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Tax Evasion on Offshore Profits and Wealth

Gabriel ZUCMAN1 May 31st, 2014

Abstract: This article attempts to estimate the magnitude of corporate tax avoidance

and personal tax evasion through offshore tax havens. In the United States, corporations

book 20% of their profits in tax havens – a tenfold increase since the 1980s – and tax

avoidance reduces corporate tax revenues by up to a third. Globally, 8% of the world’s

personal financial wealth is held offshore, costing more than $200bn to governments

annually. Despite ambitious policy initiatives, profit shifting to tax havens and offshore

wealth are rising. I discuss the recent proposals made to address these issues, and I

argue that the main objective should be to create a world financial registry.

1 London School of Economics and UC Berkeley. Comments are welcome ([email protected]).

Introduction

Globalization is making it increasingly easy for corporations to shift profits to low-‐tax

countries. Modern technology has also made it simpler for wealthy individuals to move

funds to undeclared bank accounts in offshore tax havens.

Both issues have featured prominently in the news and global economic debates since

the financial crisis. Yet quantifying their macroeconomic importance has proven

difficult. For some analysts, there are huge sums hidden abroad, enough to curb

government deficits and dramatically reduce the public debt. For others, rich countries’

residents make a legitimate use of offshore financial centers to minimize their tax

burdens. If any illegal activity takes place there, Russian oligarchs and African dictators

are to blame. On both sides, however, arguments tend to be based on relatively little

empirical evidence. What do we know about the activities taking place in tax havens and

their costs to governments?

This article attempts to make progress on this issue by bringing new data to the

discussion.

Measuring tax non-‐compliance is fraught with difficulties. However, balance of

payments data, national accounts, and corporate filings show that U.S. companies are

shifting profits to Bermuda, Luxembourg, and similar countries on a massive and

growing scale. 20% of all U.S. corporate profits are now booked in such havens. Since

multinationals usually try to operate within the letter – if not the spirit – of the law, this

profit shifting is better described as “tax avoidance” rather than outright fraud.

Corporations essentially exploit the loopholes of the current tax system. These

loopholes, by my estimate, cost the U.S. government about a third of its corporate tax

revenues.

Wealthy individuals, too, use tax havens, sometimes legally – to benefit from better

banking services than available in their home country – and sometimes illegally – to

evade taxes. Substantial progress has been made in attempting to curb that form of

evasion over the last years. Yet the available evidence – coming from Switzerland,

Luxembourg, and systematic anomalies in the international investment data of countries

– shows that offshore personal wealth is growing fast and that the bulk of it still seems

to be evading taxes. The fight against tax fraud remains an uphill battle.

To improve tax enforcement in the global economy of the 21st century, I argue that the

main objective should be to create a world financial registry. As we shall see, such a

registry could permit to both fix the loopholes of the corporate tax and make personal

tax evasion much more difficult.

1. Multinational corporations tax avoidance

The corporate tax is a key component of developed countries’ tax systems. In both

Europe and the United States, it accounts for 60% of capital tax revenues – more than all

taxes on properties, estates and inheritances, dividends, interest and capital gains

combined. Yet it is seriously challenged by globalization, and if the current trends are

sustained it could well disappear in the next two or three decades.

1.1. The three pillars of international taxation

To understand the sources of the current predicaments, a brief journey through history

is in order. In most countries, the corporate tax was born just before or during World

War 1, at the same time as the personal income tax. That is not a coincidence. Absent

corporate taxes, personal taxation would not work: People would incorporate and

shareholders would make sure money remains within companies, dodging taxation

entirely. The easiest way to prevent that scenario from happening is to tax profits

directly at the corporate level. The corporate tax is thus fundamentally a backstop; as

such, contrary to the income tax, it has no redistributive role and is usually levied at a

flat rate. When profits are paid out, the taxman recognizes that shareholders have

already been subject to corporate taxes by granting them tax reliefs. The reliefs can take

the form of relatively low dividends and capital gains tax rates, like in the United States,

or of a refund of previously paid corporate taxes, like many European countries used to

do until recently. (Over the last years European countries have tended to adopt the U.S.

system).

Corporate taxation would be straightforward in a closed economy but gets more

complicated as soon as companies operate in different countries. A U.S. person pays

taxes on all her income, wherever it comes from. Because the corporate tax is essentially

a prepayment, so too should U.S.-‐owned corporations pay taxes on all their profits,

whether they originate from the U.S. or abroad. A problem, then, arises: there is a risk of

two countries taxing the same profits. Concerned with such double taxation, in the

1920s the League of Nations asked four economists to think about how best to avoid it

(Bruins et al., 1923).

They came up with three principles, which since then have been the pillars of

international taxation.

First, the corporate tax is to be paid to the “source” country’s government. If a U.S.

person owns a Brazilian coffee producer – call it Coffee Rio – then Brazil ought to levy

the tax. In formulating that rule, the League of Nations was heavily influenced by the tax

laws of 19th century Europe, when what determined taxation was not a taxpayer’s ability

to pay but the nature of income – rents, dividends, wages, etc., were all subject to what

were known as different “schedular” taxes. To many 1920s economists, corporate

profits were just another type of income to which a tax was attached. The ultimate

economic payer did not matter much.

