‘Harmful’ Tax Competition and the Future of Offshore Financial Centres
| Pages | 302-317 |
| Date | 01 April 2002 |
| DOI | https://doi.org/10.1108/eb027311 |
| Published date | 01 April 2002 |
| Author | Terry Dwyer |
| Subject Matter | Accounting & finance |
Journal of Money Laundering Control — Vol. 5 No. 4
'Harmful'
Tax Competition and the Future of
Offshore Financial Centres
Terry Dwyer
Offshore financial centres are coming under increas-
ing pressure from both the OECD and the European
Union. They are seen by many bureaucrats and poli-
ticians in OECD countries as facilitating criminal
activities such as laundering drug money as well as
tax evasion and tax avoidance by residents of high-
tax welfare states. While there are good reasons for
nation states to cooperate to suppress criminal
activity, this is not true in relation to tax competition.
The notion that by engaging in 'harmful' tax com-
petition, offshore financial centres are damaging the
legitimate interests of OECD nations has no sound
foundation in economic theory. Competition in tax
matters is beneficial and world welfare enhancing.
Governments of offshore financial centres serve
their own and the world's interests by providing
zero or low tax environments for global business
and investment and they are right to insist that
treaties on criminal matters should not be used to
enforce other countries' tax claims.
HISTORY OF TAX HAVENS
In 1970, the then British administrators of the
Condominium of the New Hebrides introduced
Banking Regulation No. 4 of 1970. That regulation
introduced offshore banking to Vanuatu and led to
the development of Vanuatu's offshore financial
centre. Later legislation provided for trust companies,
insurance and exempt company laws. The develop-
ment of Vanuatu's financial services industry was
not a casual decision on London's part. Britain
recognised that its responsibilities to a post-colonial
country required it to think about what industries
could generate income for the Vanuatu economy
and its efforts met with the endorsement of its then
French government partner in the Condominium.
In view of more recent OECD and European
Union views on tax havens, Vanuatu might find it
worthwhile to remind the former colonial powers
of the parentage of its offshore financial sector.
Tourism and financial services are natural comple-
ments for a small South Pacific economy as part of
its development strategy. A country's development
strategy has to focus on attracting locationally
mobile industries to raise the productivity and
wages of its people. In any case, a country such as
Vanuatu with pristine coral reefs might be expected
to prefer clean industries like financial services to
dirty factories which might damage its tourism
income (as well as the environmental amenity
enjoyed by its citizens).
Where there is a largely subsistence agricultural
sector and virtually all revenue is raised by indirect
taxes or resource rents, there is no need for income
taxes,
capital gains taxes, withholding taxes or
death duties. If these taxes are not there, there is no
need to enter into tax treaties. Vanuatu is thus a nat-
ural tax haven. An absence of
taxes,
like an absence of
war or internal violence, is something a country can
turn to its advantage. It is understandable that
Vanuatu continued the policy of developing its finan-
cial sector after independence in 1980.
The presence of an offshore financial sector can
provide collateral spin-off benefits for the rest of the
economy. It may gradually lead to funds being lent
to or invested in developing the domestic economy
and it may assist in developing the legal expertise
necessary for a market economy to work. These are
no small things when one observes the problems
faced by some Eastern European economies in transi-
tion. Educating people on how money and finance
work in a market economy is an important part of
development. Notwithstanding the logical reasons
that might favour Vanuatu developing its offshore
financial sector, Vanuatu's existence as a tax haven
has not been welcomed by all people. In particular,
it would be surprising if the Australian Treasury
welcomed its emergence after closing down Norfolk
Island as a tax haven. It is therefore perhaps not
surprising that the OECD (in whose Committee on
Fiscal Affairs Australia plays an active role) has
launched an attack on 'harmful' tax competition
from tax havens. Indeed the history of offshore finan-
cial centres reflects the historical evolution of the tax
systems of major countries, notably the USA and
UK. When Lloyd George and his Treasury officials
refused the request of the Vesteys that UK taxation
Journal of Money Laundering Control
Vol.
