Needed, a more comprehensive approach to tax havens

Tax havens and their practices have attracted global attention in recent months.
The main criteria for a jurisdiction to be labelled as a tax haven are: no or very low effective taxes particularly on capital income; lack of transparency and inconsistency in applying tax laws to similarly situated tax payers; lack of cooperation in effective exchange of information; and absence of the need for substantial business activity in the jurisdiction.

It is variously estimated that $7-11 trillion are being managed through tax havens, equivalent to 13-20% of global GDP in 2007.

The G-20 Summit in London in April 2009 had tax havens as an important agenda item. The Organisation for Economic Cooperation and Development (OECD), which has been working on harmful tax practices for more than a decade, has recently become more aggressive in policies towards tax havens.

It has named Switzerland, Singapore, Hong Kong and Luxembourg as having unacceptable banking secrecy practices. It has promised to impose sanctions on them, and this has been backed by the G-20 Summit. The above entities have also been found deficient in implementing requisite international standards and sharing information with economic partners. Countries such as Germany and the US have taken a hard line with private wealth management units of the Swiss banks, in which Sovereign Wealth Funds (SWFs) of Singapore and Middle-East countries have significant equity share.

The general election campaign in India has placed a welcome emphasis on illegal Indian accounts in tax havens. The OECD has begun a review of India’s foreign direct investment (FDI) policies, which would include addressing the phenomenon of “round-tripping” of FDI through tax havens. 

“Round tripping” involves domestic entities illegally channelling funds into tax havens, and then bringing them back as foreign financial flows, whether as FDI or as portfolio investments. India’s especially generous Double Taxation Avoidance Agreements (DTAA) with Mauritius and Singapore could potentially facilitate round-tripping, while eroding India’s fiscal base.

The urgency of addressing the practices of tax havens is due to two important factors.
First, it is argued that tax havens have facilitated the operations of the “shadow banking system”, which was able to take advantage of the arbitrage opportunities provided by the inherent inconsistency in rapid globalisation and sophistication of financial products and institutions on the one hand, and nation-state based financial regulatory institutions on the other. It is often pointed out that vast majority of the hedge funds, an important component of the “shadow banking system,” are located in tax havens. Many of the large SWFs are also located either in tax havens or in jurisdictions which extensively practice “fiscal dumping”

“Fiscal dumping” practices have similar effects as tax havens, but have not received requisite attention of policymakers. These practices are usually pursued by jurisdictions with robust fiscal positions, such as Hong Kong, Dubai, and Singapore. They offer specifically designed tax and other incentives, negotiated in a non-transparent way, to businesses to locate their regional or international headquarters in their jurisdiction. This results in fiscal incentives-driven rather than economic efficiency-driven business location decisions.

These jurisdictions also target certain types of capital income (such as exempting interest income from personal income tax), which then systematically reduces the taxable base of the countries of origin.

Second, the current global economic crisis has necessitated aggressive monetary and fiscal stimuli by major economic powers around the world. Thus UK, US and Japan are expected to experience fiscal deficits of around ten percent of GDP in 2009 and 2010.

India’s scope for aggressive fiscal and monetary policies has been constrained due to the UPA government’s less-than-competent, indeed irresponsible, fiscal policies pursued during the high growth era of 2004-2007. India’s combined fiscal deficit is expected to exceed 10% in 2009. This constrains current policy flexibility, and also reduces the scope of the new government to pursue growth-enhancing policies.

There is, therefore, an urgency in finding additional sources of revenue. Tax havens and “fiscal dumping” reduce the fiscal base of many jurisdictions, which are likely to face high fiscal deficits for a prolonged period. Bringing tax havens under international norms and greater scrutiny of “fiscal dumping” practices thus represent an attractive option. It is estimated that the US alone is losing about $100 billion per year in tax revenue due to tax havens.

For India, the focus should not be on just getting back illegal money in tax havens while leaving current practices and social and political norms unchanged. This amount is conservatively estimated at about $140 billion for only the 2002-2006 period. The actual amounts are likely to be much higher. India can capitalise on the efforts by Germany and US to obtain records of their citizens that utilise tax havens to evade taxes. Even then, getting such money back would be a lengthy process given difficulties in judicial proceedings.

India, therefore, must take a more comprehensive approach to tax havens and to fiscal dumping.

The following points must be kept in mind 
- First, India must maintain disaggregated and robust databases that measure and record financial flows to different centres in the country, including by financial institutions such as hedge funds and SWFs. This will provide a firmer foundation for monitoring illegal or harmful flows. 
- Second, there is a need to reform financing rules for the political parties and for elections; and tighten disclosure requirements for NGOs and for religious and charitable organisations. This along with more persistent and effective use of the Right to Information Act can help mitigate the flow of illegal money abroad, strengthening India’s fiscal base. 
- Third, India must review its DTAAs, and monitor their use, particularly with countries such as Mauritius, which account for disproportionate share of FDI in India. It should also monitor stringently the activities of countries aggressively using “fiscal dumping” such as Singapore and Dubai. It is also imperative that Mumbai is developed as an international financial centre, minimising the need for importing financial services. 
- Fourth, India must reform its own tax policies and administration to ensure that they are internationally competitive and compatible. Frequent changes in tax policies, excessive use of cesses and surcharges, and use of such dysfunctional tax such as the fringe benefit tax must be avoided. 
- Finally, the term “black money” used by the media and in policy debates reflects colonisation of the mind, where “black” is associated with something undesirable, and “white”, with something that is desirable. This subconscious devaluation of own sense of worth must be explicitly discarded.

The writer is a professor of public policy with the National University of Singapore and can be reached at mukul.asher@gmail.com.
Views are personal.