Whoever you are, wherever you live, and whatever you do, offshore is at work nearby....undermining the government you elect, hollowing out its tax base and corrupting your elected politicians....sustaining a vast criminal economy and creating a new, unaccountable aristocracy of corporate and financial power.
- Nicholas Shaxson, Treasure Islands (1)
The world seems overflowing with crises, ranging from the revolutionary to the financial, and from the economic to the apocalyptic—think, respectively, of the Middle East, Europe's sovereign debt debacle, the ongoing malaise in America, and global warming. Stresses of all kinds have been elevated for several years, and it would be rash to forecast a return to relative calm and stability across the lion's share of the globe any time soon. Indeed, there is good reason to believe that one specific, enduring, and accelerating structural change in the world's economic and political system underpins and perpetuates most of our current crises. This change is the rise of the offshore system. It is ruinous to markets and to governments alike. It is little discussed and poorly understood. And the time is long past due for the world to come to grips with it.
It is helpful to conceive of the offshore system as a vacuum that sucks capital away from the reach of governments. Three features of the system attract capital: tax avoidance, secrecy, and lax financial regulation. Corporations and wealthy individuals have flocked to tax havens since the rise of personal and corporate income taxes in the first quarter of the twentieth century, and the momentum has gathered pace with globalization and electronic banking in the last two or three decades. Legions of accountants and lawyers specialize in devising legal methods of assigning profits and assets to low- or zero-tax jurisdictions, which effectively hollows out the tax base of the countries where the wealth is actually produced. To give a stylized example, reflecting the standard practice of multinational corporations, consider “transfer pricing”. In transfer pricing, companies artificially split off some functions—logistics, say—and declare them to be the responsibility of a subsidiary located in a tax haven. They then manipulate the prices of transfers of goods and services between the core company and the subsidiary in such a way as to attribute the profits to the logistics subsidiary, while the rest of the company shows no profits, and thus pays no taxes.
Transfer pricing and related tax avoidance techniques have spread far and wide in the commercial world, overcoming any scruples top managers might have about them. As investigative journalist Nicholas Shaxson puts it: “In competitive markets, whatever is possible becomes necessary.” (2) The volume of US corporate profits routed through offshore facilities rose by around 60 percent between 1999 and 2007. (3) 83 of the 100 largest US companies are using offshore subsidiaries (4), and according to a US government sampling of evidence from 1998-2005, the majority of all American and foreign companies doing business in the US paid no Federal income taxes at all. (5)
The burden corporate tax avoidance places on honest businesses and rank-and-file taxpayers around the world is prodigious. Transfer pricing and similar income-shifting practices now cost the US treasury up to $60 billion per year. (6) Egypt lost an estimated $57 billion between 2000 and 2008. (7) Thanks mainly to the rise of the offshore system, US corporations' share of federal tax receipts shrank from 30 percent to just 6.6 percent over the last 50 years. (8)
Beyond facilitating tax avoidance, offshore jurisdictions provide secrecy. They generally arrange record-keeping in such a way as to preclude ever divulging the identities of company owners and trust account holders, which is an open invitation for wealthy individuals to route their money offshore and evade taxes and scrutiny. Offshore tax evasion techniques of wealthy individuals deprive the US Treasury of anywhere from $40-70 billion annually. (9) Globally, as of 2005, wealthy businessmen, corrupt officials, rapacious dictators, criminal kingpins, et al. held a conservatively estimated $11.5 trillion in various offshore jurisdictions. (10) This is about one quarter of all global wealth. Assuming a modest 7 percent annual return on that sum, and a 30 percent tax rate, this sum (conservative even as of 2005, I repeat) deprives world governments of $240 billion per year in taxes.
The real cost of secrecy is much higher, however. Secrecy facilitates crime and corruption. This swells capital flight, which has been particularly debilitating for developing countries. Capital flight has assumed epic proportions in the last two decades, reaching $1 trillion per year in the middle of the 2000s, and jumping to $1.26 trillion already by 2008—the recent acceleration reflecting skyrocketing prices for commodities, a sinister phenomenon in its own right. (11) Chinese elites are capitalizing most of all on offshore facilities. Former IMF economist Dev Kar has estimated illicit outflows of almost $2.2 trillion from China in the period 2000-2008; next on the list are Russia, at $427 billion, and Mexico, at $416 billion. Kar has also determined that secrecy functions of the offshore system have accounted for ever more of the illicit outflows from developing countries, and their volume might soon surpass that of commercial manipulations like transfer pricing. (12) And of course the crime and corruption fueled by offshore secrecy undermine citizens' faith in government, with more cascading consequences.
