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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Osborne’s pre-election gimmicks do little to address Britain’s long-term economic problems

History is unlikely to be kind to George Osborne. Four years after he became Chancellor, the national debt has exploded, the budget deficit remains at dangerously high levels and an increasing share of tax revenues must be devoted to repaying creditors.

The government also faces enormous long-term liabilities which currently do not appear in the national accounts. These include pensions and healthcare commitments that are spiralling due to a rapidly ageing population. The liberalisation of pension regulation announced in today’s budget, while welcome in itself, will not make a significant contribution to resolving this problem. Indeed, other government measures, such as the triple-lock on state pension increases will greatly exacerbate the long-term fiscal shortfall. Similarly, while the Chancellor was correct to focus on poor incentives to save, the impact of policies such as expanding ISA allowances will be trivial compared with the negative effects of loose monetary policy and new disincentives to save introduced as part of the government’s flagship welfare reforms.

To add to the demographic challenges facing the UK, a series of policy decisions, implemented for short-term political gain, have done lasting damage to the future prospects of the economy. One of Osborne’s first moves was to raise harmful taxes such as VAT in a misguided attempt to reduce the budget deficit and avoid additional spending cuts. It has backfired spectacularly by suffocating economic activity, dampening the recovery and as a result actually increasing government borrowing. And despite the depth of the recent slump, the burden of regulation on business has been increased. Tax and labour-market legislation has become even more costly for firms, while energy prices have spiralled due to government intervention.

The budget failed to tackle these problems. Yet more complexity was added to the tax system: another ill-conceived crackdown on tax avoidance was combined with a series of bizarre tax breaks for favoured sectors. Disappointingly, there was no rolling back of employment rules that are hindering business activity, such as mandatory workplace pensions, the Equality Act and the National Minimum Wage. And instead of reversing the government’s incoherent green energy policies, the Chancellor treated the symptoms rather than the cause of high bills by announcing special help for the heavy manufacturing sector.

But perhaps the most worrying blunder of all is the expansion of Osborne’s policy of subsidising borrowing to ‘stimulate’ the economy. His ‘Help-to-Buy’ scheme may be effective at winning votes from certain target groups, but it is potentially very dangerous indeed for the medium-term stability of the UK economy. Asset prices are already severely distorted by the Bank of England’s policies of low interest rates and quantitative easing. The Chancellor’s sub-prime subsidies risk further inflating the housing market: more households will take on debts that could become unaffordable should interest rates return to normal levels. Thus significant default risk has been loaded onto taxpayers. There are also potentially very serious implications for the banking sector should government policies ignite another boom-bust cycle.

Indeed, there is a strong argument that a significant part of the current economic recovery is artificial in the sense that it has been generated by the easy credit policies of both the government and the Bank of England. Sceptics might point out that politicians have often boosted the economy in the run-up to general elections. The long-term consequences have usually been dire.

Reuters, 19 March 2014

Do we need to make further spending cuts?

George Osborne is taking a reckless gamble by extending his fiscal target out to 2017/18. Government borrowing will now remain at dangerously high levels for a prolonged period. Worse still, the deficit reduction plan could easily be derailed by lower-than-forecast growth. The Chancellor is relying on robust growth in the medium term to boost tax revenues and enable him to meet his targets without the need for radical spending cuts. This outcome cannot, however, be guaranteed. Recent history shows that OBR forecasts are extremely unreliable. Borrowing in 2013/14 is already likely to be almost double the figure originally expected. If stronger growth fails to materialise, the UK could quickly lose the confidence of the bond markets and face a debt spiral. Given the risks, a wiser Chancellor would have taken a much more conservative approach. Deeper cuts would have made Britain much more resilient to future growth shocks.

6 December 2012, City AM

The Chancellor is still gambling on strong medium-term growth

At the time of the last Autumn statement, the Office for Budget Responsibility (OBR) was predicting growth of 0.7 per cent in 2012, followed by 2.1 per cent in 2013, 2.7 per cent in 2014 and a robust 3.0 per cent in 2015. Yet again, these forecasts have been downgraded, to -0.1 in 2012, 1.2 per cent in 2013, 2.0 per cent in 2014 and 2.3 per cent in 2015. Forecasts of strong growth of almost 3 per cent have now been put back to 2016 and 2017.

