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What Problems and Opportunities Are Created by Tax Havens?

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DOI: 10.1093/oxrep/grn031 · Source: RePEc

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W HAT P ROBLEMS AND O PPORTUNITIES
ARE C REATED BY TAX H AVENS ?

Dhammika Dharmapala

O XFORD U NIVERSITY C ENTRE FOR

B USINESS TAXATION
S A ÏD B USINESS S CHOOL , PARK E ND S TREET
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 What Problems and Opportunities are Created by Tax Havens?

Dhammika Dharmapala∗

Prepared for Oxford Review of Economic Policy issue on “Business Taxation in a Globalised
World” (Vol. 24 No. 4, Winter 2008)

Revised version: August 2008

Abstract

Tax havens have attracted increasing attention from policymakers in recent years. This paper
provides an overview of a growing body of research that analyzes the consequences and
determinants of the existence of tax haven countries. For instance, recent evidence suggests that
tax havens tend to have stronger governance institutions than comparable nonhaven countries.
Most importantly, tax havens provide opportunities for tax planning by multinational
corporations. It is often argued that tax havens erode the tax base of high-tax countries by
attracting such corporate activity. However, while tax havens host a disproportionate fraction of
the world’s foreign direct investment (FDI), their existence need not make high-tax countries
worse off. It is possible that, under certain conditions, the existence of tax havens can enhance
efficiency and even mitigate tax competition. Indeed, corporate tax revenues in major capital-
exporting countries have exhibited robust growth, despite substantial FDI flows to tax havens.

Acknowledgments: I would like to thank the Editor (Mike Devereux), my discussant (Ken
Mayhew), an anonymous referee, and conference participants at the Oxford University Centre
for Business Taxation Summer Symposium for helpful comments. Any remaining errors are, of
course, my own.
∗
Department of Economics, University of Connecticut, email: dhammika.dharmapala@uconn.edu.

1
1) Introduction

Tax havens have attracted increasing attention and scrutiny in recent years from
policymakers, as exemplified by the Organisation for Economic Cooperation and Development
(OECD) initiative to combat “harmful” tax practices (OECD, 1998, 2000, 2004). The interest in
tax havens reflects their disproportionate role in the world economy, especially in relation to
international capital flows. Tax havens are central to many of the most important current policy
debates in taxation, including the extent of international tax competition (e.g. Slemrod, 2004;
Hines, 2006, 2007) and tax avoidance activity by corporations (e.g. Desai and Dharmapala,
2006, 2008). This paper provides an overview of the theoretical and empirical insights from a
growing scholarly literature that analyzes the consequences and determinants of the existence of
tax haven countries.

The paper begins with an analysis of the characteristics of countries that tend to be
classified as tax havens. It focuses in particular on recent evidence (Dharmapala and Hines,
2006) that tax havens tend to have stronger governance institutions (i.e. better political and legal
systems and lower levels of corruption) than comparable nonhaven countries. The popular image
of tax havens is somewhat at variance with this picture, and emphasises their role in facilitating
tax evasion by individuals. The OECD initiative also focuses on the use of havens by individuals
seeking to evade taxes. The policy questions discussed here, however, relate to the role of tax
havens in enabling tax planning by multinational corporations. Multinational corporations can
use tax havens to reduce or defer tax liabilities to other (nonhaven) countries, through the
strategic setting of transfer prices (especially for intellectual property), the strategic use of debt
among affiliates, and various other means. The paper briefly describes these types of strategies
and the empirical evidence on their prevalence.

It is often argued that tax havens erode the tax base of high-tax countries by providing
opportunities for these types of corporate activities. This traditional “negative” view of tax
havens has recently been modeled formally by Slemrod and Wilson (2006). The evidence does
show that tax havens host a disproportionate fraction of the world’s foreign direct investment
(FDI). However, according to an emerging “positive” view of havens (e.g. Desai, Foley and
Hines, 2006a, b; Hines, 2006, 2007; Hong and Smart, 2007), this need not necessarily imply that

2
their existence makes high-tax countries worse off. It is possible that havens enable high-tax
countries to impose lower effective tax rates on highly mobile firms, while taxing immobile
firms more heavily. Under certain conditions (for instance, if differentiating between mobile and
immobile firms is difficult for informational or administrative reasons), the existence of tax
havens can enhance efficiency and even mitigate tax competition.

The latter view appears to be supported by the recent experience with corporate tax
revenues: despite substantial (and apparently increasing) FDI flows to tax havens, corporate tax
revenue in the US, UK and other capital-exporting countries has not fallen, but has actually
increased. The generally robust growth of corporate tax revenues in major capital-exporting
countries, despite substantial FDI flows to tax havens, suggests that the concerns expressed about
the deleterious effects of tax havens may be somewhat exaggerated. However, there is ongoing
debate over whether the existence of tax havens spurs harmful tax competition and lowers global
welfare, and these debates have important implications for international tax policy and for the
wider development of an increasingly integrated global economy.

Section 2 describes the characteristics of tax havens. Section 3 outlines how havens can
create opportunities for tax avoidance by corporations. Section 4 assesses the consequences of
the OECD initiative. Section 5 discusses the theoretical literature on the effects of tax havens on
the welfare of high-tax countries, and considers some relevant evidence. Section 6 concludes.

2) What are Tax Havens, and what are their Characteristics?

