By Dan Mitchell and Brian Garst
The international financial sector faces a perilous future. Major challenges loom over an uncertain global economy, while a decidedly negative political climate poses an existential threat to the offshore financial community. With each passing year, thanks to demographic changes and poorly designed fiscal policies, politicians from high-tax nations will be increasingly fixated on halting the migration of jobs and investment to lower-tax jurisdictions. Individuals and jurisdictions that benefit from free international capital flows must act now if they wish to weather the coming storm.
A Bleak Onshore Economic Outlook
Decades of irresponsible spending have left many developed nations with obligations they cannot hope to meet, while demographic trends threaten to push their floundering economies over the edge. Falling birth rates and climbing life expectancies are combining to transform the world's major economies, turning population pyramids – where the young and healthy vastly outnumber the old and infirm – into population cylinders.
Consider some basic data: In 1970 the birthrate across the OECD was 2.76 children per woman. By 2010 it was 1.74, which is below the replacement level of 2.1. At the same time, positive advances in healthcare are helping people live longer than ever, but that also means an increased burden on workers to provide for the retired or infirm. As welfare states can only function when there are many more workers than dependents, this transformation poses serious fiscal challenges.
Simply stated, the burden of government spending is projected to dramatically increase in developed nations. And because budget will grow much faster than the private sector, this is a recipe for lots of red ink. If current trends continue, nations like France, Germany, Belgium, the United Kingdom, and the United States are all projected to see debt levels rise to 300 percent-500 percent of gross domestic product (GDP) over the next few decades. It's a recipe for many more Greek-style fiscal collapses.
Don’t forget that nations such as Greece, Italy, Spain, Ireland, and Portugal got into trouble with debt levels between 80 percent-120 percent of economic output. This doesn’t mean the world’s major economies will be attacked by “bond vigilantes” when their debts reach that level. After all, Japan is still stable with debt levels exceeding 200 percent of GDP. But it does suggest that the world’s big nations are heading for trouble in the absence of significant fiscal reform.
Politicians Fan the Flames
Adding to the coming calamity are politicians who have conveniently misdiagnosed the fundamental problem as one of insufficient tax revenue instead of excessive spending. Contrary to claims of widespread austerity, for instance, taxes have been climbing since the 2008 financial crisis. Average top personal income tax rates in the EU have steadily increased in recent years. So has the average standard VAT rate. But if politicians think that endlessly rising taxes will solve their fiscal problems, then they are in for disappointment.
Revenue increases do nothing to solve a problem caused by a spending burden that climbs faster than private economic output. Consider that the European tax burden as a percentage of GDP has grown 10 percent over the last 40 years, but debt grew by more than 20 percent of GDP over the same period. In other words, additional revenue simply enables a higher spending burden. Until they correctly recognize that more spending is the source of their problem, politicians can be counted on to exacerbate their fiscal problems with higher tax rates.
Another challenge is that higher tax rates don’t necessarily translate into higher tax revenue. That’s especially true if politicians impose class-warfare tax hikes on the so-called rich. Simply stated, people with lots of business and investment income have considerable ability to alter the timing, level, and compensation of their income. So when their tax rates increase, they figure out ways to reduce their taxable income.
Yet these higher tax rates almost certainly will dampen economic performance. In other words, fiscal policy in many OECD nations is in a downward spiral. Politicians seek to buy votes with more spending, particularly for income redistribution programs. These policies hurt growth by discouraging participation in the economy’s private sector. Politicians also impose higher tax rates, ostensibly for purposes of fiscal balance. Yet these higher rates further discourage productive behavior, leading to less work, saving, and investment. And as the private sector languishes, there is even more political pressure for additional government spending, which then leads to more taxes and even weaker growth.
At some point, a fiscal crisis occurs because there is too much debt and so much stagnation.
Notwithstanding this destructive cycle, the political class is still agitating for more taxes. Not only do they want increases in existing taxes, but they’re also looking to institute new taxes on financial transactions and carbon emissions, and even to revive old wealth taxes.
These trends do not bode well for the global economy. Achieving real growth is difficult with a shrinking work force and other unfavorable demographic changes. Boosting investment and deepening the stock of capital might be able to make up the difference, but not with politicians squeezing the life out of the productive sector through excessive taxes, particularly discriminatory taxes on income that is saved and invested.
Blocking the Escape
Knowing that high taxes are likely to spark an exodus of jobs and investment, politicians in high-tax nations are compounding the problem with anti-tax competition policies aimed at hindering mobility of labor and capital. More specifically, in a misguided attempt to prevent citizens (and their money) from fleeing high tax nations, they are using international bureaucracies and institutions such as the G-20 and the OECD, to attack low-tax jurisdictions and the service providers that help protect taxpayers from excessive fiscal burdens.
This is unfortunate since tax competition between jurisdictions has served an important role by making it at least somewhat more difficult for politicians to impose bad policy. It also means that one nation's fiscal mistakes can be another's opportunity to attract investment, thereby mitigating the economic harm of bad policy. Thwarting tax competition by erecting barriers to cross-border flows, on the other hand, will ensure maximum negative impact from the poor policy choices seen in recent years.
