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Economic Outlook: Tax Dodging, Tax Havens, Fiscal Space and Human Rights

Two related pieces caught my eye this morning. Both pieces explore how owners of wealth (be it large corporations, wealthy individuals, or autocratic rulers) benefit from “offshore” financial centers.

The first piece, from the NYT, emphasizes how corporate tax avoidance disproportionately shifts the burden of paying for government services to regular people:

“As muddled and broken as the individual income tax system may be, the rules under which the government collects corporate levies are far more loophole-ridden and counterproductive.

That’s not entirely Washington’s fault. Unlike individuals, multinational corporations can shuttle profits — and sometimes even their headquarters — around the globe in search of the jurisdiction willing to cut them the best deal on taxes (and often other economic incentives).

Much of this occurs under the guise of “transfer pricing,” the terms under which one subsidiary of a multinational sells products to another subsidiary. The goal is to generate as high a share of profit as possible in the lowest-taxed jurisdictions.

A study by the Congressional Research Service found that subsidiaries of United States corporations operating in the top five tax havens (the Netherlands, Ireland, Bermuda, Switzerland and Luxembourg) generated 43 percent of their foreign profits in those countries in 2008, but had only 4 percent of their foreign employees and 7 percent of their foreign investment located there.

All in all, it is a race to the bottom on the part of revenue-starved governments eager to attract even a relatively small number of new jobs.

As a consequence, the effective corporate tax rate in the United States fell to 17.8 percent in 2012 from 42.5 percent in 1960, according to the Federal Reserve Bank of St. Louis. (The share of federal revenues arriving at the Treasury from companies has fallen even more sharply, in part because an increasing number of businesses are taxed as individuals rather than as corporations.)

That’s just not fair at a time of soaring corporate profits and stagnant family incomes.”

“Happily, the gaming of the tax system is becoming a global concern, with an action plan coming from the Organization for Economic Cooperation and Development in July. The O.E.C.D. should work toward taxing business profits where they actually occur, not where they’ve been shifted by some tax adviser.

As we strive for a global solution, we should take a number of interim steps, including better policing of transfer pricing.”

Another piece, written by Jeff Sachs at the Earth Institute, expands on this topic to bring other forms of money-laundering into the mix, as well as crystallizing the fiscal space / austerity argument against tax evasion:

“In recent weeks, citizens in many countries suffering from government budget cutbacks have been learning more and more about one of the biggest and most dangerous scams in the world: the global web of tax havens that U.S. and European politicians and bankers have nurtured over the years. The only real purpose of these havens is to facilitate tax evasion, money laundering, bribery, and lack of accountability for environmental and social calamities inflicted by international companies.”

“During the boom years, the rich and powerful kept the public distracted from the tax haven reality. Yet now with budget austerity, the public is having a close look at tax evasion by the rich and powerful. As a result, the veil over the tax havens has started to slip, and the sight is not lovely.”

“The politicians of rich nations who protect the exorbitant privileges of bankers and hedge-fund managers, who wink at mega-tax evasion by billionaires, and who tolerate unpardonable games played by major companies, are playing with fire. We are now all sharing austerity. The havens represent unacceptable privilege and abuse, not fair sharing.”

“Developing countries too are saying that enough is enough. For decades they’ve been on the receiving end of hypocritical lectures about good governance. For them, the tax havens have served the purpose of paying bribes to potentates, and providing easy ways for elites to keep their money safe from tax collectors. Yet it is the rich countries that have fostered that system.”

The existence of tax havens represent the political power of the ultra-wealthy and the collective-action problem facing the rest of the world. However, the internet and watchdog groups, along with crushing austerity programs in the wake of The Great Recession, have thrust tax-avoidance into the spotlight. This is the first step towards pressuring governments for real, coordinated action against this unfair practice. 

At best, tax-havens allow wealthy people to avoid paying their fair share of taxes. Every dollar not paid in taxes is a dollar more of debt for a government, a dollar less available for an important social program. Forget the moral and ethical implications of this “reverse-Robin-Hood” system for a minute. Economically speaking, this system leads to stagnant growth. Less wealthy people have a higher average and marginal propensity to consume, and tend to keep their money in their home country. Also, diminishing marginal utility of money states that less wealthy people (in the aggregate, there is of course there is anecdotal evidence against this point), spend a greater percentage of their money on things that are beneficial for social welfare. The current system provides for less, more wasteful consumption. It corrodes the “American Dream” by reducing social mobility and perpetuates income inequality. And this is what I would consider the “best case scenario”.

