Sanctuaries from big government: how tax havens help preserve economic freedom

Governments are extending their tentacles into more and more aspects of people’s lives. They are undermining long traditions of banking privacy with international data sharing agreements. Lawyers and accountants are increasingly forced to reveal details of clients’ activities to public officials. And perhaps most worrying of all, states are engaged in the mass surveillance of their citizens, monitoring all manner of activity from e-mails and phone calls to financial transactions.

The emergence of such ‘Big Brother’ policies should come as no surprise. It is a predictable symptom of the long-term expansion of the state. During the 19th century, government spending accounted for under 10% of GDP in most Western countries. Today that figure is typically in the 40-60% range. In practice this means that politicians and officials decide how to spend roughly half of national income!

Furthermore, much of the remaining private sector is under strict state control. Although they may be nominally privately owned, many business activities are severely constrained by regulation. Indeed in many cases, the regulatory framework is so restrictive that firms are effectively under political direction. A prime example is the energy sector in the EU and many US states. Power companies are not allowed to produce electricity using the cheapest fuels. They are forced to invest in expensive offshore wind and nuclear generation.

Pervasive intervention has a heavy economic cost. Highly taxed and heavily regulated Western economies are declining rapidly relative to emerging economies. On some measures, China is expected to overtake the US as the world’s largest economy sometime this year. In Europe, Russia is close to surpassing Germany, although this may depend on current political difficulties being resolved. By contrast, both the US and EU are plagued by high living costs and stagnating wages.

Government debt has exploded as growth has declined and expenditure has risen. And official debt figures are just the tip of the iceberg. They don’t include enormous off-balance-sheet liabilities such as state pension commitments. Moreover, rapidly ageing populations will put further upward pressure on health and pensions spending. One recent estimate suggested the UK’s real national debt is about £5 trillion rather than the official total of £1.5 trillion. The US and other European countries have equally dire public finances.

Politics is part of the problem. As government spending has expanded, more and more groups have become dependent on hand-outs. This presents a major problem for politicians. For example, a government that cut state pensions might struggle to get re-elected, particularly when a high proportion of active voters are over 60.

Similarly, as regulation has become more onerous, firms have become increasingly reliant on red tape, whether as a source of business or to shut out competition. A high proportion of the West’s most talented people are now employed creating, enforcing or complying with government bureaucracy. Any deregulation programme is likely to generate strong opposition from the special interests profiting from state controls.

A combination of big government, poor economic performance and high debt means that states are now desperate for tax revenue. And given the strength of various interest groups, politicians find it easier to penalise entrepreneurs and wealth creators than risk offending the various client groups that depend on public spending.

But targeting the most productive members of society tends to be counterproductive. High tax rates deter entrepreneurship and innovation, lowering long-term economic growth and actually reducing revenues in the long term.

The most creative, talented and hardworking people might also decide to desert a country hamstrung by big government. They might relocate to places where they are allowed to keep a larger proportion of the wealth they create. Innovators will move to jurisdictions where their commercial ideas can be realised and not suppressed by red tape and bureaucracy.

Such a brain drain can send heavily regulated, high-tax countries into a spiral of decline. The top few per cent of earners make a disproportionate contribution to government budgets. For example, in the UK the top 1% contribute 28% of income tax revenues.

Entrepreneurship also has many wider economic benefits, such as creating a business friendly culture that stimulates further creativity and attracts investment from abroad. There is also a political aspect, since wealth creators will tend to support political parties that favour a light-touch approach to both tax and regulation.

By driving the gifted away, governments risk haemorrhaging tax revenues and bolstering anti-commerce attitudes in culture and politics. These trends further exacerbate a country’s long-term problems and risk driving even more talent away.

Something like this seems to be happening in France at the moment. Punitive tax rates on business people, combined with a moribund economy constrained by layers of bureaucracy, are encouraging entrepreneurs and high-skilled workers to relocate to countries such as the UK.

Faced with these problems, sensible governments would introduce economic reforms. They would cut taxes and lift the burden of regulation. Indeed, reducing tax rates tends to produce more revenue for the government in the medium term, because it improves work incentives and encourages business activity.

Reform therefore has the potential to convert a spiral of decline into a virtuous circle. Lower taxes and less red tape boost the economy, improve government finances and lower public debt. Countries then become more attractive to entrepreneurs and investors. Instead of repelling wealth creators, reforming jurisdictions attract them.

