Tax Havens: Sunny Islands?

“Located in the Caribbean, between Cuba and Jamaica, there is a collection of tropical islands that enjoy a wonderful climate, great sailing and diving, and is home to only about 50.000 people.”

This could easily be the introduction of a travel guide to the British overseas territory, the Cayman Islands. But besides being a perfect spot for a beach holiday, the Cayman Islands are a worldwide synonym for banking and tax havens. Cayman established itself as a leading financial center. So if you were a rich individual and planning your holidays, you could be sitting on a beach at Cayman with a cocktail and feel safe knowing that no government is going to take any of your money!

‘A tropical, sunny island’, like Cayman, is the first thing that pops on our minds when we think of tax havens. Tropical islands are well-known for secrecy jurisdictions. But are they the only players in the so called ‘secrecy game’? And do tax havens influence the current global financial crisis? Are they worth a holiday?

Tax Havens

Several definitions of tax havens and offshore finance exist. According to the Organization for Economic Cooperation and Development (OECD), the key characteristics of tax havens are high levels of secrecy, low regulation and often low or no taxes. Various countries claim to be the oldest tax haven in the world. Already in Ancient Greece the use of differing tax laws existed and there were traders who tried to avoid taxes. But the first corporate tax havens were set up in the US states of Delaware and New Jersey at the end of the 19th century. Modern bank secrecy emerged in the 1930s in Switzerland. After that, it took decades before the offshore economy started its expansion to today’s scale.

At the moment the world contains approximately 60 secrecy jurisdictions or tax havens. In his book, Treasure Islands, Nicholas Shaxson divides tax havens into a set of continental European havens, a British zone of influence centered on the City of London, a zone of influence focused on the United States, and a fourth category holding unclassified oddities like, Somalia and Uruguay. Shaxson’s main examples of tax havens are: the Cayman Islands, the Bahamas, Jersey, Hong Kong, the Isle of Man, Switzerland and Luxembourg.  But what happens in these centres?

Tax Evasion, Tax Avoidance and Financial Regulation Avoidance

Offshore financial centres are popular with the financial industry, because they facilitate in tax avoidance (and in some cases evasion) and financial regulation avoidance.  It is very important to make a distinction here between tax avoidance and tax evasion. Tax evasion is criminal behaviour and in most countries punishable by fines, imprisonment or both. Tax avoidance refers to structuring one’s affairs so as to reduce one’s tax liability within the limits of the law. Such activity is usually legal (although maybe unethical).

The industry of tax havens also provides foreigners with the opportunity to avoid financial regulation. For example off-balance sheet, which usually means an asset or debt or financing activity not on a company’s balance sheet. Financial regulation avoidance conducted through tax havens does not contribute to transparency of the systems. And we need transparency in order to make the global financial system stable, predictable and equitable.    

Tax Havens and the Financial Crisis

Especially the avoidance of financial regulation conducted through tax havens could have triggered today’s crisis. But there still is debate on whether tax havens played a crucial role or not during the financial crisis. Questions about the role of tax havens in the global financial architecture arise because of the sheer amount of money that goes through them and countries that are in desperately need of tax revenues.  So that is why offshore financial centres are sometimes ‘blamed’ for the crisis. For example when the British firm Northern Rock and the Benelux firm Fortis Bank went down, it appeared that they had been operating in tax havens such as the British Virgin Islands, the Cayman Islands and Jersey.

It is clear that tax havens did not cause the financial crisis, but they contributed to it mightily. Tax havens are a risk to the global financial system. In the previous Peace Palace Library blog about the financial crisis I paid attention to Cyprus. The Cyprus crisis has also shined a light on the special tax status of the island in the eurozone. That status, though, is not very different from that of other European countries. Cyprus went down, but what about the other havens?

Attack Tax Havens?

Tax HavenWhen you look at the history of tax havens it is remarkable how long it took before tax havens appeared on the agenda of international politics and global governance. The bankruptcies in the last ten years helped drawing attention to the offshore economy. During the financial crisis, G8 and G20 countries compelled tax havens to sign bilateral treaties providing for exchange of bank information to fight bank secrecy. And also this month, during the G8 Summit in Northern Ireland, countries talked about the exchange of information in tax matters.  

However, it is very difficult to ‘attack’ those tax havens. Havens are often caught between protecting those who bank with them and helping to share tax details. Sharing tax details is necessary to create financial stability and moreover openness. There is a need for more cooperation between fiscal and financial regulators. But the initiatives to address the offshore economy are a welcome beginning. It is a step forward, but we all need to continue the fight against secrecy jurisdictions. The focus should not only be on the tropical and sunny islands, but also on the U.S. and Great Britain. We are all players in the 'secrecy game'.  

That does not mean that it’s still a lovely thought to drink a cocktail on one of the beaches of the Cayman Islands. Without having to worry about money…

This was the second blog in a series of Peace Palace Library blogs about the global financial crisis. Previous Peace Palace Library Blog: Cyprus Crisis: Troika go Home?

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