In May, President Obama declared war on Americans who shelter their money in low-tax jurisdictions overseas.

Meanwhile, at the behest of politicians from high-tax nations, international bureaucracies are persecuting these tax havens. The Paris-based Organization for Economic Cooperation and Development (OECD), for instance, blacklisted 41 such jurisdictions as part of its “harmful tax competition” project earlier this decade and is now trying to bully them into changing their attractive policies. The European Commission has several anti-tax-competition schemes, including a “saving tax directive” that seeks to coerce low-tax jurisdictions into helping Europe’s welfare states track—and tax—flight capital. And the United Nations has a Committee of Experts on International Tax Matters whose objective is to impose global rules to hinder the flow of jobs and capital from high-tax nations to low-tax nations. As though this weren’t enough, the G-20 communiqué last spring singled out tax havens for a crackdown.

The common theme of all these efforts is that politicians want to replace tax competition with tax harmonization. Tax competition exists when politicians feel pressure to improve tax policy so the geese that lay the golden eggs will not fly away. Ever since the Reagan and Thatcher tax-rate reductions began the process of tax competition, nations have been racing to lower rates in hopes of attracting—or retaining—jobs and investment. Since 1980 average top personal income tax rates in the developed world have dropped about 26 percentage points and corporate tax rates more than 21 points. And there are now 27 jurisdictions with flat taxes, an amazing development. No wonder the global economy—notwithstanding current turmoil—is so much stronger today than it was in the 1970s.

According to stereotypes, tax havens are little islands in the Caribbean, and indeed that’s true of some of the world’s premiere offshore centers. But to be more accurate, a tax haven is any jurisdiction that satisfies two criteria: First, its tax laws are attractive to global investors and entrepreneurs, and second, it protects its fiscal sovereignty by choosing not to enforce the bad tax laws of other nations, at least when they are trying to tax economic activity outside their borders. This means, of course, that individuals and businesses from high-tax nations have the option of using those jurisdictions as havens against excessive taxation.

Havens Are in The Nationality of The Beholder

So what are the tax havens? Places such as Liechtenstein and the Cayman Islands belong on the list, but so do many “onshore” nations. One of the world’s leading experts on offshore issues, Marshall Langer, wrote in Tax Notes International that “the most important tax haven in the world is . . . Manhattan. . . . [T]he second most important tax haven in the world is London.” The United States and United Kingdom are havens because the law enables foreigners to invest money and not report the income to their tax police. That’s good for the U.S. and U.K. economies, and for foreign taxpayers.

By some counts there are more than 70 tax havens in the world, ranging from big nations like the United States to obscure, tiny jurisdictions such as Melilla, an autonomous part of Spain on the coast of Morocco, and Sark, a tiny British-controlled island off the coast of France. In some cases, such as the United States, the tax-haven policies are designed to attract global capital and are only available to foreigners. In other cases, such as the Bahamas, the beneficial tax rules are open to both residents and nonresidents.

Tax havens are good for the global economy primarily for four reasons. First, they promote good policy around the world by pressuring politicians in high-tax nations to lower tax rates. The pro-growth changes noted earlier have been happening mostly because of tax competition, and tax havens are valuable precisely because politicians are less likely to be greedy when they know taxpayers have escape options. Remarkably, even OECD economists understand that tax competition is a pro-growth force in the world economy. They have admitted that “the ability to choose the location of economic activity offsets shortcomings in government budgeting processes, limiting a tendency to spend and tax excessively.”

Tax havens have been especially helpful in convincing politicians to reduce the double taxation of income that is saved and invested. Many nations have lowered or eliminated death taxes and wealth taxes because the politicians have finally figured out that oppressive tax laws simply lead taxpayers to move their money to havens such as Luxembourg or Panama. Likewise, nations have reduced double taxation of dividends, interest, and capital gains. The politicians figure it’s better to have a low rate and collect some money rather than to have a high rate and drive investment to Switzerland or Singapore.

From an economic perspective, these lower tax rates are critical because they reduce the tax bias against saving and investment. This encourages people to set aside more of today’s income to finance tomorrow’s growth—and even socialist economists agree that capital formation is the key to long-run prosperity and rising living standards.

