Select Committee on Treasury Minutes of Evidence


Memorandum from Professor Michael Devereux, Professor of Economics and Finance, University of Warwick

TAX HAVENS AND THEIR IMPACT ON THE UK

  1. These notes consider a number of the economic issues underlying recent initiatives by the OECD and the EU to combat "harmful tax competition". The details of the initiatives are not discussed. Instead the focus is on issues such as: whether "harmful" forms of competition can be differentiated from those which are not harmful; whether taxes on capital have fallen and whether this combined with increasing taxes on labour should be seen as adversely affecting unemployment; and on the fundamental difficulties in the existing systems of taxing international flows of income.

2. SPILLOVERS FROM TAXATION

  2.1 Countries are not independent of each other. A change in the tax regime in one country is likely to affect the welfare of other countries. There are at least two distinct ways in which this might happen.

  2.2 First, a tax cut in one country which increases the probability of a multinational firm locating there necessarily makes it less likely that the firm will choose some other location. In practice, most leading industrial countries aim to encourage inward real investment, which might have positive effects on domestic welfare through raising total investment and employment, or by increasing productivity, for example.

  2.3 Second, introducing a new low tax regime is likely to attract mobile taxable income (through a variety of devices) from other countries. This may have little or no impact on real economic activity, but serves to reduce the taxpayers' overall tax liability, and possibly increase the tax revenue of the host country, at the expense of higher-taxed countries.

  2.4 These two have different effects on welfare: the first concerns transfers of real economic activity, while the second concerns transfers of tax revenue. In principle, "tax havens" may belong to either or both groups. It is not clear which of these transfers the OECD report "Curbing Harmful Tax Competition" is concerned with. On the one hand, it explicitly links tax havens with attracting "geographically mobile activities, such as financial and other service activities". This appears to tie tax havens into the first kind of transfer, but linked to very mobile activity. On the other hand, the OECD defines a tax haven in terms of a jurisdiction that "offers itself . . . as a place to be used by non-residents to escape tax in their country of residence". This ties it to the more popular notion that tax havens engage in the second kind of transfer.

3. IS THERE EVIDENCE THAT TAXES ON CAPITAL INCOME HAVE FALLEN?

  3.1 Measuring the extent of the first of these spillovers is very difficult, although there is some evidence to suggest that taxes do affect the location decisions of multinational firms.[1] Some idea of the impact of the second of these spillovers can be found by examining tax revenues. If the existence of tax havens has become an increasing problem for the UK and other comparable countries, it would be reasonable to expect this to be reflected in, for example, the size of corporation tax revenues. Although the European Union has frequently suggested that "taxes on capital" have fallen while "taxes on labour" have risen, the evidence actually suggests that corporation tax receipts in the EU and in OECD countries have been roughly constant over a long period.[2] This is not necessarily inconsistent with a growing threat from tax havens, but it is at least suggestive that tax havens do not pose a significant threat, at least to corporation tax revenues.

4. IS "TAX COMPETITION" EVER "BENEFICIAL"?

  4.1 In most economic markets, competition increases efficiency and drives down prices to the consumer; this is why we have the OFT and MMC. To be more precise, in perfect markets prices are driven down to be equal to marginal costs; firms with high marginal costs are driven out of business. Some commentators have tried to apply these ideas in such a way as to suggest that "tax competition" must also be beneficial. But can these simple concepts be applied to "tax competition"? The answer is no.

  4.2 The "prices" involved in tax competition are tax rates on mobile tax bases—which can apply to the location of investment, or the location of taxable income, given some investment pattern. Reducing the "price" of locating activity in one country makes that country more attractive relative to other countries. But in the long run, other countries are likely to respond by reducing their tax rates as well. Many economic models suggest that the outcome of this process must be "prices"—i.e., tax rates—of zero.

  4.3 But there are costs of reducing tax rates: the opportunity costs of raising the same tax revenue from other sources, or going without the expenditure made possible by the tax. These costs may vary from country to country. But high costs do not necessarily imply "inefficiency"; they will reflect the alternative means available to different governments of raising the same revenue.

  4.4 The fact that most OECD countries continue to have high corporation tax rates—relative to the theoretical prediction of zero—is consistent with them having relatively high opportunity costs. Important in this calculation is the size of the domestic tax base. Cutting the corporation tax rate in the UK has a high cost in terms of the tax revenue generated from domestic business. But there is a much lower cost in, say, Ireland, and a lower cost still in, say, Jersey.

  4.5 So from this discussion, there is no reason to suppose that a process of tax competition—whether competition over the location of real economic activity or over taxable income—is beneficial. Attempts by the OECD and the EU to define "harmful" tax competition appears to suggest by default at least that there is such a thing as tax competition which is not harmful—or even positively beneficial. But it is very hard to come up with examples of such competition. I have some sympathy with the OECD and the EU in attempting to address only some of the issues raised by tax competition. However, I am not persuaded that the issues which they address can really be characterised as those which are harmful.

5. SHOULD WE AIM TO TAX MOBILE CAPITAL? THE IMPORTANCE OF IDENTIFYING "EFFECTIVE INCIDENCE"

  5.1 The EU has suggested that lowering tax rates on capital income as a result of competition has led to a rise in taxes on labour. It has linked this to the problem of high unemployment in Europe. This argument is completely mistaken. It is based on the fallacy that taxes on capital are effectively borne by the owners of capital.

