Tax Havens: Avoidance or Evasion?

March 17, 2011

During a hearing before the Senate Budget Committee, Kent Conrad made reference to offshore tax havens during his prepared remarks and again during questioning. Sen. Conrad refers to them as a personal pet peeve. He singled out the Cayman Islands as one particularly egregious case. It begs the question, what is a tax haven?

The OECD has defined a tax haven as having four characteristics:

1. No or nominal taxation

2. Lack of transparency

3. Laws or administrative practices that prevent the effective exchange of information for tax purposes with other governments on taxpayers benefiting from the no or nominal taxation.

4. Absence of a requirement that the activity be substantial

If one looks at countries classified as Tax Havens by the OECD, the Cayman Islands was removed from the gray list. When people think about tax havens, the popular notion is that individuals or companies are engaged in illegal activities. This is what has been known as tax evasion. There are numerous cases of individuals hiding income in foreign bank accounts in order avoid paying income taxes. In part, because of increased international treaties and information sharing agreements, this activity has been more difficult.

The other side of this, tax avoidance, is when individuals or companies take actions that are legal for the purpose of avoiding taxes. Economists enjoy pointing out the unintended consequences of policy, and taxes are no exception. When the width of houses was taxed in Amsterdam, the houses became increasingly narrow. When windows were taxed in Great Britain, people bricked over them. While these are more humorous examples, there are numerous examples of current accounting maneuvers businesses can employ to lower their tax burden.

Tax avoiders are wrongly (or rightly) lumped in with those who attempt to evade taxes. While certainly they are denying the government revenue, they are also only following the incentives (though unintended) that the government created. Instead of demonizing the actions of individuals and companies who are following the law, perhaps one should look at the incentives that law creates.

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