Non-dom, undone?

An interesting development in the UK election campaign today, as the opposition Labour party will pledge to end ‘non-domicile’ tax status – an 18th century relic which allows residents to exempt their foreign income from tax, provided they can make at least some (often highly tenuous) connection to some other state.

It’s heartening to see tax in the centre of the discussion, not least given the minimal attention that has been paid to the UK pursuing the most extreme tax-averse austerity of any leading country (the only country to cut spending more than it cut the deficit).

Unsurprisingly, media attention has focused on the likely revenue impacts and the behavioural effects. Tax accountant Richard Murphy and tax lawyer Jolyon Maugham both suggest a top end revenue impact around £4 billion, falling with behaviour change to £1 billion or so. [Delete as appropriate: great minds/fools etc.]

The revenue numbers may be relatively small, but they’re not really the main point. Abolishing non-dom status would remove a clear injustice in the system, a deliberately created horizontal inequality in treatment of otherwise similar people.

More importantly, it responds to Piketty’s case for a wealth tax:

The primary purpose of the capital tax is not to finance the social state but to regulate capitalism. The goal is first to stop the indefinite increase of inequality of wealth, and second to impose effective regulation on the financial and banking system in order to avoid crises.

Absent a tax, even at a nominal 0.01%, data may not be collected and so policymakers will lack information about the distribution which might lead them to set policies to tackle inequality.

Aside from the aspect of tax injustice, non-dom status has been pernicious in part because it has taken a deal of high-income individuals’ income out of tax and other data – so that the actual distribution is simply not known.

If we can envisage scenarios in which policymakers may wish to address the (top end of the) distribution, then the absence of this data is an obstacle. In fact, this is one more example of the phenomenon of Uncounted – where the power of an elite group, in this case, allows them to go uncounted and this in turn militates towards higher inequality.

Finally, the existence of non-dom status is iconic – a clear message that the UK wishes to retain its role at the heart of global tax haven activity, providing differential tax and transparency treatment to a certain elite. Knocking non-dommery on the head would build the credibility of, for example, the outgoing government’s important efforts to address financial secrecy worldwide through the G8 and beyond.

The failures of international financial regulation: 1974 all over again

[D]espite the dramatic changes which have occurred in the nature of global financial markets over the past forty years, the challenges to the regulatory and supervisory system first identified in the banking scandals of 1974 have persisted.

I remember when reading Nick Shaxson’s ‘Treasure Islands: Tax havens and the men who stole the world’, being particularly struck by the archival research on the ping-pong between the Bank of England and UK Treasury officials over the potential risks of allowing financial ‘wizards’ to set up in UK territories and feed global money into the City of London. I also wondered why there wasn’t more academic research of that sort – there is, for example, on monetary policymaking, so why not on financial regulation? The answer, as so often, is just my ignorance.

Catherine Schenk (professor of economic history at Glasgow) has been doing just this for some time. ‘Summer in the city: Banking failures of 1974 and the development of international banking supervision’, reconstructs the discussions around the creation of the Basel Committee on Banking Supervision and efforts to learn the lessons of crisis – lessons that would be repeated periodically, up to 2008 at least.

The paper tells the story of the UK’s banking liberalisation and subsequent property boom of the early 1970s, followed by a sharp reversal that left many banks over-exposed. At the same time, the rapid internationalisation of banking, and growth of offshore centres since the late 1950s, was revealed to be well ahead of national regulators. Schenk’s story features frauds and fragility from St Helier to Tortola…

Schenk ewsAnd in 1975, the creation of the Basel Committee. An important consideration was the gap between home and host country regulators, as it had been for the Committee’s predecessor the Groupe de Contact – and remained unsolved. The demand for an early warning system went unmet, in the face of different regulatory approaches and a common resistance to cross-border sharing of banks’ information.

The historic parallel with the 2008 crisis (and many in developing countries) doesn’t need much elaboration – primarily the use of less regulated jurisdictions to facilitate massive credit creation, feeding into property and other asset bubbles rather than productive investment. And, sadly, the same underlying argument as in 1975 continues to prevent more effective regulation today: namely, that banks must trust their regulators in order to provide them with the sensitive information necessary for effective regulation, and this is incompatible with regulators sharing that information.

Organisations as diverse as the Economic Commission for Africa and ONE have called for the Bank for International Settlements to publish their data on bilateral banking holdings; but that old argument about regulator trust keeps it private.

