By Pascalis Raimondos, Professor of Economics, Head of School, Queensland University of Technology &
Sara L. McGaughey, Professor of International Business, Griffith University

The recently released Paradise Papers have again turned the media spotlight on small tax havens. The only difference from last year’s Panama Papers is that the contracts leaked to the public are from a respectable law firm in Bermuda (Appleby), and not from a suspicious and less-known firm in Panama (Mossack Fonseca). Otherwise, the key message is the same; individuals and firms use the services of tax havens to avoid paying taxes in their own countries. Appleby’s media response was swift and clear: there is nothing illegal in their actions. In short, Appleby uses tax law loopholes that allow individuals and firms to transfer their wealth in countries where taxation is zero.

The immediate reaction by some was that we should regulate and close these loopholes. That is the traditional regulatory way of dealing with distortions. Economists, however, tend to believe in the power of incentives and the invisible hand of markets: closing down existent tax havens and loopholes will only open new ones somewhere else in the system. As long as there is demand for such services, the supply of these services will take place. Cracking down on small islands that offer tax services may even have unwanted side effects.

Why? Let us explain.

One argument gaining credence is that the existence of small island tax havens makes it less attractive for larger countries to engage in tax competition. The widespread use of tax havens alleviates what would otherwise be aggressive competition between big countries to reduce taxes as a way of attracting and maintaining real investment. Such real investments matter for big countries as, for example, they create jobs where people live. When firms are able to shift their profits to low-tax jurisdictions through financial transactions, e.g. thin capitalisation, the location choices for real investments become less responsive to tax rate differentials.

Any viable solution … will need to focus on taxing profits in the country where they are actually generated.

Hence, closing down tax haven islands, without removing the demand for their services, may shift tax competition among large countries with even more adverse effects for the world economy (i.e. movement of activity). Such arguments are part of a new literature on tax havens that tries to make sense of the empirical data that show the high demand by global firms for tax haven services (see Desai, Foley, and Hines, 2006; Hong & Smart, 2010; Johannesen 2010).

The above issues arise only because profits are taxed in the country where they are reported, but not necessarily generated. Reporting high profits in, say, the Bermuda subsidiary of a multinational firm and low profits in, say, the Australian headquarters is legal as long as the methods used to shift profits are following the rules that each country has.[1] This Separate Accounting method of taxing firms is the basis of our current international taxing system. It was agreed back in 1926 under the auspices of the League of Nations and, almost 100 years later, nothing has changed — despite globalisation.

Any viable solution to the broader issues around profit shifting, and thereby tax havens, will need to focus on taxing profits in the country where they are actually generated. This calls for activity-based taxation for firms. To grasp the difference between income-based and activity-based taxation, think about consumption taxes: they tax the goods that you buy and not the income that you have for buying these goods. The logic behind this is that income is fungible, whereas consumption is tangible — while there are many ways of defining “income”, the purchase of a Mercedes-Benz is less disputable. The success of consumption taxes in raising government tax revenues worldwide is phenomenal. Indeed, consumption taxes are now a standard instrument in setting up sustainable tax-revenue streams in countries where tax avoidance/evasion is large. Applying the same logic to firms makes sense.

How should we implement activity-based taxation on firms?

This is, of course, not an easy task. A proposal that was entertained at the League of Nations negotiations in 1926 — but not chosen — was Formula Apportionment. Under this proposal, a firm’s consolidated/global profit is split among nations based on what activity the firm has in each of these nations, and then taxed. For example, if Apple makes 40% of its profits by selling its products to US consumers, then US tax authorities should tax 40% of Apple’s global profits. This is currently the system that operates within most federal countries in the world where member states (US), provinces (Canada), cantons (Switzerland) or landers (Germany) have the right to impose their own taxes on firms.[2] The European Union is currently working on such a taxation system as an attempt to stop the profit shifting that takes place between EU countries. What constitutes “activity” of a firm in a country can of course be many things — for a recent contribution see Gresik (2016).

A global institution like WTO can be of help, but this will take time.

While Formula Apportionment is possible in federations, it needs a high level of coordination to be implemented at an international level. One could easily imagine that those countries benefiting from our current international taxation system will oppose any change to a new system that will cost them trillions of dollars. A global institution like WTO can be of help here, but this will take time.

Radical unilateral (i.e. by single countries) reforms can be a more immediate alternative. The US Republican party proposed a destination-based cash flow tax system in January this year, which created a lot of traction in policy debates (Auerbach, 2017). Here, it is not profits that are taxed, but revenues minus labour costs (i.e. cash flow). While not a panacea to our problems, it is surely a proposal that is worthy of further investigation.

So, to answer the question put forward in our title: is everything about tax havens bad? On balance, the answer is “no”. Tax havens — operating within a world of tax competition and profit shifting — may help avoid greater harm.

[1] Here is where the big four accounting firms have their expertise in advising global firms.
[2] While a federation, Australia’s states are not allowed to tax separately firms’ corporate income.