Second, tax havens generate high living standards. According to World Bank data, nine of the world’s 13 richest jurisdictions are tax havens. Not surprisingly, academic researchers have confirmed that tax havens grow faster and create more prosperity for people than higher-tax areas. This is especially important in the developing world, where poor nations that become tax havens enjoy big reductions in poverty.

Third, tax havens promote better governance. One of the problems plaguing the developing world is the lack of sound institutions. Property rights, the rule of law, and sound money are the indispensable building blocks for wealth creation and economic growth. Two academics, James Hines and Dhammika Dharmapala, found that the desire to become a tax haven leads nations to improve their institutions for the simple reason that global investors don’t want to place their money in poorly governed jurisdictions. And the World Bank’s governance indicators find that tax havens rank very high. This is something that should be applauded not assaulted.

Fourth, tax havens promote economic activity in high-tax nations. This seems paradoxical, but most countries, even high-tax nations, generally have more favorable tax rules for inbound investment than for their citizens’ economic activities. Politicians figure their own citizens are captive customers who can be overtaxed, but they understand that they have to compete for global investment. Moreover, academic experts have found that citizens in high-tax nations often take advantage of this preference and use a neighboring tax haven as a platform to invest in their own country. This additional investment, which otherwise would not have taken place, increases the prosperity of the high-tax nation.

The case for tax competition also is bolstered by Nobel laureates who recognize that competition between nations is a critical force for better policy. To cite just three examples, James Buchanan wrote that “tax competition among separate units . . . is an objective to be sought in its own right,” and Milton Friedman noted that “Competition among national governments in the public services they provide and in the taxes they impose is every bit as productive as competition among individuals or enterprises in the goods and services they offer for sale and the prices at which they offer them.” Gary Becker, meanwhile, wrote that “competition among nations tends to produce a race to the top rather than to the bottom by limiting the ability of powerful and voracious groups and politicians in each nation to impose their will at the expense of the interests of the vast majority of their populations.”

Shelter From Persecution

Low-tax jurisdictions also offer a safe haven for people subject to persecution. The vast majority of the world’s population lives in nations where governments fail to provide the basic protections of civilized society. Indeed, in many cases governments are the problem since ruling elites use their power to exploit people. Corruption often is rampant, expropriation common, and crime endemic. There is also widespread persecution. Not surprisingly, people with money are common targets of oppression—particularly if they are members of religious, political, ethnic, racial, or sexual minorities.

Tax havens protect people from venal and incompetent governments by providing a secure place to invest their assets. A Jewish entrepreneur, for instance, would be foolish to keep his money in a local bank when the government is controlled by anti-Semites. Indeed, Switzerland’s admirable, centuries-old human-rights policy of protecting financial privacy was strengthened in the 1930s to protect German Jews who wanted to guard their assets from the Nazis.

Many groups in the world face discrimination and hostility, often from government. The ethnic Chinese in nations such as Indonesia and the Philippines frequently are resented by the local population. The same is true for people of Indian descent in East Africa. When people belong to groups that are unpopular and susceptible to being targeted by the government, it makes sense for them to protect their families’ interests by putting money someplace like Hong Kong, where the politicians from their country have no feasible way to find out about it. The same financial-privacy laws that make tax havens so attractive to French families and Swedish entrepreneurs who want to escape oppressive taxation also protect other people from different forms of persecution.

Tax Hypocrisy, Not Harmonization

It is worth noting that even the international bureaucracies acknowledge the valuable role of tax havens and financial privacy. The UN, for instance, admitted in a 1998 report that “For much of the twentieth century, Governments around the world spied on their citizens to maintain political control. Political freedom can depend on the ability to hide purely personal information from a Government.” The leader of the OECD’s anti-tax-competition campaign, Jeffrey Owens, admitted to the U.K.-based Observer that “tax havens are essential for individuals who live in unstable regimes.”