Source-‐based taxation raises a problem. Imagine that Coffee Rio is the subsidiary of

Coffee America, a U.S. company whose activity involves importing and distributing

Coffee Rio’s products in the United States. How to determine the source of Coffee

America’s profits? Do they come from the United States or from Brazil? Here the League

of Nations came up with a principle known as “arm’s length pricing”. Both entities must

compute their own profits separately, as if they were unrelated. In particular, the

American parent must do as if it purchased the products of Coffee Rio at the market

price for coffee. Since then, this is how the profits of multinationals have been allocated

across countries.

Last, the League of Nations decided that international tax issues ought to be addressed

not by a multilateral, global agreement, but at the bilateral level. As a result, since the

1920s countries have been signing thousands of bilateral “double-‐tax treaties” that

follow the general League of Nations guidelines of source-‐based taxation and arm’s

length pricing, but differ in a myriad of specificities.

The League of Nations experts foresaw many of the deficiencies of the plan they had

come up with. British economists were particularly skeptical (Coates, 1925, being a

prime example). But just at the time the principles were agreed upon, globalization

retreated. From the Great Depression to the late 1960s, foreign profits accounted for

barely 5% of total U.S. corporate profits (Figure 1). During almost half a century, what

had been decided by the Great Powers of the 1920s turned out to be inconsequential.

The situation started changing in the 1970s, but only slowly; it is only in the 21st century

that a surge in international investments brought the problems to the frontlines.

Globalization is back – on a much broader scale than in the late 19th and early 20th

century – and the choices made by the League of Nations are coming back haunting the

taxman.

Figure 1

1.2. Treaty shopping, transfer pricing, tax competition

Each of the three core principles agreed upon in the 1920s – source-‐based taxation,

arm’s length pricing, and bilateral agreements – raises issues of their own.

First, the choice of thousands of bilateral treaties over a multilateral agreement has

created a web of inconsistent rules. By carefully choosing the location of their affiliates –

what is known as “treaty shopping” – multinationals can exploit these inconsistencies to

avoid taxes.

A prime example is given by Google’s “double Irish Dutch sandwich” strategy – so named

because it involves two Irish affiliates and a Dutch shell company squeezed in between.

The first Irish affiliate, “Ireland Limited”, licenses Google’s intangible capital – its search

and advertisement technologies – to all Google affiliates in Europe, the Middle East and

Africa. (A similar strategy, with Singapore in lieu of Ireland, is used for Asia). Google

France, for instance, pays royalties to “Ireland limited” in order to have the right to use

the firm’s technologies. At this stage, the bulk of Google’s non-‐U.S. profits end up being

taxable in Ireland only, where the corporate tax is 12.5%.

But 12.5% is still a lot. The next stage involves sending the profits to Bermuda, where

the tax rate is a modest 0%. To that end, Google has created a second affiliate, “Google

Holdings”. Although it is incorporated in Ireland, for Irish tax purposes “Holdings” is a

resident of Bermuda (where its mind and management are supposedly located). Because

Ireland withholds a tax on royalty payments to Bermuda, Google cannot directly send

the profits collected by its first Irish affiliate to the Irish/Bermuda hybrid. A detour by

the Netherlands is necessary. “Ireland Limited” pays royalties to a Dutch shell company

– a tax-‐free payment because Ireland and the Netherlands are both part of the European

Union – and the Dutch shell pays back everything to the Irish/Bermuda holding – tax-‐

free again because to the Dutch authorities the holding is Irish, not Bermudian.

Playing tax treaties against each other – and in particular exploiting their inconsistent

definitions of “residency” – Google thus generates “stateless income”, nowhere taxed

(Kleinbard, 2011). Over the last years, according to the company’s filings, its effective

tax rate on foreign profits has ranged from 2% to 8%.

The issues raised by treaty shopping are compounded by the growing ability of

multinational firms to choose the location of their profits – and thus exploit treaty

inconsistencies – irrespective of where they produce or sell. The main way this profit

shifting happens is through the manipulation of transfer prices, the prices at which

companies exchange goods and services internally.2 In principle, these transactions

should be conducted at the market price of the goods and services traded, as if the

subsidiaries were unrelated. If that rule – arm’s length pricing – worked well, it would

not be possible for firms to record much profits in countries like Bermuda where no real

activity takes place.

In practice, however, arm’s length pricing faces severe limitations.

Coffee Rio, first, can sell its products to Coffee America at artificially high prices to make

the profits appear in Brazil (where they are taxed at 25%) rather than in the United

States (where the tax rate is 35%). There are billions of intra-‐groups transactions every

year, making it impossible for tax authorities to check all of them are correctly priced.

Kimberly Clausing (2003) finds compelling evidence of transfer mispricing by U.S. firms.

More important, in many cases the relevant market prices simply do not exist. What was

the value of Google’s technologies when it transferred them to its Bermuda holding in

2003, before even being listed? In retrospect, it is apparent it was manipulated down.

The issue is growing, as a rising number of transactions – such as the sale of proprietary

trademarks, logos, and algorithms – are not replicated between third parties.

Third, arm’s length pricing is conceptually flawed. A multinational company derives part

of its profits from the synergies of being present across the globe. There is no

meaningful way to attribute that income to any particular subsidiary.

2 The other popular method is the use of intra-‐groups loans, whereby low-‐tax country subsidiaries grant loans to high-‐tax country subsidiaries.

