1,000,000 that an EU citizen might have earned and transferred to his account in Switzerland (without disclosing it to the appropriate tax authority), there will be a paltry $150 of tax withheld on the average 0.5% interest paid every year. Much more importantly, the tax due on the original $1,000,000, of between $300,000 and $500,000 in most European countries, has simply not been paid. So the EUSTD captures $150, but misses out the $500,000.
However, there are currently calls for the EUSTD to be reformed so that automatic information exchange applies not only to individuals but also to all legal entities, which would be a step towards increasing its scope and plugging its prevalent loopholes. The reform would also include certain entities situated outside the EU, such as trusts and investment companies, which receive income for the benefit of individuals resident in a member state. Yet this reform has seen strong opposition by Austria and Luxembourg, who will not agree to a new directive until other non-EU states like Monaco, Liechtenstein and Switzerland comply – a movement which could prove to stall progress being made in this direction.
Beyond the EU, the G20 and OECD have made significant strides in developing an international standard on transparency and exchange of tax information, which has been endorsed by all key players. The OECD standards now serve as a model for the vast majority of the 3600 bilateral tax conventions entered into by OECD and non-OECD countries, which seek to improve transparency in order to clamp down on illicit tax fraud and avoidance.
There has also been mounting pressure by the OECD for country-by-country financial reporting of multi-national corporations in order to address the trillions of dollars held offshore by corporate entities. This transparency mechanism is particularly crucial for entities operating in the extractive industry, where huge rents are accumulated and siphoned off by both individuals and corporations through transfer mis-pricing technique, with profits hidden in secrecy jurisdictions.
But the distinction between individuals and corporations is far from clear – it is not hard to disguise personal wealth behind shell corporations or other legal constructs. Moreover, such tax evaders also benefit from the practice of ‘jurisynergy:’ combining the useful legal features of several jurisdictions to increase one’s gains and protect anonymity.
Evidently, there is much room for progress in tackling tax flight. A pressing task now is to ensure that states, particularly those in the developing world, are actually able to benefit from measures such as Tax Information Exchange Agreements (TIEA). So far, not a single LIC has signed a bilateral TIEA with any party: industrialised countries are un-interested in concluding such agreements when they lack reciprocal benefits. For this reason, a multilateral information exchange agreement is needed which would subsume the proliferating number of bilateral TIEAs and ensure that LICs are able to substantively benefit from the sea change in tax information transparency. Such an agreement would need global support, however, and global regulation.
These factors must all be taken into account when devising measures to tackle the ubiquity of tax flight practices: the measures must be holistic in scope and effective in application. Addressing just one facet of tax flight, such as the opacity of tax havens, will leave other windows open for exploitation.
Accordingly, governments and international policymakers need to look beyond the headlines of Germany and Switzerland and focus on the systemic aspects of this threat to global fiscal stability. While it may be rational for a minority of actors to facilitate illicit tax practices, at a collective level the fallout is devastating. The local and global consequences need to be reconciled so that both developing and developed countries are not starved of essential public revenue, whilst strengthening the stability of the financial system as a whole.
References
Tackling Tax Flight, A policy paper for the German government, Sony Kapoor 2008
Illicit Financial Flows, A briefing paper for the Norwegian government, Sony Kapoor 2007
Moving Beyond Liechtenstein, Newspaper Editorial, Sony Kapoor 2008