The campaign against tax havens interferes with the right of jurisdictions to pursue pro-growth policies, which is especially discriminatory against poor nations. Having “no or low taxes” is the main criterion for being listed as a tax haven by the OECD. Yet most OECD nations did not have income taxes during the 1700s and 1800s, when they climbed from agricultural poverty to middle-class prosperity. We should all be offended that such nations now want to deny that same opportunity to poor nations. It is rather unseemly for powerful white-governed nations in Europe, which control the OECD and European Commission, to target less powerful nonwhite jurisdictions in places such as the Caribbean.

Another issue is the OECD’s hypocritical treatment of capital compared to labor. The Paris-based bureaucracy is upset that investment funds are flowing to low-tax jurisdictions, many of which are in the developing world. But OECD nations are big beneficiaries of a “brain drain” from developing nations. This flow of talent is beneficial to “labor-inflow” nations, just as global financial flows are beneficial to “capital-inflow” nations. Yet the OECD is not suggesting that developing nations have the right to tax emigrant income earned in OECD nations. So why should OECD nations be allowed to tax flight capital in non-OECD nations?

Another example of hypocrisy is that the United States, United Kingdom, Austria, Belgium, Switzerland, and Luxembourg are all OECD members and yet were not on the original OECD blacklist even though they are tax havens for foreign investors. (The list was later revised.) Only smaller less-powerful nations were subject to this form of discrimination. And of course the ultimate hypocrisy of all is that the bureaucrats who work at the OECD and UN all get tax-free salaries, yet they run around the world demanding that other nations raise taxes.

Politicians from high-tax nations and their agents at the international bureaucracies often admit that the moral issues are pertinent. But then they say that they are worried that havens enable some of their residents to avoid the tax net. But why is that the fault of jurisdictions with better tax policy? If high-tax nations want better compliance, shouldn’t they fix their tax systems instead of trying to bully other nations into surrendering their fiscal sovereignty and becoming vassal tax collectors? In any event, the notion that there are huge amounts of unpaid tax is just one of several myths disseminated by opponents of tax competition. Let’s have a look at these myths.

Myths of Anti-Competition

Myth 1: Tax havens result in $100 billion of unpaid taxes. President Obama wants to dramatically increase the power of the Internal Revenue Service, claiming that this is the only way to collect the money that supposedly is hiding in low-tax jurisdictions. The number is phony. The IRS—which certainly cannot be considered a fan of tax havens—estimates that the overwhelming share of the so-called tax gap is the result of what happens in the United States. Part of the make-believe $100 billion apparently comes from a former John Kerry staffer, who concocted an estimate of $70 billion in unpaid individual income tax. But when the Congressional Research Service (CRS) asked for the method used to generate the number, the staffer confessed, for all intents and purposes, that he made it up. According to the CRS memo, he “was not able to send us a written discussion of his estimating procedure” and he “indicated that the estimate was an uncertain one.” That’s the understatement of the century.

Myth 2: Cracking down on tax havens is the best way to improve compliance. Politicians from high-tax nations and bureaucrats at the OECD claim that “offshore” jurisdictions deprive politicians of much-needed tax revenue. This assertion is rather strange since tax receipts were at record levels in OECD nations until the current downturn. But how best to improve tax compliance? Academic research strongly indicates that the biggest factor in tax compliance is tax rates. When tax rates are excessive, people are less likely to obey the law. And if they can’t protect their income using tax havens, they’ll use the domestic underground economy. Or they’ll be less productive. The world’s leading expert on the issue, Friedrich Schneider at the Johannes Kepler University in Austria, explains that income and payroll taxes are “the main causes for the existence of the shadow economy” and higher tax rates increase “the incentive . . . to work in the shadow economy.”

Myth 3: Tax Havens Lead to Higher Taxes for ordinary people. One of the worst myths is that low-tax jurisdictions reduce taxes on sneaky people and this causes politicians to raise taxes on others to make up the difference. But if this were true, increasing amounts of money flowing to tax havens should be accompanied by higher tax rates in the outflow countries. Yet, as noted, the opposite has occurred. Politicians are lowering tax rates because of the competition from tax havens. This means that all taxpayers benefit because of the risks taken by those who invest in low-tax jurisdictions.

