What Problems and Opportunities are Created by Tax Havens?

Dhammika Dharmapala

Prepared for Oxford Review of Economic Policy issue on Business Taxation in a Globalised
World (Vol. 24 No. 4, Winter 2008)

Preliminary and incomplete: please do not cite without permission

Department of Economics, University of Connecticut, email: dhammika.dharmapala@uconn.edu.

1) Introduction
Tax havens have attracted increasing attention and scrutiny in recent years from
policymakers, as exemplified by the OECDs initiatives to combat harmful tax practices
(OECD, 1998, 2000, 2004). The interest in tax havens reflects their disproportionate role in the
world economy, and in particular their centrality to many of the important current policy debates
in taxation, including international tax competition (Slemrod, 2004; Hines, 2006, 2007) and tax
avoidance activity by corporations (e.g. Desai and Dharmapala, 2006, 2008). This paper provides
an overview of the theoretical and empirical insights from a growing scholarly literature that
analyzes the consequences and determinants of the existence of tax haven countries.
The paper begins with an analysis of the characteristics of countries that tend to be
classified as tax havens. It focuses in particular on recent evidence (Dharmapala and Hines,
2006) that tax havens tend to have stronger governance institutions (i.e. better political and legal
systems and lower levels of corruption) than comparable nonhaven countries. The popular image
of tax havens is somewhat at variance with this picture, and emphasizes their role in facilitating
tax evasion by individuals. Recent estimates that have been widely influential in policy debates
suggest large revenue losses from haven-related evasion activities (e.g. Guttentag and AviYonah, 2006). This paper argues, however, that careful scrutiny of these estimates suggests that
they imply vast amounts of hidden wealth, and (if true) would have wide-ranging implications
(many of dubious credibility) for many economic phenomena far beyond the arena of taxation. It
appears more likely that evasion by individuals plays only a secondary role in generating tax
haven activity. Consistent with this view, some tentative evidence is presented in the paper
suggesting that the OECDs recent initiative (promoting international information-sharing among
tax authorities) has had little impact on financial sector employment and wages in a
representative tax haven (Jersey).
The most important policy questions surrounding tax havens thus appear to relate to their
role in enabling tax planning by multinational corporations. Multinational corporations can use
tax havens to reduce or defer tax liabilities to other countries, through the strategic setting of
transfer prices (especially for intellectual property) and the strategic use of debt among affiliates.
It is often argued that tax havens erode the tax base of high-tax countries by attracting these
2

types of corporate activities. This traditional negative view of tax havens has recently been
modeled formally by Slemrod and Wilson (2006). The evidence does show that tax havens host a
disproportionate fraction of the worlds foreign direct investment (FDI). However, according to
an emerging positive view of havens (e.g. Desai, Foley and Hines, 2006a, b; Hines, 2006,
2007; Hong and Smart, 2007), this need not necessarily imply that their existence makes high-tax
countries worse off. It is possible that havens enable high-tax countries to impose lower effective
tax rates on highly mobile firms, while taxing immobile firms more heavily. If differentiating
between mobile and immobile firms is difficult for informational or administrative reasons, the
existence of tax havens can enhance efficiency and even mitigate tax competition.
The latter view appears to be supported by the recent experience with corporate tax
revenues: despite substantial (and apparently increasing) FDI flows to tax havens, corporate tax
revenues in the US, UK and other capital-exporting countries has not fallen, but has actually
increased. Overall, while it is theoretically possible that the existence of tax havens could spur
harmful tax competition and lower global welfare, recent theoretical and empirical research has
tended to cast doubt on this view. The generally robust growth of corporate tax revenues in
major capital-exporting countries, despite substantial FDI flows to tax havens, suggests that the
concerns expressed about the deleterious effects of tax havens may be somewhat exaggerated.
Section 2 describes the characteristics of tax havens. Section 3 outlines how havens can
facilitate tax evasion by individuals and tax avoidance by corporations, and discusses recent
estimates of revenue losses from tax haven activity. Section 4 assesses the consequences of the
OECD initiative. Section 5 discusses the theoretical literature on the effects of tax havens on the
welfare of high-tax countries, and considers some relevant evidence. Section 6 concludes.
2) What are Tax Havens, and what are their Characteristics?
Although tax havens have attracted widespread interest (and a considerable amount of
opprobrium) in recent years, there is no standard definition of what this term means. Typically,
the term is applied to countries and territories that offer favorable tax regimes for foreign
investors. The elements of these favorable regimes include, first and foremost, low or zero
corporate tax rates. There are a variety of other elements common to tax havens, such as low or
zero withholding tax rates on foreign investors. Another common feature - bank secrecy laws 3

have attracted great attention, although they appear to be of declining significance (as discussed
in Section 3 below) due to growing international efforts to promote information-sharing among
the tax authorities of different countries. While the classification of countries based on these
criteria inevitably involves some degree of subjectivity, there are approximately 40 countries and
territories that appear in most published lists of tax havens. In this paper, the basic definition of
havens follows that in Dharmapala and Hines (2006; hereafter DH). DH begin with the list of
jurisdictions in Hines and Rice (1994, Appendix 2, p. 178), all of which also appear in Diamond
and Diamond (2002) and various other sources, and match these with countries and territories for
which current data on economic and other characteristics are available. This set of countries is
listed in Table 1 (under the heading: Tax havens (DH)).
What distinguishes this group of countries from the rest of the world? Even a casual
observer is likely to be aware that tax havens tend to be small and that many are islands. DH
provide quantitative measures of many other relevant characteristics, as illustrated in Figure 1.
Tax havens are on average substantially more affluent than are nonhavens. In addition to being
smaller in population size and more likely to be island countries (as expected), tax havens
geographical characteristics lead them to be more intrinsically inclined towards economic
openness. In particular, they tend to be located in closer proximity to major capital exporters, and
have a larger fraction of their population located within 100 km of the coast.1 Havens also tend to
have a relatively sophisticated communications infrastructure, as measured by the number of
telephone lines per capita. They are also poorly endowed with natural resources: the value of
their subsoil assets per capita (as estimated in World Bank (2006)) is much smaller than that for
the typical nonhaven country.
Tax havens also differ substantially from nonhavens in their legal origins (the historical
source of a countrys system of commercial law, as classified by La Porta et al. (1999)) and
political institutions. As shown in Figure 2, havens are more likely to have British legal origins
and less likely to have French legal origins than is the typical country. Havens are also more

