The Role of Offshore Tax Havens

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Table of Contents

Examining the concept of “Regulation” for offshore tax havens
Connection between Globalization, Off-shore tax Havens and the Financial Crisis
Financial Liberalization and its Connection to Offshore Tax Havens
Example of Prudent Fiscal Policy in Action
Dominance of Financial Capital and its Effect on Globalization
Effect on Consumer Markets
Outsourcing and its Effect on China
The U.S. Consumer Market Today
Conclusion
Reference List

“Giving the government its due” is the basis behind most systems of taxation since it is through the collection of various corporate, custom and income taxes that a government is able attain the necessary funds in order to continue to operate. It is due to this that a lot of aspects of a person’s income can be taxed whether it comes in the form of income tax, corporate taxes, or even a tax on wealth. While most individual’s have no problem in paying taxes since they directly benefit from the amenities and services provided by the government (i.e. paved roads, a police force, government loans etc.) some individuals with a higher degree of attained income or rather a high degree of accumulated wealth often develop the notion that since they don’t benefit as much from government services due to the comforts that their wealth provides then they shouldn’t “pay as much into the system” so to speak (Otusanya, 2011: 316 – 321). This is where off-shore tax havens enter into the picture, such countries act as a means of by-passing government regulations of taxable wealth by acting as placed where undeclared monetary assets can be hidden discreetly and above all anonymously by various wealthy patrons (Hampton & Christensen, 2011: 169 – 175). Places such as Switzerland, the Maldives and even some Third World countries with low tax rates act as places where hidden wealth is transferred and stored in order to avoid the scrutiny of other governments (Workman, 1982: 675) (Shaxson, 2011: 8 – 32). The inherent problem with this particular practice is that it in effect denies governments access to funds that they otherwise could have used in order to pay for particular services that could benefit a lot of people (Arestis & Caner, 2010: 229 – 244). It must also be noted that this practice isn’t limited to just a few million dollars but rather constitutes billions of dollars of hidden wealth that has been sequestered into various unnamed accounts over the years (Shaxson, 2011: 24 – 27). In fact some banks in Switzerland and the Maldives actually pride themselves as being locations where the wealthy can choose to hide their wealth from prying eyes (Shaxson, 2011: 8 – 32). Of course this particular practice is highly illegal and if caught most tax evaders will wind up paying either stiff fines or have to endure jail time as a result of their actions (Keeler, 2009: 21). It must be questioned though why financial institutions in such tax havens allow such an illegal practice to continue. In this scenario money is the main motivator with millions or even billions in hidden wealth acting as means of increasing a bank’s funds enabling it to invest into various loans and endeavors which boosts the overall gains they accumulate (Keeler, 2009: 21). Based on this alone, it is highly unlikely that changes to prohibit or limit the practice will originate from such banks or within the countries they are in at the present. Rather what is necessary is an internationally concerted effort in preventing such a practice from continuing since it in effect denies people access to government services they would have otherwise received if tax evaders actually had a sense of moral decency when it comes to paying “what’s right” (Treasure islands Uncovering the Damage of Offshore Banking and Tax Havens, 2011: 576).

Examining the concept of “Regulation” for offshore tax havens

The inherent problem with the concept of regulation is that while it minimizes and controls certain actions it doesn’t outright abolish it. In the case of offshore tax havens the practice should be abolished immediately since they in effect promote tax evasion and the sequestering of hidden wealth (Barrett, 1997: 12). The inherent problem though in implementing this particular method of international banking reform is that based on international law a state has sovereignty over all actions within its borders (McGlinchey, 2009: 23 – 24). Furthermore, the theory of Realism in international relations explains that only states are the primary actors within an international system and cannot be dictated by an outside entity. What this means is that international organizations that seek to reform the banking system cannot demand an offshore tax haven to change its laws and regulations which control its banking industry due to a state’s inherent sovereignty and the fact that international organizations are not the same level of power as a state when it comes to issues in the realm of international action (Rawlings, 2007: 1 – 66). The only way of actually implementing such a change is if an internationally concerted effort by a coalition of states or rather a state with sufficient international influence such as the U.S. demands a change since such a practice negatively affects them (Dagar, 2010: 82 – 85). As the theory of Realism goes on to explain, the interaction of states within the realm of international relations is in effect dictated by “power relations” wherein stronger states (i.e. states with economic or military might) can in effect dictate/control the actions of other states by asserting their military or economic advantage. This particular strategy can be accomplished by either a single strong state or a group of small states however the effect is still the same. In the case of offshore tax havens a certain degree of international action by states is required (such as the threat of trade restrictions or economic sanctions) in order to in effect convince the governments of such tax havens to change their banking policy in terms of greater transparency in order to prevent international tax evasion from occurring (Bartram, 2007: 11 – 12).