Is each crisis an opportunity? We’ve had a lot of similar crises, and missed a lot of opportunities to reduce the probability of repeat. This paper does a great job of exploring one of the big ones.

UNCTAD study on corporate tax in developing countries

UNCTAD, the UN body that tracks trade and investment with the aim of improving development impacts, has published a major new study on corporate tax. [Link broken as at 20 July 2015, thanks Lisa, so see World Investment Report 2015 chapter 5 and annexes instead – this is the updated version.] Much attention will go to the estimate of $100 billion in developing country revenue losses due to MNEs’ tax avoidance, but the study contains much more of value:

  • The first comprehensive overview of MNEs’ revenue contribution in developing countries;
  • A relatively detailed overview of the use of ‘offshore hubs’ as conduits for investment;
  • Regression analysis of the profit-shifting impact of conduit use, and an estimate of the revenue losses; and
  • A discussion of potential policy responses that emphasise the value of investment but also recognise the damage of tax avoidance.

This (long) post will summarise each area in turn, then offer a few thoughts on the importance of the study, and future research directions. [Full disclosure: I’m on the expert group for the upcoming World Investment Report, of which this study is a part; which is to say that I may be biased, but certainly not that I can take any credit.]

MNEs’ revenue contribution

The first major element of the paper consists of creating a baseline for the revenue contribution of (the foreign affiliates of) MNEs, drawing primarily on the ICTD Government Revenue Dataset.

unctad draft fig3The authors break down the pattern of revenues overall (figure 3 – click for full size), and then focus on the contribution of MNEs.

Figure 6 shows the results of the ‘contribution method’, where each component of revenues is decomposed into a corporate and a non-corporate element, and the former again into a domestic and foreign affiliate element (see Annex I for full details). This allows an overall estimate of the contribution of MNEs’ foreign affiliates, of around $725 billion or 10% of total revenues. Around 3% of revenues derives from MNEs’ corporate income tax.

unctad draft fig6

As a cross-check, the authors use balance of payments data to construct the ‘FDI-income method’ which involves estimating the total revenue contribution from both unctad draft fig7corporate income taxation and non-income items. Per figure 7 (click to enlarge), this yields an overall contribution of $730 billion. There is perhaps more uncertainty in this approach, since it rests on the estimated tax rate and on the extrapolated rate of other (non-income tax) revenue contributions. Nonetheless, the full approach (again detailed in Annex I) is plausible, and the cross-check on the contribution approach is valuable.

The investment role of ‘offshore’

The second contribution of the study is to assess the (jurisdiction) sources of investment. 42 jurisdictions are identified as either ‘tax havens’ (“small jurisdictions whose economy is entirely, or almost entirely, dedicated to the provision of offshore financial services”) or ‘SPEs’ (jurisdictions offering SPEs or other entities facilitating transit investment. Larger jurisdictions with substantial real economic activity that act as major global investment hubs for MNEs due to favorable tax and investment conditions”).

This might be considered a rather blunt approach; as I’ve written elsewhere, there are serious issues with any ‘tax haven’ definition, and the intuition of the Financial Secrecy Index is that it makes more sense to think of jurisdictions on a spectrum, rather than being either ‘havens’ or not. Nonetheless, it’s clear that the approach here identifies the major players one way or another.

unctad draft fig13

Figure 13 (click to enlarge) shows the specific picture in the US. The difference in relative tax rates is striking: averages of 3% (‘tax havens’) and 2% (‘SPE countries’) versus 17% elsewhere.

In this light, the growth in use of these conduit jurisdictions for investment in developing countries which figure 17 illustrates is of clear concern.

unctad draft fig17

Estimate of MNE tax avoidance

The logical next step of the paper is to consider the likely effect of using conduit jurisdictions for investment into developing countries on MNEs’ revenue contribution. It seems inevitable that this calculation will draw the most attention.

The estimate is based on (fixed effects OLS) regression analysis of the relationship, at the national level, between the aggregate use of investment conduits and the rate of (taxable) return on the investment stock. On the basis of a variety of specifications, the authors conclude that

“an additional 10% share of inward investment stock originating from offshore investment hubs is associated with a decrease in the rate of return of 1-1.5 percentage point” (p.34).