Proximity to major capital exporters is measured by Gallup, Sachs and Mellinger (1999) as the distance by air from
the closest of New York, Tokyo or Rotterdam. The coastal population measure is also constructed by Gallup, Sachs
and Mellinger (1999).

likely to use English as an official language and to have parliamentary rather than Presidential
political systems. They are somewhat more likely to be dependent territories, rather than
sovereign states (as reflected in a lower rate of membership in the United Nations (UN). These
differences mostly persist when attention is restricted only to haven and nonhaven countries with
small populations (below one million).2
DH (2006) focus in particular on an overall measure of governance institutions created by
the World Bank (Kauffmann, Kraay and Mastruzzi, 2005). This governance index measures
several different dimensions of governance quality, including political stability, the absence of
official corruption, respect for the rule of law, government effectiveness and democracy. The
index is normalized to have a mean of zero across all countries and a standard deviation of one,
with higher values indicating stronger governance institutions. DH (2006) find that tax havens
score substantially better on this measure relative to comparable nonhaven countries. Moreover,
tests using a variety of statistical approaches show that this relationship is highly robust, and
suggest that a causal interpretation (i.e. that countries with stronger governance tend to become
tax havens) may be reasonable.
DH (2006) interpret these results within the framework of the standard result in the
theory of optimal taxation that a small open economy should not levy any source-based tax on
foreign investors (Gordon, 1986). The burden of such a tax would be shifted entirely to domestic
workers in the form of lower wages as investors demand higher pretax rates of return, so a more
straightforward and efficient means to raise revenue would be to tax workers directly. In the real
world, this conclusion may not apply to countries that enjoy significant location-specific rents,
for instance through natural resource endowments or agglomeration externalities in capital
formation. More generally, however, this theoretical framework suggests that the real puzzle is
not why some countries become tax havens, but rather why so many small countries do not (for
instance, of 75 countries and territories with populations less than a million in the DH dataset,
only 31 are tax havens). DH (2006) argue that only countries with good governance are able to
credibly set low tax rates; those small countries that are not tax havens would generally not reap
any benefits from seeking to become havens, as stated policies would count for little with foreign
2

An exception is UN membership, which is slightly higher for small havens than for small nonhavens (DH, 2006).

investors in the absence of a strong institutional framework.3 Moreover, becoming a tax haven
appears to a successful economic development strategy for those countries that are able to make
this choice: Hines (2005) finds that tax havens experienced higher rates of economic growth over
the period 1982-1999 than did comparable nonhavens.4
3) Individual and Corporate Uses of Tax Havens
In February 2008, an international scandal relating to tax evasion unfolded after
Germanys tax authorities purchased data from a former employee of a Liechtenstein bank.5 This
information on German individuals with Liechtenstein bank accounts led to the prosecution of
prominent German citizens for tax evasion, and to a focus on the role played by Liechtenstein
and other tax havens in facilitating evasion. This scandal exemplifies the image of tax havens in
the popular mind, which emphasises the use of tax havens by individuals for the purpose of
illegally evading home country taxes. The mechanism underlying this type of evasion is
straightforward. Virtually all countries with income tax systems impose residence-based taxes on
the interest, dividends and capital gains earned by their residents abroad. The bank secrecy laws
of tax havens create the opportunity to evade these taxes. Foreign individuals can locate assets in
tax havens, thereby earning interest, dividends and capital gains. If they fail to report this income
to their home country, bank secrecy provides them with the assurance that the source country
(the tax haven where the income is earned) will not provide information on this income to the
home country.

Some limited but intriguing supporting evidence for this view is that inbound foreign direct investment (FDI)
appears to be much more sensitive to corporate tax rates in countries with stronger governance institutions (DH,
2006).

Slemrod (2008) views tax havens within a broader context of practices that involve the commercialization of
state sovereignty, a concept that also encompasses involvement in facilitating money laundering activities, and the
issuance of stamps designed to appeal to foreign collectors. Slemrod (2008) finds that better governance is related
not only to being a tax haven, but also to pandering stamp issuance (though not to involvement in facilitating
money laundering). He suggests a more general interpretation, arguing that better governance leads not only to
greater policy credibility but also to a greater capacity to undertake welfare-enhancing government activities.

See e.g. Steuerskandal erfasst Europa und die USA Der Spiegel Online (26 February 2008), available at
http://www.spiegel.de/wirtschaft/0,1518,538014,00.html. The scandal also spread to the UK see UK in
Liechtenstein Tax Data Deal BBC Online (24 February 2008) at http://news.bbc.co.uk/2/hi/business/7261830.stm.

However, corporations also locate large amounts of investment in tax havens. For
instance, about a quarter of US firms foreign direct investment (FDI) is located in tax havens (as
defined in DH (2006)), and the corresponding number for UK firms FDI is similar.6
Presumably, this is not because these firms are seeking to evade home country corporate taxes.
However dedicated corporate managers may be to the maximization of after-tax shareholder
value, they will surely not risk prosecution on behalf of their shareholders. Rather, corporations
use tax havens for legal tax avoidance and tax planning activities. Thus, the policy questions
raised by corporate uses of havens may be very different from those relating to individual uses.
Evaluating individuals use of havens is complicated by the wider context of
understanding foreign portfolio investment (FPI).7 As a general matter, FPI is worthy of
encouragement. Economists have long argued that there are substantial gains available to
investors from international portfolio diversification, which provides insurance against economic
risks that are specific to the investors home country (French and Poterba, 1991). Historically,
investors have failed to achieve these gains from diversification, partly because of capital
controls and a lack of information about foreign assets, but also for other reasons that are not
fully understood by researchers. This home bias phenomenon (i.e. that investors tend to place
too much of their portfolios in home country stocks) appears to be eroding over time.8 Given the
sophisticated financial infrastructure of the more successful havens, it might be the case that they
have many nontax advantages as vehicles for global diversification. However, if investors evade
home country taxes on their tax haven investment returns, then there may be efficiency costs that
must be weighed against the obvious benefits of FPI. For instance, the potential for evasion may
create an incentive for investors to locate too much of their portfolios abroad.9 Evasion also
6

This is apparent, for instance, in Figures 7 and 9 see the discussion in Section 5 below.