Myth 4: Tax havens are money-laundering centers. Contrary to this routine smear, all the objective evidence shows that they have the toughest rules against dirty money. Not a single tax haven is on the blacklist of the Financial Action Task Force. A few tax havens are considered money-laundering centers by the CIA, but there are far more non-havens on its list. The State Department says the same thing. It’s also worth noting that every major tax haven has been cleared by the IRS for having good know-your-customer laws to hinder dirty money, and all of the major havens also are members of the Egmont Group, which is open only to jurisdictions that have effective financial intelligence units to fight dirty money. No wonder an Australian academic found it was much easier to launder money in onshore nations than in offshore jurisdictions.

When he was a senator President Obama sponsored legislation designed to persecute tax havens, and his chairman of the National Economic Council, Larry Summers, is a harshly ideological opponent of low-tax jurisdictions. Now Obama has made good on his word. That places the U.S. on the side of countries like France and Germany, giving the OECD’s previously stymied tax-harmonization efforts new life.

Advocates of economic liberty need to resist these efforts. The Center for Freedom and Prosperity, which was founded in 2000 to help protect tax competition, has done an excellent job (I’m a board member, so perhaps I am biased). But preserving tax competition in the new political environment is going to be a major challenge.

Answers: London,Tokyo, New York, Hong Kong, and the Cayman Islands. New York is the financial capital of one of the largest and wealthiest nations in the world; London, the former capital of a globe-spanning empire and still the capital of one of the most important trading nations; Hong Kong, the center of commerce for one of the largest markets in the world; and Tokyo, the capital of one of the world’s wealthiest nations. The Cayman Islands? They are 100 square miles of an “overseas territory” (the modern, politically correct term for a colony) of Britain, 480 miles from Miami and 150 miles from Cuba. Yet those 100 square miles are now the location of billions of dollars of transactions and bank deposits.

Even more strikingly, 40 years ago Hong Kong, London, New York, and Tokyo were major financial
centers and the Cayman Islands’ major industries were exporting their men to work as sailors on merchant ships and making palm thatch ropes for sale to Jamaican fishermen. The three islands (Grand Cayman, Little Cayman, and Cayman Brac) were infested with mosquitoes and flies so fierce that inhabitants ran from their homes to their cars to escape the insects, and cows suffocated on the clouds of insects they inhaled. Today the islands are a tropical paradise, virtually free of biting insects, with more than a million tourists visiting annually and the islands importing labor (almost half the islands’ population are foreigners). What happened?

A key reason for Cayman’s success as an offshore financial center is that the islands proved a hospitable jurisdiction for policy “entrepreneurship.” Several officials in the early 1950s recognized that Cayman had no choice but to develop a financial industry if Caymanians were to become wealthier. Cayman has no natural resources other than turtles and beaches. So little of its area is arable that most statistical reports list the percentage as zero. This ruled out the traditional development projects in agriculture. The small population and lack of a local market meant that industrial development schemes were obviously hopeless. Making Cayman rich required finding a way to convince other people to bring money to the islands and buy services.

These enterprising officials set out to create a legal and business climate that could compete with jurisdictions such as the United States for investors. They studied other jurisdictions’ laws and selected the provisions they thought most likely to appeal to investors. They examined the islands’ infrastructure and built what was needed to service a financial industry. For example, in the early 1960s communications from Cayman to other countries were handled by a single wireless station, operated by a man with a drinking problem. As one Cayman lawyer from that era told me, messages were fine if sent before lunch; after noon the content would be hopelessly garbled. To solve the problem, the government built an international telephone system to ensure that businesses would have reliable communications.

This entrepreneurial attitude continues. Today Cayman is the home of more hedge funds than any other offshore jurisdiction and second only to Bermuda in “captive” insurance operations (insurance companies owned by their insureds). More than 500 banks, including most of the leading banks in the world, have operations in Cayman. These successes resulted from Cayman’s adoption of statutes that provided the legal environment necessary to lure such businesses to Cayman.

