For example, Britain colonized North America, and what now constitutes the United States, until 1783 when the Brits were kicked out because out they imposed high taxes. The Declaration of Independence had it exactly right: “He [King George III] has erected a multitude of New Offices, and sent hither swarms of Officers to harass our people, and eat out their substance.”

Today, the United States makes George III look like a piker. It is amazing how, with respect to taxes and freedom, the U.S. government has copied and often been more ruthless than the British Empire. As a consequence, the extent to which economic liberty has been destroyed in America and what is now the EU is almost beyond belief. It is as if the American and French revolutions never took place, or took place to provide cradle-to-grave management by government over our lives.

The U.S. governments—federal, state, and local—find that extracting 35–40 percent of incomes is not sufficient. They need more to continue their march toward the perfect welfare state and, in the case of the national government, military dominance of the world. As a result the tax burden under which the average American suffers is now about 20 times higher than under George III.

The EU countries are even worse, with governments raking in around 50 percent of national output. Even Louis IV of France would now be viewed as a benevolent uncle compared to that. The U.S. and EU governments intrude on the financial lives of citizens in every conceivable way, from taxes to regulations to absurd laws that shape and control their citizens.

Empire of the Welfare State

The welfare state, even more than the war on drugs or organized crime, drives the financial imperialism of the U.S. and Europe. Financing the welfare states—most of them are technically bankrupt because of the huge costs of Social Security, public-sector pensions, medical care, and aging populations—creates massive problems, so the United States and Europe look hungrily abroad for more money.

Thomas Paine, who wrote of “the greedy hand of government, thrusting itself into every corner and crevice of industry,” would be astounded at today’s situation. Some taxpayers subsidize other taxpayers, or pay taxes that they later themselves get back as subventions, or pay for services they do not want or even positively oppose. Industry after industry is regulated by millions of bureaucrats and thousands of pages of regulations.

Not content with levying excessive taxes on their citizens at home, large governments using the Organisation for Economic Co-operation and Development (OECD) have in their sights the tax policies of small and less-influential countries whose cardinal sin is to siphon off revenues or poach wealthy taxpayers.

Instead of fighting Britain, the United States has now joined hands with its former colonial oppressor and several other European countries in seeking to prevent a major threat to their treasuries. (For some examples see Daniel Mitchell’s July/August 2009 Freeman article, “In Praise of Tax Havens.”) What is the nature of this threat?

There are a number of countries, disparagingly called tax havens (or offshore financial centers), most of them small and insignificant, such as Bermuda, Monaco, Liechtenstein, and Cayman, that are allegedly sabotaging the grandiose plans of the United States and the European Union to create their utopian welfare states and undermining expensive military ventures in obscure places like Iraq and Afghanistan.

What on earth can these toe-holds on the world atlas be up to?

According to a March 2, 2009, floor statement of Senator Carl Levin of Michigan on the introduction of the “Stop Tax Haven Abuse Act” (an earlier version of which was supported by then-Senator Obama), a tax haven is a foreign jurisdiction that maintains corporate, bank, and tax secrecy laws and industry practices that make it difficult for other countries to find out whether their citizens are using the tax haven to cheat on their taxes. He went on to say, “that secrecy breeds tax evasion. Tax evasion eats at the fabric of society, not only by starving health care, education, and other needed government services of resources, but also by undermining trust—making honest folks feel like they are being taken advantage of when they pay their fair share.”

It is dubiously alleged that offshore tax abuses cost the U.S. treasury an estimated $100 billion each year in lost tax revenues. (As Mitchell says, “That number is phony.”) “Tax havens are engaged in economic warfare against the United States, and honest, hardworking Americans,” Levin said. The implication is that no country should derive a comparative economic advantage from its fiscal policies and that such policies should be harmonized with countries like the United States.

An appropriate response might be that this $100 billion is channeled from tax havens into productive investment that creates jobs, wealth, and opportunities for Americans rather than disappearing into the rat-hole of government spending. Or that tax policy should not be decided by OECD bureaucrats.

Truly in many ways the world has changed—and not always for the better—during the past two centuries. High taxes are good, and low taxes are bad now. Freedom to spend your money in the way you deem best is no longer a virtue but a sin. Diversity is out, homogeneity in. Millions of people in the United States and Europe now depend on taxing others in order to enjoy income, medical care, and unemployment and other benefits.

The greatest enemy of the modern State is not the terrorist, criminal, hoodlum, or even the foreign aggressor; it is the citizen who simply wants to keep his own income or to protect his own wealth. “Need” is defined as getting your hands on other people’s money, and greed has come to mean the natural desire to protect your own property and assets from sequestration by governments.

The jihad against low-tax jurisdictions and the imperialist tax policies being implemented by the United States and the European Union have at least four adverse consequences.