Although tax havens have attracted widespread interest (and a considerable amount of
opprobrium) in recent years, there is no standard definition of what this term means. Typically,
the term is applied to countries and territories that offer favorable tax regimes for foreign
investors. The elements of these favorable regimes include, first and foremost, low or zero
corporate tax rates. There are a variety of other elements common to tax havens, such as low or
zero withholding tax rates on foreign investors. Bank secrecy laws (another common feature)
have attracted great attention, although they appear to be of declining significance due to
growing international efforts to promote information-sharing among the tax authorities of
different countries (as discussed in Section 4 below). While the classification of countries based
on these criteria inevitably involves some degree of subjectivity, there are approximately 40
3
countries and territories that appear in most published lists of tax havens. In this paper, the basic
definition of havens follows that in Dharmapala and Hines (2006; hereafter DH).1

What distinguishes this group of countries from the rest of the world? Even a casual
observer is likely to be aware that tax havens tend to be small and that many are islands. DH
(2006) provide quantitative measures of many other relevant characteristics, as illustrated in
Figure 1a. Tax havens are on average substantially more affluent than are nonhavens. In addition
to being smaller in population size and more likely to be island countries (as expected), tax
havens’ geographical characteristics lead them to be more intrinsically inclined towards
economic openness. In particular, they tend to be located in closer proximity to major capital
exporters, and have a larger fraction of their population located within 100 km of the coast.2
Havens also tend to have a relatively sophisticated communications infrastructure, as measured
by the number of telephone lines per capita. They are also poorly endowed with natural
resources: the value of their subsoil assets per capita (as estimated in World Bank (2006)) is
much smaller than that for the typical nonhaven country.

Tax havens also differ substantially from nonhavens in their legal origins (the historical
source of a country’s system of commercial law, as classified by La Porta et al. (1999)) and
political institutions. As shown in Figure 1b, havens are more likely to have British legal origins
and less likely to have French legal origins than is the typical country. Havens are also more
likely to use English as an official language and to have parliamentary rather than Presidential
political systems. They are somewhat more likely to be dependent territories, rather than
sovereign states (as reflected in a lower rate of membership in the United Nations (UN)). These

1
DH (2006) begin with the list of jurisdictions in Hines and Rice (1994, Appendix 2, p. 178), all of which also
appear in Diamond and Diamond (2002) and various other sources, and match these with countries and territories
for which current data on economic and other characteristics are available. This set of countries is listed in Table 1
(under the heading: “Tax havens (DH)”).
2
Proximity to major capital exporters is measured by Gallup, Sachs and Mellinger (1999) as the distance by air from
the closest of New York, Tokyo or Rotterdam. The coastal population measure is also constructed by Gallup, Sachs
and Mellinger (1999).

4
differences mostly persist when attention is restricted only to haven and nonhaven countries with
small populations (below one million).3

DH (2006) focus in particular on an overall measure of governance institutions created by

the World Bank (Kauffmann, Kraay and Mastruzzi, 2005). This governance index measures
several different dimensions of governance quality, including political stability, the absence of
official corruption, respect for the rule of law, government effectiveness and democracy. The
index is normalized to have a mean of zero across all countries and a standard deviation of one,
with higher values indicating stronger governance institutions. DH (2006) finds that tax havens
score substantially better on this measure relative to comparable nonhaven countries. Moreover,
tests using a variety of statistical approaches show that this relationship is highly robust, and
suggest that a causal interpretation (i.e. that countries with stronger governance tend to become
tax havens) may be reasonable.

DH (2006) interpret these results within the framework of the standard result in the
theory of optimal taxation that a small open economy should not levy any source-based tax on
foreign investors (Gordon, 1986). The burden of such a tax would be shifted entirely to domestic
workers in the form of lower wages as investors demand higher pretax rates of return, so a more
straightforward and efficient means to raise revenue would be to tax workers directly. In the real
world, this conclusion may not apply to countries that enjoy significant location-specific rents,
for instance through natural resource endowments or agglomeration externalities in capital
formation. More generally, however, this theoretical framework suggests that the real puzzle is
not why some countries become tax havens, but rather why so many small countries do not (for
instance, of 75 countries and territories with populations less than a million in the DH dataset,
only 31 are tax havens). DH (2006) argue that only countries with good governance are able to
credibly set low tax rates; those small countries that are not tax havens would generally not reap
any benefits from seeking to become havens, as stated policies would count for little with foreign

3
See DH (2006). An exception is UN membership, which is slightly higher for small havens than for small
nonhavens.

5
investors in the absence of a strong institutional framework.4 Moreover, becoming a tax haven
appears to be a successful economic development strategy for those countries that are able to
make this choice: Hines (2005) finds that tax havens experienced higher rates of economic
growth over the period 1982-1999 than did comparable nonhavens.5

3) Tax Havens and Corporate Tax Planning

In February 2008, an international scandal relating to tax evasion unfolded after

Germany’s tax authorities purchased data from a former employee of a Liechtenstein bank.6 This
information on German individuals with Liechtenstein bank accounts led to the prosecution of
prominent German citizens for tax evasion. This scandal exemplifies the image of tax havens in
the popular mind, emphasising the use of tax havens by individuals for the purpose of illegally
evading home country taxes.7 However, corporations also locate large amounts of investment in
tax havens. For instance, about a quarter of US firms’ foreign direct investment (FDI) is located
in tax havens (as defined in DH (2006)), and the corresponding number for UK firms’ FDI is

