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A Journey from a Corruption Port to a Tax Haven

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A Journey from a Corruption Port to a Tax Haven
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    A Journey from a Corruption Port to a Tax Haven Shafik HebousVilen Lipatov CES IFO W ORKING P APER   N O .   3620 C ATEGORY 1:   P UBLIC F INANCE  O CTOBER  2011  An electronic version of the paper may be downloaded  •  from the SSRN website:www.SSRN.com •  from the RePEc website:www.RePEc.org •  from the CESifo website: T www.CESifo-group.org/wp T    CESifo Working Paper No. 3620   A Journey from a Corruption Port to a Tax Haven Abstract We sketch a model according to which tax havens attract corporate income generated incorrupted countries. In our framework, tax havens have two opposite effects on welfare. First,tax havens’ services have a positive effect on welfare through encouraging investment byfirms fearing expropriation and bribes in corrupt countries. Second, by supporting corruptionand the concealment of officials’ bribes, tax havens discourage the provision of public goodsand hence have also a negative effect on welfare. The net welfare effect depends on thespecified preferences and parameters. One source of this ambiguity is that the presence of multinational firms in corrupted countries is positively associated with demanding tax havens’operations. Using firm-level data, we provide empirical support for this hypothesis.JEL-Code: F230, H250, H320.Keywords: tax havens, tax avoidance, tax evasion, multinational firms, corruption. Shafik HebousFaculty of Economics and Business AdministrationGoethe University Frankfurt Chair of Public FinanceGrüneburgplatz 1 Hauspostfach 45Germany - 60323 Frankfurt am Mainhebous@wiwi.uni-frankfurt.deVilen LipatovChair of Public FinanceGoethe University Frankfurt Grüneburgplatz 1 Hauspostfach 4560323 Frankfurt am MainGermany Lipatov@em.uni-frankfurt.de September 2011We have received useful comments and suggestions from Clemens Fuest, Johannes Voget,Alfons Weichenrieder, Tom Zimmermann, and participants in the seminar at the NorwegianSchool of Economics and Management, Goethe University Frankfurt, the summer symposiumat the CBT at the University of Oxford, and the 67th annual congress of the IIPF in AnnArbor at the University of Michigan. We thank the research centre of the DeutscheBundesbank for its kind hospitality. The first author gratefully acknowledges the financialsupport of the Vereinigung von Freunden und Förderern at the Goethe University Frankfurt.The usual disclaimer applies.  1 Introduction Tax havens have recently been heavily debated in the policy arena for severalreasons, ranging from fragile …scal positions of many economies to recentrevolutions against many corrupt autocratic o¢cials who stored their assetsin havens. Academically, the role of tax havens in the world economy islargely viewed within the framework of international tax competition. Moststudies assume that the real operation of the …rm takes place in a high-taxcountry, possibly one with an advanced economy. The function of the a¢liatein the tax haven is to receive (a portion of) the corporate income, which isthus shifted away from the domestic high-tax country for purposes of taxavoidance. 1 In this study, we focus on other roles of tax havens in the world economy.First, we examine theoretically the connection between the operations of …rms in corrupt countries (possibly with low- and middle-income economies)and …rms’ demand for tax havens’ services. 2 Second, we model the corruptauthority’s problem of choosing the optimal bribe rate. Third, we providenew insights into welfare consequences of eliminating tax havens. Fourth, weempirically analyse the link between operating in corrupt countries and thepresence of multinational …rms in tax havens, using German …rm-level data.Firms operating in highly corrupt countries face special circumstances.First, …rms bribe o¢cials to maintain their investment activities. Second,bribes do not insulate …rms from risks. In the absence of a credible rule of law, contracts are not enforceable. Firms fear expropriation, blackmailing,or a sudden eruption of instability in the corrupt host economy. Hence,even if the corporate income tax rate in a corrupt country is relatively low,multinational a¢liates have a strong incentive to conceal and shift (a portionof) their income. The question is then: Where to? The srcin country is notthe most preferred option available for the multinational …rm, especially if the parent …rm is located in a high-tax country. Alternatively, multinationala¢liates can transfer the income generated in highly corrupt countries to tax 1 Dharmapala (2008) provides a survey. 2 The negative relationship between corruption and GDP per capita is documented inSvensson (2005), along with other variables related to corruption. 2  havens. 