FPI refers to cross-border investment by individuals (or by institutions such as pension funds on behalf of
individuals), as distinct from FDI, which is carried out by multinational firms.

For the US, Dharmapala (2008) calculates that in 2004 US investors held only 12% of their equity portfolios in
foreign stocks. However, from 2004 to 2005, increases in holdings of foreign stocks represented 43% of the total
increase in holdings of equity.

However, if the home bias is caused by an irrational aversion to foreign assets, then there may be a case for
subsidizing foreign investment; lax enforcement of home country taxes on foreign-source income may be one way
to implement such a subsidy.

raises issues of fairness and tax morale, as home country revenue is eroded and confidence in
the tax system is undermined.
The importance of the costs associated with individuals use of tax havens depends
crucially on how much tax evasion occurs through havens.10 Given the illegality of evasion, this
is obviously inherently difficult to quantify. However, some estimates have recently been
proposed, suggesting that significant amounts of revenue are lost by countries such as the US as
a result of tax evasion through havens. A representative example is provided by Guttentag and
Avi-Yonah (2006), who begin with an estimate (based on data from the Boston Consulting
Group) of the value of assets held overseas by US individuals. They assume that offshore assets
earn a 10% annual rate of return (apparently risk-free), and compute a revenue loss to the US of
$50 billion a year.
As this and similar estimates have been widely influential in policy debates, it is worth
considering their implications in some detail. It should be noted at the outset that a 10% return
appears optimistic, especially for interest income. If all of the $50 billion loss were generated by
hidden assets that were invested in bank deposits or other debt instruments, then a more
reasonable return might be 2%, which (assuming that all of the interest, if reported, would have
been taxed at the top marginal rate of 35%) implies $7.5 trillion of hidden assets. On the other
hand, if all of the hidden assets are invested in equities, then it may be reasonable to use their
assumption of a 10% return, though with the caveat that it does not necessarily account
adequately for risk.11 However, the appropriate tax rate would then be the effective tax rate on
equity returns (currently 15% on dividends and realized capital gains for a top-bracket taxpayer).
It is standard (e.g. Poterba, 2004) to use an effective capital gains tax rate of about a quarter of
the statutory rate to account for the deferral advantage enjoyed by taxpayers because capital
gains taxes are imposed only upon the sale of an asset. Assuming that one third of equity returns
10

Rose and Spiegel (2007) argue that portfolio investment in offshore financial centres (OFCs) is substantially
motivated by tax evasion. However, this conclusion rests essentially on a regression of OFC status on tax haven
status (see Table 2, p. 1319), and does not take into account the potential simultaneity of countries choices to
become OFCs and tax havens.

11

For instance, when evaders hidden assets fall in value, the evaders are effectively making a contribution to the
home country treasury because they are unable to deduct their losses.

are paid out as dividends (probably a conservative assumption) implies an effective tax rate on
equity returns of under 8%; thus, the implied value of assets hidden in tax havens by US
taxpayers would amount to about $6 trillion.
The $50 billion revenue loss estimate thus implies hidden overseas assets of $6-7.5
trillion, depending on the composition of those assets. By way of comparison, the US Treasury
reports $4.6 trillion of US portfolio investments held overseas in 2005 (in all countries, not only
in tax havens; $3.3 trillion is in the form of equity and the rest in the form of debt). These data
are from the Treasury International Capital (TIC) system, the most authoritative and
comprehensive source of information on the portfolio holdings of foreign securities by US
investors.12 TIC data are based on responses to periodic surveys from a defined panel of banks,
other financial institutions, securities brokers and dealers. It is rather unlikely that investors
would seek to evade taxes on investments reported under the TIC system. Many of the banks and
other financial institutions that are surveyed routinely report their investors taxable income to
the US tax authorities. Other US institutions and entities can also be compelled to provide
information to the US government. Moreover, most of the assets reported in the TIC data are
located in countries with information-sharing arrangements and tax treaties with the US. The $67.5 trillion of hidden assets must therefore be held in tax havens through non-US entities, and
therefore constitute an additional stock of assets (beyond the visible assets reported through
TIC). To put this additional wealth in context, the aggregate stock market capitalization of
publicly-traded US firms in 2005 was $17 trillion.13
The implications of the foregoing argument are quite far-reaching. It implies that nearly
two thirds of all US FPI is hidden from the authorities, and conversely that US FPI is more than
two and a half times as large as one might suspect on the basis of official figures. This has
widespread ramifications for a variety of economic issues extending far beyond the arena of
taxation. For instance, it would suggest that US households are in aggregate considerably
wealthier than currently believed. The home bias would be much less pronounced than currently
12

These data are available at www.treas.gov/tic/ and are described in more detail in Desai and Dharmapala (2007).

