What tax havens do – 4 – they create financial instability

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Many in tax havens / secrecy jurisdictions argue that the current world economic crisis started ‚Äòonshore’. By that they mean in the UK, USA and so on. There are those who agree. Lord Turner in his recent report on the future of regulation in the UK’s financial services sector said:

[I]t is important to recognise that the role of offshore financial centers was not central in the origins of the current crisis. Some SIVs were registered in offshore locations; but regulation of banks could have required these to be brought on-balance sheet and captured within the ambit of group capital adequacy requirements. And many of the problems arose from the inadequate regulation of the trading activities of banks operating through onshore legal entities in major financial centres such as London or New York.

That argument is hard to sustain. First of all, as those in the more conventionally recognised tax havens / secrecy jurisdictions often note, London and New York are amongst the most significant tax havens.

Second, the argument is only logical if it is recognised that in reality nothing really happens in tax havens / secrecy jurisdictions. This needs some explanation.

Remember that secrecy jurisdictions are places that intentionally create regulation for the primary benefit and use of those not resident in their geographical domain that is  designed to undermine the legislation or regulation of another jurisdiction and that, in addition, create a deliberate, legally backed veil of secrecy that ensures that those from outside the jurisdiction making use of its regulation cannot be identified to be doing so. There are therefore three components:

  1. The place that creates the abusive regulation / legislation – let’s cal it the tax haven for ease.
  2. The people who sell this abusive regulation – let’s call them the offshore finance centre (OFC) for ease. This is populated by accountants, lawyers and bankers in the main.
  3. The clients of the OFC – who by definition will not be located in the place that creates the regulation or where the lawyers, accountants and bankers are.

As a result of course it can be argued that tax havens did not create the financial crisis. By definition secrecy jurisdictions serve a population that is not resident where they are. That means by definition what they do is ‚Äòelsewhere’. And that means that whatever tax havens facilitate does not happen within them – so of course the financial crisis was not created offshore.

Except that’s not the whole story. The financial crisis might have happened ‚Äòelsewhere’ as far as the tax havens are concerned – but they did their very best to make sure that whatever did happen ‚Äòelsewhere’ was a lot more serious by the time they had finished it. They did this in a number of very deliberate ways.

First, they offered what has been called a "get out of regulation free" card to businesses that use them. Whenever banks (in particular) were threatened by onshore regulation that might have reduce the impact (or even prevented) the speculative bubble that has created our current world recession their response was that they would move offshore. They didn’t need to: they just needed it and its lax regulation (and yes, it is lax regulation) to be there to ensure no-one properly regulated them. There is no doubt that this massively contributed to our current crisis.

Second, competition on regulation between tax havens, and between them and other jurisdictions has undoubtedly led to a steady degradation in regulation, over the last decade.  This has been especially true in regulation in areas such as trust law, the need to place data on public record and on hedge funds.

Third, the tax incentives and opportunities created by tax havens undoubtedly accelerated the build-up in debt and leverage across the global financial system. This is especially true in activities like private equity and hedge funds – where tax relief on their enormous borrowings was given onshore but their profits flowed tax free offshore – meaning that in effect they got a double benefit, which encouraged them to borrow more and more – and we all know that the rest is history.

Fourth, “satellite” tax havens like some Caribbean islands or Britain’s Crown Dependencies have acted as conduits for illicit and other financial flows, often from developing countries into the wealthy financial centres like London, New York, and these flows have contributed to large-scale macroeconomic imbalances. The entire mainstream economics profession has neglected to measure most of these vast flows but they did, for example, contribute to the significant over-valuation of sterling for many years which massively harmed the UK’s export capacity, helped undermine our manufacturing capacity and left us with an over reliance on financial services which all too obviously cannot now provide for our needs. 

Fifth, one of the most important features of the crisis is that the financial system has become frozen as a result of mutual mistrust and impenetrable complexity making it impossible for trading partners to understand each other’s accounts. The secrecy jurisdictions, by giving companies incentives to festoon their financial affairs across multiple jurisdictions, and by covering these affairs in a veil of secrecy, have played a major part in this. As such they were the catalyst for the crisis that emerged in August 2007.

Sixth – subprime debts may have been created onshore, but they were sliced, diced and repackaged offshore.

Seventh – hedge funds have massively undermined the stability of the world’s markets and significantly distorted rewards in them, as well as creating the idea that he long term might be less than a minute, so distorting concepts of value. Almost all are offshore – and unregulated.

Eighth – private equity is very largely offshore – meaning that many employees are much less secure than they once were. The ramifications are obvious.

I could go on. The point is clear. The deliberate opacity that offshore creates might hide no real economic activity – but it also makes it impossible to tell what is happening elsewhere. The consequence has been a massive loss of trust – and much of the blame for that can be appropriately laid at the door of tax havens. As such they probably contributed more to the current financial crisis than anything else.

Hat tip to Tax Justice Network for some elements of this blog.

Other articles in this series are:

What tax havens do

What tax havens do – 1 – they handle stolen property

What tax havens do – 2 – they redistribute wealth from the poor to the rich

What tax havens do – 3 – they facilitate corruption