Tax Havens and Foreign Direct Investment
AEI—INTERNATIONAL TAX POLICY FORUM SEMINAR; With a Keynote Address by Congressman Bill Thomas (R-Calif.), Chairman of the House Ways and Means Committee
About This Event

At this conference, panelists will consider the distinguishing characteristics of “tax haven” countries, the use of tax havens by U.S. and foreign investors, and the economic impacts of tax havens on high-tax countries. Unilateral and multilateral policy responses will be discussed, including presentations by Bill Thomas, chairman of the U.S. Listen to Audio

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House Ways and Mean Committee; Jeffrey Owens, director of the Organisation for Economic Co-operation and Development’s Center for Tax Policy and Administration; and Michel Aujean, the European Commission’s director for tax policy.

8:30 a.m.
Registration and Continental Breakfast
Opening Remarks:
Kevin A. Hassett, AEI
John Samuels, General Electric
Panel I: Tax Havens Old and New
James Hines, University of Michigan
Paul Oosterhuis, Skadden Arps
Michael Graetz, Yale University Law School
Panel II: Economic Effects of Tax Havens
Mihir Desai, Harvard Business School
Mark Spiegel, Federal Reserve Bank of San Francisco
Martin Sullivan, Tax Analysts
Alan Auerbach, University of California at Berkeley
Panel III: Policy Responses to Tax Havens
Rosanne Altshuler, Rutgers University
Michel Aujean, European Commission
Will Morris, General Electric
Jeffrey Owens, Organisation for Economic Co-operation and Development
R. Glenn Hubbard, AEI and Columbia University
12:30 p.m.
Luncheon and Keynote Address
R. Glenn Hubbard, AEI and Columbia University
The Honorable Bill Thomas, chairman, U.S. House Ways and Means Committee


Event Summary

December 2006

Tax Havens and Foreign Direct Investment

At this AEI conference on December 11, 2006, panelists considered the distinguishing characteristics of "tax haven" countries, the use of tax havens by U.S. and foreign investors, and the economic impacts of tax havens on high-tax countries. Unilateral and multilateral policy responses were also discussed.

Panel I: Tax Havens Old and New

James Hines
University of Michigan

Tax havens are countries that offer favorable tax regimes to foreign investors. These countries tend to be small, affluent, and well-governed. Potential incentives to be a tax haven include attracting foreign investment and reaping the resulting economic benefits.

Tax havens score well on governance indicators for their GDP level. They are better governed as measured by political stability, government effectiveness, rule of law, control of corruption, and accountability. For tax havens, the governance effect is positive and significant. Good governance improves the probability of a country being a tax haven, as long as the population is below one million.

Evidence suggests that the reason for the correlation between governance and tax havens results because poorly governed countries have a harder time attracting foreign investors. Lower tax rates are more likely to spark foreign investment if the country is better governed.

Paul Oosterhuis
Skadden Arps

Hybrid-entity tax-haven planning also involves the planning of manufacturing, supply chains, and finances. There are two options: first, to place a lot of economic activity in the tax haven; and second, to place economic activity elsewhere and shift risk to the tax haven.

An example of the principal manufacturing option is if an Irish entity takes the risk to contract between the manufacturer and the local businesses. The selling company takes little risk, because the Irish entity is the one contracting with the plant. The returns then accrue in Ireland, a low-tax-rate country. The financial risk is shifted to successful tax havens because returns are then taxed at a lower rate.

Other circumstances include debt financing and reverse hybrids or a tax-haven entity without jurisdiction. In the United States, a limited liability company (LLC) is a tax-haven vehicle. For example, a foreign parent company set up an LLC in Spain as a finance vehicle for non-U.S. subsidiaries it wishes to leverage. The LLC has a branch in the United States, but the interest is from foreign sources, so there is no tax in the United States and dividends return to Spain.

Panel II: Economic Effects of Tax Havens

Mihir Desai
Harvard University

Many governments are concerned about the use of tax havens, especially the loss of tax revenue, economic activity, and the "race to the bottom." Tax havens do not necessarily decrease economic activity, because the total amount of activity is not fixed. Tax havens can stimulate greater activity by providing inputs used elsewhere and by lowering after-tax cost-facilities activity in non-haven countries.

Larger firms, greater intra-firm trade, elevated research and development, and higher non-haven tax rates all contribute to greater haven usage.

There is no evidence of diversionary activity from havens to non-havens, but there is symmetry resulting from increased activity in non-haven locations. The two are complementary because a corporation is able to do more business with a haven nearby.

The data do not support a race to the bottom because open economies have the incentive to tax differentially. Efforts to get rid of tax havens will be destructive.

Mark Spiegel
Federal Reserve Bank of San Francisco

Offshore financial centers (OFC) are jurisdictions that oversee a disproportioned amount of non-residential financial activity. In 2000, the Organisation for Economic Co-operation and Development (OECD) identified thirty countries engaging in harmful tax practices and issued deadlines for change. The G8 has also created a task force in response to money laundering concerns.

If a country is a tax haven or money launderer, then there is a higher probability of it being an OFC. OFCs facilitate circumvention of local jurisdictions and tax laws. No significant relationship was found between OFC determination and institutional quality or legal regime. OFC remoteness is associated with an increase in monopoly power at statistically and economically significant levels.

The positive effects of having an OFC nearby include greater financial depth and the potential for more competition in the banking sector. Countries close to OFCs have lower interest rates and a lower bank-concentration ratio. OFCs are more appropriately characterized as symbiotic.