13

This is obtained from the World Banks World Development Indicators (WDI), available at
http://econ.worldbank.org.

thought. Depending on how this stock of hidden wealth has changed over time, the savings rate
of US households may not be approximately zero (or even negative), as currently believed.
Before we revise our (generally well-attested) beliefs about this wide range of economic
phenomena, it may be worth exercising some degree of caution about these large estimates of
revenue losses from evasion.
It may seem that a naively optimistic view of human nature is required to believe that
evasion is not widespread when the theoretical opportunity for it clearly exists. However, a
limited prevalence of evasion would be consistent with the tax compliance experience in the
domestic setting. In circumstances where taxpayers have some discretion over the reporting of
domestic-source income (e.g. among the self-employed), there tends to be a significant amount
of evasion, but far less than might be expected on the basis of probabilities of audit and expected
sanctions (e.g. Andreoni, Erard and Feinstein, 1998). In other words, taxpayers seem to comply
to a greater degree than is consistent with the principles of Homo Economicus. It would not be
entirely surprising if this tendency extends to the international setting. Thus, it appears unlikely
that income tax evasion through havens is as big a problem as has sometimes been claimed. To
be sure, large estimates of tax revenue losses due to haven-related evasion are not beyond the
realm of possibility. However, believing them would require us to also revise our beliefs about a
wide range of other economic phenomena; such inferences do not seem warranted, given the
very limited data on evasion.14 It should also be remembered that in countries such as the UK
and Germany that impose a value-added tax (VAT) in addition to an income tax, income tax
evasion should result in higher VAT revenues of course, there are differences in timing and in
rates, but to some degree, what governments lose on the swings they gain on the roundabouts.
If individual evasion is not as widespread as has been thought, then the primary policy
questions relating to tax havens concern their use by multinational corporations (MNCs). MNCs
can use havens to reduce or defer their tax liabilities to other governments. Understanding how
14

Even if the $50 billion revenue loss estimate is thought to be credible, it should be viewed in the context of the
total revenues collected by the US Federal government (over $2.5 trillion in 2005, based on data from the US
Bureau of Economic Analysis, available at http://www.bea.gov). It should also be remembered that in countries such
as the UK and Germany that impose a value-added tax (VAT) in addition to an income tax, income tax evasion
should result in higher current or future VAT revenues. There are of course differences between the taxes in terms of
timing and rate structure, but, to some degree, what governments lose on the swings they gain on the roundabouts.

10

they can do this requires a brief digression on how governments tax the foreign income of their
resident corporations. Most (nonhaven) governments insist on taxing economic activity that takes
place within their borders, whether undertaken by domestic or foreign firms. There are two
alternative approaches to taxing the foreign-source income generated by a countrys resident
corporations. A worldwide system (used for instance by the US, the UK and Japan) taxes this
foreign income. However, to avoid the double taxation that would result from the overlapping
claims of the source and residence countries, a foreign tax credit (FTC) is allowed for taxes paid
to foreign governments.15 On the other hand, a territorial system (used by most other capital
exporting countries, such as Germany and the Netherlands) exempts foreign-source income from
home country taxation.16
For MNCs resident in territorial countries, there is an obvious advantage to being able to
reallocate income from the home country (or some other high-tax country) to a tax haven. This
incentive would not exist under a pure worldwide system. In practice, however, worldwide
systems are not pure for instance, the US permits the deferral of US taxation of foreign income
until that income is repatriated to the US. Repatriation consists of the payment of a dividend
by the foreign subsidiary to the US MNC. Delaying the payment of these dividends by retaining
earnings abroad can thus confer a substantial deferral advantage on the MNC by significantly
reducing the present value of its US tax liability (Hines, 1994). Moreover, the reallocation of
income to a tax haven affiliate can magnify this deferral advantage (because the immediate
source-based tax paid to the tax haven government is low or zero).
Thus, MNCs based in countries with either territorial or worldwide tax systems have
incentives to use tax havens to reduce or defer their tax liabilities. The major mechanisms for
achieving this aim involve transfer pricing and the use of debt among affiliates. When affiliates
of the same MNC trade goods or services among themselves, they must choose prices for these
transactions. The prices used inevitably affect the allocation of the MNCs income across
different jurisdictions. Governments generally insist that firms use arms-length prices (those
15

Note, however, that the FTC is limited to the home country tax liability on the foreign income.

16

The exemption pertains to active income generated by the firms normal business operations. Generally,
passive income from firms cash holdings or portfolio investments is taxed by the home country.

11

that would be used by unrelated parties engaging in market transactions). However, for certain
transactions, arms-length markets are thin or nonexistent. A particularly important example in
practice is intellectual property: affiliates of the same MNC can, to a significant degree, choose
where to locate research and development activity in order to ensure that royalty payments from
other affiliates flow towards lower-tax jurisdictions.17 MNCs can also choose to have affiliates in
tax havens lend to affiliates in high-tax countries (i.e. locate debt in high-tax jurisdictions, while
holding fixed the aggregate capital structure of the MNCs family of affiliates). This practice
(known as interest stripping or earnings stripping) directs interest payments to low-tax
countries, while generating interest deductions in high-tax countries. Governments seek to
restrict this practice through thin capitalization rules (imposing some restrictions on capital
structure), but apparently with less than complete success.
Thus, there are strong incentives for MNCs to use tax havens for international tax
planning. Empirical research (as surveyed for instance in Devereux (2007)) shows that MNCs
are highly responsive to these tax incentives. For instance, Hines and Rice (1994) and a
substantial subsequent literature find a large elasticity of US FDI holdings and of US affiliates
profits with respect to foreign countries corporate tax rates. Desai, Foley and Hines (2004) find
evidence consistent with MNCs locating debt in higher-tax countries (despite the thin
capitalization rules noted above). The overall result is that (as noted above) a vastly
disproportionate amount of the worlds FDI is located in tax havens. This situation has not gone
unnoticed in policy debates (e.g. Sullivan, 2004); Section 5 below addresses the question of how
it might best be evaluated from a normative standpoint.
4) The OECD Initiative and its Consequences for Tax Havens
Concern about the use of tax havens to erode the tax bases of higher-tax countries has
prompted a major effort by the Organisation for Economic Cooperation and Development
(OECD) to combat tax havens (OECD, 1998, 2000, 2004; Hines, 2006). The OECD in 1998
introduced what was originally known as its Harmful Tax Competition initiative (OECD, 1998),
17

Consistent with the importance of this strategy, Desai, Foley and Hines (2006a) find that US MNCs with
extensive trade among affiliates and greater focus on research and development are more likely to establish affiliates
in tax havens.

