Offshore Financial Centres (OFCs) Are Under Attack

The severity of the crackdown is almost certainly related to the financial crisis. Governments that imprudently increased their spending during the recent boom are now running record budget deficits. But heavily indebted governments are mistaken if they think their campaign against OFCs will solve their fiscal crisis. In reality such measures, by penalizing productive, wealth-generating individuals, are likely to prove counterproductive.

Opponents of OFCs argue that they reduce investment; threaten essential public services by lowering the tax-take; and lead to a ‘race to the bottom’, forcing governments to reduce taxes to ensure their countries remain competitive. These arguments are misleading. In fact, OFCs have a positive economic impact. Most importantly, they provide protection from predatory governments and deter politicians from imposing tax rates that are economically harmful.

High taxes do immense economic harm by discouraging hard work, entrepreneurship and innovation. They also reduce investment, with the government taking a larger share of economic resources that could have been put to productive use in the private sector. This in turn means taxes act as a barrier to the new technologies that drive economic growth. Without sufficient investment, potentially valuable innovations are never developed and exploited, while the implementation of productivity improvements is delayed.

At current tax levels, most Western governments confiscate two-fifths of people’s earnings – with devastating consequences. Many growth-creating entrepreneurial activities are no longer viable. Businesses face crippling compliance costs to follow tax rules. And high-income individuals spend vast amounts of time and money trying to reduce their payments by employing armies of lawyers and accountants. This ‘negative-sum game’ is a gigantic waste of highly skilled people, who might otherwise be profitably employed in wealth-generating activities.

Governments are notorious for wasting taxpayers’ money. Politicians tend to base spending decisions on their need to please special interests and gain re-election. Unlike entrepreneurs, they do not face personal losses if they decide to waste resources.

As a result, government services are often inefficient, with high costs but poor results. State education is a prime example. Despite decades of high expenditure in countries such as the US and UK, a significant share of school leavers are functionally illiterate. Transport is another case in point. Huge sums are wasted on big infrastructure projects that are so uneconomic they require continued subsidies to keep operating. Welfare benefits are perhaps the most striking illustration. Designed to help the poor, they actually trap large numbers in poverty by destroying work incentives for the low-skilled – a disastrous outcome that also costs taxpayers dearly.

It would be better for consumers if many government services were instead provided by the private sector. Entrepreneurs have far greater incentives to satisfy customer requirements than politicians and bureaucrats. Their success depends on responding to consumer demand rather than pandering to special interests.

The positive effects of OFCs go beyond the benefits of tax competition. Low-tax jurisdictions also make investment more efficient. Indeed, arguments that tax competition damages investment are deceptive. In practice, investment is not ‘captured’ by OFCs and thereby denied to other locations. Rather, OFCs act as intermediaries, re-allocating resources to where they can be used best.

Channeling money through OFCs avoids many complications and makes cross-border investment much easier. The economic benefits are huge. Investment opportunities are opened up all over the world. Resources are allocated to those enterprises that offer the best returns rather than focused on businesses in the investor’s home country. OFCs have therefore played a key role in connecting investors in rich countries with enterprises in emerging markets, to the benefit of both parties. The resulting creation of wealth has lifted hundreds of millions of people out of abject poverty.

If politicians in the US and the EU are really concerned about the welfare of their citizens they should end their attack on OFCs. Better still, they should learn from them and encourage greater tax competition in their own jurisdictions. Tax competition therefore has the potential to revive stagnating economies. Greedy governments need to step aside and allow investors and entrepreneurs the freedom to create wealth.

By Dr. Richard Wellings (full article can be found in Offshore Investment magazine, May 2011)