The Center for Tax Competition researches the impact of strong tax competition and the preservation of financial privacy on individual freedom and property.

Heavenly Tax Havens

The German government's purchase of data stolen from a Liechtenstein bank has reinvigorated longstanding debates about privacy, law enforcement and international relations.

Much of the fallout has followed predictable patterns. Some argue that Germany's richest citizens should be brought to justice for failing to comply with the tax laws, while others point out that it is unseemly for a nation to spy on a peaceful neighbor.

The conflict between Germany and Liechtenstein also has triggered a broader debate about tax competition and the role of so-called tax havens. The Paris-based Organization for Economic Cooperation and Development is trying to use the imbroglio to resuscitate its initiative against tax competition. Willem Buiter, a professor at the London School of Economics, is using the issue to push an even more radical agenda: the forcible annexation -- by nations like Austria and France, under some unknown authority -- of jurisdictions such as Liechtenstein, Andorra and Monaco.

At best, these crusades against tax havens are misguided. At worst, they are an effort to create a tax cartel for the benefit of high-tax nations. This OPEC for politicians would mean higher tax rates for everyone and bigger government.

Wealthy tax evaders may not be sympathetic figures, especially to those of us who meekly comply with the law. But low-tax jurisdictions serve a valuable role in the world economy. Simply stated, they keep other governments honest. Globalization makes it easier for labor and capital to cross national borders, forcing governments to improve tax policy to keep the geese with the golden eggs from flying away.

Tax competition first became a big issue following the Thatcher and Reagan tax cuts in the 1980s. Responding to the increased attractiveness of the U.K. and U.S. economies, every single industrialized nation has been forced to lower personal tax rates in an effort to stay competitive. The average top tax rate in the developed world has dropped from more than 67% in 1980 to barely 40% today.

The same thing is happening to corporate tax rates. Back in 1980, corporate tax rates averaged nearly 50%. Today, led by Ireland's 12.5% corporate tax, the average corporate rate in the industrialized world is less than 27%. As the World Bank explained in its recent "Paying Taxes" report, these lower rates create incentives for more investment, which leads to faster growth, more jobs, higher incomes and what Berlin seems to be most concerned about: better compliance.

Perhaps most amazing, there is now a flat-tax revolution sweeping the globe. In 1980, there were just three flat-tax jurisdictions. Today, prompted by Estonia's 1994 reform, there are 25 governments with simple and fair flat-tax regimes.

All of these reforms have yielded big benefits -- particularly for the nations that have been the most aggressive tax cutters, notably Ireland, Estonia and Slovakia.

But tax rates are just part of the equation. In an ideal tax system, income also should be taxed just one time. This means no death tax, no wealth tax and no double taxation of interest, dividends or capital gains. Politicians often are tempted to impose extra layers of tax on saving and investment, both because they think such policies will give them more money to spend and because voters sometimes are sympathetic to class-warfare campaigns to "tax the rich." Yet the academic literature increasingly shows that excess taxation of capital income causes significant economic damage, largely because people have less incentive to set aside some of today's income to finance tomorrow's growth. High tax rates on saving and investment also cause inefficient tax-avoidance behavior.

Tax havens are particularly helpful since they encourage governments to reduce tax biases against saving and investment. From Sweden to Spain, politicians in Europe have been lowering tax rates on capital income. Death taxes have been killed. Wealth taxes have been abolished. And many nations have adopted lower tax rates for capital income.

Governments are improving their tax systems because they know that punitive tax burdens cause capital flight. In other words, they have finally realized that it is better to have modest tax rates and collect more tax revenue than it is to have confiscatory tax rates and collect less revenue.

But more important, the changes caused by tax competition and tax havens are good for ordinary people. The global economy today is much stronger than it was in the 1970s, in part because tax laws are much less hostile to work, saving and investment. This mean more jobs, higher income and greater prosperity. As Richard Teather of Bournemouth University noted, in a 2005 book published by London's Institute for Economic Affairs, "tax havens benefit us all, whether or not we personally invest through them."

Liechtenstein has a tax code that rewards productive behavior, and it is now the world's third-richest jurisdiction according to the World Bank. German tax laws, by contrast, are rated among the world's worst by the World Economic Forum's Global Competitiveness Report. Liechtenstein has privacy laws that respect individual rights, but which also have received a green light from the Financial Action Task Force and the U.S. Internal Revenue Service for being tough on dirty money. Perhaps most interesting, Liechtenstein scores highly on the World Bank's six governance indicators, beating out nations such as -- you guessed it -- Germany.

None of this should be surprising. Researchers have found that tax havens consistently rank as the best governed, most stable, fastest growing and most prosperous places in the world. Promoting better policy in other nations, though, may be their most important role. If Liechtenstein is forced to act as a deputy tax collector for other nations, the world's taxpayers will be the biggest losers.

(This article appeared in The Wall Street Journal Europe on 26 February 2008 and is republished here with the author's permission.)

February 2008