Most governments have not followed this path, however. The struggling economies of the Eurozone are a case in point. Countries such as Greece, Spain and Portugal are experiencing a full blown depression of a similar magnitude to the US in the 1930s but have so far refused to change course. In fact their ill-conceived policies have exacerbated an already severe slump. Steep tax increases have been the main focus of their attempts to address the debt crisis, choking off business activity and making a bad situation worse.

A similar attitude has been evident in the bureaucracies of the European Union. Despite the depth of the depression caused by the failed Euro experiment in southern Europe and Ireland, the EU has continued piling on more and more burdensome rules. These countries desperately needed a radical programme of deregulation to cut the costs of doing business, but instead Brussels has made it even more expensive to raise finance, employ workers, buy energy, dispose of waste, and so on.

Recent EU policies augur very badly for the future. If the worst economic crisis since the aftermath of World War 2 doesn’t stimulate reform, then what hope is there under more normal conditions?

There are several reasons for the counterproductive policies of national governments and the European Commission. Obviously any programme of tax cuts and deregulation would negatively affect groups that depend on big government for their livelihoods. The bureaucrats in national and European agencies comprise one of the largest such groups themselves. But these special interests can be overcome, as shown by examples of reform elsewhere. Indeed, it can be possible to bring senior officials onboard by giving them key roles in streamlining their own organisations. Measures such as recruitment freezes can dramatically shrink bureaucracies without placing undue pressure on existing staff.

Big-government ideologies are arguably a more challenging obstacle to change. The political culture in many countries and within the European institutions is anti free enterprise and views large-scale state intervention as the best solution to social and economic problems. Despite the rapid relative decline experienced by big-state jurisdictions in the West, and the striking success of small-state competitors such as Hong Kong, these attitudes seem to be firmly entrenched.

In this context, recent attacks on economic freedom are unsurprising. Rather than rolling back the state to foster entrepreneurship and wealth creation, administrations in both the US and the EU have moved towards further centralisation and top-down control.

The focus is on preventing countries from competing with one another by harmonising tax rates and regulations. This is gradually making it harder and harder for entrepreneurs to escape big-government controls. Increasing centralisation also makes it difficult for all but the largest corporations to influence policy decisions. Whereas local governments are relatively accessible to smaller businesses, elite transnational organisations are remote, and their decision-making processes opaque.

The centralisation agenda is likely to have dire consequences for the economy. Supranational bodies are detached from the localised and place-specific knowledge that is needed to adjust policy to suit changing circumstances. Harmonisation also destroys the diversity that is so essential to economic development.

When different jurisdictions are free to try out different policies, the successful ones can be copied and the failed ones discarded. This process was vital in bringing prosperity to the West. Lots of small political units competed with one another and successful policy experiments in one area were rapidly adopted by others. This kind of evolution is not possible in large political blocks governed by top-down bureaucracies.

The trend towards centralisation makes tax havens more important than ever. As more countries become harmonised by bodies like the EU, tax havens are among the last bastions of economic freedom.

While they exist there is still a deterrent to those predatory politicians wishing to impose punitive tax rates or draconian regulations that discriminate against entrepreneurs and investors. Tax havens give wealth creators alternative options when policies move in the wrong direction or, in more severe cases, where various forms of confiscation are threatened.

In this way, enclaves of freedoms perform a highly valuable service for the populations of countries afflicted with big government. More capital is retained by the people who produce wealth rather than captured by those who squander it to buy votes and bolster their own power.

Restraints are placed on those leaders tempted to drag their countries into a spiral of decline. The high likelihood of the brightest and best transferring their assets and activities elsewhere deters even the most reckless politicians, particularly given the implications for tax revenues.

The economic importance of tax havens is therefore out of all proportion to their often small geographical size. They are sanctuaries from big government and safety valves for a world increasingly suffocated by the dead hand of centralisation. This is why tax havens must resist bullying tactics from the US and EU and seek to retain their long-held traditions of respect for private property and financial privacy. They might also consider extending their role as safe havens by providing asylum for entrepreneurs facing persecution for violating increasingly complex and incomprehensible regulations.

By sticking to their guns, tax havens can become a source of inspiration for the opponents of big government in the West. As Europe and North America are harmonised into stagnation, these islands of prosperity will point the way to successful reform.

An earlier version of this article was published in the July/August 2014 edition of Offshore Investment.

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