4
Some limited but intriguing supporting evidence for this view is that inbound foreign direct investment (FDI)
appears to be much more sensitive to corporate tax rates in countries with stronger governance institutions (DH,
2006).
5
Slemrod (2008) views tax havens within a broader context of practices that involve the “commercialization” of
state sovereignty, a concept that also encompasses involvement in facilitating money laundering activities, and the
issuance of stamps designed to appeal to foreign collectors. Slemrod (2008) finds that better governance is related
not only to being a tax haven, but also to “pandering” stamp issuance (though not to involvement in facilitating
money laundering). He suggests a more general interpretation, arguing that better governance leads not only to
greater policy credibility but also to a greater capacity to undertake welfare-enhancing government activities.
6
The scandal also spread to the UK – see “UK in Liechtenstein Tax Data Deal” BBC Online (24 February 2008) at
http://news.bbc.co.uk/2/hi/business/7261830.stm.
7
The tendency for a disproportionate share of foreign portfolio investment (FPI, i.e. cross-border investment by
individuals, or by institutions such as pension funds on behalf of individuals) to be located in tax havens seems to
support this view. Data from the US Treasury International Capital (TIC) reporting system (available at
www.treas.gov/tic/ and described in more detail in Desai and Dharmapala (2007)) shows that 21% of US FPI is
located in tax havens (as defined in DH (2006)). However, as the TIC data is based on survey responses by US
financial institutions, it is unlikely that investors would evade taxes on these investments. More generally,
evaluating individuals’ use of havens is complicated by the wider context of understanding FPI. Economists have
long argued that there are substantial gains available to investors from international portfolio diversification (e.g.
French and Poterba, 1991). Historically, investors have failed to achieve these gains, although this “home bias”
phenomenon appears to be eroding over time (Dharmapala (2008) calculates that in 2004 US investors held only
12% of their equity portfolios in foreign stocks; however, from 2004 to 2005, increases in holdings of foreign stocks
represented 43% of the total increase in holdings of equity). If the home bias is caused by an irrational aversion to
foreign assets, then there may be a case for subsidizing FPI; lax enforcement of home country taxes on foreign-
source income may be one way to implement such a subsidy.

6
similar.8 Presumably, this is not because these firms are seeking to evade home country corporate
taxes. However dedicated corporate managers may be to the maximization of after-tax
shareholder value, they will surely not risk prosecution on behalf of their shareholders. Rather,
corporations use tax havens for legal tax avoidance and tax planning activities. Thus, the policy
questions raised by corporate uses of havens are likely to be very different from those relating to
individual evasion.

Understanding how multinational corporations (MNCs) can use havens to reduce or defer
their tax liabilities to other governments requires a brief digression on how governments tax the
foreign income of their resident corporations. Most (nonhaven) governments insist on taxing
economic activity that takes place within their borders, whether undertaken by domestic or
foreign firms. There are two alternative approaches to taxing the foreign-source income
generated by a country’s resident corporations. A “worldwide” system (used for instance by the
US, the UK and Japan) taxes this foreign income. However, to avoid the “double taxation” that
would result from the overlapping claims of the source and residence countries, a foreign tax
credit (FTC) is allowed for taxes paid to foreign governments.9 On the other hand, a “territorial”
system (used by most other capital exporting countries, such as Germany and the Netherlands)
exempts foreign-source income from home country taxation.10

For MNCs resident in territorial countries, there is an obvious advantage to being able to
reallocate income from the home country (or some other high-tax country) to a tax haven. This
incentive would not exist under a pure worldwide system. In practice, however, worldwide
systems are anything but pure – for instance, the US permits the deferral of US taxation of
foreign income until that income is “repatriated” to the US (“repatriation” consists of the

8
The data on US FDI are from the US Bureau of Economic Analysis, and are available at http://www.bea.gov. The
data on UK FDI are from the UK Office for National Statistics, available at http://www.statistics.gov.uk/. Tax
havens are defined as in DH (2006). Note that FDI, which is carried out by multinational firms, typically involves
holding a controlling stake in a foreign affiliate (in contrast to FPI, which is carried out by individuals or by
institutions such as pension funds on behalf of individuals).
9
Note, however, that the FTC is limited to the home country tax liability on the foreign income.
10
The exemption applies to “active” income generated by the firm’s normal business operations. Generally,
“passive” income from firms’ cash holdings or portfolio investments is taxed by the home country.

7
payment of a dividend by the foreign subsidiary to the US parent).11 The early literature
analysing this system showed that the US tax imposed at the time of repatriation does not affect
the decision to repatriate or to reinvest foreign earnings in the foreign affiliate’s operations, if
these are the only available options (Sinn, 1984; Hartman, 1985). In practice, however, firms
also have the option of using foreign earnings to acquire passive assets that are held abroad
through their foreign affiliates (Hines, 1994; Weichenrieder, 1996). Delaying repatriations in this
way can confer a substantial deferral advantage on the MNC by reducing the present value of its
US tax liability.12 Moreover, this deferral advantage is magnified for tax haven affiliates
(because the immediate source-based tax paid to the tax haven government is low or zero).

Thus, MNCs have incentives to use tax havens to reduce or defer their tax liabilities,
regardless of whether they happen to be based in countries with territorial or worldwide tax
systems. One mechanism for achieving this aim involves the strategic use of transfer pricing.
When affiliates of the same MNC trade goods or services among themselves, they must choose
prices for these transactions. The prices used inevitably affect the allocation of the MNCs’
income across different jurisdictions. Governments generally insist that firms use “arm’s length”
prices (those that would be used by unrelated parties engaging in market transactions). However,
for certain transactions, arm’s length markets are thin or nonexistent.13 A particularly important
example in practice is intellectual property: affiliates of the same MNC can, to a significant
degree, choose where to locate research and development activity in order to ensure that royalty
payments from other affiliates flow towards lower-tax jurisdictions. This is illustrated in Figure
2a: firm A (a Dutch parent) has affiliates in (high-tax) Germany and (low-tax) Ireland, and
locates its intellectual property (and the associated stream of royalties) in Ireland. Consistent

11
Deferral also applies only to “active” income generated by the foreign affiliate’s business operations. Passive
income generated by the foreign affiliate’s cash holdings or portfolio investments is taxed immediately by the US
under the Subpart F rules.
12
The deferral advantage applies only to the active income generated by the foreign affiliate; the interest earned on
the passive assets held by the foreign affiliate is subject to immediate US taxation under the Subpart F rules.
13
Thus, the primary difficulty with the arm’s length standard is usually thought to be its administrative feasibility.
However, Devereux and Keuschnigg (2008) argue that it may be inefficient, even if perfectly implemented. In their
model, heterogeneous firms endogenously choose whether to engage in arm’s length trade with a foreign entity or to
acquire it, based on factors such as agency costs and financing constraints; imposing arm’s length pricing on those
firms that choose to acquire the foreign entity can potentially distort their choices.

