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.

The member states of the European Union, in their struggles to find some form of international authority, are going through debates that have a strange resonance with America’s arguments about constitutional forms in the late 1780s. However, there has been no Philadelphia—no equivalent European city at which the fundamental issues of freedom and constitutionalism have been thrashed out. Instead, there has been a steady accretion of power to central regulatory authorities in Brussels, either by international treaty or even more significantly, by innovative and creative decisions of the European Court of Justice, which is rapidly becoming what its U.S. equivalent took some time to achieve—the de facto creator of a constitutional order.

Even in its original structure the European Union (it’s had various names in the past) was markedly biased toward the executive. The European Commission, executive arm of the EU, has always been more than a civil service. It actually initiates legislation, which is almost routinely passed by the Council of Ministers, the nominal legislature composed of representatives from the member states. The Commission keeps a close watch on them to prevent the emergence of any independent, competitive, and innovative actions. It normally wins cases against member states that it brings before the European Court. Indeed, Brussels, headquarters of the main governmental institutions, is rapidly becoming the capital of a new superstate.

In theory, the original Treaty of Rome (1957), which bound the creators of an economically integrated Europe, was not especially illiberal (in the classical sense). It embodied the “Four Freedoms”—of movement, of goods and services, of capital, and of labor—that constitute the sine qua non of a market society. International regulation was originally limited to the enforcement of the common rules of practice necessary for free economies. True, there were regulations that had immediate legislative impact on member states and directives that were adopted by local legislatures to fit particular circumstances. But in its early days, European-wide law did not automatically take precedence over the laws of member states; so there was some similarity with America’s Articles of Confederation, which required the agreement of all states for laws to be nationally applicable. Unanimity was never achieved, and that is why the framers of the Constitution aimed to make federal law directly applicable to all Americans, as well as to permit direct taxation by the proposed federal government.

The End of Competitive Governments

In Europe, there was still the possibility of jurisdictional competition, which is the essence of federalism, up until 1964, when the Costa v. ENEL case was decided; the European Court held that European law was superior to any domestic law with which there might be a conflict. Nothing in the Treaty of Rome validates this legislative capture by the central body. It was simply another example of a centralized court asserting its power to create constitutional law. Ever since, the Court has expanded the power of the Council of Ministers and its legislation. As the American authors of the Anti-Federalist Papers said, a federal court is bound to augment central power at the expense of local autonomy: it reduces the effectiveness of “exit” (that is, voting with the feet), and eventually the domain of individual liberty is diminished. What is the value in moving to another state if all the laws are more or less the same?

Although the European authorities in Brussels have no direct taxation powers (they do have the power to set a minimum level of value-added tax) and the budget is financed by subventions from each member state, one doubts that this will survive very long. Encouragement toward a European-wide income tax will come about through the new European currency, which is under the control of the European Central Bank, an institution that will set an interest rate for all member states that join. (Britain negotiated an opt-out under John Major’s Tory government, but this is not likely to survive the newly discovered Euro-enthusiasm of Tony Blair’s Labour government.) With a monopoly currency, a central bank, and treaty obligations to maintain various fiscal targets, the tendency toward the promotion of European-wide economic policies will be irresistible. The power to tax, exercised in effect by a centralized state, will complete the European project.

It is a project that subjects European citizens to common economic standards, welfare arrangements, civil liberties, and ultimately most aspects of law. From its inception as the European Economic Community (a mere free-trading area with elementary uniform rules), each stage in its progress has been toward increasing centralization. The major developing institutional arrangements, from the Treaty of Rome itself through the Single European Act (1986), the Social Charter (1989), the Treaty of Maastricht (1993), and the Treaty of Amsterdam (1997), attest to this.

A Benign Beginning

Much of this evolution proceeded under the suitably benign banner of elaborating on the originally modest liberal project of fashioning the principles of a free market as envisaged in the Treaty of Rome. Indeed, some steps could easily find a rationale in public choice theory. For example, under the original arrangements, when unanimity prevailed in the Council of Ministers, progress toward a free common market was successively blocked by member states anxious to preserve anti-market privileges (such as restrictions on capital movement). In good Virginia-school style, qualified majority voting was introduced under the Single European Act, although unanimity remained in certain areas. However, this modest and necessary constitutional innovation soon made possible a mania for “harmonization”: many competitive advantages were gradually eliminated so that every member state had to conform to uniform regulations on the environment, labor law, health and safety at work, and so on. A “social chapter” was introduced by which a common welfare policy was formulated.

Most of these standards were, in effect, set by the richer countries, especially Germany and France, which did not want competition from poorer countries anxious to attract capital by offering more favorable regulation. They were, in turn, “bribed” by significant financial redistribution. When countries attempted to avoid these standards, ways were found to thwart them. Britain tried to veto a directive limiting the number of hours in the work week (as proposed, unanimity was required), but it was carried as a health and safety measure, which can be passed under qualified majority rule.

Predictably, the European Court has been a complaisant actor in all this. It doesn’t proceed like a common law court, working from case to case and deciding by purely legal reasoning, rather than on political grounds. Instead, it tends to regard itself as being responsible for implementing the European “idea”; this of course lets almost anything in. Subordinate courts, for fear of being overruled, correctly anticipate what the European Court would do. Thus a British court struck down laws that exempted part-time workers from the anti-competitive requirements (including generous redundancy payments) enjoyed by full-time employees. It said that since most part-timers were women, the exemption was in breach of various equality provisions in European law. The court even had the audacity to add that this would have no effect on employment.