Despite the unreliable nature of such forecasts, the Chancellor is still gambling that strong medium-term growth and the consequent increases in tax revenues will allow him to meet borrowing targets without making radical spending cuts. So far this strategy has not been successful. As a result of lower-than-expected growth over the last two years, government borrowing in 2012/13 on a like-for-like basis will be around 50 per cent higher than projected in the original deficit reduction plan. Borrowing in 2013/14 is now forecast to be almost double the figure expected back in 2010. At around 7 per cent of GDP, it will remain at a similar or higher level than in several countries currently experiencing debt crises, such as Italy, Spain and Portugal.

In addition, there are good reasons to believe that the long-term ‘trend’ rate of growth in the UK has declined over the last decade or so. This reflects a large rise in public spending – to a peak of 50 per cent of GDP – as well as an expanded regulatory burden on businesses. Moreover, various government stimulus policies since 2008 have hindered recovery by preventing necessary adjustments, such as the liquidation of boom-time malinvestments and the reallocation of resources to more productive activities. Going forward, significant increases in energy and transport costs, resulting from the government’s environmental policies, are likely to have a negative effect on economic output. And, as the Chancellor mentioned in his statement, the ongoing euro zone crisis adds further uncertainty to the medium-term growth outlook.

In this context, the Treasury is taking a major risk in basing its deficit reduction plans on growth forecasts that are likely to be inaccurate. Given that government borrowing remains at dangerously high levels, and that the confidence of the bond markets could quickly be eroded if outcomes disappoint, there is a strong case for taking much more radical action to reduce public spending. The real terms reductions in working-age benefits are a good start, but the Chancellor could also have acted to cut age-related benefits, as well as abandoning the coalition’s deeply unpopular plan to increase foreign aid. Significant medium-term savings could be achieved by cancelling major projects such as Trident and High Speed 2. The IEA’s recent publication, Sharper Axes, Lower Taxes, provides a long list of potential savings.

5 December 2012, IEA Blog

Do we need to make further spending cuts?

The government has behaved recklessly. Assuming a strong recovery with high growth and rising tax revenues, it gambled that relatively modest spending cuts would be enough to fulfil the deficit reduction plan. The latest borrowing figures betray the magnitude of this miscalculation. It seems likely that the deficit will remain dangerously high, and there is a very real risk of the UK losing credibility in the bond markets.

Given the gravity of the situation, a combination of more substantial spending cuts and radical deregulation is the only realistic option for the Chancellor. The former would reduce the deficit directly while the latter would translate rapidly into higher growth. By contrast, a stimulus programme would only increase the risks facing the economy. Additional borrowing would put the deficit further into the danger zone and an even larger state would suffocate private-sector activity.

23 August, City AM

Cut more, regulate less

Relying on growth was always going to be a risky strategy. Yet a healthy recovery, with robust GDP increases of 2%-plus, formed the core of the government’s deficit reduction plan. In this context, the combination of prolonged recession and yesterday’s higher-than-expected borrowing figures is a cause for deep concern. Indeed, there are several reasons to believe that the outlook for the UK economy is bleak and that growth will not be sufficient to play the key role in deficit reduction assumed by the government.

Firstly, the stimulus policies adopted after the onset of recession have hampered the necessary market adjustment process by which resources ‘malinvested’ during the artificial boom are reallocated. In other words, stimulus measures have cushioned the decline in the short term but at the expense of recovery in the longer term. Secondly, the expansion of the state under New Labour will have reduced the long-term growth rate of the economy by crowding out wealth-creating private sector activity. Finally, there are a number of more specific negative factors, including an ageing population (contributing to slowing labour force growth); regulatory pressure on the banking sector; the euro crisis; and the potentially disastrous impact of various green policies on business costs.

Since the government can no longer rely on growth (and the extra tax revenues that flow from it) to bring the deficit down and stimulus measures would be counterproductive, spending cuts are the only realistic policy option. And the likely scale of the tax shortfall resulting from the double-dip recession means that these cuts will have to be very substantial indeed. Many of these cuts can, however, be combined with reform to produce long-term economic benefits, as set out in the recent IEA study, Sharper Axes, Lower Taxes. In particular, spending reductions should be combined with deregulation. Reducing unnecessary burdens on business feeds directly into higher productivity. Strict planning controls, green energy policies and restrictive employment legislation are key restraints on business growth and should be urgent priorities for liberalisation.