8
with the importance of this type of strategy, Desai, Foley and Hines (2006a) find that US MNCs
with greater focus on research and development are more likely to establish affiliates in tax
havens.14

Another strategy that MNCs can pursue involves the strategic use of debt among
affiliates. In particular, they have an incentive to locate debt in high-tax jurisdictions, while
holding fixed the aggregate capital structure of the MNC’s family of affiliates.15 This practice
(known as “interest stripping” or “earnings stripping”) directs interest payments to low-tax
countries, while generating interest deductions in high-tax countries. Figure 2b illustrates this
strategy, where the Irish affiliate (B) lends to the German affiliate (C). Consistent with the
importance of such strategies, Desai, Foley and Hines (2004) find evidence that US MNCs tend
to locate debt in higher-tax countries, while Mintz and Weichenrieder (2005) find that wholly-
owned affiliates of German MNCs in countries with higher tax rates tend to use more debt.

Governments seek to restrict interest stripping through “thin capitalization” rules (which
restrict the tax deductibility of interest payments when the use of debt in a firm’s capital structure
exceeds some specified level). Emerging evidence suggests that these rules have significant
effects on capital structure, even if they are less than completely successful in preventing
international tax planning. Buettner et al. (2006) use data on a panel of German-owned affiliates
abroad, and find that foreign countries’ introduction of thin capitalization rules reduces the use of
debt by German-owned affiliates. However, they also find that this reduced use of debt is
accompanied by a greater sensitivity of investment to tax rates, as opportunities for tax planning
are constrained. Weichenrieder and Windischbauer (2008) analyse the strengthening of
Germany’s thin capitalization rule in 2001, finding that foreign-owned affiliates operating in
Germany reduced their use of debt in response. However, the effect is limited in magnitude; the
authors attribute this to the availability of other, more complex, tax planning strategies.

14
Outside the context of intellectual property, Swenson (2001) and Clausing (2003) find evidence of tax-motivated
transfer pricing using data on international trade prices.
15
Huizinga, Laeven and Nicodeme (2008) argue that the MNC’s aggregate capital structure should itself depend not
just on the tax rate in its home country, but on a weighted average of tax rates in the countries in which it operates;
they find evidence consistent with this view.

9
 It is important to emphasise that MNCs’ use of tax havens depends crucially on home
country tax rules (e.g. Roin, 2007). To illustrate this point, suppose that the parent in Figure 2b is
based in the US (rather than in the Netherlands). As the US taxes the interest received by B
immediately, there would seem to be no tax advantage to this strategy. However, in 1997, the US
Treasury implemented what are known as the “check-the-box” (CTB) regulations, enabling firms
to choose their organisational form for tax purposes. While designed to reduce the administrative
burdens faced by small firms, the CTB regulations also enable US-based MNCs to use what are
known as “hybrid entities” (Altshuler and Grubert, 2005). These are classified in two distinct
ways – for instance, as separately incorporated affiliates under the tax rules of Germany and as
unincorporated branches under the tax rules of the US. In terms of Figure 2b, the CTB
regulations make it possible for A to elect (for US tax purposes) to have B treated as an
unincorporated branch of C. This makes the interest payments received by B “invisible” to the
US tax system, and so facilitates the avoidance (or deferral) of US tax on the interest income
paid by C to B. At the same time, B can be treated as a separately incorporated affiliate for
purposes of German taxation (so that C receives the interest deduction).16

The strategies discussed above are extremely simple (for a discussion of more complex
MNC financial strategies, see Altshuler and Grubert (2003)). This brief discussion, however, is
sufficient to show that there are strong incentives for MNCs to use tax havens for international
tax planning. Empirical research (as surveyed for instance in Devereux (2007)) shows that
MNCs are highly responsive to these tax incentives. For instance, Hines and Rice (1994) and a
substantial subsequent literature find a large elasticity of US FDI holdings and of US affiliates’
profits with respect to foreign countries’ corporate tax rates. The early literature used aggregate
data on US FDI by country. More recently, Desai, Foley and Hines (2003) use firm-level data on
US-owned affiliates and find an average -1.5 elasticity of asset ownership with respect to the tax
rate. As a result of this tax sensitivity, a vastly disproportionate amount of the world’s FDI is

16
Desai and Dharmapala (2008) use the introduction of the CTB regulations as a source of exogenous variation in
their study of the impact of corporate tax avoidance on firm value: they construct instruments for tax avoidance
activity by interacting a dummy for the post-CTB period with time-varying firm characteristics that affect the
incentives for tax avoidance.

10
located in tax havens.17 This situation has not gone unnoticed in policy debates; Section 5 below
addresses the question of how it might be evaluated from a normative standpoint.

4) The OECD Initiative and its Consequences for Tax Havens

Concern about the use of tax havens to erode the tax bases of higher-tax countries has
prompted a major effort by the OECD to combat tax havens (OECD, 1998, 2000, 2004; Hines,
2006). The OECD in 1998 introduced what has subsequently come to be known as the Harmful
Tax Practices initiative, intended to discourage the use of preferential tax regimes for foreign
investors and to encourage effective information exchange among the tax authorities of different
countries. As part of the initiative, the OECD (2000, p. 17) produced a list of countries and
territories that it deemed to be tax havens.18 In the years since, most of these havens have agreed
to improve the transparency of their tax systems and to facilitate information exchange.19
However, the extent of information-sharing in practice is unclear, as is the impact of this
initiative.