12

which was subsequently renamed the Harmful Tax Practices initiative. The initiative was
intended to discourage the use of preferential tax regimes for foreign investors and to encourage
effective information exchange among the tax authorities of different countries. As part of the
initiative, the OECD (2000, p. 17) produced a list of 35 countries and territories that it deemed to
be tax havens. In addition, another six countries (listed in Hishikawa (2002, fn. 72, p. 397)) that
otherwise satisfied the OECDs tax haven criteria were not included on the list because they
provided advance commitments to eliminate allegedly harmful tax practices. The complete set
of 41 OECD-designated havens is listed in Table 1 (under the heading Tax haven (OECD)). In
the years since, most of these havens have agreed to improve the transparency of their tax
systems and to facilitate information exchange.18
Thus, the OECD initiative appears to have been successful, in the sense of persuading
most havens to agree to information-sharing arrangements. However, the practical impact of
these agreements remains uncertain. For instance, the commitments of many tax haven countries
to exchange information and improve the transparency of their tax systems are often contingent
on similar practices by OECD member countries. More generally, the extent of informationsharing in practice is unclear. Moreover, evidence on the impact of the OECD initiative is
severely limited. Kudrle (2008) examines total foreign portfolio investment (as reported by the
Bank for International Settlements) in the Cayman Islands and in a broader set of tax haven
countries. His time-series analysis finds no significant impact of the OECD initiative; he
concludes that it was ineffective because the information-sharing provisions were too weak.
However, Kudrle (2008) does not use a control group of countries to account for possible shocks
that affected FPI in haven and nonhaven countries alike. More generally, any analysis based on
reported investment data is vulnerable to the criticism that evasion occurs primarily through asset
holdings that are unreported not just to tax authorities but also to statistical agencies.
To circumvent these difficulties, an alternative approach is to consider other variables
that are less likely to be subject to misreporting. Examples include the levels of employment and

18

OECD (2004) lists five recalcitrant tax havens that had failed to make such commitments as of 2004 see Table
1. The preferential regimes identified by the OECD have also generally been abolished or modified to remove the
features that the OECD found objectionable.

13

wages in the financial sectors of tax haven countries. The International Labour Organisation
(ILO) reports data on employment and wage levels by industry for a large sample of countries.19
Unfortunately, the coverage of smaller countries (including most tax havens) is very limited,
rendering a cross-country longitudinal study of the impact of the OECD initiative difficult.
Instead, without any pretence of econometric rigour, we report the data for the Bailiwick of
Jersey, using employment and wages in the financial sector of the UK as a control. Figure 3
reports employment levels in the financial sectors of the two countries for the period 1997-2005.
The most notable feature is that the two series follow a very similar trend. There is a slowdown
in employment in Jersey around the time of the initial announcement of the OECD initiative in
1998, but this is mirrored in the UK. Similarly, there is a decline around 2001-2002 (after Jersey
was named as a haven in OECD (2000, p. 17) and the information-sharing agreements began to
take shape), but this pattern is also shared by the UK.
A negative effect of the OECD initiative on investment in tax havens may manifest itself
not in a quantity effect (on employment levels) but a price effect (on the wages of workers in the
financial sector). The basic conclusions, however, are similar when examining the average wage
(measured in pounds per week) in Jerseys financial sector. There is a general upward trend that
does not appear to be interrupted by the OECD initiative; if anything, wages in Jersey seem to
increase faster over this period than in the UK financial sector. Thus, this evidence (limited
though it undoubtedly is) does not suggest any impact of the OECD initiative on tax haven
activity. One may conclude (as Kudrle (2008) does) that this implies that evasion via tax havens
was a significant problem before the initiative, and that the OECDs measures were insufficient
to address it. As we have seen, however, this view commits us to believing in the existence of
vast amounts of hidden wealth, and to various related implications of dubious credibility. An
alternative conclusion from this evidence is that evasion via havens was not a very important
problem before the OECD initiative, and that hence the OECD measures had little effect. This
could perhaps be because most tax haven activity involves corporate tax planning (which was not
targeted by the OECD measures), rather than individual evasion.

19

These data are available at http://laborsta.ilo.org/.

14

5) The Consequences of Tax Havens for High-Tax Countries

The foregoing arguments suggest that individual evasion is not as important a problem as
has been claimed. However, the various forms of corporate tax planning outlined in Section 3
may nonetheless constitute a significant policy problem for high-tax countries. This point of
view has been given a rigorous formal exposition by Slemrod and Wilson (2006). They develop
a model of tax competition in which tax havens are viewed as being parasitic on the tax bases
of nonhavens. In their framework, firms based in nonhaven countries can choose to purchase
concealment services from havens, thereby avoiding (or evading) home country taxes. In
addition to the resource costs incurred by havens in providing concealment services, tax
avoidance also induces nonhavens to expend additional resources on enforcement. In the
equilibrium of this model, small countries endogenously choose to become tax havens.20 The
existence of havens intensifies tax competition, forcing nonhaven countries to set lower tax rates
than they otherwise would, and thereby reducing the supply of public goods. These welfare
losses can be ameliorated in their model by the elimination of tax havens.
Slemrod and Wilson (2006) present a rigorous statement of a set of conditions under
which the existence of tax havens spurs harmful tax competition and lowers global welfare. It is
certainly a logical possibility that these conditions hold in the real world. However, their
equilibrium entails that the (small and relatively powerless) havens impose significant welfare
costs on the populations of larger and more powerful countries. Thus, this perspective requires a
belief in a political (and indeed military) equilibrium in which major powers tolerate substantial
harm inflicted on them by small parasite countries and territories. However, many prominent
tax havens (such as Bermuda and the Cayman Islands) are British dependent territories; they
enjoy a substantial degree of fiscal autonomy, but it is difficult to believe that in practice they do
not face any constraints in pursuing policies that are harmful to the UK. Even tax havens that are
independent sovereign entities (such as the Bahamas) are acutely vulnerable to economic,
political (and indeed military) pressure from major powers. Even without exerting any pressure
on havens, nonhaven capital exporters could eliminate the use of havens by their corporations by

20

This prediction is of course consistent with the evidence on population size shown in Figure 1.

