Regulatory Competition: OFCs’ Vital Role in the World Economy

Politicians in many jurisdictions are outraged that some firms and individuals might be paying less tax than the politicians think they should as a result of offshore financial centers (OFCs). UK Chancellor George Osborne insisted that “it is necessary to collect tax that is owed and it is necessary to reduce tax avoidance and the crown dependencies and the overseas territories need to play their part in that drive and they need to do more.” Note, the complaint is not that any taxpayer broke the law. It is that there are tax strategies reducing taxes by following the letter of the law. Thus UK Prime Minister Cameron rejected the notion that being “within the law” was sufficient; “really aggressive tax avoidance” might be legal, he conceded, but would not be “playing fair”. 

While we might expect such rhetoric from French cabinet ministers (particularly those caught illegally evading French taxes), OECD bureaucrats enjoying tax-free salaries, or NGOs such as the Tax Justice Network (TJN), funded by tax avoiders making use of deductible donations to reduce their tax bills, it is remarkable to hear such claims from nominal friends of the rule of law and markets. This new focus on attacking legal tax avoidance measures makes the current assault on OFCs more frightening than mere political hypocrisy because it threatens to damage institutions which are vital to the world economy.

What the critics ignore is the important role OFCs play in promoting regulatory competition. Of course, governments and businesses both despise competition because it forces them to work hard. Firms must respond to price cuts and new products from competitors. Governments must work to persuade investors to locate wealth-generating activities within their borders. Competition pushes governments – as it does businesses – to innovate, to attract businesses and wealth. It means governments face limits on the exercise of their regulatory powers. Naturally, instead of focusing on the difficult task of enhancing their countries’ competitive advantages, like any would-be monopolist, politicians prefer to limit competition. 

In his book On Competition, Harvard Business School Professor, Michael Porter, who pioneered the idea of economies and firms focusing on sustainable, competitive advantages, examined what governments can do to promote successful firms and so sustain economic growth. He argued that one of governments’ most important roles is creating “the overall microeconomic rules and incentives governing competition that will encourage productivity growth.” These include “a competition policy enhancing rivalry, a tax system and intellectual property laws encouraging investment, a fair and efficient legal system, laws providing consumer recourse, corporate governance rules holding managers accountable for performance, and an efficient regulatory process promoting innovation rather than freezing the status quo.” This is precisely what OFCs help create by fostering regulatory competition. 

For countries where corruption is rampant, legal systems underdeveloped, and courts dysfunctional, OFCs offer alternative venues where businesses can be organised safely and efficiently. In particular, British Crown Dependencies and Overseas Territories have modern companies laws, sophisticated business trust arrangements, and well-regarded courts (often with a final appeal to the Privy Council, one of the world’s best commercial law courts). 

Taking advantage of the favourable legal environment, accounting firms, banks, insurance companies, law firms, and other professionals provide sophisticated services in these jurisdictions. Similarly, Hong Kong offers those investing into China a sophisticated legal and market alternative to the still developing mainland systems, just as Singapore does for South Asia. Many other OFCs have similar advantages. It would be nice if every jurisdiction had legal systems of the calibre of Germany, Japan, the United Kingdom or the United States. While not perfect, these jurisdictions have legal systems that allow financial markets to operate, firms to raise capital, promoters to organise businesses, and so on. Sadly, most countries lack the institutions necessary for a growing market economy.

Even with respect to well-functioning legal systems, OFCs offer opportunities to reduce regulatory costs, making firms more efficient. For example, investment vehicles aimed at institutional investors are often established offshore because being legally located in an OFC relieves them of the costly burden of regulations aimed at protecting small investors in broad financial markets. When a fund’s minimum investment threshold criteria already excludes all but the largest investors, there is no need to incur the regulatory costs of complying with onshore regulations focused on protecting unsophisticated investors. Not surprisingly, funds aimed at pension funds or sophisticated investors seek to avoid such costs.

Critics charge that this regulatory competition is a “race to the bottom”. In particular, they worry that competition from OFCs forces governments to cut taxes below the level needed to provide important public services in onshore countries. No doubt it is true that OFCs do exert pressure on tax rates. That’s not necessarily a bad thing, but it is not the most important pressure OFCs put on other legal systems. Critics’ and politicians’ focus on tax revenues misunderstands OFCs’ roles in the world economy and their real impact on onshore jurisdictions. To understand why, consider the types of transactions that actually occur offshore.

One of the biggest areas of growth offshore has been insurance. OFCs such as Bermuda, Guernsey, and the Cayman Islands, among others, have pioneered legislation and regulations that facilitate innovation in insurance. Offshore innovation led to the expansion of the captive insurance industry, the development of catastrophe bond markets, and fuelled the growth in global reinsurance. None of these have much to do with taxes – many American owners of health care captives are tax-exempt, non-profit hospitals. What captives offer is control over the coverage the insured can obtain, broadening businesses’ ability to risk-shift relative to the types of insurance offered by the commercial market. For charity hospitals, lowering the cost of malpractice (and other) insurance policies, increases the amount of reduced cost health care these non-profits can provide. 