Extrapolating to all (non-haven) developing countries generates a range of revenue loss estimates from $70 billion to $120 billion. Figure 20 shows the central estimate of $100 billion in revenue losses: towards half of the actual tax paid.

unctad draft fig20

The $100 billion is also around a tenth of the ‘potential value at stake’ – in effect, the total development finance associated with the activities of MNEs’ foreign affiliates. As an earlier draft had noted, the leakage of development resources is not limited to the loss of domestic fiscal revenues but it also affects overall GDP (as the profit component of value added is reduced) and potentially the reinvested earnings component of FDI. As companies shift away profits from the recipient country they may also undermine the development opportunities related to reinvestment of those profits for productive purposes.

Applying an average reinvestment rate of 50%, for example, to the calculated (after-tax) profit shifting of $330 – $450 billion would yield lost reinvested earnings in the range of $165- $225 billion. Summing up the revenue loss component and the reinvested earnings component the total leakage of development financing resources would then be in the order of $250 billion and $300 billion – in other words, between a quarter and third of the potential value at stake.

The pot of gold, however, should not be overstated: although this is likely to be a lower bound, since it does not capture all forms of corporate tax reducing behaviour, we’re talking about something like 1.5 percent of developing country government revenues on average. The absolute amount involved is clearly worth pursuing, and can have a substantial benefit in revenue terms and beyond; but the tax justice agenda cannot be boiled down to this alone. Much broader improvements, with both domestic and international components, are required to achieve a step change in effective taxation for development.

Policy recommendations

The study concludes with a range of policy recommendations, focused on improving the sustainable development impact of investment into developing countries. These are summarised in figure 21.

Multiple measures are set out, each worthy of more detailed discussion. A particular strength is the clarity of intent to ‘Ban tolerance or facilitation of tax avoidance as a means to attract investment’. If such an aim could be made operational and effective, it would imply an end to ‘competition’ among jurisdictions to take the tax base arising from economic activity elsewhere, of the type so clearly exposed in LuxLeaks.

I would have liked to see more emphasis on transparency measures – including, crucially, public country-by-country reporting – that would not only make the analysis here much more of a calculation and less of an estimation, but also provide an ongoing tool for accountability to ensure progress in reducing avoidance.

Summary

The UNCTAD study marks a major step forward in our understanding of the scale and nature of multinational tax avoidance in developing countries. Both the baseline for multinationals’ revenue contribution, and the assessment of the losses to avoidance, are likely to become part of the literature and the policy discussion for a good time to come.

No doubt some of the approaches will be challenged, including the regression results (when aren’t they?); and data will evolve over time (for example, the updating of the ICTD dataset in a few months’ time). But the pioneering approaches in the contribution method and the FDI-income method, as well as the model for the avoidance estimate, are likely to endure.

The policy recommendations are likely to have influence, perhaps including in the FfD process, and provide a valuable reminder of the importance of maximising not investment, nor revenues, but the development benefits that result. Better tools to resist avoidance will improve the ability of governments to make any necessary trade-offs.

3 ways to remove obstacles to effective taxation: #FFD3ECE

Update 24 March:

An interesting conference, including Amina Mohamed’s stressing of the urgency for development finance of tackling tax evasion and illicit financial flows. Of the three elements I discussed, it was governance that generated the most interest (perhaps in part because the suggestions on norms and transparency fall more clearly under post-2015 targets).

There felt to be quite broad consensus that simply upgrading the UN tax committee to intergovernmental standing would not do – resources are crucial if this is to become the globally representative, rule-setting body. To think about how much resourcing is required, think of the OECD’s current capacity on tax – and then scale up to global level.

But much supportive capacity already exists, if so mandated – for example, James Zhan of UNCTAD was on the same panel and spoke impressively about the work they have done on ensuring investment is not pursued for its own sake, nor maximised in terms of quantity, but rather seen as an important tool in the pursuit of the sustainable development. UNCTAD’s expertise in, for example, assessing investment and tax treaties in terms of their overall development benefit can be of value.

Is the required level of resourcing realistic? I’m not sure. But one suggestion from IBIS seems the right starting point: to hold a ministerial panel on the subject during the Financing for Development summit in Addis in July. If there is sufficiently broad desire to address the failed international governance of taxation, it should start in Addis – and if nobody turns up, I guess that’s the signal that the same failure will be accepted for the next wee while…

The pdf of my slides, in case the viewer below is too fiddly.

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Here are the slides I’m presenting at the UNECE regional consultation on Financing for Development in Geneva today (click on them to see the controls to move forwards). I’m arguing for a bit of focus in FfD on changing norms, governance and transparency at the international level, in order to open up space for effective taxation at the domestic level.