The G-20 and OECD continue to serve as the primary vehicles through which high tax nations seek to undermine tax competition. The anti-tax competition campaign began in the 1990s as a response to globalization. Politicians from high-tax nations resented the fact that some governments were lowering their tax rates to attract more jobs and investment. And because it was increasingly easy for labor and capital to cross borders, this created a virtuous cycle, at least from the perspective of taxpayers.
But high-tax welfare states weren’t happy. So they decided to use international bureaucracies to fight back. The campaign became public with the release of a 1998 report called, “Harmful Tax Competition: An Emerging Global Issue.” In the years since, the OECD has grown increasingly bold in its reach.
First came the blacklists, where jurisdictions with low tax rates and attractive policies were singled out and pressured into counterproductive reforms. Among other things, they were required to sign Tax Information Exchange Agreements with a certain number of countries in order to be taken off the OECD's naughty list.
When that proved insufficient to stop the flow away from high-tax nations, bureaucrats unveiled the Multilateral Convention on Mutual Administrative Assistance in Tax Matters. It would require signatories to enforce the bad tax laws of other nations, while granting the OECD power of judge, jury, and executioner over any disputes.
At the same time, the United States began a unilateral effort at global tax enforcement. Under the threat of protectionist tax penalties, the Foreign Account Tax Compliance Act (FATCA) conscripts financial institutions throughout the world, as well as their governments, to act as American tax enforcers. The OECD's tax collectors apparently saw the pain caused by FATCA and got jealous. If the United States could demand that other nations and foreign institutions enforce bear the cost and responsibility for enforcing US tax law, why could others nations not do the same?
The latest Common Reporting Standard takes all the work jurisdictions have put into placating the OECD for the last decade by meeting TIEA requirements and throws it out the window. The idea that a jurisdiction should sit back and wait for another nation to request the financial information of a resident – based on a reasonable suspicion – is now scoffed at. The new standard of automatic exchange instead obliterates the presumption of innocence that formed the foundation of past cooperation and treats international investors and low-tax jurisdictions alike as little more than resources of high-tax nations to exploit at will. Due process legal protections no longer apply.
This has all sorts of disturbing implications. Until now the United States has, with narrow exceptions, been the most aggressive perpetrator of worldwide taxation. Not only worldwide taxation of capital income, but also corporate income and labor income. But it is not through generosity or sound principles that politicians elsewhere refrain from reaching into their citizens' pockets regardless of where they live or work. Rather, they lack the institutions and resources to operate at a global scale. With a regime of automatic exchange in place, however, more can be counted on to soon follow in American footsteps and adopt destructive worldwide tax systems.
Offshore Must Be Proactive
Politicians have always resented the ability of the private sector to adapt and dodge their most destructive policies. In today's economic climate, they are more desperate than ever to contain and harvest revenue from the productive sector of the economy. They are also politically emboldened to take radical steps in a misguided quest to mitigate the damage from decades of profligate spending and unsustainable welfare systems.
Their efforts will ultimately backfire economically at both the national and international levels, but not before doing serious harm to onshore economic performance and the offshore tax-planning community. To mitigate the damage, low-tax jurisdictions and offshore service providers must come together and defend their right to exist by advocating for the principles that have allowed it to thrive.
Globalization provided opportunities for low-tax jurisdictions. If they were willing to implement pro-growth policies, they could capitalize on the mistakes of high-tax nations. But if the G-20, OECD, and high-tax nations are successful, low-tax jurisdictions will no longer be allowed to benefit from the free flow of labor and capital.
Those jurisdictions, as well as the private sector in those nations, must now decide whether meek acceptance of a harsher climate dictated by the whims of high-tax nations is the wise approach. At best, acquiescence means slow death.
Resistance might seem difficult, but it's not without precedence. When the OECD first pushed its Harmful Tax Competition initiative, pushback from the US and others forced the global tax collectors to retrench. Though they returned to pursue their goals through other, more indirect means, they nevertheless suffered a serious setback.
Today, resistance is already taking shape against one pillar of the global tax crackdown. FATCA not only faces growing political opposition within the US in addition to widespread international hostility, but it will soon be subject to major legal challenges. Its significant practical obstacles also continue to reveal the folly of prioritizing enforcement of bad laws at the expense of all other considerations – like cost, privacy and international comity.
FATCA was acknowledged as a precipitating force for the OECD's current push for automatic exchange. If it fails, it may provide opportunity to push the OECD back as well. Doing so will require an offshore community organized around a common understanding of principles for international finance such as respect for privacy and recognition of sovereign boundaries.
Most people in offshore jurisdictions, whether in government or the private sector, don’t appreciate their perilous situation.
Onshore nations, particularly members of the OECD, have very dismal fiscal outlooks. This unambiguously will give them big incentives to seek out new sources of tax revenue. Yes, they will impose higher taxes inside their borders in order to prop up their welfare states.
But they will have an even greater incentive to attack the offshore world in the search for new revenue.
And this isn’t just an issue of financial privacy and so-called tax evasion. The OECD and G-20 now explicitly are seeking to undermine and cripple tax avoidance and other forms of legal tax planning. The OECD’s Base Erosion and Profit Shifting initiative is just one example.
From an economic perspective, one hopes the offshore world will survive these attacks. There aren’t many constraints on the greed of the political class. And if they succeed in destroying tax evasion and tax avoidance, politicians will feel even further emboldened to implement destructive tax laws.