15

the simple expedient of changing the source rules for corporate income, or imposing immediate
worldwide taxation.
On the whole, it appears more reasonable to believe that the worlds major economies
benefit from the existence of tax havens. This claim may appear to be at odds with the OECD
initiative described in Section 4, where many of the largest economies engaged in multilateral
action to curb the activities of tax havens. It should be remembered, however, that the OECD
initiative focused on the use by individuals of havens for tax evasion, and on related issues of
information-sharing. It was not aimed at corporate uses of havens.21 How might corporate tax
haven activities beneficial for the MNCs home countries? A number of models (Keen, 2001;
Desai, Foley and Hines, 2006a, b; Hong and Smart, 2007) have specified conditions under which
such benefits may be generated. The rest of this section summarizes this positive view of
havens, and considers some relevant evidence (see also Hines (2006, 2007)).
Keens (2001) model is not explicitly motivated by the question of tax havens, but rather
by preferential tax regimes for foreign investors or specific sectors (which were also targeted by
the OECD initiative). In a simple model of tax competition, Keen introduces the assumption that
capital may be heterogeneous in its mobility across borders. If preferential regimes (i.e. lower tax
rates for more mobile forms of capital) are not allowed, then countries are constrained to
compete by setting a single tax rate for all forms of capital. This will result in a needlessly low
rate on immobile capital. On the other hand, when preferential regimes are permitted, countries
can set high tax rates on immobile capital, while competing only over tax rates imposed on
mobile capital. Preferential regimes can thus mitigate tax competition by restricting its effects to
a subset of the tax base. This intuition extends quite readily to the analysis of the role of tax
havens, as discussed below.
Hong and Smart (2007) develop a general equilibrium model of a small open economy in
which the corporate tax serves to both tax the returns to inbound FDI and to tax the rents earned
by domestic entrepreneurs. As in Gordon (1986), the burden of the former is entirely shifted to
domestic workers in the form of lower wages. Despite this, the optimal corporate tax rate will
21

The OECD initiative initially included provisions directed at corporate activities, but this element was soon
dropped see Kudrle (2008, p. 7).

16

generally be positive when the government wishes to redistribute from domestic entrepreneurs to
domestic workers.22 In this setting, the existence of tax havens can increase the welfare of
nonhaven countries. Tax planning by MNCs (e.g. sourcing income in the tax haven through
interest stripping) lowers their effective tax rate and makes them more willing to invest in the
nonhaven for any given statutory tax rate. This directly makes domestic workers better off. It
also increases the optimal corporate tax rate, enabling more redistribution from domestic
entrepreneurs to domestic workers (without driving away FDI). The key to their result that the
existence of tax havens raises welfare is that the government cannot discriminate between
(immobile) domestic entrepreneurs and foreign investors in setting the corporate tax rate.
Desai, Foley and Hines (2006a) analyze the determinants of US MNCs choice of
whether to establish affiliates in tax havens. They find that the scale of a MNCs foreign
operations is a crucial factor in driving the establishment of affiliates in havens. They exploit
exogenous variation in the scale of operations in foreign nonhavens by using foreign countries
economic growth rates as an instrument. To explain their findings, Desai, Foley and Hines
(2006b) develop a model in which there are complementarities between investment in havens
and investment in neighboring nonhaven countries. On the one hand, investment in nonhaven
countries spurs demand for tax haven operations in order to reduce tax liabilities on the income
from the former. On the other hand, the presence of a tax haven enables tax planning that lowers
the cost of investing in neighboring nonhavens. Thus, the existence of havens can stimulate
investment in nonhavens.
The insights from this literature that are most relevant for analyzing the role of tax havens
can be illustrated using a simple example. Assume that there are two symmetric countries (A and
B). A is home to an immobile firm A1 and a mobile firm A2 (each of which generates net
income of 50 through domestic operations), and B is home to an immobile firm B1 and a mobile
firm B2 (each of which generates net income of 50 through domestic operations). There are two
corporate tax policies available to each government a rate of 50% and a rate of zero (neither of
22

Slemrod and Wilson (2006) also model small open economies. They derive positive optimal corporate tax rates
through a different route. Specifically, taxes on wages can be evaded, at some resource cost. Thus, governments
prefer (up to a point) to tax workers indirectly by imposing taxes on capital rather than to tax them directly and thus
incur these costs of evasion.

17

which can discriminate between the two firms). It is assumed that this is tax imposed on a
territorial basis (i.e. it applies to all domestic income, but exempts foreign-source income). The
marginal cost of public funds in each country is 1.2, reflecting the notion that alternative sources
of revenue impose deadweight costs.
It is assumed that immobile firms are nonstrategic. Mobile firms choose the location of
their operations in order to maximize after-tax profits. Each country maximizes a payoff that is
the sum of revenue collected (multiplied by 1.2) and the after-tax profits generated within its
borders (whether by domestic or foreign firms). Equivalently, a countrys payoff ca be defined as
the (pretax) profits generated within its borders (whether by domestic or foreign firms), plus the
social benefits (0.2 per dollar) of the revenue transferred from firms to the government. The
profits generated can be viewed as a proxy for the amount of capital employed within the
domestic economy, and hence for the wages of domestic workers (which are obviously higher
when more capital is employed domestically).
The payoffs in the case where tax havens do not exist are shown in Figure 5. If both
countries set the same tax rate, firms do not choose to move from their original locations, even if
they are mobile. If B sets a zero rate while A sets a 50% rate, then A2 will (costlessly) move its
real operations to B. This raises Bs payoff by the extra 50 of profits that A2 generates in B. The
dominant strategy equilibrium is for each country to set a zero rate, even though this is Paretoinferior to the outcome where both set their rates at 50%.
Now, imagine that a third country exists and functions as a tax haven. It imposes no taxes
on firms profits and facilitates their tax planning activities. In these circumstances, if A imposes
a 50% tax, then A2 has available the option of keeping its real operations in A, but sourcing all
of its profits in the tax haven (thus ensuring a zero effective rate). A1 (the immobile firm) is
assumed to be unable to use the tax haven, in much the same way that it cannot move its
operations to B. The new payoffs when a tax haven exists are shown in Figure 6. The Nash
equilibrium is now for each country to set its rate at 50%. Thus, tax competition is mitigated by
the presence of the tax haven, which results in welfare gains for both A and B. The existence of
havens thus enables nonhavens to sustain higher equilibrium tax rates. Of course, this will be of
little value to them unless there are some immobile firms that can be taxed. This underscores the
18

