Tax Evasion and Tax Avoidance – A Multi-Trillion-Dollar Business

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The topic of income and wealth inequality is closely linked to the practice of tax avoidance and evasion, both by international corporations and by wealthy individuals. For example, it is often argued that an increase in top-income taxes and capital taxes intended to mitigate economic inequality will only end up scaring off investors and high-skilled workers or encouraging them to circumvent the law and ultimately hurting national prosperity. The related difficulties of implementing national policies in a globalised world have been highlighted by the recent disclosures of the Panama Papers and the European Comission’s decision to hit Apple with a tax bill of €13 billion after years of paying an effective corporate tax below one percent due to a deal with the Irish government. Unfortunately, any discussion about tax avoidance and evasion is seriously constrained by the opacity of tax havens and the global financial system and its laws and the lack of robust data. Recent research may help to shed some light on the issue at hand. But while there has been made some progress on the international level recently, it remains highly doubtful whether the gigantic globalised financial shadow economy can be tamed.

First, it is important to distinguish between tax avoidance, which is the use of legal methods to minimise tax payments, and tax evasion which is the illegal practice of avoiding to pay taxes. Most of the time when there are reports on international corporations “not paying their fair share”, it is a matter of tax avoidance. Note for example that in the famous Apple-EU case, the decision was based on issues of competition, not on any illegal dodging of tax payments. A classic example of corporate tax avoidance is  Google’s “double Irish Dutch sandwich” (Zucman, 2014, in a simplified version): In 2003, Google US transferred some of its intangible assets to its subsidiary incorporated in Ireland, registered as a resident of Bermuda for Irish tax purposes. This Irish/Bermudian subsidiary then created another subsidiary incorporated in Ireland and granted it a license to use Google’s technologies. This subsidiary then in turn licenses these technologies to all Google affiliates in Europe, the Middle East and Africa and pays the returns as royalties to a shell company in the Netherlands which then in turn pays back everything to the first Irish/Bermudian subsidiary. Since it is Irish for the Dutch tax authorities and Bermudian for the Irish authorities, and the corporate tax rate in Bermuda is zero percent, no corporate tax is paid anywhere. Exploiting inconsistent bilateral tax treaties, this is legal. Tax evasion, mostly conducted by individuals, on the other hand is strictly against the law. Illegal tax evasion by an individual can be illustrated by another short example: A US company owner creates a shell company in the British Virgin Islands, which in turn opens a bank account in Switzerland. The US company then pays fees for fictitious consulting services by the shell company to the Swiss bank account. The US company avoids paying corporate taxes, while the company owner can invest the money from Switzerland without paying taxes on the returns as long as his banks are not cooperating with foreign tax authorities. Note that tax avoidance and evasion are interconnected and rely on the same system of tax havens and the lines between them are often blurred.

Many things that are known today about tax havens stem from the book “The Hidden Wealth of Nations” by Gabriel Zucman et al . (2015)*, which is probably the most comprehensive work on the topic to date and a large part of this article is based on. Zucman paints a picture of a globally linked tax-evasion economy, where shell companies registered in the British Virgin Islands, the Cayman Islands or in Liechtenstein hold securities in Swiss bank accounts from funds that are domiciled in Luxembourg (the number-two country in the world for the incorporation of mutual funds, after the United States), Ireland, and the Cayman Islands. It is a symbiotic system, exploiting different countries’ specific loopholes, often resulting in zero taxes for its wealthy beneficiaries. The size of it can be called impressive: According to the Swiss National Bank, foreign wealth in Switzerland had reached $2.3 trillion in 2015, comparable to the annual GDP of Italy. Taking all tax havens together, Zucman estimates that eight percent of the global financial wealth of households is held in tax havens. In 2014, that amounted to $7.6 trillion (at the time, about 22 times the public debt of Greece). This staggering number is estimated by observing anomalies in the international investment positions of countries. For example if a German individual secretly holds a stock in a US company in a Swiss bank account, it will show up as a foreign liability in US statistics, but neither Switzerland nor Germany will register an asset. In Luxembourg alone, $1.5 trillion in shares of mutual funds in circulation around the world had no identifiable owners in global statistics in 2015. Zucman readily points out that his estimates suffer from many uncertainties, but they give an idea of the magnitude of global tax havens (they are conservative compared to the estimate of $21 to $32 trillion in 2010 that Henry (2012) arrives at, which is likely overstated). Note that these numbers do not include non-financial assets such as art, jewelry, gold, yachts and real estate (Zucman points out that “registry data show that a large chunk of London’s luxury real estate is held through shell companies”). The wealth stored in offshore havens translates into about $200 billion in annual losses to governments around the world in taxes at the least, Zucman suggests. Additional social costs, for example due to the facilitation of the concealment of profits from criminal activities remain unknown.

