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Friday, November 18, 2011

How to Tackle the Tax Havens

As I argued in a recent post, tax havens cost the middle class worldwide hundreds of billions of dollars a year, which has to be made up via higher taxes on the middle class, higher budget deficits, or program cuts. In this post, I will discuss several ways to cut the tax havens down to size. Broadly speaking, we need to expose tax haven activities, neutralize them, and ultimately roll back banking secrecy, the key element of havens' existence.

Just as with subsidies, tax havens can only emerge as a political issue if their activities are widely known. One element of this is simply to report on them and keep them in the spotlight. Stories like "Tax Me If You Can" on Frontline exposed tax scams run out of the Caymans that were promoted by one of the world's major accounting firms, KPMG. But the reform that would illuminate the largest dollar volume of tax haven activity would be to force companies to report their accounts on a country-by-country basis rather than the consolidated accounts they now publish. As Palan, Murphy, and Chavagneux point out, consolidated accounts let companies hide their transfer pricing abuses because they do not report inter-affiliate transactions. Being forced to report sales, profits, size of workforce, taxes paid, etc., by location would immediately expose cases where tiny workforces, or none at all, generated big profits in tax havens. Moreover, Palan et al. note, because this regulation is enforced via the companies, it would not require the cooperation of the tax havens, most of which have been uncooperative in providing information despite agreements they may have signed.

Once exposure generates enough political pressure to get something done, specific reforms can be enacted. One way to neutralize corporate use of tax havens is to prevent transfer pricing. This can be done through what is variously called "combined reporting" or worldwide unitary taxation. This approach ignores the legally separate existence of each of a multinational corporation's subsidiaries and treats them as a single entity, using a formula to determine what percentage of the company's profits to tax. For example, if BP makes $25 billion in 2012 and 20% of its operations are in the U.S., under combined reporting the U.S. would tax BP on $5 billion. If 5% of BP's operations are in Louisiana, the state could tax BP on $1.25 billion of income. Determining the proper percentage is done by formula, using factors such as sales, employment, and assets. With combined reporting, it doesn't matter where a company claims it made its income, because the formula overrides such shenanigans.

It should be noted that the Organization for Economic Cooperation and Development, which began targeting tax havens in 1998, opposes combined reporting, despite its efficacy, because multinational corporations oppose it, and the OECD's model tax rules strongly reflect the preferences of the multinationals. Hence, there is something of a contradiction in the OECD position, as I argued in 2002.

However, these reforms still would not get at individual tax evasion, which by itself is estimated to cost governments worldwide $255 billion a year. This requires tackling secrecy directly. One model is the European Union's Savings Tax Directive, which requires that Member States either withhold 35% of interest income earned or provide complete information on all interest income earned in their territories. As Palan et al. recommend, this can be expanded beyond individuals to corporations and trusts (currently a loophole in the directive); it could obviously be expanded to other forms of income. Other measures have been used over the years that can also be effective. One, used by the U.S. Internal Revenue Service in relation to Caribbean tax havens like the Netherlands Antilles, is simply to step up auditing on transactions involving tax havens.

There is still a long way to go in stamping out tax havens. Nevertheless, progress is being made in the EU, and the political climate in the U.S. is far more favorable now than under President Bush. Palan et al. are optimistic that tax havens will be subject to continuing pressure as a result.

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