22 August 2012, IEA Blog

Pride before a fall: Osborne looked to special interests, not the UK’s perilous state

The Autumn Statement showed that George Osborne has failed to grasp the gravity of the economic crisis facing the UK. Urgent action was needed to brace the economy for double-dip recession and the fallout from the euro crisis. Instead, the chancellor announced a big increase in government borrowing, together with a series of measures that, while attractive to key groups of target voters, will do little to encourage growth.

Worse still, collapsing growth means the government’s deficit reduction plan is now in tatters. Government borrowing has been increased by £110bn over the next four years, meaning a staggering £350bn added to the national debt.
This may in fact be a best-case scenario. The Office for Budget Responsibility predicts slow growth of 0.7 per cent in 2012 but then assumes a healthy recovery, with growth rising to 2.1 per cent in 2013, 2.7 per cent in 2014 and a robust 3.0 per cent in 2015. But given the severity of the euro crisis, high levels of public and private debt, and the possibility of a downturn in overheated emerging markets, it is equally plausible that Britain will go into recession next year, followed by several years of stagnation.

A wise chancellor would be preparing for such a scenario. Vague talk of contingency plans does not pass muster.
A double-dip recession would decimate tax revenues while adding to welfare spending through higher unemployment. If UK GDP were just five per cent lower than predicted in 2015, for example, this would reduce the annual tax take by around £35bn.

Under such circumstances, with the budget deficit remaining unsustainably high, the chancellor cannot assume that the UK will retain investor confidence and continue to pay very low interest rates on its debt. With high debt and low growth there may be little to separate Britain from the struggling economies in the rest of Europe, such as Spain and Italy.
Given the severity of the potential risks, Osborne should have had the courage to announce further cuts – at least enough to return the deficit reduction plan to its original trajectory. He should also have taken far bolder steps to encourage growth, through radical deregulation and by rationalising the tax system.

He could, for example, have cut spending by uprating benefits rates in line with average earnings rather than inflation. Planned increases in foreign aid – deeply unpopular with a sceptical public – could have been abandoned at negligible political cost.

Instead, several new spending announcements were made, using money that could have been used to reduce government borrowing. Ill-conceived “credit easing” policies will mean taxpayers will guarantee risky loans to businesses and first-time buyers. Additional enterprise zones were announced, even though these subsidise firms to relocate to sub-optimal locations. An extra £1bn was found for the Regional Growth Fund for England, despite five decades of failure in regional policy and governments’ lamentable record at picking winners.

Much was also made of extra infrastructure spending: £5bn extra over the next three years plus significant additional investment from the private sector. Unfortunately, a high proportion of this expenditure is politically motivated and the economic returns will be negative. Loss-making public transport schemes will require ongoing operating subsidies, creating significant future liabilities for short-term political gain.

The counterproductive gimmicks were combined with almost a complete absence of policies to reduce burdens on businesses and thereby encourage growth. Osborne made some welcome statements on the need to liberalise planning controls, reduce the cost of employment law and simplify business taxes – but few concrete measures were announced.

In fact, current government policies are likely to work in direct opposition to many of the chancellor’s announcements. For example, new regulations forcing builders to produce expensive “zero-carbon” homes will dwarf the impact of special help for 100,000 first-time buyers. Indeed, Osborne recognised the calamitous impact of the government’s green policies when he announced subsidies for energy-intensive industries struggling to cope with spiralling costs.

The lack of action on deregulation is mirrored in tax policy. Several tax rates are now so high that they actually lower revenues by destroying incentives to work and invest. The Autumn Statement was a golden opportunity for Osborne to signal his intention to rationalise the tax system. In particular, a cut in the 50p rate of income tax would have increased tax revenues and sent a strong message to international investors that the UK offers a pro-business climate.

On this and other issues the chancellor proved too timid to step up to the challenge. He missed his chance to prepare the country for economic turmoil by cutting spending and removing key impediments to growth. It now seems likely his hand will be forced by events.

30 November 2011, City AM