Connection between Globalization, Off-shore tax Havens and the Financial Crisis

Globalization has in effect allowed the faster flow of capital from one international location to another however as a direct result this has enabled tax evaders to hide their wealth in other countries which actually contributed to the financial crisis (Palan, Murphy and Chavagneux, 2010: 13 – 24). What must be understood is that one of the main causes behind the financial crisis was that banks became unwilling to lend money to businesses due to their exposure to toxic subprime debt which affected their capital (Poole, 2010: 421 – 435). Compounding this problem was the subsequent out-flight of monetary assets by various consumers who became afraid that several banks may collapse the same way that Lehman Brothers did during the onset of the financial crisis (The Great Financial Crisis: Causes and Consequences, 2009: 41). With millions of dollars in effect being transferred to offshore tax havens this caused the already stringent policies of banks to become even more closed off due to the out-flight of capital which caused the financial crisis to worsen even more (Martin, 2011: 587 – 618). It was only when the U.S. government intervened with a bailout package that banks were able to gain sufficient capital to start lending once again (Yandle, 2010: 341 – 255). Based on this situation it can be seen that even though globalization has made it easier for capital to be transferred from one location to another in order to facilitate any manner of financial transaction this has actually introduced a certain degree of vulnerability to various banking institutions due to the possibility of capital out-flights to various tax havens which are considered a “safe” place to store money during times of economic uncertainty (Alloway, 2008: 125 – 141) (Martin, 2011: 587 – 618). Another way of looking at this problem is from the perspective of capital and how it affects a bank’s lending policies. If a bank has a sufficiently high level of capital due to good investments and high deposit rates this in effect enables it to lend to local businesses and communities which in effect contributes towards improving the local economy (Alloway, 2008: 125 – 141). Wealthy depositors contribute to this system by increasing the overall capital of banks which allows them to loan even more money. In cases though where people with high degrees of wealth choose to practice tax evasion by utilizing off-shore tax havens this in effect denies local banks the high levels of capital needed to loan money at low interest rates. In effect the practice of offshore tax havens contributes to the deterioration of local economies since banks either become unwilling to lend due to a low degree of capital or implement high interest rates on loans which affect the ability of local businesses to function properly (Crotty, 2009: 563 – 570). This particular scenario was seen in the aftermath of the 2008 financial crisis wherein despite the bailouts provided by the government there was still a certain degree of hesitance on the part of banks to lend due to the continued out-flight of capital which reduced their ability to actually loan money without placing themselves at significant risk due to the possibility of loan defaults as a result of the economic downturn. From a certain perspective it can be stated that if offshore tax havens didn’t exist then the sudden inexplicable outflow of monetary assets wouldn’t have occurred as gravely as it did and as such it would have lessened the overall impact of the financial crisis.