The last – and core – problem of today’s tax international tax environment is the rule

that profits should primarily be taxed in source countries. Absent that rule, there would

be no point in trying to make profits appear as if they originated from zero-‐tax Bermuda.

Source-‐based taxation provokes two types of inefficiencies. First, it causes a wasteful

expenditure of resources: multinational companies spend billions in treaty shopping

and transfer pricing (the tax department of General Electric employs close to one

thousand individuals); tax authorities devote substantial effort to curb abuses, in turn

triggering even bigger corporate expenses. The end result is tax revenue and welfare

losses in non-‐haven countries (Slemrod and Wilson, 2009).

But while profit shifting to Bermuda mostly involves notional transactions, source-‐based

taxation also gives firms incentives to move real activity – factories, headquarters, etc. –

where taxes are low. There will always be small open-‐economies choosing a 0% source

tax – for them, that is indeed the optimal thing to do (Diamond and Mirrlees, 1971). To

non-‐haven countries such competition can be more costly than artificial profit shifting,

because it involves losses of physical capital and employment.

Ironically, artificial profit shifting and tax competition for real investments cannot be

fought simultaneously: Every time the taxman attempts to limit shifting to Bermuda, it

makes it more valuable for firms to relocate to Singapore or Dublin (Hong and Smart,

2009; Johannesen, 2010). In brief, a corporate tax founded on source-‐based principles

only is self-‐defeating: there are powerful forces pushing toward zero rates – and indeed

nominal rates are declining globally, with few exceptions.

1.3. The costs of corporate tax avoidance by U.S. firms

While many analysts worry about the costs of tax competition for real investment,

available evidence suggests corporate revenue shortfalls are mostly due to artificial

profit shifting.

The U.S. case is particularly striking. Tax avoidance of the “double Dutch Irish” type

extends much beyond firms like Google. Data collected by the Bureau of Economic

Analysis show that U.S. multinationals book 55% of their foreign profits in six tax

havens, the Netherlands, Bermuda, Luxembourg, Ireland, Singapore, and Switzerland

(Figure 2), where only 5% of their overseas workforce is employed. Although the

country allocations in Figure 2 should not be over-‐interpreted – they mostly reflect the

location of the last holding involved in the tax avoidance scheme – the point is that profit

shifting has steadily increased since the 1980s and continues to rise. At current pace, all

the foreign profits of U.S. firms will “originate” from tax havens in 30 years.

Figure 2

Since tax havens rise as a share of foreign profits and foreign profits rise as a share of

total profits, the share of tax havens in total – domestic plus foreign – U.S. profits is

booming. As shown by Figure 3, this share is about 20% today, despite the fact that

many companies have no overseas activity. That is a tenfold increase since the 1980s.

(The rapid increase during the financial crisis is due to the relative strength of offshore

profits at a time when domestic profits collapsed.)

Figure 3

The U.S. profits booked in tax havens barely bear any tax at all. On average, they are

taxed at a rate of 3% by foreign governments. In principle, they should also be taxed in

the United States, because the U.S. corporate tax is supposed to be worldwide (i.e., to tax

domestic and foreign profits alike). Foreign earnings, however, are not taxed until they

are repatriated in the United States – and so in practice companies let their offshore

profits accumulate abroad tax-‐free. To prevent abuses Congress has – like most other

countries – enacted rules to immediately tax some type of undistributed foreign income

(what is known as “subpart F” income). The application of these complicated rules, in

turn, has been largely suspended over the last few years. The bottom line is that, if the

profits in the top 6 havens were taxed at the same rate as other profits, U.S.

multinationals would pay 20% more in taxes.

Yet even this estimation is probably conservative. International tax avoidance extends

beyond profit shifting to places like Bermuda; it also encompasses transfer price

distortions on intra-‐group transactions between, say, U.S. and U.K. affiliates. Another

way to assess the total revenue cost is to study the evolution of the effective tax rate

paid by U.S. corporations. As Figure 4 shows, the effective tax rate is always below the

nominal rate. The Tax Reform Act of 1986 attempted to bring the two rates in lines – the

nominal rate was reduced to 34% in 1988 in exchange for a base broadening. For about

a decade, that strategy proved successful. But the situation changed in the late 1990s.

Over the last 15 years, the effective tax rate paid by U.S. firms to the U.S. and foreign

governments has been reduced by a third (from 30% to 20% today). If it had stayed

constant, these companies would have, all else equal, paid $200 billion in additional

taxes in 2013. Given that U.S. tax laws have changed little over that period – the nominal

federal tax rate has remained constant – it is reasonable to attribute a large fraction of

the decline in the effective tax rate to increased international avoidance. In sum, tax

havens enable U.S. corporations to reduce their taxes by at least 20% and up to a third.

Figure 4

The cost of tax avoidance by U.S. firms is born by both the U.S. and other countries’

governments. Some of Google’s profits shifted to Bermuda are made in Europe; absent

tax havens, Google would pay more taxes in France and Germany. The IRS would grant

Google credits for these foreign taxes paid; no extra revenue would be raised in the U.S.

On the other hand, some U.S. corporations also use tax havens to avoid taxes on their

U.S.-‐source income. It is hard to know who loses most. In both cases, U.S. shareholders –

everybody who owns equities, either directly or through pension plan – win. Since

equity ownership is very concentrated (Saez and Zucman, 2014), so too are the benefits.