3 Public debates and media reports often assert that not only …rms butalso corrupt o¢cials use tax havens for hiding income. Our theoretical sketchexplicitly considers the transfer of bribes to o¤shore tax havens, and allowsthe probability of revolt against the corrupt authority (eruption of instability)to be a function of the provided amount of public goods. A higher bribe rateincreases the extracted rent by o¢cials, but at the same time it reduces thebribe base, since …rms’ demand for tax havens’ services increases with higherbribes.We analyse the welfare implications under various scenarios. The e¤ectsof eliminating tax havens on the citizens of the corrupt country can be sum-marised as follows:  Firms’ investment in the corrupt country decreases under standard as-sumptions on the interest elasticity of capital demand and on the cost of shifting income fromthe corrupt country to the tax haven. Accordingly,private consumption by the citizens of the corrupt country decreases.Thus, the e¤ect on welfare through …rms’ investment is negative.  In a world without tax havens, it is more di¢cult for corrupt o¢cialsto conceal bribes. As a result, the provision of public goods unambigu-ously increases in order to lower the probability of revolt and losingo¢ce. Hence, eliminating tax havens has a positive e¤ect on welfareby precluding their support for corruption.The overall welfare e¤ect depends on the functional forms and parametersof the model. These new welfare results for a corrupt country complementthose in Slemrod and Wilson (2009), who consider only a non-corrupt coun-try. In our framework, as in theirs, tax havens constitute a drain on revenuesof the non-corrupt country. In our setting, the welfare e¤ect of eliminatingtax havens’ operations on the non-corrupt country is positive provided thatfactor prices are constant.Other, related studies point out that tax havens have positive e¤ects onwelfare. These are summarised in three e¤ects: (1) Tax havens support anequilibrium where all non-havens set the same (high) tax rate and henceraise revenues (Johannesen; 2010a), (2) borrowing from tax havens increases 3 Firms in the corrupt country can be broadly interpreted to include not only foreigna¢liates but also domestic …rms. 3  the e¢ciency of the …rm and its investment at home (Hong and Smart;2010), and (3) tax havens with advanced banking sectors (o¤shore …nancialcentres) improve competition in the banking sectors in neighbouring coun-tries, generating positive welfare e¤ects (Rose and Spiegel; 2007). However,these studies consider the issue from the standpoint of su¢ciently advancedeconomies, whereas our model stresses the importance of viewing the welfaree¤ects of tax havens from a global perspective by incorporating features of less advanced economies. The notion that tax havens are linked to corruptionand development has been a concern in many discussions. The NorwegianMinistry of Foreign A¤airs published in 2009 a report focusing on tax havensand development. In a chapter of this report, Torvik (2009) emphasises thee¤ects of tax havens on resource-rich countries and gives examples of dicta-tors who shift money from dubious sources to tax havens. Related studiesare by Schjelderup (2011), who argues that tax havens reduce the costs of entering illegal businesses, and Slemrod (2008), who underlines the status of tax havens as a means of commercialisation of state sovereignty. 4 Empirically, welfareanddetailedinformationontaxevasionandcorruption-related matters are unobservable. However, we test the hypothesis stemmedfrom our model positing that the presence of multinational …rms in corruptcountries is positively associated with a high probability of demanding taxhavens’ operations. Based on conditional …xed-e¤ects logistic regressionsand after controlling for …rm size and unobserved heterogeneity at the par-ent …rm level, we …nd empirical support for this hypothesis. This new resultcontributes to the existing empirical literature that links …rms’ demand fortax havens’ a¢liates to the tax regime of the home country or the size of the…rm (e.g., Desai et al., 2006, and Gumpert et al., 2011). 5 We proceed as follows. Section 2 presents the benchmark model andthe resulting equilibrium equations determining the share of …rms that usetax havens and the optimal bribe rate. In section 3, we provide a welfareanalysis of shutting down tax havens. Section 4 generalises the benchmarksetup by allowing the probability of revolt against the corrupt government tobe endogenous. Section 5 provides empirical results using the German MiDi 4 The increasing academic interest in the tax havens’ businesses is re‡ected in a num-ber of recent contributions focusing on other, related aspects. Examples are Johannesen(2010b), and Ma¢ni (2009). Hebous (2011) provides a recent survey. Bardhan (1997)surveys the literature on corruption and development. 5 In a distinct but related study, Kesternich and Schnitzer (2010) show that multina-tional a¢liates have higher debt levels in environments of high expropriation risks. 4
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