If you’ve heard of the Cayman Islands, chances are you’ve heard that they do not have an income tax. Not only is there no income tax, there is no direct taxation of any kind: no sales tax, no real-estate taxes, no value-added tax, nothing. What Cayman has is a series of fees for “service” (for example, for a banking license) and a 20 percent-plus duty on almost everything imported into the island. (The major exceptions to the high tariff schedules are luxury goods; luxury goods help the tourist industry and lower tariffs on them boost economic activity by allowing Cayman to offer attractive prices on goods from Rolexes to perfume.) Because virtually everything is imported, except for some fish and turtle meat, this is effectively a consumption tax rather than a trade-distorting selective tariff.

The absence of direct taxation is important for two reasons. First, it encourages foreigners to invest capital in Cayman. Income earned by a Cayman trust or business remains tax-free until it is paid to someone in a country (such as the United States) that taxes income earned worldwide. Investors thus need not worry about losing their assets to Cayman. To ensure that investors have confidence that it will not renege on this bargain and impose a tax later, business entities, when created, are routinely granted 20-year renewable tax exemptions from the nonexistent taxes. As a result, if the Cayman government attempted to impose a tax in the future, investors would have plenty of time to move their capital elsewhere.

Even more important, the absence of direct taxation means that the Cayman government simply does not collect the sort of information routinely gathered by most countries’ governments. Want to know how much a Cayman business earns? You can’t find out by asking the government, since it never asks the business. If other governments want information, the Cayman government can’t tell them since it doesn’t collect the information in the first place.

The Cayman government’s unwillingness to pry into Cayman companies’ (and individuals’) private affairs is paralleled by the strong protection provided by Cayman’s Confidential Relationships (Preservation) Law 1995. Building on a foundation provided by the English common law, Cayman criminalized the breach of privacy by anyone with access to confidential information. Moreover, Cayman protects confidential information by requiring those seeking it to provide assurances that they can pay the costs of collecting the information and any harm that results from the disclosure.

Rule of Law

A critical part of Cayman’s success, and one reason it is more successful than some other offshore financial centers, is that investors have confidence in the legal system. Putting money in a foreign jurisdiction is risky—if a new government takes power, it can easily renege on prior government commitments. Since governments generally have a poor record in keeping their promises, this political risk is a serious problem for small jurisdictions seeking to lure investors.

Caymanians understand this and have taken several steps to guarantee to investors that the legal system is stable.

First, the final court of appeal is not a Caymanian court but the British Privy Council. By effectively “outsourcing” this critical judicial function to an entity trusted by outsiders and incapable of being pressured by Cayman politics, Cayman has shown investors that it can be trusted not to violate its legal obligations.

Second, Cayman brings in outsiders to handle sensitive cases, importing jurists from other Commonwealth jurisdictions for specific trials and even to serve on the islands’ appellate court. This helps assure investors that local prejudices will not sway the court, much as “diversity” jurisdiction in the U.S. legal system moves cases between residents of different states (over a financial threshold) to federal court to avoid the appearance of a “home court” advantage for the in-state litigant.

Third, the Cayman constitution (embodied in a British Parliament passed statute) limits the scope for local political pressure to result in changes adverse to outside capital. There is no chief minister in the Cayman government; cabinet meetings are chaired by the British-appointed governor (who is never a Caymanian); and three “official” members of the legislature are appointed by Britain rather than elected.

Fourth, Cayman has repeatedly rejected independence, preserving these crucial links to Britain. When the United Nations Special Committee on Decolonization visited Cayman in 1977, for example, Caymanians firmly rejected its efforts to push them toward independence. As Sir Vassel Johnson, former financial secretary, put it in his memoirs: “They were told by the people of the three islands in a loud clear voice, ‘Leave us alone.’”

Fifth, the key Cayman regulatory body for the financial sector, the Cayman Islands Monetary Authority (CIMA), is an independent agency rather than a politically controlled one. CIMA oversees banks and other offshore financial entities. The potential for rent-seeking in such an agency is huge—the chance to get even just a small slice of foreign investors’ money has tempted many a nation’s political class to take regulatory steps inconsistent with economic liberty. To prevent such behavior, Cayman gave CIMA extensive autonomy from local politics. For example, four of the nine directors on its board are non-Caymanians (currently two Americans, a Canadian, and a Englishman). Independent agencies and central banks per se raise their own problems, of course, but the point here is that Caymanians recognized that the need to provide security to investors required depoliticizing the regulatory framework and so raising the cost of political expropriation of outsiders’ assets.