How can we reconcile the sharp decline in the effective tax rate paid by U.S. corporations

with the widely noted fact that as a share of national income, corporate taxes have not

declined in recent years – they still amount to about 3%? Figure 5 provides the answer:

corporate profits have boomed, because of a rise of the share of capital in corporate

value added.3 This increase has more than offset the fall in the effective tax rate. Capital

is back, but capital taxes, not at all.

Figure 5

3 The corporate profits depicted in Figure 5 are net of interest payments, and so another factor behind the U-‐curve is the evolution of interest rates (high in the 1970s-‐1980s, low in recent years). Whether one should look at corporate profits before or after interest payments is a matter of perspective: if the aim is to look at the evolution of factor shares, then it’s better to look at profits gross of interest payments, but if one is interested in comparing nominal and effective corporate tax rates, then it’s better to look at profits net of interest payments, because these payments can be deducted from the corporate tax base.

1.4 Corporate tax reforms

There is no shortage of plans to fix the corporate tax. The proposals differ in their

willingness to reconsider any of the three pillars of international taxation –

decentralized rules through bilateral treaties, arm’s length pricing, and source-‐based

taxation.

A first class of reforms pushes for more harmonization of treaty rules. Advocates

acknowledge that the thousands bilateral tax treaties have created scope for “treaty

shopping” and transfer mispricing, but remain committed to the principles of source-‐

based taxation and arm’s length pricing. That is broadly speaking the OECD position. In

2013, the organization has disclosed an ambitious “action plan on base erosion and

profit shifting” along those lines (OECD, 2013).

A second class of proposals suggests abandoning arm’s length pricing. The profits of

multinational companies would instead be apportioned to each country according to

some formula, such as a combination of sales, capital, and employment – analogous to

the way that corporations are taxed by the states within the United States.4 For instance,

if Google makes half of its sales, has half of its capital and workers in the United States,

then half of its profits would be taxable there. This method would address the issue of

artificial profit shifting. If capital and employment entered the formula, there would

remain incentives for firms to move real activity to low-‐tax countries. A more radical

proposal thus allocates a multinational’s profits to each country based on where it

makes its sales only.5 Starbucks can easily shift its profit or move its headquarter to

Ireland, but not its customers. Profit apportionment based on sales would therefore

address both artificial profit shifting and tax competition. Yet this proposal raises an

issue. Sales, capital, or employment, are only mildly correlated with profits (Hines,

2009). So if one considers that corporate taxes ought to be paid to the countries from

4 Clausing (2013) evaluates the U.S. experience with formula apportionment. 5 Auerbach et al. (2008) discuss several options for a “destination-‐based” corporate tax that follows broadly similar principles.

which profits originate – the third key League of Nations principle – then formula

apportionment would misattribute taxing rights.

A third class of proposals abandons source-‐based taxation. Remember that the

corporate tax is fundamentally a pre-‐payment for the personal income tax. From that

perspective, profits should not be attributed to the countries from which they originate,

or where sales are made, but to the countries where shareholders live. If a U.S. person

fully owns a company that has all its capital and employment in Germany but sells all its

products in China, then in today’s tax system all the taxing rights are allocated to

Germany, with formula apportionment based on sales they would be allocated to China,

although, as the corporate tax is essentially a pre-‐payment for the U.S. income tax, they

should be attributed to the United States.

The League of Nations favored source-‐based taxation because it thought it would be

technically impossible to allocate corporate profits to the countries where shareholders

live. And indeed, in the 1920s it was hard to identify who shareholders were: equity

shares took the form of paper certificates – similar to banknotes – that could be moved

across borders easily. Today, however, paper certificates have been replaced by

electronic records; anonymous “bearer” securities do not exist anymore; shareholders

could be easily recorded in a world financial registry.

1.5 A world financial registry

The registry would enable countries to run a proper residence-‐based corporate tax. If

Google belongs 60% to U.S. residents, 7% to German residents, 5% to French residents,

etc., then 60% of its global profits would be taxable in the United States, 7% in Germany,

5% in France, and so on. There would be no point anymore in trying to make profits

appear in Bermuda, or in moving headquarters and factories across the globe for tax

purposes. Then, once the profits are paid out to shareholders, each government would

reimburse any corporate tax previously withheld. European countries abandoned this

imputation system because they found it unacceptable to reimburse domestic

shareholders for corporate taxes levied by foreign countries, and also because it became

apparent that some were reimbursed for taxes that had actually never been paid in the

first place. With a corporate tax based on the residence of shareholders, drawing on the

information contained in the world financial registry, both these concerns would

disappear.

Is a world financial registry utopian? There are a number of potential obstacles.

First, the register would have costs – but they must not be overstated. In each country a

central securities depository already keeps track of who owns the equities and bonds

issues by domestic firms (the Depository Trust Corporation in the United States,

Euroclear in many European countries, or Clearstream, in Luxembourg, for example).

The name of the game is to merge these partial, privately-‐managed registries to create a

comprehensive one that would be used for running a proper residence-‐based corporate

tax. Europe and the United States – which together account for close to 50% of world

GDP – could pave the way by jointly moving to a residence-‐based corporate tax and

joining forces to identify the ownership of U.S. and European companies.