During the 2009 G20 summit, leaders declared “the end of bank secrecy” and vowed to improve countries’ capacity to tackle tax evasion. And while recent treaties between Western countries and tax havens (such as the Foreign Account Tax Compliance Act, FATCA, enacted by the US in 2010) are likely to increase international cooperation between offshore banks and foreign authorities, banks in tax havens are increasingly focussing on the growing number of ultra-high net-worth clients that can afford sophisticated legal constructs, and developing countries remain mostly excluded, enabling their rising class of super-wealthy individuals to benefit from the privileges their first-world counterparts have been enjoying for a century. This issue is emphasised by the fact that since 2009, wealth that is being managed in tax havens has risen by an estimated 25 percent (Zucman).

International treaties designed to enforce tax laws are nothing new. The first one was established already in 1908 between France and the United Kingdom in order to prevent cross-border inheritance tax evasion. Today, “tax havens have signed hundreds of treaties for the on-demand exchange of information” (Zucman), but countries can only demand information if they have evidence of tax fraud, making them dependent on stolen or leaked files. Moreover, since 2009, assets have simply been shifted into the least cooperative tax havens, leading to a growth of the market especially in Asia. The FATCA enacted by the US represents a more rigorous approach, imposing an automatic data exchange, independent of prior suspicion, between foreign banks and the US tax authorities. Every bank that is not cooperating faces a 30 percent penalty tax on all dividends and interest paid from the US, meaning that the FATCA takes advantage of the leverage the US has as the biggest economy in the world. The OECD and the European Comission have recognised that this approach can be a promising one to tackle tax evasion and are now moving towards an automatic global information exchange. However, international coordination develops slowly and it remains doubtful whether tax agencies can keep up with the schemes of the super-wealthy with their opaque network of shell companies, holdings and trusts. Especially in the EU, where Luxembourg, a country Zucman calls “an offshore platform for the global financial industry”, has a veto right.

The FATCA’s approach is building on economic findings: In order to make sure that tax havens comply with international tax standards, they have to face credible threats of concrete sanctions proportional to their profits from uncooperative tax practices. According to the rules of the WTO, sanctions may only amount to the costs that the tax havens’ policies induce, thus internalising the negative externalities. In this context, it becomes particularly important to estimate the magnitude of tax havens. Looking at the issue from this perspective can help understand two things. First, only if enough countries form a coalition in their attempt to eradicate tax havens, the costs of remaining a tax haven will outweigh the benefits. Second, if some tax havens close down, the market power and hence the profits of other tax havens go up, making them more resilient  to international pressure. However, one thing is worth pointing out: Tax havens always earn less from their activities than other countries lose in tax revenue, since otherwise tax evaders would have no incentive to move their assets to tax havens. Hence, if the costs of tax evasion were known, there should always be an international coalition that can enforce the shutdown of a tax haven. (For a nuanced game-theoretical approach of this coordination problem, see Konrad & Stolper, 2016, who also find that special programs with reduced fines for tax evaders such as repatriation tax holidays encourage tax evasion on the personal level and strengthen the resistance of haven countries against international pressure.)