The slides are a little basic, because (a) I am, and (b) I’ve only got 7 minutes. With those excuses in place, comments are very welcome. And the hashtag is #FFD3ECE…

Alex-Cobham-UNECE-Geneva-FfD-230315

A couple of bits of related reading:

Poverty – a bad money-laundering risk factor

The UK’s Financial Conduct Authority has revealed the basis on which it ranks jurisdictions as low or high risk for money laundering – and it seems inevitable that it will support debanking of poorer countries.

AML rules under pressure

First a little context. There has been growing pressure lately on anti-money laundering (AML) rules. In recent years, a string of major banks has faced large fines for apparently systematic sanctions-busting. This has been followed by a pattern of withdrawal – ‘debanking’ – from a range of countries where the risks of inadvertently channelling funds of sanctioned and/or terrorism-related entities and individuals have come to be seen as too high.

On the one hand, there are reasons to be rather cynical about this process. First, because supporting generally small-scale remittances to Somalia, for example, is a far cry from accepting and anonymising Iranian funds – and presumably much less profitable. And second, because it feels a little convenient for major banks to be making a case for reduced financial regulation, in which their interests align with those of some of the world’s poorest people.

On the other hand though, there are good reasons to take the issue seriously. (Disclosure – I’m on a CGD working group looking at just this question, so I would say that…) First, even if debanking is motivated by relative profitability of Somalian remittances compared to Iranian sanctions-busting, the potential development impact of remittance channels becoming more expensive is nonetheless substantial. (And we surely don’t expect banks not to respond to profitability.) Financial inclusion also seems to be associated with lower inequality.

And second, we should take the issue seriously because ultimately we want AML rules that work, for everyone, and demonstrably so – which is not the case now.

The question is not whether and how AML rules should be relaxed. It is this:

How can AML rules be designed so that the risks facing banks and other financial institutions are proportionate to the risks of carrying criminal flows, and not inadvertently supporting discriminatory outcomes against poorer countries (and people)?

An inexplicably bad approach

The UK’s Financial Conduct Authority (FCA) is accountable to HM Treasury and the UK parliament for regulating more than 50,000 firms to ensure integrity of financial markets. As Matt Collin points out in a great post, the FCA has just fined the (British branch of the) Bank of Beirut £2 million, and ordered it to sort out its AML procedures.

In the interim, the bank is barred from taking on new business in ‘high risk’ jurisdictions – which the FCA defines as anywhere scoring 60 or less out of 100 on Transparency International’s Corruption Perceptions Index (CPI).

Matt makes two important points about the weaknesses of this approach:

  1. The CPI doesn’t reflect AML risks. Not a single one of the surveys which are aggregated into the CPI involves perceptions of money-laundering.
  2. The threshold is arbitrary – and includes nearly 80% of the 175 countries for which ratings are produced. See Matt’s great figure.

Let’s add a couple of other points:

  1. Even on its own terms, the CPI is a very bad measure of corruption. Sorry and all, and I think many TI chapters do really fantastic work; but the quicker the organisation drops the CPI, the better. Nor should anybody else be using it, as if it were some kind of objective indicator of corruption (never mind money-laundering) – it’s not.
  2. And here’s the real kicker. The CPI is mainly telling you one thing: how poor a country is. Per capita income ‘explains’ more than half of the variation of the CPI (for 2012, which I happened to have to hand). The equivalent for the Basle Anti-Money Laundering Index, which includes the CPI among its components, is a little over a third.

CPI v lngdppc

So: the FCA is basing their AML risk measure on an arbitrary threshold, in a bad measure of corruption, which has nothing to do with money laundering, and mainly reflects income poverty.

 

An alternative approach

What could the FCA do instead? Well, they could use the Basle index. Or they could follow the lead of researchers at the Italian central bank, or a German rating agency among a good many others – and use TJN’s Financial Secrecy Index (FSI).

The FSI – which is also a component of the Basle index – brings together 48 variables, predominantly from assessments by international organisations, to create 15 indicators of financial secrecy – that is, of the risk factor for money-laundering, tax fraud and other financial crimes. These are then compiled into a single ‘secrecy score’.

For the FSI, this is combined with a measure of each jurisdictions’ global scale in order to produce a final ranking that reflects the relative potential to frustrate other countries’ regulation, taxation and anti-corruption efforts.