The third lure of offshore is lax financial regulation. Legislatures in obscure, backward territories are eminently susceptible to the blandishments of foreign interests aiming to skirt regulations on financial activities. For appropriate (hidden or indirect) compensation, these legislatures are willing to sanction all sorts of behavior that regulators have fought to control ever since the Great Depression. They can decide to relax or dispense with required bank capital ratios, to permit the issue of new securities without preliminary inspection, to immunize accounting firms from liability for fraud on the part of their customers, etc, It is no accident that, in these and other respects, offshore entities figured prominently in the recent financial crisis. (13)
Given the extraordinary costs of the offshore system to governments and markets alike, one would expect treasury departments to combat the system and bring it to heel. But here history has played a cruel trick on society. As the offshore system grew, it enriched the financial sector in the UK and the US immensely. Thus, UK financial sector stocks outperformed the broader UK equity market by an average of over 16 percent per year from 1986-2006, thanks largely to offshore activities. (14) Banking interests were soon powerful enough to influence their governments and thwart any efforts at concerted reform of their offshore trough (the last serious attempt actually came from John F. Kennedy).. Far from neutering the offshore system, the UK and the US actually incorporated it into their domestic systems. They brought offshore onshore, in effect, by offering tax avoidance and secrecy functions themselves, especially to foreigners. The Tax Justice Network's most recent (2009) Financial Secrecy Index ranked the US state of Delaware (registered home to an incongruous 882,000 companies as of 2008) an ignominious No. 1 in the world. (15)
The trillions of dollars of capital fleeing developing countries in recent years winds up in (or at least passes through) leading Western banks, and is serving to intensify the financial sector's resistance to reform of offshore practices. While analysis of stillborn reform efforts must await treatment in a separate article, suffice it to say that the offshore system is alive and well today, notwithstanding the escalating costs it is imposing on society. The silence of the media regarding the offshore system in the midst of bitter struggles over sovereign balance sheets and proposed austerity programs is all the more evidence of the grip the Western banking sector now has on political life.
(1) Nicholas Shaxson, Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens, Palgrave MacMillan, 2011, p. 231. Shaxson's thoughtful work informs most of the present article.
(2) Shaxson, op. cit., p. 113.
(3) See Testimony of Martin A. Sullivan... Before the Committee on Ways and Means, U.S. House of Representatives, July 22nd, 2010, Hearing on “Transfer Pricing Issues and the Global Economy”, pp. 1-2.
(4) As of 2008. Government Accountability Office, “International Taxation: Large U.S. Corporations and Federal
Contractors with Subsidiaries In Jurisdictions Listed as Tax Havens or Financial Secrecy Jurisdictions,” December 2008.
(5) Cited in Shaxson, op. cit., p. 15.
(6) Jane Gravelle, “Tax Havens: International Tax Avoidance and Evasion”, Congressional Research Service, July 2009, p. 2.
(7) Tax Justice Network (http://www.taxjustice.net/cms/upload/pdf/FACT_110512_TH_abuse_by_numbers_Final1.pdf), p. 1.
(8) David Kocieniewski, “G.E.'s Strategies Let it Avoid Taxes Altogether”, New York Times, March 24th, 2011.
(9) Jane Gravelle, “Tax Havens: International Tax Avoidance and Evasion”, Congressional Research Service, July 2009, p. 2.
(10)Tax Justice Network, “The Price of Offshore”, March 2005, p. 1.
(11)Kar, Dev, and Curcio, Karly, Illicit Financial Flows from Developing Countries 2000-2009, Global Financial Integrity, January 2011, p. 1. Regarding the forces inflating commodity prices in recent years, see my recent piece in this forum, “US-Led Commodity Boom: Fake Prices, Global Crises”, June 29th, 2011.
(12)Kar and Karly, op. cit., pp. 15-16, 64.
(13) A concise overview is “Economic Crisis + Offshore” from the Tax Justice Network (http://www.taxjustice.net/cms/front_content.php?idcat=136). For further discussion see Shaxson, op. cit., ch. 10.
(14) Andrew G. Haldane, Bank of England, “Small Lessons From a Big Crisis”, Remarks at the Federal Reserve Bank of Chicago 45th Annual Conference, May 2009, p. 1.