Finally, Cayman’s budget depends heavily on financial industry fees. Given the mobility of capital, this vulnerability helps ensure that Cayman will not renege on its commitments. Indeed, Cayman’s success was partially made possible by the Bahamas’ post-independence attempt to benefit Bahamians at the expense of its offshore financial sector. In the 1960s the Bahamas was the leading offshore jurisdiction in the Caribbean. But when the newly independent Bahamian government refused in the 1970s to renew work permits for non-Bahamians in the financial industry, in order to shift lucrative jobs to Bahamians, capital fled to the Cayman Islands.

By guaranteeing its end of the bargain with foreign investors, Cayman has purchased prosperity at the price of some of its sovereignty. The price paid is remarkably low, however. Anytime Cayman wants full sovereignty, there is every indication that Britain would willingly cede it. The one thing Cayman can’t do is get its sovereignty back fast enough to seize all the money and value in Cayman companies, banks, insurance companies, trusts, mutual funds, and hedge funds. By the time the British government had the paperwork done, investors would have had their accounts in a new jurisdiction if they wish. That gives investors the comfort to invest in Cayman.

Indeed, for many Caymanians, the highest cost of remaining associated with Britain comes from its imposing its own social-policy preferences on Cayman. For example, Britain unilaterally legalized homosexual sex in 2001 and abolished the death penalty in 1991. Both actions were unpopular in Cayman, a socially conservative and deeply religious society. Even more unpopular was Britain’s action through an “Order in Council” that overrode local legislation.

Pressures to Change

Offshore jurisdictions face a variety of pressures to change their laws to eliminate their competitive advantages. Not surprisingly, for example, the countries that “lose” tax revenue to Cayman and other offshore jurisdictions aren’t happy about it. The Organization for Economic Cooperation and Development (OECD; the cartel of wealthy developed countries) dislikes the whole idea of tax competition, the “harmful” lowering of tax rates to lure business. Fortunately, the Bush administration has shown less interest in helping the other high-tax OECD countries in their quest to reduce tax competition than the Clinton administration did, but the problem lurks in the background.

The offshore financial industry also faces threats from crime. The term “offshore” often calls to mind unsavory deals of the type John Grisham wrote about in The Firm. And some offshore jurisdictions have fallen victim to corruption and crime. For example, historian Jan Rogozinski called Aruba “the world’s first independent mafia state,” and most of Montserrat’s banking industry was closed down after a financial scandal involving money laundering.

Resisting illegal activity is essential for successful offshore jurisdictions for at least two reasons. Most important, illegal transactions often bring with them corruption that is destructive of the level of trust necessary for a civil society to function. More pragmatically, illegal activity threatens the toleration of offshore jurisdictions by “onshore” jurisdictions such as the United States and the European Union. The physical and legal independence of jurisdictions such as Cayman, Bermuda, or the Channel Islands is precarious. It would take little effort for Britain to simply override Caymanian laws by altering the constitution or, in a more extreme case, for a company of U.S. Marines to overrun the island.

Less extreme onshore legal changes could cripple important aspects of the offshore financial industry. Of course, offshore jurisdictions are useful to European and American investors, which provides a degree of political protection against such threats. If, however, offshore centers become identified with al Qaeda financing, they are extremely vulnerable to onshore nations’ pressure. Keeping their businesses in the legitimate financial sectors helps offshore financial centers protect their independence.

Cayman has struck a balance between cooperating enough with onshore jurisdictions to preserve their toleration of offshore activity and maintaining its competitive advantage. Three steps help Cayman succeed in doing so. First, it insists on the principle of dual criminality in all cooperative efforts. That is, it will help other jurisdictions obtain information about funds in Cayman only if the activities being investigated are illegal there also. The result: cooperation on terror financing but not on tax investigations.