At worst, tax-havens offer a stable place for oppressive regimes to park their money. Elites can amass rents from a variety of places (most commonly extractive industries, or through black-markets / drug trade), and know that they have a safe place to keep that money. This money can then be used for personal reasons, or to build up a military to further entrench Elite control–particularly in less developed countries where democracy does not exist. It is not difficult to draw the link between entrenching autocratic, rent-seeking regimes, and human rights abuses.

A Reuters blog about the book “Treasure Islands”, by Nicholas Shaxton, articulates this point very well. “The broad brush — and this is a simplication of the overall argument — is that tax havens enable the flight of scarce capital from Africa to other regions, stunting the continent’s ability to develop on a range of fronts. Such havens inclue not only tropical destinations like the Cayman Islands but the City of London and the U.S. state of Delaware.” The book “Offshore: Tax Havens and the Rule of Global Crime”, by Alain Deneault, makes a similar argument.

The U.N. recently passed an Arms Treaty, with human rights considerations at it’s core. While arms trade was a natural starting point,  I believe this is a strong model for all international transactions. Any time large amounts of money are transferred, be it tax-avoidance or the hiding or ill-gotten gains, this money has the potential to fund / perpetuate human rights abuses. The sooner the international community realizes this, and acts in a coordinated fashion to review and (act on) the human rights implications of ALL financial flows, the sooner we will see a meaningful reduction in human rights abuses around the globe.

The U.S. famously prosecuted Al Capone, not for criminal activities, but because of tax avoidance. Autocratic regimes are in many ways similar to mafias, and they enjoy the additional protection of “national sovereignty” which allows them to continue to abuse human rights with relative impunity. Maybe we can take a page from history and allow the paper-trail bring down some of today’s worst human-rights abusers. Of course this would require a strong international justice system–with real punitive powers–which unfortunately does not currently exist.

The best case scenario of tax-avoidance is it unfairly shifts the burden of paying for government services from the wealthy to the not-wealthy, which compromises the ability of governments to pay for social programs. The worst case scenario is the perpetuation of human-rights violations. Obviously neither of these outcomes should be tolerable–we can only hope that a silver-lining of The Great Recession is that it will force governments to work together to tackle the issue of tax-avoidance and offshore financial centers, which affects developed and developing countries alike.          

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Economic Outlook: The Ripeness of Cyprus


That ripeness refers to the need for Cyprus to diversify it’s economy. Ripeness may not be the right word, as Cyprus is not willingly taking these measures but rather having them imposed, but what else rhymes with Cyprus? (Lack of ripeness, like with this peach, is often a good indicator it is time to throw out said peach, no?)

“Cyprus has a huge banking system — assets around 8 times GDP — based on a business model of attracting offshore money with high rates and good opportunities for tax avoidance/evasion.”

The problem with such a large banking sector is that it creates asset bubbles and leads to  a loss of competitiveness in other sectors. As Cyprus now faces the inevitability of having to diversify its economy away from the banking sector, it faces the difficulty of having wages that are uncompetitive with the rest of its neighbors. It is difficult to be competitive in export industries with a high cost of labor and a high cost of living, as these costs ultimately fall on producers making their goods less competitive. A high cost of living also depresses tourism, as people will choose to go to cheaper destinations.

Transitioning to export based growth is tough in today’s economic conditions, even when labor costs constitute a comparative advantage. This is due to a slump in global aggregate demand, particularly with Cyprus’s current trading partners—EU countries. The EU remains mired with high unemployment and recessions (which are currently hitting Cyprus particularly hard as well), meaning that finding markets for diversified exports would be difficult. The high unemployment (14.7%) and recession conditions (-3.3% GDP growth Q4 2012) mean that Cyprus cannot rely on its domestic markets to buy its goods either.

For these reasons, Cyprus has been reluctant to admit that it must abandon its unsustainable reliance on the financial sector. Cyprus tried to secure an EU bailout by imposing a tax on banking deposits—a measure that Cypriots forcefully rejected. It seems that ultimately Cyprus will have to agree to spare small depositors (average citizens) and force large depositors (who are often foreigners who go to Cyprus as a tax haven) to take a large “haircut”. This would undermine confidence in Cyprus’s banking sector, leading to capital flight.

