When I was in college in the late 1970s, a friend made the mistake of inviting a cult-like political organisation to give a presentation in his dorm room. A group of us attended, to protect him from their clutches. Whenever we would challenge one of the cult’s more absurd statements (my favourite was that Queen Elizabeth II was behind a conspiracy to poison America’s youth with drugs, which had begun with the Beatles’ infiltration of the US music market), a different member of the group would interrupt with the statement with “but that’s not the point”, and make a wholly different (and equally absurd) claim. The debate over whether international financial centres (IFCs) somehow increase global economic instability reminds me of that experience.
The critics of IFCs have previously argued that tax competition promoted ‘treaty shopping’, led to money laundering, was ‘harmful’, and promoted financing of terrorism. When confronted by the flaws in each of these arguments, they just pivot to a new claim. The claim that tax competition increases global financial instability is just the latest iteration in a series of shifting arguments made by what we can call the high-tax coalition: intergovernmental organisations (the OECD, IMF, EU), high-tax governments (eg France, Germany), and NGOs (eg Global Witness, the Tax Justice Network).
As they often do, this coalition gets things backwards. The high-tax coalition fails to grasp with whom IFCs are competing, and so makes a fundamental mistake in its analysis of the effects of IFCs as competitors. Moreover, the high-tax coalition is stuck in a 1960s view of IFCs as ‘sunny places for shady people’, a business model that was long ago made obsolete by the expansion of information exchange and global cooperation by financial regulators.
With Whom Do IFCs Compete?
For the most part, high-tax coalition critics focus on nominal rates, not considering the significant differences between nominal and effective tax rates, which take into account different rules on things such as depreciation, investment tax credits, and the like. These differences have a dramatic difference in how much businesses actually pay in taxes, so comparisons that depend on comparing nominal rates should be dismissed as unserious. Even taking into account such differences, as well as the substantial fees and transaction costs firms incur to do business in IFCs today, IFCs generally do offer relatively low net taxes compared to most large jurisdictions. But focusing on this misses the point that their tax structures are more about providing a tax neutral environment than lowering overall taxes paid. Thus, the competition provided by IFCs today is less about tax than it is about regulatory competition.
This should not surprise anyone. IFCs are competing for types of business in which money is going to flow through them, rather than be invested in them. For example, Bermuda, the Cayman Islands, and Guernsey, have successfully persuaded firms from around the world to use them to form insurance entities of various types (eg captives, reinsurers), in part by not taxing the profits from the investment of an insurer’s reserves. Crucially, those reserves are not invested in these small island economies, but in assets in large economies. Similarly, while investment funds are legally formed in IFCs, few hold assets located in those jurisdictions. Thus, the growth in value of the investments occurs outside IFCs (and the jurisdictions where the investments are made have opportunity to tax them should they so desire). The profits of an offshore insurer’s investment of its reserves or an investment fund are ultimately shared with the parent of or investors in those entities, who can be taxed in their home jurisdictions. IFCs are thus competing not for investment but for the business of legally forming and operating the entities that conduct the investments. Not adding the expense of an additional layer of tax to the cost of using an IFC is more a matter of removing an obstacle than providing a positive incentive. IFCs simply aren’t competing in the same market as onshore governments.
Because of their backward-looking mindset, the high-tax coalition incorrectly sees IFCs as the equivalent of jurisdictions competing for businesses seeking to locate manufacturing plants. For example, the luring of employers to lower tax states within the United States – for example, my home state of Texas, which has no state income tax, is particularly successful in persuading California businesses to escape California’s punitive levels of state taxes by physically moving their facilities to Texas – is a wholly different kind of tax competition. (There’s a good case for it too, which we need not go into here.) When a US business uses a Cayman entity for its captive insurer or an investment fund organised in Cayman is used to direct international capital flows into the United States, Cayman isn’t ‘stealing’ business or tax revenues from another jurisdiction, but reducing the cost of doing business in the United States (captives) and bringing capital investment to the US economy (funds). In the absence of IFCs, there would be fewer such transactions and so less economic activity onshore, which would reduce onshore governments’ tax revenues.
