Finance & Public Economics | Why Tax Havens Should Exist

Tax Competition vs. Tax Harmonisation | What are the pros and cons of tax havens and fiscal competition?

Tax Havens (Fiscal Paradise Countries) | Tax Competition vs. Tax Harmonisation

Tax Competition vs. Tax Harmonisation in Finance

To understand why, let's first define the concept of tax competition. We observe tax competition when the so-called fiscal paradise countries competing for investments, subsidies or localisation of multi-national companies offer economic agents low or even zero tax rates as opposed to high-tax jurisdictions. Those measures concern in most cases the corporation tax, but they can also affect the income labour tax. In contrast, tax harmonisation is directed at equalising tax rates among different countries, thus stealing the comparative advantage of low-tax countries in favour of high-tax countries.

Effects for which tax competition has recently become subject to strong criticism from all circles of policymakers are galore. Let's outline some of them.

First and foremost, preferential tax regimes are allegedly conducive to violations of tax law, i.e. financial crime and money laundering. The reasoning behind is simple. The presence of tax and bank secrecy laws together with other benefits created by tax competition are perceived as harmful tax practices by less tax attractive 'social' and 'welfare' states which fight hard against fiscal paradise countries.

Next, the 'social' and 'welfare' states in question lose a significant part of the tax burden they could have acquired in the absence of tax competition in favour of fiscal paradise countries. The arguments usually used are that the lost net gain could have been attributed, for instance, to more public spending. That spillover is said to occur both between competing countries and inside each country taken separately. In many situations, the high-tax countries jump at the possibility to enhance their tax law procedures and raise tax rates which are not relevant for tax competition such as VAT.

As a result, high-tax governments try to curb tax competition collectively and make the existence of fiscal paradise countries even more complicated. A number of OECD and EU agreements such as BEPS (Base erosion and profit shifting) have been devised to harmonise tax law and create rules and control tax competition in order to get rid of the negative effects discussed above. However, the real goals are very often to implement more tax harmonisation measures and prevent efficient and competition-ready corporations from prospering. The recent crackdown on bank secrecy laws in the EU and challenging the principles of tax secrecy by demanding more 'facilitation of information exchange' is another proof of the high-tax governments' real ambitions.

By contrast, the benefits of tax competition and, consequently, of fiscal paradise countries lie on the surface. The competitive advantages in form of less abusive tax law, lower corporation tax rates for firms and less monopolistic market competition together with more investments and subsidies are direct effects of tax competition. A higher level of fiscal discipline, reduced wasteful spending and diversified tax rates add up as indirect effects of tax competition.

For more info about the pluses and minuses of fiscal competition (or tax competition) vs. tax harmonisation as well as about tax havens (or as they are also called 'fiscal paradise countries'), you might like to read my research essay 'What are the pros and cons of tax havens ('fiscal paradise countries') and fiscal competition (tax competition)' in public economics by following the link.

Fiscal Paradise Countries ('Tax Havens')

The existence of tax havens is a consequence of fiscal competition and different tax law systems. Tax havens or fiscal paradise countries are low-tax and politically stable countries with strong governance where investors can pay lower taxes than in other countries. Tax havens can be used by both individuals and firms that contribute foreign portfolio investments and foreign direct investments respectively. For the same reasons as tax competition, the very existence of tax paradise countries is deemed 'unfair'. Why? Below is only some of the reasons why it is not correct.

Tax avoidance and financial crime are some of the terms which often appear together with fiscal paradise countries (tax havens) in the media. However, although some of the welfare indeed goes from high-tax countries to tax havens, it cannot be denied that due to that firms which are localised in tax havens acquire a higher investment potential which allows them to invest more in high-tax countries, thus increasing their welfare and growth. Moreover, in most cases tax law is abused in neither of the jurisdictions.

If you like this post and if you want to learn more about the instrument of tax competition (or fiscal competition) as opposed to tax harmonisation as seen from the perspective of public economics, you are very welcome to read my summary essay 'Is Tax Competition a Fair Instrument' in public economics covering not only economic, but also legal aspects of tax law (primarily, as far as the corporation tax is concerned) and tax secrecy issues tightly related to bank secrecy laws.

All things considered...

In this post, outlining the pros and cons of fiscal competition and tax havens (fiscal paradise countries) we wanted to point out that both of the mentioned phenomena reveal the shortcomings and even dangers of modern 'welfare' governments' economic policies. The basic economic assumption that governments act benevolently and in the interest of economic agents - primarily tax payers - no longer holds. It is also the case with tax competition and tax havens. Although we have left the considerations of politics and normative equity beyond the scope of this post, we still feel obliged to point out that the phenomena of tax competition demonstrate a way to limit governments' redistribution ambitions. They illustrate namely a strong alternative to the modern welfare state's power to finance such useless and - now really - unfair projects as Obamacare, for example. Thus, tax competition and tax havens give the middle classes and firms a good instrument to confront the volatility of modern governments and their tax law traps.