Cyprus could impose capital controls to prevent capital flight, as Iceland did in a similar situation. This, along with uncertainty of Cyprus’s future in the EU, could mean less FDI (uncertainty is a huge deterrent to investment, especially in the case of a potential EU-exit) which Cyprus will need to diversify its economy due to high levels of debt (84% GDP as of Q3 2012) and high borrowing costs (7% interest rates on long term bonds).

Cyprus is currently at a crossroads, a point summarized nicely by Paul Murphy at FT Alphaville:

“Big depositors in Cypriot banks stand to lose circa 40 per cent of their money here, which has drawn plenty of fury and veiled threats from Russia.”

“Cyprus now has a binary choice: become a gimp state for Russian gangsta finance, or turn fully towards Europe, close down much of its shady banking sector and rebuild its economy on something more sustainable.”

So how are Cyprus’s prospects for economic diversification? Actually, this is a potential bright spot in an otherwise dismal picture (for data, see end of the post):

Cyprus has increased its spending, per person, at all levels of schooling over recent years. There has also been a shift to more advanced technological manufacturing, which could be a growth industry (High-technology exports as % of manufactured exports have risen from around 4% in 1990 to close to 40% in 2010). Energy production, specifically a natural gas field adjoining the Cyprus-Israel border, has been discussed as a potential growth sector.

The problem is such exploration requires large upfront costs and profits will not be realized for at least a few years. Given Cyprus’s high borrowing costs, an immediate bailout is needed—Cyprus simply cannot afford to wait for its economy to diversify, even if it was able to secure the funding needed explore it’s gas fields and / or avoid a Euro Zone exit.

Luckily, Cyprus has been laying down the seeds of economic diversification, but those seeds are not ready to sprout. Economic diversification will be painful, based on the composition of Cyprus’s labor force (agriculture 8.5%, industry 20.5%, services 71% (2006 est.); presumably a large portion of people in the services sector work in financial services).

Compounding the problem; “There’s still a real estate bubble to implode, there’s still a huge problem of competitiveness (made worse because one major export industry, banking, has just gone to meet its maker), and the bailout will leave Cyprus with Greek-level sovereign debt.”

Cyprus needs the troika (IMF, ECB, and EC) to provide emergency liquidity to allow its economy time to diversify. There will inevitably be some growing pains—hopefully harsh austerity is not imposed as a condition for receiving these loans, although recent history suggests it will be. Some internal devaluation will be needed to make Cypriot wages competitive again—something that is politically and socially undesirable (as wages tend to be “sticky”) but an inevitable consequence of losing control of monetary autonomy (being in the EU, Cyprus cannot devalue it’s currency to increase export competitiveness)

Cyprus has been investing in human capital, and already has the infrastructure for export based growth through its advanced system of ports, what is needed is stimulus spending to help mobilize Cyprus’s factors of production away from the financial sector.

Just like a child who knows he must do something he doesn’t want to do, Cyprus initially faced it’s unfortunate reality by trying to return to its security blanket—the financial sector. Ultimately, Cyprus needs to be weaned off the teat of the financial sector—even Russia, the biggest loser if large depositors take a loss, has stated it will not extend financing to Cyprus until it secures troika financing (Cyprus pursued Russian financing as an alternative to a troika bailout, presumably to allow it continue with its unsustainable banking practices, in exchange for preferential exploration rights by Russian firms of Cyprus’s natural gas fields. These talks thankfully did not bear fruit, as they would’ve moved Cyprus in the wrong direction; doubling down on an unsustainable financial sector while compromising its most obvious means of economic diversification–it’s natural gas reserves).

It is important to avoid a Euro Zone exit, as this would undermine investor confidence which is needed alongside troika loans to allow Cyprus to diversify its economy. Ultimately, investors will react favorably if Cyprus admits its financial sector is unsustainable and commits to economic diversification. A sustainable economic outlook will attract investment, especially in an industry as profitable a natural gas exploration, but also in other sectors due to low taxes (10% corporate tax rate in Cyprus–lowest in the EU, can help offset the current high wages in Cyprus and temper the social costs of internal devaluation).

Uncertainty and trying to hold onto an exposed unsustainable financial sector will drive away investors. Everybody can now see that Cyprus will have to force a “haircut” on large depositors. The sooner Cyprus “takes its medicine”, the sooner it can get on the path to sustainable economic development.

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