A more serious concern is that a large fraction of the world’s equities might not initially

be attributable to any well-‐identified beneficial owner. First, equities are largely held

through intertwined financial intermediaries, like investment funds, pension funds, and

the like. To identify the residence of the ultimate owner, it would be necessary to know

the relationships of the different entities involved in the wealth-‐holding chain. Progress

has started in this area since the financial crisis, under the auspices of a committee of

authorities from around the world working to create a global system of legal entity

identification.6 Second, a growing fraction of U.S. (and rich countries’) equities are

managed by intermediaries located in offshore financial centers, such as hedge funds in

the Cayman Islands, insurance companies in Bermuda, Luxembourg mutual funds, Swiss

banks, and so on (Figure 6). Who are the ultimate owners of the shares managed by

these intermediaries? Some of them are investors who make a legal use of offshore

intermediairies. But many, as we shall now see, are individuals using offshore banks to

6 See Regulatory Oversight Committee (ROC) of the Global Legal Entity Identifier System, http://www.leiroc.org.

evade taxes. To pierce this veil of secrecy, international cooperation would be necessary,

which might involve sanctions against reluctant tax havens.

Figure 6

2 Offshore evasion by wealthy individuals

2.1 Eight percent of the world’s financial wealth

Switzerland, Singapore, Hong Kong, and the Bahamas, among others, have attracted a

large offshore private banking industry. Banks located in these countries cater to

wealthy individuals from around the world and provide them with opportunities to

evade taxes.

To understand how tax evasion works, think of an American businessman, Mr. Maurice,

who owns a carpet-‐making company, Dallas Carpet. In order to send funds offshore, Mr.

Maurice proceeds in three steps. He first creates a shell company, say in the Cayman

Islands. (Findley et al., 2012, report it is even easier to form anonymous companies in

Delaware and many OECD countries). The Caribbean shell then opens a bank account in

Hong Kong, where all the major global banks operate. Last, Dallas Carpet purchases false

services (like management advice) to the Cayman company and pays for them by wiring

funds to Hong Kong.

The whole transaction generates a paper trail that seems legitimate. It is unlikely to

trigger any anti-‐money-‐laundering alarms inside the banks, because there are billions of

electronic transfers out of the United States each year, making it is almost impossible to

distinguish in real time those that are legal (such as payments made to real exporters)

from those conducive of tax evasion.

The benefits for Mr. Maurice are twofold. By paying for false services, he fraudulently

reduces Dallas Carpet’s profits and thus its corporate tax in the United States. Then, once

the funds have arrived in Hong Kong, they can be invested in global bonds, equities, and

mutual funds, and generate interest, dividends, and capital gains. The IRS can only tax

that income if Mr. Maurice self-‐reports it or if Hong Kong banks inform the U.S.

authorities. Otherwise, Mr. Maurice will evade the federal income tax as well.

How big are the sums held in offshore accounts? Until recently, evidence on that issue

was lacking. Tax havens rarely publish informative statistics. There are two exceptions,

however. Thanks to an exhaustive, detailed, monthly survey conducted by the Swiss

National Bank, we know the amount of wealth held by foreigners in Switzerland. The

latest data point, for February 2014, puts the total at $2.4 trillion.7 Luxembourg’s

national statistical office has also recently released similar information, showing that

foreign households have $370bn there.8 (Luxembourg, a country of half of million

inhabitants, has a national income of $35bn). Unfortunately, it seems no other country

publishes similar data. Even the U.S. does not disclose the assets held by, say, Latin

American residents in Florida banks.

7 See the online Data Appendix to this article, Table S.1 8 See Adam (2014, p. 8). This figure understates the true amount of offshore wealth in Luxembourg because it excludes some $350 billion not directly held by households but through family offices and other intermediaries. In actual facts the private offshore wealth managed in Luxembourg could be as high as $720 billion.

To have a sense of the global amount of offshore wealth, one has to use indirect

methods. My own attempt relies on the anomalies in global investment statistics caused

by offshore fortunes (Zucman, 2013a, 2013b). Take Ms. Smith, a U.K. resident who owns

Google equities through her Swiss account. What is recorded in the international

investment positions of countries? In the United States, statisticians observe that a

foreign investor owns U.S. securities and record a liability. U.K. statisticians should

record an asset but they don’t, because they have no way to observe Ms. Smith’s offshore

holdings. And since Ms. Smith’s equities are neither assets nor liabilities for Switzerland,

over there nothing is recorded at all. In the end, more liabilities than assets show up in

global data. Strikingly, more than 20% of the world’s cross-‐border equities have no

identifiable owner. It is as if planet Earth was partly owned by Mars.

By analyzing these anomalies in a systematic manner, I reckon that 8% of the global

financial wealth of households is held in tax havens, about $7.6 trillion at the end of

2013. Other estimates are generally larger. Based on interviews with wealth managers,

the Boston Consulting Group (2013) has an $8.5 trillion figure for 2012. James Henry’s

(2012) estimate is as high as $32 trillion.

My method probably delivers a lower bound, however, because it only captures financial

wealth and disregards real assets. Now high net worth individuals can stash works of

art, jewelry and gold in freeports – Geneva, Luxembourg, and Singapore all have one.

They also own real estate in foreign countries. Registry data show that a large chunk of

London’s luxury real estate is held through shell companies, largely domiciled in the

British Virgin Islands, a scheme that enables owners to remain anonymous and to

exploit tax loopholes. Although real assets may be growing, there is no way yet to

estimate their value.