Kudrle (2008) examines total foreign portfolio investment (as reported by the Bank for
International Settlements) in the Cayman Islands and in a broader set of tax haven countries. His
time-series analysis finds no significant impact of the OECD initiative. Similar conclusions can
be reached using other approaches. For instance, the International Labour Organisation (ILO)
reports data on employment and wage levels by industry for a large sample of countries.20 Figure
3a reports employment levels in the financial sector of a major tax haven, Jersey, for the period

17
As noted above, about a quarter of US and UK FDI is located in tax havens. By way of comparison, tax havens
are home to only 0.7% of the world’s population when havens are defined as in DH (2006), or just 0.2% when using
the OECD definition.
18
In addition to the se 35 countries, another six countries (listed in Hishikawa (2002, fn. 72, p. 397)) that otherwise
satisfied the OECD’s tax haven criteria were not included on the list because they provided “advance commitments”
to eliminate allegedly harmful tax practices. The complete set of 41 OECD-designated havens is listed in Table 1
(under the heading “Tax haven (OECD)”).
19
OECD (2004) lists five recalcitrant tax havens that had failed to make such commitments as of 2004 – see Table
1. The preferential regimes identified by the OECD have also generally been abolished or modified to remove the
features that the OECD found objectionable.
20
These data are available at http://laborsta.ilo.org/. Unlike the investment data used by Kudrle (2008), employment
data is not subject to the problem that evasion may occur through asset holdings that are unreported not just to tax
authorities but also to statistical agencies. Unfortunately, the coverage of tax havens in the ILO data is very limited,
rendering a cross-country longitudinal study of the impact of the OECD initiative difficult.

11
1997-2005, using employment in the financial sector of the UK as a control. The two series
follow a very similar trend, and the conclusion is similar when examining the average wage in
Jersey’s financial sector (Figure 3b).

Thus, the evidence (limited though it undoubtedly is) does not suggest any impact of the
OECD initiative on tax haven activity. One may conclude (as Kudrle (2008) does) that the
OECD’s measures were insufficient. It is also reasonable to argue that the OECD initiative has
not been implemented in practice to any meaningful extent. However, it is also clear from the
discussion in Section 3 of the differences between (legal) corporate tax planning and (illegal)
individual evasion that information-sharing only threatens the latter.21 Thus, the OECD initiative
cannot be expected to have much impact on corporate uses of tax havens, even if (or when) the
initiative is fully implemented.22

5) The Consequences of Tax Havens for High-Tax Countries

The various forms of corporate tax planning outlined in Section 3 are widely believed to
constitute a significant policy problem for high-tax countries. This point of view has been given
a formal exposition by Slemrod and Wilson (2006). They develop a model of tax competition in
which tax havens are viewed as being “parasitic” on the tax bases of nonhavens. In their
framework, firms based in nonhaven countries can choose to purchase “concealment services”
from havens, thereby avoiding (or evading) home country taxes. In addition to the resource costs
incurred by havens in providing concealment services, tax avoidance also induces nonhavens to
expend additional resources on enforcement. In the equilibrium of this model, small countries
endogenously choose to become tax havens.23 The existence of havens intensifies tax
competition and forces nonhaven countries to set lower tax rates than they otherwise would,
thereby reducing the supply of public goods. These welfare losses can be ameliorated in their
model by the elimination of tax havens.
21
The OECD initiative initially included provisions directed at corporate activities, but this element was soon
dropped – see Kudrle (2008, p. 7).
22
Klautke and Weichenrieder (2008) find evidence that another recent initiative directed at tax havens – the EU’s
Savings Directive – has been ineffective. This measure also targets individual evasion rather than corporate
avoidance.
23
This prediction is of course consistent with the evidence on population size shown in Figure 1a.

12
 Slemrod and Wilson (2006) present a rigorous statement of a set of conditions under
which the existence of tax havens spurs harmful tax competition and lowers global welfare. It is
certainly possible that these conditions hold in the real world. However, recall the point made
earlier that MNCs’ use of havens depends crucially on home country tax rules. In particular,
nonhavens could eliminate the use of havens by their corporations through the simple expedient
of changing the source rules for corporate income, or imposing immediate worldwide taxation
(Roin, 2007).24 This suggests that it may be more reasonable to believe that the world’s major
economies benefit from the existence of tax havens. A number of models (Keen, 2001; Desai,
Foley and Hines, 2006a, b; Hong and Smart, 2007) have specified conditions under which
corporate tax haven activities may be beneficial for the MNCs’ home countries. The rest of this
section summarizes this “positive” view of havens, and considers some relevant evidence.

Keen’s (2001) model is not explicitly motivated by the question of tax havens, but rather
by preferential tax regimes for foreign investors or specific sectors (which were also targeted by
the OECD initiative). In a simple model of tax competition, Keen introduces the assumption that
capital may be heterogeneous in its mobility across borders. If preferential regimes (i.e. lower tax
rates for more mobile forms of capital) are not allowed, then countries are constrained to
compete by setting a single tax rate for all forms of capital. This will result in a needlessly low
rate on immobile capital. On the other hand, when preferential regimes are permitted, countries
can set high tax rates on immobile capital, while competing only over tax rates imposed on
mobile capital. Preferential regimes can thus mitigate tax competition by restricting its effects to
a subset of the tax base. This intuition extends quite readily to the analysis of the role of tax
havens, as discussed below.

Hong and Smart (2007) develop a general equilibrium model of a small open economy in
which the corporate tax serves to both tax the returns to inbound FDI and to tax the rents earned

24
In addition, their equilibrium entails that the (small and relatively powerless) havens impose significant welfare
costs on the populations of larger and more powerful countries. For example, many prominent tax havens are British
dependent territories, yet the “negative” view of havens implies that they pursue policies that are harmful to the UK.
There are possible explanations for this state of affairs – for example, the UK may prefer to subsidize its territories
by allowing them to become havens, the costs of which fall partly on other capital exporters, rather than by direct
subsidies. However, this apparent disjuncture between theory and reality is not directly addressed in the literature
critical of tax havens.