importance to the positive view of havens of the assumption of heterogeneity across firms in
their degree of mobility.23
The relevance of these alternative models of tax havens thus depends on factors such as
whether there are significant differences in the international mobility of different firms, and
whether governments can discriminate between firms on this basis in setting tax rates. These are
difficult issues to determine, but it is also possible to examine the testable implications of each
view. The standard negative view of tax havens, as formalized by Slemrod and Wilson (2006)
implies that increased tax haven activity would intensify international tax competition, and so be
associated with declining corporate tax revenues in major capital-exporting countries. In
particular, the rapid growth in international capital flows in recent years (a disproportionate
amount of which is located in tax havens) would be expected to have led to precipitous declines
in revenues from the corporate tax. In contrast, the positive view of havens suggests no
necessary decline in revenues: even though increased tax haven activity may reduce tax rates on
firms that use havens, it also enables more taxation of immobile domestic firms (Desai, 1999;
Hines, 2007).
The data on corporate tax revenues does not suggest any decline, precipitous or
otherwise. It is true that statutory corporate tax rates have tended to fall in recent decades.
However, this has been accompanied by base broadening, so that revenues have not fallen. In the
US, Figure 7 shows the pattern of FDI in tax havens over the period 1994-2006.24 A large
fraction of US FDI about a quarter is located in tax havens. This is obviously vastly
disproportionate relative to tax havens share of world population, and presumably reflects the
various opportunities for tax planning provided by havens (discussed in Section 3 above).
Moreover, there is a slight upward trend over this period. Nonetheless, the fraction of US Federal

23

Desai, Foley and Hines (2006a) find that in their sample of US MNCs, a significant fraction (about 40% in 1999)
do not have affiliates in tax havens, despite the obvious potential benefits discussed in Section 3 above. This
evidence suggests considerable heterogeneity in the mobility of firms, even among MNCs. This heterogeneity would
be even greater, of course, if purely domestic firms were also considered.
24

The data on FDI and on US corporate tax revenues are from the US Bureau of Economic Analysis, and are
available at http://www.bea.gov. In Figure 7, tax havens are defined as in DH (2006), while Figure 8 uses the OECD
definition (see Table 1).

19

tax revenues derived from corporate taxes has increased over this period, especially since a
decline associated with the 2001-2002 economic downturn. The increased revenues are not due
to increases in the US statutory corporate tax rate (which has remained unchanged over this
period). There are various explanations for why US corporate tax revenues have increased (see
Auerbach (2006)); the very fact that they have increased, however, starkly contradicts the notion
that tax haven activity by MNCs has eroded the US corporate tax base.
This increase does not appear to be sensitive to the precise definition of tax havens. In
Figure 8, the definition of havens is restricted to those designated as such by the OECD (see
Table 1). As this list omits some important destinations for investment (such as Luxembourg,
Switzerland, Hong Kong and Singapore), the fraction of US FDI located in havens is
considerably lower under this definition (around 10%). Figure 8 also reports US corporate tax
revenue as a fraction of GDP (rather than total revenues). Nonetheless, the basic pattern is very
similar to that in Figure 7. Moreover, the robustness of corporate tax revenues in the face of
global economic integration is by no means confined to the US. Figure 9 shows a very similar
pattern for the UK (although data limitations restrict the period covered).25 The phenomenon also
appears more broadly across Europe (as discussed in de Mooij and Nicodeme (2007)).
It is of course possible to imagine a counterfactual world in which corporate tax revenues
would have grown even faster in the absence of tax havens. This, however, appears unlikely. For
instance, in the US, the recent increases shown in Figure 7 represent the reversal of a longer-term
decline going back to the early 1960s (Auerbach, 2006). (which, incidentally, cannot easily be
attributed to tax havens). A counterfactual involving significantly higher growth in corporate tax
revenues than has actually occurred would represent a dramatic departure from past experience.
Thus, the generally robust growth of corporate tax revenues in major capital-exporting countries,
despite substantial FDI flows to tax havens, suggests that the concerns expressed about the
deleterious effects of tax havens may be somewhat exaggerated.
6) Conclusion [to be written]
25

The data on UK FDI is from the UK Office for National Statistics, available at http://www.statistics.gov.uk/. The
data on UK corporate tax revenues are from the European Commissions Taxes in Europe database, available at
http://ec.europa.eu/taxation_customs/taxation/. Tax havens are defined as in DH (2006).

20

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23

Table 1: List of Tax Havens

Country or Territory

Tax
Haven
(DH)

Tax
Haven
(OECD)

Andorra*
Anguilla
Antigua and Barbuda
Aruba
Bahamas
Bahrain
Barbados
Belize
Bermuda
British Virgin Islands
Cayman Islands
Cook Islands
Cyprus
Dominica
Gibraltar

1
1
1
0
1
1
1
1
1
1
1
1
1
1
1

1
1
1
1
1
1
1
1
1
1
1
1
1
1
1

Grenada
Guernsey
Hong Kong
Ireland
Isle of Man
Jersey
Jordan
Lebanon
Liberia*
Liechtenstein*

1
1
1
1
1
1
1
1
1
1

1
1
0
0
1
1
0
0
1
1

Country or Territory

Luxembourg
Macao
Maldives
Malta
Marshall Islands*
Mauritius
Monaco*
Montserrat
Nauru
Netherlands Antilles
Niue
Panama
Saint Kitts and Nevis
Saint Lucia
Saint Vincent and the
Grenadines
Samoa
San Marino
Seychelles
Singapore
Switzerland
Tonga
Turks and Caicos Islands
Vanuatu
Virgin Islands (U.S.)