Fiscal Responsibility And Economic Instability
A second critique from the high-tax coalition is that this competition leads to global financial instability. This argument has two parts. First, the high-tax coalition argues that tax competition starves onshore governments of needed tax revenues, preventing them from making necessary investments that would increase global financial stability. We can easily see the flaw in this argument by looking at large economies’ tax revenues over time. For example, between 2000 and 2022, the French tax-to-GDP ratio rose from 43.4 per cent to 46.1 per cent, while real French GDP grew over 30 per cent in the same period. This is not a sign of a tax-revenue-starved French government! If – while substantially increasing the tax-to-GDP ratio and overall GDP, so a bigger slice of a bigger pie – France somehow managed to underinvest in infrastructure or social welfare, that should be attributed to poor French policymaking rather than a shortage of tax revenue.
The second part of this argument is that transactions which occur in IFCs undermine global financial stability because they are opaque to onshore regulators. This argument fails to recognise that transactions in IFCs are not opaque to offshore regulators. And offshore regulators in every major IFC not only face fewer constraints on their ability to regulate than onshore regulators do, but they are also well connected to global regulatory infrastructure. Every major IFCs’ regulators belong to and participate in numerous international associations of regulators, from insurance to banking to anti-money laundering. Moreover, IFC regulators have an important source of control over financial flows that few onshore governments have: they require important parts of virtually all offshore transactions to be conducted using the services of professionals they licence.
The role of these licensed professionals is a crucial distinction between onshore and IFC regulatory environments. Their livelihoods – lucrative ones – depend on their maintaining their licences. This provides them with a powerful incentive to assist regulators in spotting and dealing with potentially problematic transactions. By contrast, onshore jurisdictions rarely regulate the crucial links – trust companies and corporate service providers, for example – in financial structures. Thus, in addition to the powerful incentive provided by IFCs’ dependence on revenue from the financial services sector that IFC regulators must ensure their jurisdictions do not contribute to global financial problems, the professionals in IFC financial industries also have a strong incentive to prevent problems that would cut off their future income.
Contributing To Financial Stability
Global financial stability depends on well-functioning financial markets, the free movement of capital to its highest and best uses, and regulators who can monitor potential problems and act when they discover them. IFCs enhance all three of these components of global financial markets.
First, IFCs both provide platforms for funds from investors in a wide range of jurisdictions to pool resources to fund productive activities around the world and reduce the transaction costs of engaging in productive activities. Tax neutrality enables investors to use a jurisdiction as a platform without incurring an additional layer of tax. Creative legal systems provide business vehicles – from segregated portfolio companies to limited liability companies – which enable investors to efficiently pool resources in productive endeavors.
Second, when capital markets’ arteries get blocked up by the plaque of unnecessary and cumbersome regulations, the movement of capital out of unproductive activities into productive ones is hindered. Those blockages leave pools of dead capital, preventing economic growth.
Third, IFC regulators are better positioned to monitor what is going on in their financial sectors. They have the tools and the incentives to deploy them, while it is not clear that many onshore regulators are in equally strong positions. Financial regulation in the United States, for example, is fragmented among multiple federal and state regulators, often with no single regulator positioned to understand particular sectors. The competition among IFCs for business – tax and regulatory – has pushed them to build cost effective regulatory regimes.
The temptation in large jurisdictions to blame IFCs and tax competition for global financial instability, rather than take responsibility for their own policy mistakes, has been irresistible. The transformation of the OECD from an agency dedicated to promoting economic growth in Europe after World War II into an advocate for higher taxes and increased bureaucracy worldwide (ironically while its own employees live tax free in Paris) has proven to be an effective vehicle for cartelisation of taxes.
If we total up the innovations introduced by IFCs over the past decades, as they have evolved from jurisdictions competing to provide cheap vehicles for holding assets outside high tax jurisdictions into sophisticated legal systems that grease the wheels of global commerce, IFCs’ contributions to the world economy become clear. If we want global economic growth to restart, those living in onshore jurisdiction need IFCs to continue cleaning the arteries of the global economy of the plaques created by our own dysfunctional legal systems.
Andrew Morriss
Andrew Morriss is Professor of the Bush School of Government & Public Service and School of Law at Texas A&M University.
Prior to this position, he was the Dean of the Texas A&M School of Innovation, the Dean of the Texas A&M School of Law, the D. Paul Jones & Charlene A. Jones Chairholder in Law at the University of Alabama, the Ross & Helen Workman Professor of Law at the University of Illinois, and the Galen J. Roush Chair in Law at Case Western Reserve University.