Second, Cayman assists foreign governments only in response to requests for specific information; it will not participate in “fishing expeditions” into a suspect’s funds or activities.

Third, Cayman has expanded the areas in which it offers a competitive advantage well beyond tax levels. Caymanian accounting rules and insurance laws, for example, are far more favorable to the operation of captive insurance companies (through which firms can self-insure against some risks) than either U.S. accounting rules or most U.S. states’ laws.

Not Quite Perfect

But wait—isn’t this the Cayman government that is doing these things? Doesn’t that compromise the integrity of the system? We should be skeptical of the classical-liberal pedigree of offshore jurisdictions for precisely this reason. Cayman may be freer than most places with respect to financial matters, but it is still not a libertarian haven, and so there had to be a flaw.

And it definitely is not a libertarian haven. A socially conservative society, Cayman has plenty of laws that many libertarians would object to: drug prohibitions, bar closing rules (midnight on Saturdays) built around religious observance, and the like. Cayman has also made many of its investments in infrastructure through government entities. The government built the airport, runs a national airline that frequently loses money, created the law school, set up the telecommunications network, and has undertaken a host of other activities that most libertarians and classical liberals would reject as outside the acceptable range of government activities.

Despite all these flaws, Cayman plays an important role in limiting government elsewhere. What Cayman provides is competition that keeps larger states more honest. All aspects of Cayman’s legal system need not meet the ideal for it to play this role. Cayman’s tax and regulatory rules force governments elsewhere to restrain their resource grabs. By providing an alternative, Cayman forces a sorely needed measure of discipline on the United States, European Union, Japan, and other “developed” countries not just with respect to taxes but also to a host of regulatory measures.

Moreover, because Caymanian society is small, the government is a lot less like the grasping Leviathan of larger states. Indeed, the society seems to have reached a consensus on the value of the offshore financial industry that is making the population among the wealthiest in the Caribbean, and that consensus is reflected in the tenor of the politics. Parties have not yet taken root in Cayman, and competition for office seems more based on personalities and competency than partisan divisions. The Cayman government has certainly made missteps from a libertarian perspective. Nonetheless, they have been less destructive of liberty, particularly economic liberty, than those of many of its larger neighbors.

Cayman’s success is due to thinking differently about government. Cayman has gotten rich by realizing that the fundamental problem of government is to find institutions that convince people that the government won’t take their money. In part, it is because it is small that Cayman is able to make credible commitments in the ways I have described. But it is also due to the creative design of its institutions that Cayman has succeeded. For example, in 1776 separating from Britain was a means of limiting government rent-seeking; today remaining connected to Britain offers Cayman an equivalent set of limits.

Can Cayman serve as a model for other governments? Many of the specific solutions chosen by Caymanians are unlikely to function if scaled up to a country the size of the United States. It could, however, prove an important model for local governments seeking to reassure investors that they will not find a new set of rules in place the day after their investment becomes final.

The entrepreneurial attitude that made Cayman the fifth largest financial center less than 40 years after the biggest local industry was thatch-rope manufacturing could be translated even to larger-scale governments. If people can learn to stop viewing governments as the source of subsidies and recognize the connection between institutions that protect property rights and wealth, other entrepreneurs may discover institutions that effectively limit even the most rapacious Leviathan.

Read More

Literature on Cayman history is hard to come by, and most Caribbean histories give Cayman little attention. The story of it offshore industry is told in Sir Vassel Johnson’s somewhat uneven autobiography, As I See It (Book Guild Ltd., 2001). Michael Craton’s Founded Upon the Seas (Ian Randle, 2004) is an excellent general history of the islands and includes some material on the financial industry. If you visit Grand Cayman, the government archive (near the airport) has a fascinating collection of oral histories; unfortunately none are available on the web. The Cayman Islands also feature in a sadder story involving classical-liberal principles, the destruction of a highly successful private conservation effort to save the endangered Atlantic green sea turtle by U.S. environmental legislation. This is described in Peggy Fosdick, Last Chance Lost (I.S. Naylor, 1994).