13
by domestic entrepreneurs. As in Gordon (1986), the burden of the former is entirely shifted to
domestic workers in the form of lower wages. Despite this, the optimal corporate tax rate will
generally be positive when the government wishes to redistribute from domestic entrepreneurs to
domestic workers.25 In this setting, the existence of tax havens can increase the welfare of
nonhaven countries. Tax planning by MNCs (e.g. sourcing income in the tax haven through
interest stripping) lowers their effective tax rate and makes them more willing to invest in the
nonhaven for any given statutory tax rate. This directly makes domestic workers better off. It
also increases the optimal corporate tax rate, enabling more redistribution from domestic
entrepreneurs to domestic workers (without driving away FDI). The key to their result that the
existence of tax havens raises welfare is that the government cannot discriminate between
(immobile) domestic entrepreneurs and foreign investors in setting the corporate tax rate.

Desai, Foley and Hines (2006a) analyse the determinants of US MNCs’ choice of
whether to establish affiliates in tax havens. Using foreign countries’ economic growth rates as
instruments for the scale of a MNC’s operations in foreign nonhavens, they find that the latter is
a crucial factor in driving the establishment of affiliates in havens. To explain their findings,
Desai, Foley and Hines (2006b) develop a model in which there are complementarities between
investment in havens and investment in neighboring nonhaven countries. On the one hand,
investment in nonhaven countries spurs demand for tax haven operations in order to reduce tax
liabilities on the income from the former. On the other hand, the presence of a tax haven enables
tax planning that lowers the cost of investing in neighboring nonhavens. Thus, the existence of
havens can stimulate investment in nonhavens.

The insights from this literature can be illustrated using a simple example. Assume that
there are two symmetric countries (A and B). A is home to an immobile firm A1 and a mobile
firm A2 (each of which generates net income of $50 through domestic operations), and B is
home to an immobile firm B1 and a mobile firm B2 (each of which generates net income of $50
through domestic operations). There are two corporate tax policies available to each government

25
Slemrod and Wilson (2006) also model small open economies. They derive positive optimal corporate tax rates
through a different route. Specifically, taxes on wages can be evaded, at some resource cost. Thus, governments
prefer (up to a point) to tax workers indirectly by imposing taxes on capital rather than to tax them directly and thus
incur these costs of evasion.

14
– a rate of 50% and a rate of zero (neither of which can discriminate between the two firms). It is
assumed that this tax is imposed on a territorial basis (i.e. it applies to all domestic income, but
exempts foreign-source income). The marginal cost of public funds in each country is 1.2,
reflecting the notion that alternative sources of revenue impose deadweight costs.

It is assumed that immobile firms are nonstrategic. Mobile firms choose the location of
their operations in order to maximize after-tax profits. Each country maximizes a payoff that is
the sum of revenue collected (multiplied by 1.2) and the after-tax profits generated within its
borders (whether by domestic or foreign firms).26 The payoffs in the case where tax havens do
not exist are shown in Figure 4a. If both countries set the same tax rate, firms do not choose to
move from their original locations, even if they are mobile. If B sets a zero rate while A sets a
50% rate, then A2 will move its real operations to B, incurring a small resource cost of $1. This
raises B’s payoff by the extra $49 of profits that A2 generates in B. The dominant strategy
equilibrium is for each country to set a zero rate, even though this is Pareto-inferior to the
outcome where both set their rates at 50%.

Now, imagine that a third country C exists and functions as a tax haven. There are
assumed to be no real investment opportunities in C, but it can facilitate firms’ tax planning
activities.27 In these circumstances, if A imposes a 50% tax, then A2 has available the option of
keeping its real operations in A, but (costlessly) sourcing all of its profits in the tax haven (thus
ensuring a zero effective rate). A1 (the immobile firm) is assumed to be unable or unwilling to
use the tax haven, just as it cannot move its real operations to B. The new payoffs when a tax
haven exists are shown in Figure 4b.28 The Nash equilibrium is now for each country to set its

26
Equivalently, a country’s payoff can be defined as the (pretax) profits generated within its borders (whether by
domestic or foreign firms), plus the social benefits (0.2 per dollar) of the revenue transferred from firms to the
government. The profits generated can be viewed as a proxy for the amount of capital employed within the domestic
economy, and hence for the wages of domestic workers (which, given the complementarity of capital and labor, are
obviously higher when more capital is employed domestically). Incidentally, the assumption that tax revenue is
socially valuable highlights that this is not a “Leviathan” framework, in which tax competition can be beneficial by
constraining a government inclined towards excessive spending.
27
C is thus a “financial” haven, rather than a “production” haven. Admittedly, this limits the generality of the
example, but it nonetheless captures an important element of the characterization of tax havens in this literature.
28
Note that there is now no incentive for the mobile firms to move their real operations between A and B, as this
incurs a real resource cost, while using the tax haven for financial transactions is assumed to be costless.
15
rate at 50%. Thus, tax competition is mitigated by the presence of the tax haven, which results in
higher equilibrium tax rates and welfare gains for both A and B.

Of course, higher equilibrium tax rates are of little value unless there are some immobile
firms that can be taxed. In an era of global economic integration, it is reasonable to ask whether
there are still any immobile firms left. Desai, Foley and Hines (2006a) find that in their sample
of US MNCs, a significant fraction (about 40% in 1999) do not have affiliates in tax havens.
This evidence suggests considerable heterogeneity in the ability of firms to undertake tax
planning, even among MNCs. This heterogeneity would be even greater, of course, if purely
domestic firms were also considered. This underscores that the relevance of these alternative
models of tax havens thus depends on factors such as whether there are significant differences in
the international mobility of different firms, and whether governments can discriminate between
firms on this basis in setting tax rates.29 These are difficult issues to determine theoretically, but
it is possible to examine the testable implications of each view.