Privacy is reduced. Increasingly, the right to be left alone or to tell the government, “Mind your own business,” is seen as a quaint throwback to the eighteenth century. But is not the principle a fundamental part of privacy and liberty?

The enjoyment of financial and personal privacy is the essence of a free and civilized society. Freedom means the right to spend your own money as you like and to talk to your lawyer or banker without fear he is a government agent.

Government power is increased. The tax laws of most countries are voluminous, so much so that even tax lawyers and accountants have trouble interpreting them. Everyone breaks them inadvertently. The more laws, the greater is the power of government, and proportionately the freedom of the individual is diminished. John Mitchell, the attorney general under President Nixon, is alleged to have said to his boss, “Let me know who you wish to be arrested, and I will find a law he has broken.” He likely wouldn’t have to look further than the tax code. For anyone.

The sorry and tragic history of government power is that it is likely to be abused, and the likelihood, or even the certainty, of abuse grows along with that power. This point was made early on after the creation of the income tax, when Richard E. Byrd, speaker of the Virginia House of Delegates, predicted, “[A] hand from Washington will be stretched out and placed upon every man’s business. . . . Heavy fines imposed by distant and unfamiliar tribunals will constantly menace the taxpayer. An army of Federal officials, spies and detectives will descend upon the state.”

The income tax changed the relationship between the taxpayer and government. Taxpayers are allowed to retain a portion of their earnings as pocket money while the government filches the rest. Freedom to spend hard-earned wages is at the discretion of the tax authorities.

Capital investment is reduced. One of the fundamental and settled propositions of sound economics is that the standard of living of everyone depends on capital investment, which today is not only tools, factories, and equipment, but human capital. Capital investment requires resources not consumed but saved. Ludwig von Mises said it best: “The confiscation of business profits does not benefit the masses. It prevents the efficient entrepreneur from expanding his efforts to supply the consumers in a better and cheaper way, and it shelters the less efficient against the competition of more efficient newcomers. It substitutes rigidity and immutability for progress and continuous improvement.”

Inhibiting, through punitive taxation, the production of wealth in order to create the impression of equality is not humanitarianism but simply stupidity because it makes everyone less well-off—especially the poor.

Tax policy is “harmonized,” that is, “cartelized.” Tax harmonization is the equivalent of tax bullying. The hypocrisy of governments’ bullying tax havens is appalling. If the OECD tax systems were mild, most people who now use tax havens wouldn’t bother.

The belief that tax harmonization is sound public policy has its genesis in the mistaken belief that government spending is good and private spending is bad. This is the private affluence/public squalor argument sanctified by the 1958 publication of The Affluent Society by the late John Kenneth Galbraith—patron saint of political big spenders. However, history tells us that when you leave people alone and keep taxes low, economies flourish and people prosper. If the ability to avoid taxes were impossible, a tyrannical regime could squeeze the taxpayer orange until the pips squeaked.

Guilt by Lack of Association

One of the latest stunts of the OECD is to compel offshore financial centers to sign tax information exchange agreements (TIEAs), under which authorities in these centers can be forced to provide information. Failure to sign a sufficient number of TIEAs can place a jurisdiction on a blacklist. This is a bully-boy tactic.

Appearing on the blacklist means that there is a strong suspicion that monkey business is going on, and that the low-tax jurisdiction is using improper secrecy to shelter potential money launderers, terrorists, tax evaders, and other assorted financial riffraff. However, the pristine reputation of the United States has been undermined lately by research conducted by Jason Sharman of Griffith University on Australia’s Gold Coast. Sharman tested the difficulty in setting up anonymous bank accounts in various places around the world, including tax havens. The highest standards of probity were small island tax havens, while the lowest standards arose in Somalia and the United States, where service providers were prepared to set up anonymous bank accounts without proper identification. This led Jean-Claude Juncker, prime minister of Luxembourg, to state, “If there must be a blacklist, then America should have its place on it.”

Tax competition compels governments to think more carefully before spending the public’s money and frees entrepreneurs for greater access to investment funds. Contrary to common belief, low-tax jurisdictions do not siphon off capital from high-tax areas, but allow a better and more effective means of making investment decisions.

The Bible established a tax rate of 10 percent, known as the tithe. That should be enough for governments. There is little hope for optimism on that score.

Low-tax countries are an affront to high-tax countries that believe they have a right to tell the rest of the world how to live. So high-tax countries try to force their tax regimes on everyone else. That is financial imperialism.

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).

Little upsets politicians more than people attempting to escape their control. So it is with U.S. companies that have fled overseas, now attacked as being unpatriotic and worse by Washington pols.

Over the last decade, at least 25 major firms have reincorporated in Bermuda or the Cayman Islands. Eleven have emigrated since 2000.

The reason is simple: taxes. As Jonathan Weisman of the Washington Post put it: “The United States, with its 35 percent corporate income tax and its Byzantine rules for taxing worldwide profits, is not a particularly friendly tax environment, especially when compared with Bermuda, where there is no corporate income tax.”

