Once upon a time there was a liberal vision for Europe. A free trade zone, with free movement of goods, services, people and capital, a single currency (fixed exchange rates), and fiscal competition between jurisdictions. Besides public pressure to limit the free movement of people within the European Union because of the immigration crisis, a trend has been developing over the past few years toward ‘uniform’ corporate tax rates. Taxes have to be equal across the European Union. A big danger, because this will give governments a greater ability to raise taxes. And the Panama Papers — 11.5 million confidential documents involving 214,000 offshore entities that became public through a leak at the Panamese company Mossack Fonseca — will intensify this trend.
Every individual must pay his “fair share.” Petitions erupt urging to “Stop Tax Havens.” Many people express their disgust on social media. Tax avoidance becomes a criminal act in the public eye. The semantical debate has been won by populism.
Trying to avoid taxes is disgraceful. Tax havens are despicable. People hold a mental image of a Caribbean island with white sand beaches, where the cronies of this world entrust their wealth to a bunch of shady bankers. The word “tax haven” is full of negative connotations.
But the definition of a tax haven is surprisingly simple: a jurisdiction with a (relatively) favorable tax …. .
All (popular) connotations are irrelevant.
Competition between Fiscal Regimes
The term “tax haven” finds its origin in a common phenomenon: competition between states to attract companies and capita.
Why would states compete?
Many politicians keep their electorate in the dark. But governments compete on (corporate) taxes, because low taxes lead to economic growth. Something unfortunately many still deny.
What do Singapore, Hong Kong, Australia, Estonia and Ireland have in common? Low taxes.
It is important to note that in some countries (Australia and Estonia for instance), only dividends are taxed. That means that as long as profits are retained, and the company keeps reinvesting them, that no taxes have to be paid.
Low (Corporate) Taxes Cause Economic Growth
Economic growth is nothing else than a bigger abundance of consumption goods (products and services). The more we produce, the more we can consume.
But only the private sector produces consumption goods. Only the private sector forms capital. Only the private sector uses money to finance production which increases the (future) supply of consumption goods. A greater supply of consumption goods, means that our (real) wages and purchasing power increase.
A government can only decrease the purchasing power of a society as a whole.
A government can only take something away from somewhere and give it someone else. But it does not create assets that will generate future welfare. The only thing it achieves is to take money away from businesses, and spend it. Businesses and entrepreneurs create capital, governments consume capital.
Economists even came up with a word to describe this phenomenon: the “crowding out” effect. When governments dominate capital markets, our future wealth diminishes, because businesses compete on capital markets with governments. If government occupy a greater part of that capital market, less capital is available to finance production. Less production means less (future) consumption. The “crowding out” effect is especially relevant today, because of the immense debt Western governments have accumulated.
The Case of Philips
Let’s take a quick look at the case of the Dutch multinational Philips, originally from Eindhoven. Philips was founded in 1890. Like every company, it once was a startup.
Would Philips have been able to grow as hard if it had to pay (corporate) taxes from the very beginning? The answer is probably “no.”
A profitable company that can reinvest 100% of its earnings for the first ten years, will be able to finance more activities than a similar company that can only reinvest 70% of its earnings.
Just like compound interest is the secret behind the success of self-made billionaire Warren Buffett, the same effect applies to the growth of companies and production, although in a negative sense in this case. Investing 30% less of your exponentially growing profits over a period of ten years is lethal.
Many countries that first served as a source of many multinational companies, are no longer capable of producing new multinationals, because their tax regimes are suffocating. New companies with the size of Philips, are no longer Dutch.
Fiscal Appeal of the Netherlands
The Netherlands tries to find a balance. Corporate taxes are reasonable and “flexible,” while taxes on consumption and wages are high.
The reason is simple: companies and capital leave, while people will be hesitant to relocate to another country.
However, the problem is that skilled labor has no incentive to go to the Netherlands. Employers cannot attract these skilled employees, because their wages after taxes would be considerably lower. The solution? Give these employees a tax advantage for the first five years. As soon as their soci, they will have less incentive to leave.
The fact that talented Dutch employees emigrate, is quietly tolerated.
Tax Avoidance versus Tax Evasion
Tax avoidance means nothing else than companies and persons looking for the fiscally most favorable location to store wealth. In this sense, there is nothing odd about avoiding taxes, because we act as consumers in exactly the same way: seeking rent. We also want the most value out of our money, we want the best for the lowest price.
Tax evasion is however something different. Tax evasion is fraud. Someone evades taxes when he or she hides taxable income or assets to his or her government.
The More Countries Are “Excluded,” the Less Fiscal Competition
If countries are labeled as tax havens, and governments make it impossible for us to bring our capital to those countries, then governments will have increased power to raise taxes, without experiencing the (direct) negative consequences in the form of capital flight and an exodus of corporations.
In other words, if countries are “excluded” from the global banking system, our option set diminishes. Higher taxes would lead to a comparably lower outflow of capital.
If country blocks blocks of countries, such as the European Union, uniformly raise taxes, there is no way to escape the pain to which these tax increases lead.
What we in fact have, is a fiscal cartel, in which “dissidents” are and excluded.
Something occurs that everyone would disapprove with in another context. If tomorrow all foreign producers of chocolate are excluded, then a monopolistic arises in the market. The few Dutch chocolate producers suddenly experience less competition, and they can raise prices without diminishing sales. It seems clear that everyone who loves chocolate would disapprove of diminishing competition between chocolate producers.
The same is happening right now with taxes. With all
The Panama Papers will intensify the trend that began earlier: higher taxes, less competition between fiscal regimes, more centralization, and a diminished standard of living in the world.
The ideal of fiscal competition within Europe has begun to vervagen, but due to the Panama Papers the ideal of fiscal competition in the global economy will get further out of sight. Despite the joy of seeing all corrupt politicians resign.