The impact of offshore captives does not stop there. Competition from the Cayman Islands spurred Vermont and the District of Columbia, among others, to seek to develop their own captive industries. These onshore jurisdictions created legislation that offered some of the features of offshore captives and regulatory bodies that compete with offshore regulators. This competition continues, with the new Caymanian Portfolio Insurance Company law being the latest innovation in the North American captive market. It is unlikely that these American jurisdictions would have innovated in this fashion without the pressure from Cayman and elsewhere. 

The growth of the global reinsurance market, pioneered by Bermuda, is another example of the value of OFC-driven competition to economic growth. Reinsurance allows greater risk shifting, reducing the financial exposure to everything from natural disasters to terrorism. The risks reinsured are largely those occurring in onshore economies; there simply aren't enough risks in even the largest OFC to account for the US$500 billion in capital in global reinsurance markets. Similarly, the development of a market for catastrophe bonds – also pioneered by OFCs – expands the ability to shift risk to reduce the cost of insurance around the world. Again, business costs are lowered in onshore jurisdictions by the competitive innovations by OFCs. That means more economic growth, more jobs, and - ultimately - more tax revenue from the more profitable companies that evolve in onshore economies. 

Similarly, many international investment funds are legal entities in OFCs, as are many special purpose entities (SPEs) used to finance everything from commercial airliners to construction projects to credit card transactions. These are some of the entities OFC critics have in mind when they claim, as TJN does in its The Price of Offshore-Revisited, that “[a] significant fraction of global private financial wealth … has been invested virtually tax-free through the world’s still-expanding black hole of more than 80 ‘offshore’ secrecy jurisdictions.”   

OFCs do provide conduits for financial investments to flow into onshore economies, but little of the money that flows through them remains in the OFCs. TJN alleges billions are “idle in relatively-low-yield offshore investments”. This is simply silly and illustrates the intellectual incoherence of TJN’s argument. Even if it were true that the investors were content to receive low yields, the financial institution offering them such investments would need to invest the funds elsewhere to earn a profit. One way or another, funds in offshore investment vehicles flow into economies offering investment opportunities. Thus, money invested via offshore vehicles flows to larger economies where it is put to use financing economic activity and taxed by the jurisdiction where the activity occurs. 

Investment funds and SPEs are created offshore because the competition for this business has pushed OFCs to innovate in law and regulation. Offshore investment vehicles benefit from the high quality regulatory infrastructure available in OFCs and because tax neutrality lowers administrative costs. OFCs are better than onshore jurisdictions at regulating complex financial transactions because they are more focused on their tasks than the more cumbersome onshore regulators that must devote considerable resources to consumer protection regulations and other tasks.

Consider the US Securities and Exchange Commission’s (SEC) failure to catch Bernie Madoff during the many years in which Madoff ran one of the largest Ponzi schemes in history. Not only did the SEC itself not notice the numerous red flags Madoff’s activities raised, such as his funds’ accountant being a firm with just a single CPA and his implausibly consistent returns, but the agency failed to act when repeatedly provided evidence of Madoff’s fraud by whistleblower Harry Markopolos. (See Markopolos’ book No One Would Listen: A True Financial Thriller for the details). 

In contrast, OFC regulators’ close relationships with financial service providers make it far more difficult for someone bent on defrauding investors from slipping an unqualified accountant past the regulatory agency. As Clifford C Henson and I showed in Regulatory Effectiveness in Onshore & Offshore Financial Centers (Virginia Journal of International Law 53(2): 417-465 (2013)), OFC regulators generally have equivalent or better resources compared to onshore regulators relative to the number of entities they regulate and offshore regulators compare favourably to onshore regulators in their qualifications. 

OFCs innovate and in doing so increase the efficiency of the world economy and spur onshore governments to innovate in response. OFCs’ drive to innovate is stronger than their onshore competitors because of the importance of the revenue they derive from encouraging businesses to use their services. Fortunately for those of us living in less nimble societies, that competition helps keep all governments a bit lighter on their feet. Without regulatory competition, governments would behave like a classic monopoly, leaving us all poorer.

About the Author:

Andrew P Morriss is the D. Paul Jones, Jr & Charlene A. Jones Chairholder in Law at the University of Alabama School of Law and Chair of the Editorial Board, Cayman Financial Review. His article (with Tony Freyer), Creating Cayman as an Offshore Financial Center: Structure & Strategy since 1960 is forthcoming in the Arizona State Law Journal.