But the economic incentive isn’t enough. Unlike European rules, U.S. law allows companies to shift to another country without shifting their headquarters.

Naturally, the legislators who enacted both the tax rates and the tax loophole are furious. Charles Grassley of the Senate Finance Committee says such inversions are “immoral and unethical.” Representative Jim Maloney calls firms that migrate “unpatriotic and immoral in a time of war.”

Even some nominal conservatives have joined in the hunt. Former Reagan administration defense aide Ken Adelman wants to go after companies that aren’t paying their “proper share of taxes to the U.S. Treasury.” Moving offshore to reduce Washington’s take is “shady” and “just awful.”

A half dozen laws have been drafted in response. The companies responded with their usual weapon of choice, lobbyists. Said Todd Malan, executive director of the Organization for International Investment: “They’ve hired everybody in town.”

Corporate inversion is one of those issues that invite demagoguery. Yet moving to lower one’s taxes is common in America. States without an income tax attract retirees; many people compare the level of taxation before deciding between adjoining states. Many people even avoid cities, such as New York, which hit up their residents coming and going.

Moving across national borders is more difficult, but makes equal sense. It’s not just small Caribbean nations that have lower corporate tax rates. So do Hong Kong and Taiwan, Norway and Sweden, Chile and Ecuador, Hungary, and Switzerland.

Playing by the tax rules enacted by Congress in order to lower one’s taxes hardly seems immoral, unethical, and unpatriotic. Rather than complaining, legislators could, perish the thought, lower tax rates and rationalize the regulations to make America more competitive.

Indeed, when it comes to blame, Congress is the obvious culprit. First, consider the mess Congress has made of international taxation. Senator Orrin Hatch admits that the foreign tax credit doesn’t fully offset foreign levies, resulting in double taxation. Thus, he says, “the effective tax rate of American-based firms is often much higher than that of their non-U.S. competitors.”

The second problem is the overall tax burden. Despite the modest Bush tax cut, the government’s take remains at historically high levels.

According to the Tax Foundation, Tax Freedom Day, when Americans stop paying for government, ran to April 27 in 2002. The good news is that this is down from May 1 in 2000, after the Clinton tax hikes. But it’s still the record before 1998. It’s almost a month longer than in 1945, at the end of World War II, because state and local governments then took so much less. Americans are working for government almost two weeks longer than they did in 1984, the low point over the last two decades.

Third, toss in the regulatory burden and you get Cost of Government Day. That, reports Americans for Tax Reform, came to July 1 last year, up six days over 2001. By this measure, people spend half their lives working for the state.

Thus, it seems a little churlish to demonize people as they attempt to lighten this burden a bit. That applies to corporate America too. For one thing, individuals, not businesses, pay the taxes.

High Taxes

In any case, U.S. tax rates are excessive. America’s corporate rate, combining federal and state taxes, averages 40 percent, 8 percent higher than the average of other industrialized states. Indeed, last year U.S. levies went from fourth to second highest in the developed world. Compliance costs in America are also among the highest in the world.

This extra money is going for an orgy of spending. In fact, the increase in outlays in George W. Bush’s first two years equals that in the first five years of Bill Clinton. Since February 2001 Congress increased discretionary spending by over $400 billion.

This isn’t due to the War on Terrorism. Representative John Spratt admits it: “The cost of 9/11 is a small fraction of the total deterioration of the surplus.” About two-thirds of increased spending is due to other factors. Reports Jeffrey Birnbaum of Fortune: “The rest is testament to a fact that predates Sept. 11: the era of big government has returned.” Indeed, he adds, the fight against terrorism has been a “ruse to justify all sorts of spending.”

Citizens Against Government Waste reported that last year the House and Senate included $662 million and $801 million, respectively, in pork in the 2003 military construction appropriations bill. No occasion is to be missed when it comes to lathering federal cash on constituents.

Rather than cut spending, in recent years the GOP majority elected in 1994 worked to shift the money to Republican districts. By 2000 the average Republican district was getting $612 million more in federal funds than the average Democratic district. “To the victor goes the spoils,” observed then-House Majority Leader Richard Armey. The National Taxpayers Union has found that the average legislator has been casting votes to increase the so-called budget baseline by twice as much as two years ago. Observes Brian Riedl of the Heritage Foundation: “Republicans and Democrats basically make a deal with each other—‘I’ll vote for your increase if you’ll vote for my increase.’”

People should feel immoral, unethical, and unpatriotic when they avoid this?

Congress should deal with corporate inversions, but not by punishing companies tired of seeing a large share of their revenues seized by politicians to reward favored interest groups and buy votes. It wouldn’t be easy: restricting inversions would make U.S. firms more susceptible to a foreign takeover, which would automatically result in a lower tax rate.