Even disregarding real estate and freeports, the world’s offshore wealth is large enough

to significantly affect inequality measures. As shown by Table 1, U.S. residents own

about $1.2 trillion abroad, the equivalent of 4% of America’s financial wealth. Europe is

more affected, with $2.6 trillion offshore, 10% of its financial assets. The widespread use

of tax havens means that survey and tax data probably under-‐estimate the concentration

of wealth substantially. Take the case of Spain: according to tax records the top 0.01%

owns about 5% of the country’s financial wealth (Alvaredo and Saez, 2009, Figure 10). If

indeed 10% of Spain’s financial wealth is held unrecorded by very rich individuals, the

true figure could be as high as 15%.9 In developing countries, the fraction of wealth held

abroad is considerable, ranging from 20% to 30% in Africa and Latin America to as

much as 50% in Russia and Gulf countries. For anyone interested in studying global

inequalities, accounting for tax havens is crucial.

Table 1: The world’s offshore financial wealth

Notes: Offshore wealth includes financial assets only (equities, bonds, mutual fund shares, and bank deposits). Tax revenue losses only include the evasion of personal income taxes on investment income earned offshore as well as evasion of inheritance and estate taxes. Source: author’s computations, see Zucman (2013a, 2013b) and the online data Appendix supporting this article.

How is offshore wealth evolving? In Switzerland, foreign holdings are at an all time high.

They have increased 4.6% per year since the Swiss National Bank has started publishing

data at the end of 1998. The trend does not seem to have been much affected by recent

enforcement efforts: since G20 leaders have declared the “end of bank secrecy” in April

2009, the offshore fortunes managed in Switzerland have increased 15%.10 The growth

is stronger in the emerging Asian centers, Singapore and Hong Kong, so that globally,

according to my estimate, offshore wealth has grown 28% from end-‐2008 to end-‐2013.

9 See Roine and Waldenstrom (2009) for an analysis along similar lines in Sweden. 10 Adam (2014) similarly reports a 20% growth for Luxembourg offshore wealth from 2008 to 2012 (the latest available data point).

The post-‐2008 growth reflects valuation effects – world equity markets have recovered

from their post-‐Lehman trough – but also net new inflows.11 In turn, inflows seem to be

coming largely from developing countries: as their share of global wealth rises, so too is

their share of offshore wealth. At the stock level, more than half of offshore assets still

belong to rich countries’ residents (Table 1), but if the current trend is sustained,

emerging countries will overtake Europe and North America by the end of the decade.

Two other recent developments are worth noting.

First, tax haven banks are getting more elitist. The main Swiss banks are re-‐focusing

their activities on their “key private banking” clients, those with more than $50mn in

assets.12 Recent policy changes are indeed making it more difficult for moderately

wealthy individuals to dodge taxes: for them the era of bank secrecy is coming to an end.

But more fundamentally, offshore banks are responding to the increasing concentration

of global fortunes. In the United States, the share of wealth held by the top 0.1% –

families with more than $20mn in net wealth in 2012 – was 7% in 1980; it is now 22%

(Saez and Zucman, 2014). For the top 0.01% (more than $100mn), the rise has been

spectacular, from 2.5% to 11.5%. By contrast, households between the top 10% and the

top 0.1% have been losing ground. “Ultra-‐high net worth” clients are prospering, other

rich clients less so. The banks know it and adapt.

Offshore banking is also becoming more sophisticated. Wealthy individuals increasingly

use shell companies, trusts, holdings, and foundations as nominal owners of their assets.

This is apparent in Switzerland, where more than 60% of foreign-‐owned deposits

“belong” to the British Virgin Islands, Jersey, and Panama – the leading centers for the

domiciliation of shell vehicles.13

11 In the case of Luxembourg, the 20% 2008-‐2012 growth reported by Adam (2014) is despite a 20% drop in the EuroStoxx 500, Europe’ leading equity index. In Switzerland, the 15% since April 2009 is comparable to the growth of Europe’s financial wealth. 12 The same trend seems to be at play elsewhere. In Luxembourg, “the number of clients seems to be declining, at least over the 2009-‐2012 period” (Adam, 2014, p. 8). Offshore assets are rising, the number of clients falling, and the average wealth per client booming. 13 In Luxembourg as well, “assets are moving to legal structures such as family wealth-‐holding companies” (Adam, 2014, p. 8).

The revenue costs of offshore tax dodging are sizable. Admittedly, some taxpayers duly

declare their Swiss or Cayman holdings. Yet in Switzerland, about 80% of the wealth

held by Europeans seems to be evading taxes, according to data published by the Swiss

tax authority. On the assumption of a like basis for other tax havens, Table 1 provides

estimates of the revenue losses for the main economies. Globally, the costs amount to

about $200bn annually.14 This is about 1% of the total revenues raised by governments

worldwide, but since offshore evasion benefits a tiny fraction of the population, it makes

more sense to compare this sum to the taxes paid by the richest taxpayers. In the U.S.,

eradicating offshore evasion would raise as much revenues as increasing the top 0.1%’s

federal income tax bill by 25%. (All of these computations only include the cost of tax

evasion on investment income earned offshore and on inheritances, disregarding

evasion on the principal. The results should thus be seen as an extreme lower bound).

