Would you like to pay less tax? One way is to make a sandwich: specifically, a “double Irish with a Dutch sandwich.”
Suppose you’re American. You set up a company in Bermuda and sell it the right to use your intellectual property, such as a brand name or a patent. Then that company sets up a subsidiary in Ireland. Now set up another company in Ireland. The second company finds a reason to bill your European operations for amounts resembling their profits. Now start a company in the Netherlands. Have your second Irish company send money to your Dutch company, which immediately sends it back to your first Irish company. You know, the one headquartered in Bermuda.1
Are you confused yet? That’s part of the point. If two-part pricing sometimes confuses customers, it’s a model of simplicity compared with cross-border tax laws. Tax havens depend on making it, at best, very difficult to get your head around financial flows; at worst, impossible to find out any facts. Accounting techniques that make your brain hurt enable multinationals such as Google, eBay, and IKEA to minimize their tax bills—completely legally.2
You can see why people get upset about this. Taxes are like membership fees for a club: it feels unfair to dodge the fees but still expect to benefit from the services the club provides its members—defense, police, roads, sewers, education, and so on. But tax havens haven’t always had such a bad image. Sometimes they’ve functioned like any other safe haven, allowing persecuted minorities to escape the oppressive rules of home. Jews in Nazi Germany, for instance, were able to ask secretive Swiss bankers to hide their money. Unfortunately, secretive Swiss bankers soon undid the good this did their reputation by proving just as happy to help the Nazis hide the gold they managed to steal and reluctant to give it back to the people they stole it from.3
Nowadays, tax havens are controversial for two reasons: tax avoidance and tax evasion. Tax avoidance is legal. It’s the stuff of double Irish, Dutch sandwiches. The laws apply to everyone: smaller businesses and even ordinary individuals could set up border-hopping legal structures, too. But of course most of us just don’t earn enough to justify the accountants’ fees.
If everyday folk want to reduce their tax bills, their options are limited to various forms of tax evasion, which is illegal: VAT fraud, undeclared cash-in-hand work, or taking too many cigarettes through the “nothing to declare” lane at customs.4 The British tax authorities reckon that much evaded tax comes from countless such infractions, often small-time stuff, rather than the wealthy entrusting their money to bankers who’ve shown they can keep a secret. But it’s hard to be sure. If we could measure the problem exactly, it wouldn’t exist in the first place.
Perhaps it’s no surprise that banking secrecy seems to have started in Switzerland: the first known regulations limiting when bankers can share information about their clients were passed in 1713 by the Great Council of Geneva.5 Secretive Swiss banking really took off in the 1920s, as many European nations hiked taxes to repay their debts from World War I—and many rich Europeans looked for ways to hide their money. Recognizing how much this was boosting their economy, in 1934 the Swiss doubled down on the credibility of their promise of banking secrecy by making it a criminal offense for bankers to disclose financial information.6
The euphemism for a tax haven these days, of course, is “offshore”—and Switzerland doesn’t even have a coastline. Gradually, tax havens have emerged on islands such as Jersey or Malta, or, most famously, in the Caribbean. There’s a logistical reason for this: a small island isn’t much good for an economy based on manufacturing or agriculture, so financial services are an obvious alternative. But the real explanation for the rise of the offshore haven is historical: the dismantling of European empires in the decades after World War II. Unwilling to prop up Bermuda or the British Virgin Islands with explicit subsidies, the United Kingdom instead encouraged them to develop financial expertise, plugged into the City of London. But the subsidy happened anyway—it was implicit, and perhaps accidental, but tax revenue steadily leaked away to these islands.7
The economist Gabriel Zucman came up with an ingenious way to estimate the wealth hidden in the offshore banking system. In theory, if you add up the assets and liabilities reported by every global financial center, the books should balance—but they don’t. Each individual center tends to report more liabilities than assets. Zucman crunched the numbers and found that globally, total liabilities were 8 percent higher than total assets. That suggests at least 8 percent of the world’s wealth is illegally unreported. Other methods have come up with even higher estimates.
The problem is particularly acute in developing countries. For example, Zucman finds that 30 percent of wealth in Africa is hidden offshore. He calculates an annual loss of $14 billion in tax revenue. That would build plenty of schools and hospitals.
Zucman’s solution is transparency: creating a global register of who owns what, to end banking secrecy and anonymity-preserving shell corporations and trusts. That might well help with tax evasion. But tax avoidance is a subtler and more complex problem.
To see why, imagine I own a bakery in Belgium, a dairy in Denmark, and a sandwich shop in Slovenia. I sell a cheese sandwich, making one euro of profit. On how much of that profit should I pay tax in Slovenia, where I sold the sandwich; or Denmark, where I made the cheese; or Belgium, where I baked the bread? There’s no obvious answer. As rising taxes met increasing globalization in the 1920s, the League of Nations devised protocols for handling such questions.8 They allow companies some leeway to choose where to book their profits. There’s a case for that, but it opened the door to some dubious accounting tricks. One widely reported example may be apocryphal, but it illustrates the logical extreme of these practices: A company in Trinidad apparently sold ballpoint pens to a sister company for $8,500 apiece.9 The result: more profit booked in low-tax Trinidad; less in higher-tax regimes elsewhere.
Most such tricks are less obvious, and consequently harder to quantify. Still, Zucman estimates that 55 percent of U.S.-based companies’ profits are routed through some unlikely-looking jurisdiction such as Luxembourg or Bermuda, costing the U.S. government $130 billion a year. Another estimate puts the losses to governments in developing countries at many times the amount they receive in foreign aid.10
Solutions are conceivable: profits could be taxed globally, with national governments devising ways to apportion which profit is deemed taxable where. A similar formula already exists to apportion national profits made by U.S. companies to individual states.11
But political desire would be needed to tackle tax havens. And while recent years have seen some initiatives, notably by the Organisation for Economic Co-operation and Development, they’ve so far lacked teeth.12 Perhaps this shouldn’t surprise us, given the incentives involved. Clever people can earn more from exploiting loopholes than from trying to close them. Individual governments face incentives to compete to lower taxes, because a small percentage of something is better than a large percentage of nothing; for tiny, palm-fringed islands it can even make sense to set taxes at zero percent, as the local economy will be boosted by the resulting boom in law and accounting.
Perhaps the biggest problem is that tax havens mostly benefit financial elites, including some politicians and many of their donors. Meanwhile, pressure for action from voters is limited by the boring and confusing nature of the problem.
Sandwich, anyone?