Tax
Haven
(DH)

Tax
Haven
(OECD)

1
1
1
1
1
0
1
1
0
1
0
1
1
1
1

0
0
1
1
1
1
1
1
1
1
1
1
1
1
1

0
0
0
1
1
0
1
1
0

1
1
1
0
0
1
1
1
1

Source: Tax haven (DH) refers to the definition of tax havens used in Dharmapala and Hines (2006), who begin
with the list of jurisdictions in Hines and Rice (1994, Appendix 2, p. 178), all of which also appear in Diamond and
Diamond (2002) and various other sources, and match these with countries and territories for which current data on
economic and other characteristics are available. Tax haven (OECD) refers to the definition of tax havens in
OECD (2000, p. 17), but includes an additional six countries (listed in Hishikawa (2002, fn. 72, p. 397)) that
otherwise satisfied the OECDs tax haven criteria but were not included on the list because they provided advance
commitments to eliminate allegedly harmful tax practices. In each case, 1 = tax haven and 0 = nonhaven.
* Tax haven designated by the OECD (2004) as having failed to make commitments on information exchange.

24

Figure 1: General Characteristics of Tax Havens (Relative to Nonhavens)

GDP pc (PPP; Havens=1)

Population (Nonhavens=1)
Distance by air (Nonhavens=1)
Island (fraction)

Nonhavens
Havens

Coastal population (fraction)

Telephone Lines pc (Havens=1)
Subsoil Assets pc
(Nonhavens=1)
0

0.2

0.4

0.6

0.8

1.2

Source: Authors calculations, based on the dataset used in Dharmapala and Hines (2006). GDP per capita (in US$
in PPP terms), population and telephone lines per capita are all from the World Banks World Development
Indicators (WDI), available at http://econ.worldbank.org, for 2004. Distance by air measures proximity to major
capital exporters (constructed by Gallup, Sachs and Mellinger (1999) as the distance by air from the closest of New
York, Tokyo or Rotterdam. Coastal population is the fraction of the population living within 100 km of the coast,
also constructed by Gallup, Sachs and Mellinger (1999). Subsoil assets per capita are from World Bank (2006).

25

Figure 2: Institutional Characteristics of Tax Havens (Relative to Nonhavens)

British legal origin (fraction)

French legal origin (fraction)
Ethnolinguistic
Fractionalization
English as an Official Language
(=1)

Nonhavens
Havens

Parliamentary System (fraction)

UN Member (fraction)
Governance Index
-0.2

0.2

0.4

0.6

0.8

Source: Authors calculations, based on the dataset used in Dharmapala and Hines (2006). Legal origins and
ethnolinguistic fractionalization are from La Porta et al. (1999). The use of English as an official language is from
the Centre dEtudes Prospectives et DInformations Internationale (CEPII) dataset (available on Thierry Mayers
website at: http://team.univ-paris1.fr/teamperso/mayer/data/data.htm)The World Banks Database of Political
Institutions (Beck et al., 2001). UN membership is obtained from the United Nations Organization website, at
http://www.un.org/Overview/unmember.html. The governance index (for 2004) is from Kauffmann, Kraay and
Mastruzzi (2005).

26

Figure 3: Financial Sector Employment in Jersey and the UK, 1997-2005

1.4
1.2
1
0.8

UK (millions)

0.6

Jersey (tens of
thousands)

0.4
0.2
0
1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: Authors calculations, based on data from the International Labour Organsation (ILO), available at
http://laborsta.ilo.org/. The UK financial sector data includes real estate and insurance.

Figure 4: Financial Sector Wages in Jersey and the UK, 1997-2005 (Pounds/Week)
800
700
600
500
400

UK

300

Jersey

200
100
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: Authors calculations, based on data from the International Labour Organsation (ILO), available at
http://laborsta.ilo.org/. The UK financial sector data includes real estate and insurance.

27

Figure 5: Payoff Matrix when there is no Tax Haven

Country B
Tax Rate: 50%

Tax Rate: 0%

Tax Rate: 50%

110, 110

55, 150

Tax Rate: 0%

150, 55

100, 100

Country A

Figure 6: Payoff Matrix when there is a Tax Haven

Country B
Tax Rate: 50%

Tax Rate: 0%

Tax Rate: 50%

105, 105

105, 100

Tax Rate: 0%

100, 105

100, 100

Country A

Figure 7: US Investment in Tax Havens and Corporate Tax Revenues, 1994-2006

30
25
20
% of US FDI in Tax
Havens

15

% of US Federal Tax
Revenue from
Corporate Taxes

10
5

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

Source: Authors calculations, based on data on FDI and US corporate tax revenues from the US Bureau of
Economic Analysis, available at http://www.bea.gov. Tax havens are defined as in Dharmapala and Hines (2006).
while Figure 8 uses the OECD definition (see Table 1).

28

Figure 8: US Investment in OECD-Designated Tax Havens and Corporate Tax Revenues,

1994-2006
12
10
8
% of US FDI in OECDdesignated Tax Havens

US Corporate Tax
Revenue as a % of US
GDP

4
2

1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006

Source: Authors calculations, based on data on FDI and US corporate tax revenues from the US Bureau of
Economic Analysis, available at http://www.bea.gov. Tax havens are defined as in OECD (2000) see Table 1.

Figure 9: UK Investment in Tax Havens and Corporate Tax Revenues, 1994-2006

Source: Authors calculations, based on data on UK FDI from the UK Office for National Statistics, available at
http://www.statistics.gov.uk/ and on data on UK corporate tax revenues from the European Commissions Taxes in
Europe database, available at http://ec.europa.eu/taxation_customs/taxation/. Tax havens are defined as in
Dharmapala and Hines (2006).

29