  5.2 Consider a company which pays corporation tax. Who bears the effective burden (or effective incidence) of the tax? The shareholders may see a reduction in dividends and in the share price. But in a competitive market, it is likely that firms will attempt to pass on the tax in terms of higher prices to consumers, or lower wages paid to employees. The effective incidence is uncertain.

  5.3 Now consider a small economy with capital inflows. Non-residents have the opportunity to invest anywhere in the world. Suppose they could earn 10 per cent at home or on world markets. And suppose that this country charges a 50 per cent tax rate on capital income. The non-resident investors will still demand a return of 10 per cent—but this must be after tax. This means that they require a pre-tax rate of return of 20 per cent in that country. This is most likely to be achieved by reducing total inward investment—selecting only the better projects.

  5.4 So who has borne the cost of the tax? Not non-residents—who still earn 10 per cent post-tax. It must therefore be borne by residents: there is less investment in the country, and this will be reflected either in higher unemployment or lower wages, or both. A more efficient alternative would be to tax residents directly—a tax on labour. Such a tax would not distort inward investment decisions. So inward investment would be higher and overall welfare would be higher. Local residents still bear the tax burden. This argument largely carries over when considering larger countries; except that for a large country there may be some impact on the "world" rate of return.

  5.5 So the distinction between taxes on capital and taxes on labour turns out to be far from clear cut. In fact it has been argued that a process of tax competition which drives taxes on capital income to zero may after all be good—because it prevents distortions to investment patterns, while not affecting the effective incidence of taxes. But this is going too far. Countries which accept the analysis which suggests that zero capital income tax rates are beneficial always have the option to reduce such taxes; that they choose not to do so presumably reflects other factors. Tax competition, however, may leave them no choice.

6. THE OECD APPROACH AND THE EU APPROACH

  6.1 Both the EU and the OECD focus on tax regimes with a low or zero effective rate of tax. The EU's code of conduct is aimed at persuading Member States not to engage in such tax measures, especially in the context of essentially discriminatory treatment, with benefits given only to non-residents, ring-fenced from the domestic economy, or without there being any real economic activity. The OECD supplements its definition with a consideration of the exchange of information, and makes a number of recommendations concerning combating such regimes.

  6.2 Of course, both initiatives face very difficult problems. For example, for the EU, even if such practices were completely removed from the EU, there remain plenty of jurisdictions outside the EU which offer scope for reducing the tax on international investment flows. To be effective, these initiatives must be supplemented with penalties applying to taxpayers who make use of identified regimes. Even then, the problem of definition of the regime is very difficult and likely to become increasingly more so.

7. SOURCE-BASED CAPITAL INCOME TAXES V RESIDENCE-BASE CAPITAL INCOME TAXES

  7.1 Some international income flows are taxed primarily in the country in which they originate (the source country); this is true of profit earned by multinational corporations—although such profit may also face further tax when repatriated. But some international income flows are taxed primarily in the country of residence of the recipient. This is true of most interest flows, for example. Each of these approaches creates difficulties; further difficulties are created since both are used simultaneously.

  7.2 The problem of tax havens primarily results from income being taxed on a source basis. Suppose instead that, say, UK resident multinational firms were taxed purely on a residence basis—they would account for their world-wide income to the Inland Revenue, and the country in which the income was earned would be irrelevant. If this system could be made to work, there would be no incentive to locate in a tax haven, or any low tax country. (However, note that on its own this would not remove the possibility of tax competition, since countries may seek to give their firms a competitive advantage by reducing their tax rates.)

  7.3 Such a system makes sense in economic terms. Suppose I have an idea in London, I develop that idea in a laboratory in Paris, I produce the subsequent good in Milan, financing it in Frankfurt, and I sell it all over Europe. Where did I make the profit? There is no logical way to allocate the total profit earned between different locations. Yet that is precisely what the international tax system attempts to do.

  7.4 Of course, the principal problem with a residence based tax is evasion: domestic tax authorities find it difficult to identify income earned abroad (and quite possibly not repatriated). This problem is at the heart of the EU's proposal to introduce a withholding tax on individual savings income.

  7.5 Modern financial instruments combine elements of both debt and equity finance. As such, they create problems even in a domestic setting—for example, interest payment are deductible for corporation tax; so corporation tax is levied on the return to shareholders, but not to creditors. But these problems are multiplied in an international setting where alternative financial arrangements make it relatively easy for taxpayers to choose a preferred location in which to declare income.

  7.6 So problems of tax havens should be seen in the light of the fundamental problems of the international tax system. It is easy to have sympathy with both the OECD and the EU: attempting to reform the basis on which international income is taxed is a gargantuan task. But in that context, their recent initiatives—even if reasonably successful—will leave these fundamental problems untouched.

29 April 1999


1   One estimate is that a reduction of one percentage point in the effective average corporation tax rate in the UK increases the probability of a US multinational locating in the UK instead of elsewhere in Europe by 1 per cent (Michael P Devereux and Rachel Griffith, "Taxes and the location of production: evidence from a panel of US multinationals", Journal of Public Economics (68)3, 1998, 335-367). Back

2   See Lucy Chennells and Rachel Griffith, Taxing Profits in a Changing World, Institute for Fiscal Studies (1997). Back


 
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