Here is the truth about tax havens

It is now bipartisan policy to turn Australia into a funds management tax haven. Kevin Rudd announced in his budget reply speech that an ALP government would halve the withholding tax. The government are still somewhat vague on their policy. Nonetheless, the fact that Australia will engage in tax competition to attract funds management business will qualify us as being a tax haven. Tax havens can be defined as any jurisdiction, anywhere in the world, that has preferential rules for foreign investors.

Many Australians are likely to associate tax competition and tax havens only with illegal behaviour. Nothing, however, could be further from the truth. Some people do evade their legal obligations to pay tax, but even the ATO concede, “Most transactions between Australia and [other] tax havens are lawful”.

Despite this bipartisan policy, political elites tend to disapprove of tax competition and tax havens. The Australian states and territories, for example, have officially stopped competing for business. The argument being that tax competition will lead to ‘inefficient’ low taxes on capital (that is, corporate income tax), and also ‘inefficient’ low levels of public expenditure, and the under-provision of public goods. One commentator even argued tax competition was bad for the environment.

The OECD actively promotes the view that tax competition has the potential to create harm by distorting investment flows, undermining the integrity and fairness of existing tax structures, discouraging tax compliance, changing the ‘desired’ mix and level of taxation and government spending, causing the tax burden to shift to less mobile tax bases and increasing the costs of tax administration and compliance burdens. The OECD, however, has yet to produce any evidence that these harms have occurred.

The arguments against tax competition consist of allegations of harm by assertion. As it turns out OECD economies have not experienced any difficulty in generating tax revenue. Indeed, most European OECD economies are known for their high tax burdens. Total tax revenue in the OECD has increased over the past 30 years. Corporate tax revenue in particular has been strong, particularly in Australia.

Many OECD economies have lowered their corporate tax rates, yet have benefited from increases in corporate tax revenues. In other words, none of the adverse consequences of tax competition have occurred.

In contrast, Peter Sorensen of the University of Copenhagen has undertaken an extensive modelling exercise and found that tax coordination would lead to higher capital taxes, and higher income and wealth redistribution—but lower infrastructure spending, lower capital stocks, lower profits, lower real wages, lower GDP, and higher real interest rates. It is hard to see Australian voters agreeing to any of that. It seems that tax competition does not have any downside, while tax coordination has no up-side.

Three US economists, Mihir Desai, Fritz Foley and James Hines have reported that tax haven activity increases economic activity in nearby non-tax haven economies. Due to the higher after-tax returns that multinational firms are able to enjoy as a consequence of tax havens, they are able to maintain higher levels of foreign investment than otherwise.

Far from having a negative impact on their neighbours, it seems tax havens have a positive impact on economic activity; and there is no evidence that governments suffer any adverse revenue effects from tax competition either. What is particularly damning for the harmful tax competition argument is the fact that tax haven governments do not appear to be smaller than non-tax haven governments.

The lesson to be learnt from the tax competition debate is that lower taxes leads to more economic activity. Both the ALP and the government understand that concept – why else would they turn Australia into a tax haven? Yet, it is troubling that at the same time neither has a well-developed plan to cut domestic tax rates for Australians. To date the ALP has not released any plan beyond the funds management area, while the government seem to be satisfied with the ad hoc piecemeal cuts they have delivered to date. If taxes have massive disincentive effects for foreigners, they then also have the same disincentives for locals. Both the ALP and the government should commit to cutting taxes for foreign investors, and also for Australians.

Professor Sinclair Davidson is a professor in the School of Economics, Finance and Marketing at RMIT University. He is author of ‘Tax Competition: Much to do about very little’ released Monday 15 October by the Centre for Independent Studies.