The standard “negative” view of tax havens, as formalized by Slemrod and Wilson
(2006), implies that increased tax haven activity would intensify international tax competition,
and so be associated with declining corporate tax revenues in major capital-exporting countries.
In particular, the rapid growth in international capital flows in recent years (a disproportionate
amount of which is located in tax havens) would be expected to have led to precipitous declines
in revenues from the corporate tax. In contrast, the “positive” view of havens suggests no
necessary decline in revenues: even though increased tax haven activity may reduce tax rates on
firms that use havens, it also enables more taxation of immobile domestic firms (Desai, 1999;
Hines, 2007).

The data on corporate tax revenues does not suggest any decline, precipitous or
otherwise. Figure 5a shows US FDI in tax havens over the period 1994-2006.30 A large fraction
of US FDI is located in tax havens, and there is a slight upward trend over this period.
29
Slemrod and Wilson (2006) allow for heterogeneity among firms in their cost of using tax havens. However, the
tax rates set by the government are not contingent on this cost.
30
The data on FDI and on US corporate tax revenues are from the US Bureau of Economic Analysis, and are
available at http://www.bea.gov. In Figure 5a, tax havens are defined as in DH (2006), while Figure 5b uses the
OECD definition (see Table 1).

16
Nonetheless, the fraction of US Federal tax revenues derived from corporate taxes has increased
over this period, especially since a decline associated with the 2001-2002 economic downturn.
The increased revenues are not due to increases in the US statutory corporate tax rate (which has
remained unchanged over this period).31 The increase does not appear to be sensitive to the
precise definition of tax havens. In Figure 5b, the definition of havens is restricted to those
designated as such by the OECD (see Table 1), and US corporate tax revenue is reported as a
fraction of GDP. The basic pattern is very similar to that in Figure 5a, and starkly contradicts the
notion that tax haven activity by MNCs has eroded the US corporate tax base.

The robustness of corporate tax revenues in the face of global economic integration is by
no means confined to the US. Weichenrieder (2005) shows that this is also true in Europe, where
there have been substantial reductions in statutory corporate tax rates in recent decades. These
rate reductions have been accompanied by base broadening, and one possible explanation for
why revenues have remained stable is that the lower corporate tax rates may have induced
changes in the organisational form of businesses by encouraging incorporation (Weichenrieder,
2005; de Mooij and Nicodeme, 2008). It is thus possible that tax haven activity by corporations
may indeed be harmful, but an increased propensity to incorporate among domestic firms (driven
by corporate tax rate reductions spurred by tax competition) may have offset the effects on
corporate tax revenue. However, even if this is true for Europe, it cannot explain the experience
of the US, where there has been no reduction in the corporate tax rate, either absolutely or in
relation to personal rates.32 Thus, the generally robust growth of corporate tax revenues in major
capital-exporting countries, despite substantial FDI flows to tax havens, suggests that the
concerns expressed about the deleterious effects of tax havens may be somewhat exaggerated.33

31
See Auerbach (2007) for an analysis of why US corporate tax revenues have increased.
32
Indeed, since 2001, personal rates have fallen while the corporate rate has been unchanged.
33
It is of course possible to imagine a counterfactual world in which corporate tax revenues would have grown even
faster in the absence of tax havens. This, however, appears unlikely. For instance, in the US, the recent increases
shown in Figure 5a represent the reversal of a longer-term decline going back to the early 1960’s (Auerbach, 2007).
A counterfactual involving significantly higher growth in corporate tax revenues than has actually occurred would
represent a dramatic departure from past experience. Incidentally, the long-term decline from the early 1960’s until
the 1990’s cannot easily be attributed to tax havens, as it predates the emergence of the degree of international
economic integration that would presumably be required for havens to be a major factor.

17
6) Conclusion

Tax havens have attracted increasing attention in recent years from policymakers, in view
of their centrality to many of the leading current issues in international tax policy. This paper has
provided an overview of the theoretical and empirical insights from a growing scholarly
literature that analyzes the consequences and determinants of the existence of tax haven
countries. An intriguing finding within this literature is that tax havens tend to have stronger
governance institutions (i.e. better political and legal systems and lower levels of corruption)
than comparable nonhaven countries. This does not necessarily imply that their existence is good
for the rest of the world, but does provide an alternative perspective on the popular image of tax
havens that emphasises their role in facilitating tax evasion by individuals.

The focus in this paper, however, has been on how tax havens provide opportunities for
tax planning by multinational corporations. It is important to remember that these opportunities
are contingent on the tax rules adopted by multinationals’ home countries. Evaluating the impact
of these tax planning activities is conceptually difficult. While it is often argued that tax havens
erode the tax base of high-tax countries, this paper has stressed an emerging “positive” view of
havens that suggests that, under certain conditions, their existence can enhance efficiency and
even mitigate tax competition. This view appears to be supported by recent experience with
corporate tax revenues: despite substantial FDI flows to tax havens, corporate tax revenue in
major capital-exporting countries has increased. Of course, scholarly and policy debates about
the consequences of the existence of tax havens are ongoing, and any conclusions reached at this
stage are merely tentative. The aim here is simply to highlight the importance of these debates,
and their wide-ranging implications for international tax policy and for more general policy
responses to an increasingly integrated global economy.

