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There is a case for tax havens
April, 26th 2016

What prompted people to set up offshore companies through Mossack Fonseca was the fact that RBI did not allow individuals to set up companies abroad. Photo: AFP
In a work aptly titled The Hidden Wealth of Nations, Gabriel Zucman studied the extent of wealth parked in offshore accounts. According to his findings, 8% of the world’s financial wealth is parked offshore (for reasons legitimate and legal, and illegal). But here is the interesting bit: the extent of wealth parked internationally varies dramatically—from 4% in the US and Asia, to 10% in Europe to close to 50-57% in Russian and the Gulf countries. Clearly, in countries with better and, quite literally, less taxing regulatory frameworks, the extent of wealth parked offshore is smaller.

What explains these differences?

To understand the black economy—why it exists and why it is as extensive as it is—it is imperative to look at the regulatory framework that leads to it. A restrictive and bad regulatory framework would increase the cost of compliance of staying in the formal economy. At some point, the cost of compliance becomes so large that it is profitable and rational to move out of the formal economy into the black economy. The same reason that makes people move to economically freer economies to work is what makes them park their funds in tax havens—incentives matter. And you can’t legislate away incentives.

The recent Panama Papers leaks, touted to be the biggest since Wikileaks, brought black money and the shadow economy back into the public eye. It included 11.5 million documents and 2.6 terabytes of data. Politicians, heads of states, celebrities and big businessmen indicted throughout the world—it was a damning revelation unparalleled in scale. The way the matter plays out in public discourse and popular imagination makes one believe that dodgy dealings outside the formal economy is the exclusive domain of the rich and powerful, and the recent revelations just affirm that impression.

The black economy is not, in fact, the monopoly of the rich and corrupt; the common man partakes in it too. The shadow economy flowers where bad regulation takes root, and there is no dearth of bad regulation in this country. Consider real estate—the amount of wealth parked in real estate is estimated to be many times of what is parked abroad, and our common man—you and I—is a part of that. Where is the moral outrage there?

And it is not that everything that occurs in the black market is bad. Black markets, being a consequence of bad regulations, are, as Milton Friedman observed, “a way of getting around government controls.” Indeed, tax havens even have positive economic consequences, and much of the money that leaves India finds its way back here, with empirical data suggesting that tax havens do not divert economic activity . Capital that leaves high-tax jurisdictions is re-routed back to the same jurisdictions, disguised as foreign direct investment while escaping the domestic country’s restrictive regulatory regime.

Insofar as tax havens are an expression of tax competition, there is nothing wrong with them. Jurisdictions that lower their taxes to attract capital are simply exercising their sovereignty, and the states that create a regulatory framework to restrict people from parking their money offshore and force tax havens to divulge private information are, in fact, using coercion to clamp down on a practice that is, in theory, perfectly reasonable and legitimate.

There is, however, one major concern about tax havens—the lack of transparency and the problem of money laundering. But contrary to conventional wisdom, money laundering is a problem in high-tax and low-tax jurisdictions (with low-tax jurisdictions, or tax havens actually faring better that their high-tax counterparts), and “bank secrecy laws do not prevent governments from obtaining information when investigating crime .” In an annual report on money laundering prepared by the Basel Institute on Governance, many of the high-risk countries for money laundering are not, in fact, tax havens, and low-income countries with weak institutions take the top ranks in being the most vulnerable to money laundering. The concern about money laundering in low-tax jurisdictions, while legitimate, is overstated and does not, by itself, constitute a case to crack down on tax havens.

Here is the takeaway from the present episode. In our domestic economy, formal institutions ought to extend a degree of protection and create a framework that inspires confidence—a framework in which the benefits of being a part of the formal economy outweighs the costs (the costs, of course, being taxes). What prompted people to set up offshore companies through Mossack Fonseca was the fact that the Reserve Bank of India (RBI) did not allow individuals to set up companies abroad. But why should there be that restriction to begin with? If we are to seriously tackle corruption, we need to see what regulations we have, and the incentives we are creating. The easiest way to ensure tax compliance is not to crack down on tax havens but to lower taxes and to participate in legitimate tax competition.

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