2.2. Recent progress and challenges ahead

Since the financial crisis, remarkable progress has been achieved in curbing bank

secrecy. Prior to 2008, tax havens refused to share any information with foreign tax

authorities. The tipping point occurred in 2010 when the U.S. Congress enacted the

Foreign Account Tax Compliance Act (Fatca), which compels foreign banks to

automatically disclose accounts held by U.S. customers to the IRS, each year, under the

threat of economic sanctions – a 30% tax on all US-‐source income. Other rich countries

are following suit, and under the impetus of the OECD (2014), the automatic sharing of

bank data is becoming the global standard. Key havens, including Switzerland,

Singapore, and Luxembourg, have already agreed to participate. In 2008, the vast

14 As with any attempt at quantifying the underground economy, there is a margin of error involved. While it is beyond doubt that global offshore wealth is on the rise, the main uncertainty relates to the fraction of it that evades taxes. The 80% assumption I retain is an estimate for 2014. We know that up to 2008, 85% to 95% of U.S.-‐owned accounts at UBS and Credit Suisse were undeclared (U.S. Senate, 2008, 2014), so my assumption factors in some improvements. Some observers believe that enforcement has improved much more dramatically, but this view is inconsistent with the fact the funds declared to tax authorities in recent years, though not negligible, have been quite modest (see Johannesen and Zucman, 2014, Section V). The share of offshore wealth dodging taxes may decrease more substantially in the future. To compute it, we would ideally like to compare the data published by the Swiss National Bank (and other tax havens’ authorities) to the assets that taxpayers report to the IRS (and other tax agencies). The problem is that very few havens publish any useful statistics and tax authorities do not systematically disclose the amounts declared to them. Filling in these data gaps should be of the highest priority to policymakers.

majority of tax experts deemed such worldwide cooperation utopian. One lesson of

recent history is that tax havens can be forced to cooperate if the threats are big enough.

Despite this achievement, however, current enforcement efforts face a number of

obstacles.

First, not all bankers in Switzerland, the Caymans and elsewhere may truthfully report

to foreign authorities. For decades some of them have indeed been doing the contrary,

hiding their clients behind shell companies, smuggling diamonds into toothpaste tubes,

handing bank statements concealed in sports magazine, all of this in violation of the law

and the banks’ stated policies (U.S. Senate, 2008, 2014). More than a handful “rogue

employees” were involved: in 2008, over 1,800 Credit Suisse bankers were servicing

Swiss accounts for U.S. customers. They made vast fortunes from it. Can offshore wealth

managers now be trusted to do the taxman’s job?

Securing their cooperation will partly depend on the penalties cheating financiers will

face and the rewards whistleblowers will be able to claim. In the United States, the IRS

has paid as much as $104mn to the employee who denounced UBS’s wrongdoings, the

Justice Department has imposed fines, and regulators have threatened to revoke

banking charters a number of times over the last years. Yet Europe, which has about 30

times more wealth hidden in Switzerland than the United States, has done none of that.15

Looking forward, countries unwilling or unable to impose sanctions and reward

informants will remain vulnerable – this includes nations with corrupt governments,

small economies, most of the developing world, and, as it stands, the European Union.

15 Even the U.S. approach has been weak in many ways, according to a bi-‐partisan Senate staff report (2014). In May 2014, only two banks (Wegelin and Credit Suisse) had been indicted, and the United States had obtained few names and little account information (Credit Suisse sent less than 1 percent of its 22,000 American accountholders, Wegelin none). More fundamentally, the United States has so far failed to put pressure on other tax havens. Among the taxpayers who have voluntarily disclosed previously hidden assets, 42% reported a Swiss account, 8% one in the U.K., but almost none reported any holdings in Hong Kong (3%), the Caymans (1%), and Singapore (1%), where the bulk of U.S. offshore money lies (Government Accountability Office, 2013, 2014). Only about a quarter of the funds that left Credit Suisse between 2008 and 2012 have been repatriated to the United States, half have stayed in Switzerland, and the remaining quarter have moved to other countries (US Senate, 2014, p. 114). Accounts disclosed have also tended to be small, with a median amount of $570,000. Overall, just $6bn in back taxes, interest, and penalties had been paid by January February 2014 – which pales in comparison to the yearly losses for the IRS (table 1 above).

Another important factor will be the evolution of the size distribution of banks.

Whistleblowing by rational (or moral) employees is more likely to occur in big than

small firms (Kleven, Kreiner and Saez, 2009). If tax evasion activities move to small

“boutique” banks, shielded from U.S. outreach, then enforcement might prove

increasingly hard. On the other end of the spectrum, systemic banks might find it

profitable to continue conducting criminal activities, because charging them with a

crime, regulators often fear, would endanger financial stability – they seem “too big to

indict”.16

Second problem: the automatic sharing of bank information will bump into financial

opacity. Take Mr. Maurice’s Hong Kong account: on paper, it belongs to a Cayman

corporation managed by nominees with addresses in George Town. The law makes it

clear that such a widespread trick should not be enough to dodge taxes. Yet because of

one “gaping loophole” in Fatca’s implementing regulations, banks are not systematically

required to treat this account as a U.S.-‐account that must be reported to the IRS (U.S.

