Now is the time to crack down on offshore finance

Since the start of 2009, a throng of countries around the world have signed up to new rigorous standards on exchange of information for tax purposes.

The likes of the Cayman Islands, Jersey, Andorra and Liechtenstein that not so long ago were considered handy places to hide money from the tax man have pledged to bring their rules on tax transparency into line with international standards. Meanwhile, countries such as Austria, Belgium, Luxembourg and Switzerland are effectively signing away the banking secrecy laws that for decades were part of their stock in trade.

It’s no secret why this is happening now. The G20 leaders made it clear at their summit in Pittsburgh in September that there is no more room for tax havens in the post-financial crisis global economy. Once a grace period ends in March next year, any jurisdiction that persists in maintaining strict bank secrecy rules that hamper other countries’ ability to apply tax laws fairly could face painful sanctions.

And yet, despite the welter of recent commitments to improve tax information sharing, there are still plenty of voices calling for the havens to be left alone. Their argument is that the advantages they offer to business and private investors outweigh the need for financial sector reforms.

So is this simply a case of bullying and buck-passing on the part of the large and developed economies? Or is there a genuine need to tackle what many see as a key fault-line in the global financial system?

Since the onset of the financial crisis, politicians around the world have come to realize that improved sharing of tax information is essential in a reformed global financial system. What is at issue is the shielding of business and private investor transactions from legitimate tax scrutiny in their home country. Governments have long been alert to tax-avoidance opportunities from what is euphemistically known as “structured finance,” but the involvement of secretive jurisdictions in complex chains of structures and transactions has often hampered their attempts to counter it.

The crisis threw a spotlight on the negative aspects of tax havens. Tax savings for borrowing engineered through such artificial and circular transactions clearly boosted financial sector balance-sheet and share values. But they added no real value to the global economy and served simply to further inflate global asset bubbles.

Tax havens were also home to the majority of the funds – mutual funds, hedge funds, private equity funds – investing in high-yield securities and highly leveraged shareholder investment that drove the pre-crisis credit boom.

Secretive tax-driven arrangements were partly to blame for the gearing up that led to the bubble that preceded the crisis. Circular, “double-dip,” financing arrangements that give companies fiscal advantages both at home and offshore ensured that normal tax benefits for debt financing were magnified out of all proportion to any conceivable tax policy justification.

This resulted in tax subsidies for excessive debt as well as for high-risk investments that would otherwise have been unviable. Tax secrecy can tip the balance between an unattractive, taxed investment and one which is only attractive on the basis of non-taxation.

Since the collapse of the bubble, financial-sector deleveraging has been sharp and painful. If so many countries are now signing up to Organization for Economic Cooperation and Development’s (OECD) tax information exchange standards, it is because they recognize that with the privilege of participation in the global financial market comes the responsibility of cooperation and transparency – not just for the benefit of the tax revenues of other countries, but also for the stability of the financial sector as a whole.

To be sure, there is much that countries can do to reform and improve their tax systems. All countries have a responsibility to use these systems to promote, and not distort, sustainable economic growth, and to bear down on tax-driven distortions in the economy, while addressing local public expenditure needs.

It’s true that most countries’ tax systems have an inbuilt bias to companies financing themselves with debt. It’s also true that complexities and differences between many countries’ tax systems offer opportunities for tax arbitrage that can distort investment decisions, irrespective of the level of transparency. And it may be that administrative burdens, complexity, or the perceived ineffectiveness of some tax systems encourage taxpayers to evade or avoid tax, with or without the use of tax havens.

But reforming tax systems in order to address such shortcomings requires international cooperation, and that in turn calls for an open, cooperative approach. It is inconceivable that any country could be part of a future stable, global financial market without a clear commitment to such openness.

This is the message that came out clearly from the G20 Pittsburgh summit, and it’s one that the OECD will continue to promote.