Financial Liberalization and its Connection to Offshore Tax Havens

Financial liberalization can be defined as a subsequent reduction of regulations that either inhibit or restrict certain actions within the financial industry of a particular country. What must be understood is that the financial system itself is inherently connected to the lending system wherein financial liberalization results in either the lifting or lessening of restrictions on particular lending instruments or institutions (Ghosh, 2007:171 – 186). This also impacts the types of financial instruments that can be actively traded between banks, hedge funds, financial institutions of countries and the stock market itself (Auerbach & Siddiki, 2004:231 – 235). For example, the repackaged toxic subprime debt that was sold off as “viable” investments was a type of financial instrument that was created as a direct of financial liberalization. What must be understood is that as of late the U.S. has been criticized as being a prime example of what can go wrong with financial liberalization. Since the U.S. has an extremely liberated system which was put into place over the course of three decades this has in effect led to the creation of various risky financial instruments. One example of a risky financial instrument is the practice of short selling wherein investors “bet against” the value of a particular stock speculating that the value will fall. The practice involves borrowing assets from either a bank, institution or broker (usually in the form of securities) and then subsequently selling them off and giving back the same type of securities back to the bank, broker etc. at a later date. What investors are after in this particular case is that they speculate that the price of that particular security will go down after a particular point in time. If the price of the security goes down and the investor buys the same amount he bought and gives it back to the bank, institution, etc. that he borrowed it from he in effect makes a profit off of the difference between prices. As you can imagine this particular practice comes with a high degree of risk wherein the price of the security borrowed may in fact go up resulting in the investor paying more for what he bought in the first place. There is also the case of micro-transactions operated by computers that try to make money off of the difference in stock prices that occur over a few seconds. While the price difference is small, usually amounting to a few cents, the sheer proliferation and scale of the practice has many analysts stating that micro- transactions actually account for more than 60% of all stock trading done in a single day. These practices along with the creation of risky loans and too much credit have been stated as some of the primary causes behind the problems the U.S. economy is currently facing due to a “backfire” effect of having a system that is “too liberal” for its own good. Financial liberalization also has the effect of allowing monetary assets to be easily transferred without limit which also further worsens the economic chaos that occurs in an overly liberalized economy. For example, in 2011 from August to October stock prices reached highs and lows so much within a given week that it was unprecedented in the entire history of the New York stock exchange. The sheer amount of variations that occurred were theorized as being not only the result of competing speculations regarding the strength of certain stocks but were also the result of risky financial instruments at work as well as rapid and numerous capital out-flights and in-flights which came as a direct result of ever changing financial outlooks. It was during this time that various offshore tax havens experienced great increases in the amount of money that was deposited into them as a direct result of uncertainties within not only the U.S. economy but the European economy as well due to the debt crisis that has adversely impacted the region. The inherent problem though with this practice is that, as mentioned earlier, this in effect denies banks access to sufficient capital which has become an ever increasing problem within Europe. In fact Europe is looking far more likely to enter into a depression by 2012 or 2013 as a direct result of capital out-flights which makes the debt crisis even worse. Banks within the region don’t have sufficient capital in order to encourage lending practices and this impacts the overall economy of several countries within the region. While it may be true that the main problem within Europe is the accumulation of sovereign debt which came about as a direct result of financial liberalization and the utilization of new financial instruments the fact remains that one of best ways of helping a region out of a recession is to boost the economy through more lending practices which unfortunately banks can’t do due to significant capital out-flights to safe haven banks in other regions. The fact is that financial liberalization has in effect led to a situation where investors and the wealthy feel “less loyal” to their local economies since through globalization they can in effect preserve their wealth from problems within local economies by merely transferring it elsewhere. The problem with this particular practice is that it doesn’t help local economies at all and in fact makes an already bad situation even worse as seen in the case of Europe and the U.S. In this scenario governments have to help the banks through the use of bail out packages which come directly from taxpayers. This in effect places more of the burden on low to middle class incomes instead of people with high incomes that further compound the problem by practicing tax evasion. Taking all these factors into consideration it must be questioned whether an overly liberalized economy actually helps a country or leads it to fiscal and financial ruin.

Example of Prudent Fiscal Policy in Action

In order to better understand the inherent problems with financial liberalization it is important to examine the case of the East Asian miracle and see prudent fiscal policies in action. An examination of the historical factors leading up to the East Asian Miracle show that the actors involved, namely: Hong Kong, Indonesia, Japan, South Korea, Malaysia, Taiwan and Thailand had several years of supercharged growth as a direct result of market liberalization and a focus on increasing exports to other countries (Yung Chul, 1996: 357 – 363). What must first be understood is that each economy, society and culture in each of the actors involved in the East Asian Miracle is unique and as such it cannot be stated that their sudden growth is inherent to special factors inherent in the countries themselves. A better approach would be to examine the common threads that unite each specific case that gives a better picture of the whole instead of trying to interpret each country on a case by case basis. One of the first aspects that must be answered is how the rapid growth and industrialization happen in these countries did in the first place? One of the reasons why East Asian countries were able to create the “Asian Miracle” was due to the establishment of “prudent” fiscal policies that focused on macroeconomic stability. Compared with other developing countries, the governments of East Asia paid great attention to maintaining macroeconomic stability and creating a good environment of investment and operation activities for enterprises (Yung Chul, 1996: 357 – 363). They followed two basic principles: the use of a prudent fiscal policy and avoiding overvalued exchange rates (Yung Chul, 1996: 357 – 363). It was due to this that they were able to respond to rapid changes in the economic system and create a flexible response to the changes of the economic situation which resulted in the successful management of fiscal deficits, inflation, external debts and exchange rates. These countries usually limited the fiscal deficit carefully in order to cover the deficit without causing sudden inflationary pressures and internal and external debt. It must be noted that macroeconomic stability is conducive to long-term planning and private investment, thereby promoting steady economic growth. All in all, the high savings rate, relatively low taxation, a strong educational system as well as a lower price pressure, access to foreign knowledge and technology, a friendly investment environment and the strategy of government intervention were key factors behind the success of the East Asian countries which resulted in the supposed “miracle”. Another factor that should be taken into consideration is that in 2008 economies and banking institutions within South East Asia, particularly the Philippines, were not as affected or exposed to toxic subprime debt investments compared to their counterparts within Europe. While it may be true that the Philippines or other South East Asian states are not as “financially liberalized” as compared to the U.S. the fact remains that their economies have been stable and growing for years which shows how advocating for financial liberalizations isn’t always a good thing (Orlowski & Corrigan, 1999: 68).