Zucman argues that, after a tax haven has agreed to cooperate, a second measure is needed to ensure that it does so in practice. Just as Piketty (2014) proposes a global capital tax as a response to growing inequality, Zucman proposes a wealth register on a global level as a response to global tax evasion. Of course, both suggestions appear quite utopian today. However, a global central register is not completely unrealistic since there are already international registers, however private, in place (e.g. DTC for American securities and Euroclear Belgium and Clearstream in Luxembourg for stateless securities). The proposed register would record “who owns all the financial securities in circulation, stocks, bonds, and shares of mutual funds throughout the world”. Without verifiable information on who owns which assets, banks in tax havens always have the option of declaring that they do not have any international clients, fundamentally undermining measures against tax evasion. Naturally, a global wealth register would also be a first and vital step towards a global wealth tax.

The above findings and discussed measures are predominantly concerned with tax evasion by wealthy individuals. But also multinational corporations use tax havens for their purposes by making their profits appear in the countries with the lowest corporate tax rates. This is done for example by cross-country loans between subsidiaries or by manipulating transfer prices. Zucman writes that “In principle, intragroup transactions should be conducted using as a reference the market price of the goods and services traded, as if the subsidiaries were unrelated, what is known as arm’s-length pricing”. But in practice, international companies often have a multitude of options to influence their transfer prices, due to the lack of reference points, in order to transfer profits to tax havens such as Bermuda, where the corporate tax rate is zero percent (For example, how should the fair market value of Google’s technologies have been determined in 2003?). The magnitude of this tax avoidance is staggering: According to Zucman, 55 percent of all foreign US corporate profits were made in the six tax havens Netherlands, Bermuda, Luxembourg, Ireland, Singapore, and Switzerland in 2013, reducing the tax liabilities of US corporations by about $130 billion.

Regarding the tax avoidance by multinational corporations, Zucman suggests a profit taxation deriving from worldwide consolidated profits instead of country-by-country profits, as is true today. For example, the global profit of Google could be distributed across countries following a key determined by a combination of sales and employment. Manipulating transfer prices could be rendered meaningless by such an approach. A comparable system is already in place today in the US, attributing profits to the different states. It remains a question whether corporations should be taxed at all, or whether taxes should only be levied on the individual level. However, this topic is one for another time. But as long as countries chose to impose corporate taxes, it cannot be the goal of policy makers that only the multinational companies can avoid them.

As Piketty notes in Zucman et al. (2015), in modern societies, part of the social contract is that everybody pays taxes, preferably in a way that reflects their ability to contribute and if especially the largest companies and the wealthiest individuals find ways to avoid paying their share, this can pose a serious threat to a nation’s solvency and its social cohesion. In simple terms, taxes not paid by the rich have to be borne by the middle class or lead to cuts in government spending. There are promising ideas to tackle the issue of tax avoidance and evasion and some of them are already being implemented. It remains to be seen how nations will manage to coordinate their efforts on a global level, but one can hope that it will help that there is likely more credible data available today than ever before.

I want to conclude with two personal notes: The first is a recurring theme of this blog: Is is hard to see how these global issues should be improved with the recently growing influence of nationalism around the world. This is tragic since a society in which everybody contributes their share might not drift into the hands of populists in the first place. The second is a recommendation to Western policy makers: The next time they try to sell an international trade agreement to their voters that have no influence on its design, maybe they should focus more on implementing international tax standards and automatic information exchange on matters of tax evasion and less on intricately devising secret courts without public control.

For an intriguing, more personal perspective on the topic I recommend the article “How to Hide $400 Million” by Nicholas Confessore recently published in the New York Times Magazine.

*Henceforth simply referred to as “Zucman”.


References

Henry, J. S. (2012). The price of offshore revisited, new estimates for missing global private wealth, income, inequality, and lost taxes. Tax Justice Network, July, 5.

Konrad, K. A., & Stolper, T. B. (2016). Coordination and the fight against tax havens. Journal of International Economics, 103, 96-107.

Piketty, T. (2014). Capital in the 21st Century. Cambridge: Harvard Uni.

Zucman, G. (2014). Taxing across borders: Tracking personal wealth and corporate profits. The Journal of Economic Perspectives, 28(4), 121-148.

Zucman, G., Fagan, T. L., & Piketty, T. (2015). The hidden wealth of nations: The scourge of tax havens. University of Chicago Press.

written by Jonas

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Author: Jonas Send

I analyse current topics that interest me in opinion pieces and share my research in economic articles. the10thmanblog.wordpress.com

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