Martin Sullivan
Tax Analysts

The 1962 international tax scene is different than today’s. There were then far fewer multinational corporations and little foreign direct investment (FDI). For example, in 1983 a mere 7 percent of investment was in low-tax countries. John F. Kennedy supported international tax reform to promote economic growth in third world countries. Today we are concerned with runaway corporations, cross-border transactions, and higher amounts of FDI in low-tax countries.

Excepting Canada and Mexico, we have a $32 billion trade deficit with an average tax rate of 12 percent. With high tax countries such as Japan and Australia, we have a positive $26 billion trade balance. With Ireland, we have a $12.3 billion trade deficit, which indicates that investment in low-tax countries increases our trade deficit.

Because of the problems associated with direct investment in low-tax countries, the United States should consider modestly tightening rules pertaining to active income generated in low-tax countries. We can do this by requiring U.S. companies investing abroad to pay additional taxes equal to the difference between the minimum rate and the foreign rate.

Jeffrey Owens
Organisation for Economic Co-operation and Development

Tax treaties minimize friction between national tax differentials. The issues here are not so much those of low taxes as they are secrecy, unwillingness to cooperate, and lack of transparency, which can lead to money laundering, misuse of corporate vehicles, terrorist financing, tax abuse, and threats to the stability of the financial system. The OECD uses the term "tax haven" to indicate a place that maintains secrecy and uses the minimum tax illegally.

More than $5 trillion are held offshore, creating a potential economic loss not only for OECD countries but for developing ones as well. Research should examine the implications of revenue loss and distortions of capital flows. The illegitimate use of tax havens undermines taxpayers’ perceptions of a fair system, and tax evasion constrains the ability of governments to reduce tax rates.

The OECD is seeking from tax havens more transparency and access to bank records, more cooperation with tax authorities, and more exchanges of information. It is not enforcing certain tax rates and giving unfair advantage for OECD countries in order to set up a harmonized tax system.

Panel III: Policy Responses to Tax Havens

Michael Aujean
European Commission

Tax competition is an issue for the European Union (EU) because of its impact on tax revenues, tax structure, correct allocation of resources, and equity. There is a tax-rate discrepancy between new and old EU states which is necessary in order for newer members to develop through FDI.

The continued decline of corporate statutory tax rates is a concern in Europe. The problem is not FDI but rather profit-shifting activities and harmful tax measures. The latter include advantages given only to non-residents.

The common corporate consolidated tax base is a viable solution because it addresses profit allocation for participating nations. While a uniform tax rate is not the solution, rates should be monitored with regard to tax competition.

The code of conduct for business taxation for member states is a political commitment not to enter into harmful tax competition and to promote the adoption of aforementioned principles in developing countries. This measure is not against general tax competition but instead asks all OECD countries to commit to and respect the code of conduct.

Will Morris
General Electric (GE)

These proposals can be helpful to businesses. Yet the leverage which debt allows means that businesses can expand, so debt financing and interest payments are not bad. Governments have the right to protect tax payments, so there should be rules about interest deductibility.

The government can include tax to equity, safe harbors, hybrid rules, and interest cover. Interest cover requires looking at earnings to determine what interest payments a business could support.

But these measures do not necessarily take into account what businesses do. For instance, GE has many kinds of businesses, so one leverage ratio will not be sufficient. In the United Kingdom, there are three interest-restriction regimes, and this inhibits efficiency because of the complexity it imposes on business. The use of debt is widespread and efficient, and it is something we should not limit.

Roseanne Altshuler
Rutgers University

Territoriality refers to applying all income or retaining anti-deferral rules for highly mobile incomes. The proposed dividend-exemption system requires allocation of expenses with tax exempt income. Should the United States have something in addition to the anti-deferral rule? Canada restricts exemptions to countries with which it has a treaty. Singapore maintains a territorial system and restricts exemptions to countries with at least a 15 percent rate. Other additions to the anti-deferral rule include being subject to tax requirements and a minimum level of foreign taxation.

The response could be a dividend-exemption system in which active foreign income would be exempt from U.S. taxation. Royalties and interest paid to the U.S. parent company would be taxed, and passive income would be taxed based on the current system. The parent company’s overhead expenses would be allocated to exempt income, and research and development expenses would be fully deductible, since royalties are taxed.

If we need a special tax haven regime, maybe we need help from tax planners, since rates are transitory. The Joint Committee on Taxation and advisory panel proposals both retain Subpart F. We could use the dividend-exemption system to revisit Subpart F and pay attention to behavioral responses.

Keynote Address

The Honorable Bill Thomas (R-Calif.)
Chairman, House Ways and Means Committee

The Democrats have been talking about the approach they want to take with taxes. They want to use Pay-Go. But structurally, it is difficult to make meaningful legislative changes while having to figure out where the money to do it will come from. Instead of focusing on the alternative minimum tax, it is important to look at changing the fundamentals of the tax code and creating a different tax structure that modifies behavior.

The Democrats also talk about closing the tax gap. A Government Accountability Office study estimates a $345 billion difference between what was owed and what was paid in 2005. In order to close the gap, the IRS must receive additional funding for education and enforcement. This sounds good in theory, but the process is too lengthy. The data on the tax gap is imprecise or unavailable, so estimates are most likely incorrect.

In the last six years, Congress has accomplished more than expected on Social Security and health savings accounts. However, we have to fundamentally change the relationship between living and health by continuing to educate, work with Congress, and show companies that they need to plan for the long term rather than the present. For the future, we need to focus on individual wellness and investment in health.

AEI intern Jenna Lally prepared this summary.

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