Dominance of Financial Capital and its Effect on Globalization

As financial capital becomes easily transferrable from one location to another this has resulted in companies having the ability to establish new factories and resource centers in other countries due to the ease in which funding can be transferred. This in effect has led to the creation of the modern day outsourcing industry which has been a rather interesting yet controversial issue in the U.S.

Effect on Consumer Markets

When examining either the U.S. or Chinese markets at the present it is important to first take note of the impact the global outsourcing industry has had on both economies. Outsourcing is a way in which companies reduce operational expenses by transferring a particular division or aspect of the company to an international location that has cheaper labor, lower production and utility costs as well as having local government units that promote business through the use of special economic zones that have far lower or next to no taxation (seen in Qingdao region of China and the Subic bay area within the Philippines). This is possible due to the way in which globalization has interconnected markets in such a way that methods of communication, financing and transportation have made transferring businesses and products from one global location to another faster, easier and above all affordable for companies.

Outsourcing and its Effect on China

It was due to this that a distinct trend in production outsourcing began in the U.S. during the late 1980s and accelerated during the late 1990s wherein more companies began outsourcing their manufacturing facilities to locations such as India and China. Within the past 2 decades China’s economy has grown to become the second largest economy in the world as a direct result of government initiatives into encouraging foreign direct investment, local entrepreneurship and real estate development. The outsourcing industry in particular has greatly improved the Chinese economy within the past 2 decades resulting in not only the rapid development and expansion of various urban centers but the creation of an increasingly prevalent Chinese upper class.

The U.S. Consumer Market Today

In comparison the U.S. consumer market today has not only stagnated but is apparently in recession as consumer spending is at an all time low while reliance on government aid programs is at an all time high. The origin of the current problem can be connected to the U.S. housing crisis wherein banks lent consumers more money than they could afford to pay back with various investment companies repackaging the bad debt into what appeared to be viable investments yet when consumers failed to pay their mortgages this created a financial domino effect which up till this day has affected the U.S. economy. The effects of this can be seen in how companies within the U.S. have scaled back their operations, how up to eight million Americans at the present are unemployed with other factors creating a strangle hold on the economy resulting in consumer spending being reigned back in favor of caution during such difficult financial times which has further deteriorated the local economy since consumer spending is the primary driver of a healthy economy.

Conclusion

Based on the data provided in this study it can be seen that the implementation of some means of mitigating offshore tax havens is necessary in order to prevent the constant capital out-flight into other countries during instances of economic instability. On the other and the main problem really isn’t offshore tax havens themselves but rather the misguided financial liberalization practices that have been instituted not only in the U.S. but in Europe as well. As seen in this paper, prudent and conservative fiscal policies lead to slow but stable growth while an overly liberalized financial market can lead to the creation of financial instruments that can create havoc on local economies. It is actually due to this that it isn’t surprising that there has been a distinct trend in international outsourcing brought about by globalization as companies and investors attempt to find more “stable” regions to invest in. China and the Philippines in particular with their prudent and controlled fiscal policies shows how investors are beginning to invest in less open but stable economies due to “safety” such economies provide. Lastly, this paper would like to conclude that one of the reasons behind capital out-flight to tax havens is the fact that financial liberalization has caused economies around the world to be so unstable that the wealthy are beginning to lose faith in the local economy and only go to tax havens as a means of self-preservation during tough economic times.

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