5,
No
4,
2002, pp 302-317
Henry Stewart Publications
ISSN 1363-5201
Page 302
'Harmful'
Tax Competition and the Future of Offshore Financial Centres
not be extended to overseas income in World War I,
the Vesteys decided on self-help. Their overseas
income eventually flowed to the trustees of a settle-
ment based in Paris at a time when France did not
seek to tax overseas gains. Given the current attitude
of France as an OECD member to offshore financial
centres, it is worth noting that France was one of the
first offshore financial centres.
After World War I, as tax rates rose in the USA
and the UK, both countries sought in the 1930s to
attack the transfer of assets abroad. The UK legislated
against offshore schemes based in Canada and
the USA legislated against offshore pocketbook
companies held by US millionaires in the Bahamas.
For the vast majority of taxpayers in industrial
countries, tax havens held little interest. With
onshore tax havens such as life insurance, pension or
superannuation funds available, only the very
wealthy found much need to consider the use of
off-
shore tax havens. In the UK, the combination of a
still-wealthy upper class facing extraordinarily high
marginal tax rates, a tradition of overseas investment
and the unique circumstances of offshore tax havens
within the then exchange control area meant the
British were leaders in tax haven development. To
these were added after World War II the multi-
national corporations which found that the services
of tax havens were essential in overcoming the
problems created for international business by
inconsistent tax treaties or dual claims to income.
It is not generally recognised by most economists
that without tax havens, multiple national taxation
would still exist and pose enormous difficulties for
mutually beneficial trade and commerce.
As public expenditure rose, notably on expanding
welfare states, and as onshore tax shelters or tax
havens were attacked, one after the other, by treasu-
ries in industrial countries, the demand for the
services of offshore tax havens rose. No longer were
offshore tax havens merely of interest to major multi-
national corporations or the super-wealthy. With
high postwar income tax rates and death duties and
a widespread legacy of colonies that had inherited
the common law and the law of trusts, the British
led the offshore migration. The Americans were not
slow to patronise the British-developed Caribbean
jurisdictions and to take advantage of common law
legal systems with which they were familiar.
The Europeans with a tradition of territorial taxa-
tion and civil law systems had less need to patronise
Anglo-Saxon tax havens with whose legal systems
they were less familiar. However, as European
countries moved to wind back the scope of exemp-
tions for extra-territorial income, it was no longer
enough merely to have undisclosed bank accounts
in Switzerland or Luxembourg. By the 1980s the
gradual removal of capital controls in the UK and
the European countries opened the way for further
European patronage of places such as the Channel
Islands.
The consciousness of European treasuries was
raised after Germany failed in an attempt to impose
an interest withholding tax in the face of a flight of
capital. It now seemed clear to the treasuries of
ageing welfare states that tax competition, when
combined with freedom of capital movement, was
a threat to their ability to raise further revenue.
European writers increasingly recognised that the
emergence of a global capital market set limits to
the redistributive financing of welfare states.1 Since
the 1980s, there has been the adoption generally
within Europe of controlled foreign companies legis-
lation as well as other anti-avoidance legislation.
More significantly, the OECD Report on harmful
tax competition and its cognate Report on tax
sparing,2 together with EU initiatives, have seen the
emergence of a multilateral attack on tax havens or
offshore financial centres.3 The OECD Council is
expected to consider a list of tax havens at its meeting
in June 2000. In particular the UK has clearly come
under pressure from its European partners to 'do
something' about its dependent territories. The first
example of this was the UK Edwards report4 which
examined the Channel Islands and the Isle of Man
and which has now been followed by the White
Paper on the overseas
territories.5
The Edwards report, which, in the method of its
inception, broke long-established constitutional
usages governing the relationship between the UK
and the Crown's offshore islands, did not recommend
wholesale elimination of the offshore tax havens.
Indeed the Edwards report was surprisingly fair,
given its genesis, but it did foreshadow substantial
inroads on client privacy in the interests of overseas
regulators and tax collectors. Since before the
American revolution, the UK has had a practice
that British colonies with self government are entitled
to administer their own taxation affairs.6 No pressure
from its European partners is likely to alter that
position.
Hence the UK government is proceeding to
assuage its European partners by seeking more
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