DO TAX HAVENS DIVERT ECONOMIC ACTIVITY?

An important contribution to the ongoing debate about the economics of tax havens.

ABSTRACT

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When multinational firms expand their operations in tax havens, do they divert activity from non-havens? Much of the debate on tax competition presumes that the answer to this question is yes. This paper offers a model for examining the relationship between activity in havens and non-havens, and discusses the implications of recent evidence in light of that model. Properly interpreted, the evidence suggests that tax haven activity enhances activity in nearby non-havens.

4. Conclusion

Contrary to many policy concerns and the assumptions of much of the tax competition literature, reduced costs of using tax havens do not appear to divert activity from non-havens.

The empirical evidence indicates that firms facing reduced costs of establishing tax haven operations respond in part by expanding their foreign activities in nearby high-tax countries. Hence it appears that careful use of tax haven affiliates permits foreign investors to avoid some of the tax burdens imposed by domestic and foreign authorities, thereby maintaining foreign investment at levels exceeding those that would persist if tax havens were more costly.

The available macroeconomic evidence indicates that countries have not reduced their taxation of foreign investment, or of capital income, to anything approximating the degree implied by many models of capital tax competition.

The use of tax havens by foreign investors may help to explain this empirical pattern, as high-tax countries are able to maintain high tax rates while continuing to draw significant levels of foreign investment. It is not even necessary that high-tax countries are aware of the importance of tax havens in preserving their ability to attract foreign investment. One further implication of this analysis is that tax harmonization within federations may actually foster, rather than restrict, tax competition. Some initiatives to harmonize tax rates would effectively raise the costs that investors face in order to obtain the benefits of using tax havens, thereby reducing foreign investment in the region. Downward pressure on national tax rates might well follow in an effort to attract investment, a process that could have been made less likely with the diversity afforded by allowing havens within a region.