For a risk measure, you’d only want to use the secrecy score (or perhaps a subset of indicators that are most tightly relevant to money laundering). Relationships with per capita income are much weaker and of mixed direction, reflecting the basis in objectively assessed secrecy and scale criteria rather than perceptions of corruption.

FSI 2013 and components lngdppcConclusion

To recap: If a financial regulator were to design a simple risk measure that would be most likely to lead to debanking of poor countries, while at the same time having no impact on the most risky jurisdictions, it’s hard to see how they could have done better than the FCA.

The broader lesson for the necessary rethinking of AML rules seems fairly clear. What are needed are context-sensitive measures that encourage responses proportionate to the actual financial crime risks – rather than encouraging the blanket withdrawal of services to poorer countries and/or people.

Mbeki panel showcases new risk-based illicit flows approach

We’ve already blogged at TJN about the Mbeki panel’s historic report on illicit financial flows (IFF) out of Africa. Here I want to pull out a particular aspect, a new approach to IFF which is pioneered in the report.

All IFF approaches to date have focused on estimating the actual scale of flows, in currency terms, on the basis of anomalies in data on cross-borders flows and/or stocks. This raises (at least) two inevitable problems. First, the data are imperfect – and hence anomaly-based estimation may confuse bad data on ‘good’ behaviour with good data showing ‘bad’ behaviour. Second, the behaviour in question is, by definition, likely to be hidden – so it may be unrealistic at some higher level to expect public data to provide a good measure.

Intuition for a risk-based approach

The alternative, or complementary approach, is to pursue a risk-based analysis. Because of the behaviours involved, whether IFF are strictly legal or not, they contain some element of social unacceptability that means the actors involved will prefer to hide the process. For that reason, the risk of IFF will be higher – all else being equal – in transactions and relationships that are more financially opaque.

That will mean, for example, that the chances of uncovering IFF will be higher in anonymous shell companies than in companies with complete transparency of accounts and beneficial owners. Not all anonymous shell companies will be used for IFF, but the risk is higher. Similarly, at a macroeconomic level (at which level much data tends to only be available, unfortunately), trading with a relatively financially secretive jurisdiction such as Switzerland will be characterised by a higher IFF risk than trading with a relatively financially transparent jurisdiction such as Denmark.

Scoring financial secrecy

At present, the most common measure of financial secrecy is the Financial Secrecy Index (FSI), published every two years by the Tax Justice Network, and now used widely—for example, as a component of the Basle Anti-Money Laundering Index and of CGD’s Commitment to Development Index, and as a risk assessment tool recommended in the OECD Bribery and Corruption Awareness Handbook for Tax Examiners and Tax Auditors.

The secrecy score on which the FSI is based reflects 49 measures, grouped to form 15 indicators, which capture a range of aspects of financial secrecy from transparency of beneficial ownership and accounts, through international juridical cooperation. The secrecy score ranges in theory from zero (perfect financial transparency) to 100 per cent (perfect financial secrecy); in practice no jurisdiction has scored less than 30 per cent.

Calculating IFF risk measures

Consider an illustration, involving one country’s exports – say Ghana. For each trading partner, we combine its share of Ghana’s exports with its secrecy score (which ranges from zero to 100). The results can be summed to give an overall level of secrecy for all of Ghana’s exports, and this score reflects Ghana’s vulnerability to IFFs in its exports (the flow-weighted average financial secrecy of all partners). If we multiply this vulnerability score by the ratio of Ghana’s exports to GDP, we obtain a measure of the country’s exposure to IFF risk, which can then be compared across other stocks or flows.

A vulnerability of 50, for exports equal to 10 per cent of GDP, would give an exposure of 5 per cent. This is equivalent to Ghana carrying out 5 per cent of its exports with a pure secrecy jurisdiction (that is, one scoring 100 out of 100), while all other exports go to completely transparent trading partners. The exposure can then be thought of as Ghana’s pure secrecy-equivalent economic activity, as a ratio to its GDP. (Note: Where no secrecy score is available we apply the lowest observed score of 33. This will bias scores downward, though much less so than assuming a zero score.)

IFF risk calculation

This measure of intensity of exposure to IFF risk can then be compared (given data), across time, countries and stock or flow types (with some important caveats). Table AIV.4 from the Mbeki panel report provides an indication of the overall intensity of exposure across African countries (excluding the major conduit jurisdictions).

Further detail can be found in Annex IV of the Mbeki panel report, while Alice Lépissier and I are working on a full paper to follow. Comments on the approach are very welcome indeed.

IFF risk intensity