A great stride down the road to centralization was taken by the Maastricht Treaty (1993). This extended majority voting, introduced plans for a common currency (although not yet obligatory), and confirmed all the movements toward legal uniformity that had been previously established by the Court. The only interesting feature of the ratification process was the ruling of the German Constitutional Court in Karlsruhe. Although the legality of the treaty was upheld, (superficially) strict conditions were laid down for future European integration. Europe was declared to be a confederation of autonomous legal systems (to which European law was not superior), and no regulation or directive could abrogate any individual right protected by the German Basic Law.

This nicely contrasted with Britain’s much-vaunted sovereignty system, in which its citizens had no recourse to constitutional law once its parliament had signed away legal authority by treaty. (There never was a British constitution.) It may have been a good thing for liberty that sovereignty was effectively renounced, but its replacement is hardly a bastion of freedom. The European Court may have been quite efficacious at striking down some national laws that were obstacles to economic liberty, but it has been singularly ineffective at protecting European market freedoms from regulations and directives from the Council of Ministers; the similarity here with the behavior of the U.S. Supreme Court since 1937 is striking. Whatever the German Constitutional Court may have said about Maastricht, there is no evidence that it will take a stand against European legislation; in fact, with scarcely a murmur it upheld Germany’s abandonment of the mark on joining the European Monetary System.

What Is Federalism?

What the enthusiasts for Europe do not understand is that freedom is better protected by competition, both in economics and law, than by constitutional documents: “exit” always beats “voice” (democratic privileges).¹ This would be so even if the embryonic European constitutional documents were themselves particularly friendly toward liberty. It took the U.S. Congress and Supreme Court about 150 years to integrate the country under one more or less uniform economic, regulatory, civil liberties, and welfare system; Europe has done the same in less than 30. The elimination of constitutional competition in the United States was formally recognized in the notorious Garcia v. San Antonio Transit Authority case, where the Supreme Court, in defiance of the Tenth Amendment, said that federalism consisted merely in the fact that the states were represented in the Congress.

Europe has repeatedly given formal obeisance to the (originally Roman Catholic) principle of “subsidiarity,” which in the Maastricht Treaty is held to mean that “in areas which do not fall within its exclusive competence, the Community shall take action . . . only if . . . the objective of the proposed action . . . can by reason of the scale of effects of the proposed action be better achieved by the Community.” Subsidiarity is a kind of surrogate for genuine federalism. But even as a “parchment” protection for local autonomy, it is feeble. There is nothing like the precision of the original American Constitution, which at least does specify the areas of competence for the federal government and leaves the rest to the states. In Europe there is not even wording that can function as a principle for demarcating centralized authority from local. In any disputed area, the European Court will always side with Brussels.

One solution repeatedly recommended to stem the growing bureaucratization of Europe is the closing of its “democratic deficit.” It is true that European governmental institutions are not subject to much democratic accountability. The parliament has little or no formal legislative role (in fact, it is a rent-seeker’s paradise, as is much of Europe), and the members of the Council of Ministers are only indirectly elected. But more “democracy”—that is, legislative authority for the directly elected parliament—is not the answer. People who make this case repeat the error of Madison, in Federalist 10, on the grand scale. He thought that the “extended republic” would remove the danger of faction because a federal system with divided legislative power would dissipate the malign effects of otherwise unrestrained majority rule. But he neglected the fact that modern-day factions, coalitions of interest groups, would form to plague the central legislature with sectional demands, and dispersed voters would have little rational incentive to control them. The same public choice considerations tell against a democratized Europe, for well-organized and committed minorities always have an interest in formulating (normally redistributive) policies that are inconsistent with the long-run aims and purposes of an apathetic and rationally ignorant populace. Only the objective enforcement of a universal rule of law, which protects property rights as well as civil liberties, can restrain potentially predatory government. Conventional majority-rule democracy is quite inadequate to the task.

One crucial feature of a genuine federal system is the right of exit from the constitutional arrangement: this is justified not merely on the ground of local autonomy but also as a prudential device to restrain the seemingly inevitable centralizing tendencies of all forms of government. For if enough provinces/states object to the actions of the general government, then that government will find it has very little left to govern over. There was always a great doubt about the constitutionality of secession in America, and a hypothetical federal government could go a great deal toward preserving that form by specifically acknowledging the right of exit.

It is continually debated now whether Britain (the least enthusiastic of member states) could legally leave the European Union. That question would appear to be answered by an obscure clause in the as-yet-unratified Treaty of Amsterdam, where it is declared that the Commission will bring actions against any member state thought to be in breach of its Treaty obligations; the case will be heard by the European Court. These are the two institutions least likely to be in favor of secession. There is, then, no right of exit; it is a permission that is never likely to be granted. Any such action by a member state will therefore be political, with all the adverse consequences that will follow from its exercise. Dover Castle may well be Britain’s Fort Sumter.

It is not the case that British Euroskeptics are necessarily fanatics for parliamentary sovereignty, the very system that has done so much to undermine the market economy and the rule of law in their country.² What they fear most of all is the reproduction of that institutional phenomenon on a much more dangerous scale in Europe. There is no escape from its depredations except by the costly and time-consuming process of amendment by treaty. And the European rent-seekers will always be able to fend off any such move. The only virtue of retaining independent states (which could still bind themselves by minimalist general rules, mainly for promotion of free trade and protection of the right to free movement) lies in the possibility of preserving genuine institutional competition. This strategy has nothing to do with promoting grandiose schemes for a “more perfect union.”

Notes

1. See R. Vaubel, The Centralisation of Western Europe (London: Institute of Economic Affairs, 1995).
2. See my “Sovereignty, the Rule of Recognition and Constitutional Stability in Britain,” in Hume Papers on Public Policy, vol. 2, no. 1, 1994, pp. 10–27.