Senate, 2014, p. 8, p. 173). Even if this loophole were addressed, the fundamental

problem that many assets cannot be traced to they real owners would remain. Imagine

that Mr. Maurice’s Hong Kong bankers enquire about who owns the Cayman shell

company. Will they find out? In 2012, Findley et al. attempted to create anonymous

companies by asking 3,700 incorporation agents in 182 countries: in about a quarter of

cases, they were able to do so without providing any identification document. But the

problems don’t stop there. Imagine there are documents showing that the Cayman

company belongs to a Jersey discretionary trust. In such a trust, who is to benefit from

the assets is left to the discretion of the trustees. When asked, the trustees, who are

goods friends of Mr. Maurice, say the beneficial owner is Mr. Chang, Mr. Maurice’s

business partner in China. The Hong Kong account, then, does not belong to a foreign

person and no information is sent to the IRS. And even that example is much simplified.

16 In 2014, Credit Suisse pleaded guilty of a criminal charge of conspiracy to defraud the IRS, yet it was able to keep its U.S. banking license. In 2012, U.S. authorities decided against indicting HSBC over concerns that it would destabilize markets, despite evidence the bank enabled Mexican drug cartels to move money through its American subsidiaries, in violation of basic anti-‐money laundering regulations. Instead, the bank was fined $1.92bn. Once criminal charges are considered off-‐limit, it is unclear whether such fines are enough to deter illegal behavior. (HSBC’s pre-‐tax profits were $22.6bn in 2013).

In the real world, tax evaders can combine countless holding entities in numerous

havens, generating de jure ownerless assets or effectively disconnecting them from their

holdings.

Thus, even though Fatca and similar laws are broad in scope – indeed, some lament the

burden they impose on banks and the law-‐abiding, in particular U.S. citizens living

abroad – they may prove unable to catch even moderately sophisticated tax dodgers.

Evasion opportunities are disappearing for those who do not use sham corporations but

may remain for those who do.

Last, to be effective, any crackdown on offshore evasion needs to be global. The OECD

has convinced many offshore centers to automatically share bank information. Yet the

more havens agree to cooperate, the bigger the incentives for the remaining ones not to

(Elsayyad and Konrad, 2011). The data analyzed in Johannesen and Zucman (2014)

show that when two countries like Switzerland and France agree to share information,

French tax evaders move their assets to less cooperative places like Hong Kong. Such

transfers are child’s play, because the funds remain within the same banks that have

subsidiaries all over the world. A handful of non-‐cooperative centers can quickly attract

a lot of money.

The obstacles to current enforcement actions are not insuperable, though.

Global cooperation can be achieved by threatening havens with sanctions proportional

to the income they generate in abetting tax dodgers. This approach is not unlike that

adopted by the United States with Fatca, but opposite to that of Europe. Threats may not

always be necessary: the recent success of the OECD and the G20 shows that diplomacy

can go a long way in securing commitments. Yet a number of small havens derive a large

fraction of their income from illegal activities; at this stage they have little incentive to

give up this lucrative business. Clearly specified incentives may also foster effective

cooperation on the part of the havens that have already promised to implement the

automatic exchange of bank information. In addition to fines, criminal charges, and the

revocation of banking licenses, credible threats include trade tariffs. A 30% tariff jointly

imposed by Germany, France, and Italy on Swiss exports, for instance, would cost

Switzerland more than what Swiss banks gain by managing the evaded wealth from

these three countries (Zucman, 2013b).

Progress can also be made in curbing financial opacity, by using the world financial

registry described above to administer a residence-‐based corporate tax. A world

financial registry would enable tax authorities to check that taxpayers duly declare their

offshore holdings, whatever information bankers are willing to disclose. More

important, it would make it possible to address major flaws in public statistics that have

adverse consequences for tax enforcement, financial stability, and policymaking. As we

have seen, about 20% of the world’s cross-‐border equities are “ownerless” – recorded as

liabilities but nowhere as assets. This is a serious impediment to the surveillance of

global financial stability. The problem is magnified for derivatives – in 2008, who knew a

London firm, AIG, had insured hundreds of billions of U.S. banks’ bonds? In many

countries, there is no publicly available information on the distribution of wealth at the

top – a void that magazine like Forbes attempt to fill in – making it harder to have an

informed discussion on inequalities. A world financial register would help addressing

these challenges.

For fixing the corporate tax, the world financial registry only needs to include equities.

For tax enforcement purposes, it would be necessary to include other types of financial

claims, bonds, and derivatives. Some argue it would threaten individual privacy. But

countries have public property records for land and real estate – anybody can connect to

acris.nyc.org and find out about who owns real estate on Park Avenue – and there seems

to be little misuse. These records only capture part of people’s wealth, but when they

were created, centuries ago (e.g., in 1791 in France), land accounted for the bulk of

private wealth, so that they indeed recorded most of peoples’ fortunes. Not all countries

have the same attitudes toward transparency (and these attitudes change over time): in

Scandinavia taxpayers’ income and wealth is made public, not in the U.S. (although that

was the case in 1924). So there’s a case for keeping the world financial register private,

or to initially start it with only those countries sharing similar attitudes toward

transparency. In any case, the stakes go beyond tax enforcement, as financial opacity

facilities money laundering, bribery, and the financing of terrorism.

While progress has undoubtedly been achieved over the last years in curbing tax

avoidance and evasion, the data currently available should force us to be very cautious,

and much more could be done to go after the dark sides of capital mobility.

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