18
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 Table 1: List of Tax Havens
Country or Territory Tax Tax Country or Territory Tax Tax
Haven Haven Haven Haven
(DH) (OECD) (DH) (OECD)

Andorra* 1 1 Luxembourg 1 0
Anguilla 1 1 Macao 1 0
Antigua and Barbuda 1 1 Maldives 1 1
Aruba 0 1 Malta 1 1
Bahamas 1 1 Marshall Islands* 1 1
Bahrain 1 1 Mauritius 0 1
Barbados 1 1 Monaco* 1 1
Belize 1 1 Montserrat 1 1
Bermuda 1 1 Nauru 0 1
British Virgin Islands 1 1 Netherlands Antilles 1 1
Cayman Islands 1 1 Niue 0 1
Cook Islands 1 1 Panama 1 1
Cyprus 1 1 Saint Kitts and Nevis 1 1
Dominica 1 1 Saint Lucia 1 1
Gibraltar 1 1 Saint Vincent and the 1 1
Grenadines
Grenada 1 1 Samoa 0 1
Guernsey 1 1 San Marino 0 1
Hong Kong 1 0 Seychelles 0 1
Ireland 1 0 Singapore 1 0
Isle of Man 1 1 Switzerland 1 0
Jersey 1 1 Tonga 0 1
Jordan 1 0 Turks and Caicos Islands 1 1
Lebanon 1 0 Vanuatu 1 1
Liberia* 1 1 Virgin Islands (U.S.) 0 1
Liechtenstein* 1 1

Source: “Tax haven (DH)” refers to the definition of tax havens used in Dharmapala and Hines (2006), who begin
with the list of jurisdictions in Hines and Rice (1994, Appendix 2, p. 178), all of which also appear in Diamond and
Diamond (2002) and various other sources, and match these with countries and territories for which current data on
economic and other characteristics are available. “Tax haven (OECD)” refers to the definition of tax havens in
OECD (2000, p. 17), but includes an additional six countries (listed in Hishikawa (2002, fn. 72, p. 397)) that
otherwise satisfied the OECD’s tax haven criteria but were not included on the list because they provided “advance
commitments” to eliminate allegedly harmful tax practices. In each case, 1 = tax haven and 0 = nonhaven.

* Tax haven designated by the OECD (2004) as having failed to make commitments on information exchange.

23
Figure 1a: General Characteristics of Tax Havens (Relative to Nonhavens)

GDP pc (PPP; Havens=1)

Population (Nonhavens=1)

Distance by air (Nonhavens=1)

Island (fraction) Nonhavens

Coastal population (fraction) Havens

Telephone Lines pc (Havens=1)

Subsoil Assets pc
(Nonhavens=1)

0 0.2 0.4 0.6 0.8 1 1.2

Source: Author’s calculations, based on the dataset used in Dharmapala and Hines (2006). GDP per capita (in US$
in PPP terms), population and telephone lines per capita are all from the World Bank’s World Development
Indicators (WDI), available at http://econ.worldbank.org, for 2004. Distance by air measures proximity to major
capital exporters (constructed by Gallup, Sachs and Mellinger (1999) as the distance by air from the closest of New
York, Tokyo or Rotterdam. Coastal population is the fraction of the population living within 100 km of the coast,
also constructed by Gallup, Sachs and Mellinger (1999). Subsoil assets per capita are from World Bank (2006).

24
Figure 1b: Institutional Characteristics of Tax Havens (Relative to Nonhavens)

British legal origin (fraction)

French legal origin (fraction)

Ethnolinguistic
Fractionalization
English as an Official Language
(=1) Nonhavens

Parliamentary System (fraction) Havens

UN Member (fraction)

Governance Index

-0.2 0 0.2 0.4 0.6 0.8 1

Source: Author’s calculations, based on the dataset used in Dharmapala and Hines (2006). Legal origins and
ethnolinguistic fractionalization are from La Porta et al. (1999). The use of English as an official language is from
the Centre d’Etudes Prospectives et D’Informations Internationale (CEPII) dataset (available on Thierry Mayer’s
website at: http://team.univ-paris1.fr/teamperso/mayer/data/data.htm). Data on parliamentary systems is from the
World Bank’s Database of Political Institutions (Beck et al., 2001). UN membership is obtained from the United
Nations Organization website, at http://www.un.org/Overview/unmember.html. The governance index (for 2004) is
from Kauffmann, Kraay and Mastruzzi (2005).

25
Figure 2a: Strategic Transfer Pricing

Figure 2b: The Strategic Use of Debt

26
Figure 3a: Financial Sector Employment in Jersey and the UK, 1997-2005

1.4

1.2

0.8 UK (millions)

0.6
Jersey (tens of
thousands)
0.4

0.2

0
1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: Author’s calculations, based on data from the International Labour Organsation (ILO), available at
http://laborsta.ilo.org/. The UK financial sector data includes real estate and insurance.

Figure 3b: Financial Sector Wages in Jersey and the UK, 1997-2005 (Pounds/Week)

800

700

600

500

400 UK

300 Jersey

200

100

0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Source: Author’s calculations, based on data from the International Labour Organisation (ILO), available at
http://laborsta.ilo.org/. The UK financial sector data includes real estate and insurance.

27
Figure 4a: Payoff Matrix when there is no Tax Haven

Country B

Tax Rate: 50% Tax Rate: 0%

Tax Rate: 50% 110, 110 55, 149

Country A
Tax Rate: 0% 149, 55 100, 100

Figure 4b: Payoff Matrix when there is a Tax Haven

Country B

Tax Rate: 50% Tax Rate: 0%

Tax Rate: 50% 105, 105 105, 100

Country A
Tax Rate: 0% 100, 105 100, 100

28
Figure 5a: US Investment in Tax Havens and Corporate Tax Revenues, 1994-2006

30

25

20
% of US FDI in Tax
Havens
15

10 % of US Federal Tax
Revenue from
Corporate Taxes
5

0
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Source: Author’s calculations, based on data on FDI and US corporate tax revenues from the US Bureau of
Economic Analysis, available at http://www.bea.gov. Tax havens are defined as in Dharmapala and Hines (2006) -
see Table 1.

Figure 5b: US Investment in OECD-Designated Tax Havens and Corporate Tax Revenues,
1994-2006

12

10

8
% of US FDI in OECD-
designated Tax Havens
6

4 US Corporate Tax
Revenue as a % of US
GDP
2

0
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006

Source: Author’s calculations, based on data on FDI and US corporate tax revenues from the US Bureau of
Economic Analysis, available at http://www.bea.gov. Tax havens are defined as in OECD (2000) – see Table 1.
29
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