Restrictions would also encourage established firms to move their headquarters overseas and startups to begin there. For example, a company that located in Ireland, with a corporate tax rate less than half that in America, would be protected by a tax treaty from punitive retaliation.

The real immorality is when politicians take people’s money for their own purposes. The real lack of patriotism is when politicians put their interests before freedom.

To the Editor:

Lawrence Reed argues against taxation of Internet sales in his recent article “Don’t Tax the Internet” (June 2000). There is an evil worse than excessive taxation: that of selective taxation . . . . Exemption of Internet-originated sales from taxation, while still allowing taxation of phone-originated sales taxes, amounts to a form of discrimination. Indeed, arguments in Congress for the temporary moratorium on Internet sales taxes always talk about trying to support the nascent industry.

A better solution is to allow jurisdictions to levy sales taxes based on the source point of the sale (rather than the destination). This would encourage competition between taxing entities as merchants move from high-tax states to low-tax states in order to offer best prices to consumers.

—John Shelton
Redwood City, California

Lawrence Reed replies:

Mr. Shelton is right that “selective taxation” is bad because it involves government’s creating an unlevel playing field by picking winners and losers and bestowing discriminatory special privileges. But it’s important to remember that government indirectly taxes some Internet purchases already (those made through dial-up connections) via the taxes it imposes on telephone service. Also, Internet firms do pay all relevant taxes in the respective states where each is physically located, just like other companies.

One could argue that allowing jurisdictions to levy sales taxes based on the source of thesale rather than the product’s destination would be the fairest solution, but that would require the five states that do not currently levy a sales tax to begin doing so.

If the moratorium on new Internet taxes serves to restrain increases in existing sales taxes or even to spur reductions, then we all will benefit.

Defending the Rich

To the Editor:

“In Defense of the Rich” by Mark Skousen (June 2000) is not only an amoral defense of the rich, it is much more sinister than that: It is an immoral defense of the rich. In the article, Dr. Skousen discusses the auxiliary benefits that the rich provide society, as well as some of the moral attributes and undertakings of some rich people. No argument could be made that is more harmful to capitalism, and no argument could more effectively deliver up the rich to their attackers than the one offered in this article.

The only proper defense of the rich is a moral one. In a free society, the people who own a large sum of wealth created it by means of their own toil, and this is why they are entitled to it. The wealth that they created is their own, regardless of whether this is good for the economy, and regardless of what the people who own it spend it on. The argument that is used in the article is in defense of the latter two issues instead of the primary one. This is an egregious error because it abdicates the moral argument . . . . As long as the majority of people think that all wealth is created and owned by society, then an attempt to persuade people in favor of the rich is doomed. Just imagine the implications of such an idea: if society owns the wealth, then it is by the grace of society that any person can own property. An attempt to persuade people that it is better for them not to confiscate the property of the rich and to wait patiently for whatever crumbs the rich people drop their way will convince only a very few people. The implicit argument of the article is as follows: “The rich are good citizens. They pay their taxes, they give to charity, and they have families. And since they create opportunities for the rest of us, let us as a society decide to let them keep their money.” Not only will this fail, but it is immoral because using this type of argument strips the rich of the proper moral defense that is necessary for people to understand if they are ever going to be convinced that capitalism is a just system.

Just as it is in every other aspect of capitalism, it is interesting and useful to examine the reasons it is actually better for the people “as a whole” if they are secure in their property. But the positive attributes of capitalism should not be used as its defense for the reasons stated above. By titling his article “In Defense of the Rich” and then leaving out the moral, i.e., proper, defense of the rich, Dr. Skousen is promoting the downfall of that which he claims to be defending . . . . That having been said, the information contained in the article is interesting to read, but any future attempt to defend any aspect of capitalism needs to include the moral argument.

—Nicholas A. Curott
Colorado Springs, Colorado

Mark Skousen replies:

Nicholas Curott protesteth too much. I agree wholeheartedly with his moral defense of property. Everyone, rich or poor, has a right to his own wealth—to spend, invest, or even waste it as he pleases. The state has no right to tax or confiscate his property without his permission, no matter how egregious his behavior. I did not think such an elementary principle needed to be explained to readers of Ideas on Liberty.

But amoral? Give me a break. If anything, my article is all about high moral standards and how the rich have a responsibility to make money honestly and to spend it wisely. Otherwise, politicians and the media will continue to bash the rich and promote high marginal tax rates and anti-rich policies. My purpose was to debunk a long-standing myth held by the public and the media—that the rich are profligate pigs, womanizers, and “robber barons” who engage in “conspicuous consumption.” I wished to dispel the Marxist view that “behind every great fortune is a great crime.” Early critics such as Thorstein Veblen, Matthew Josephson, and Sinclair Lewis portrayed the wealthy as robber barons who smoked $100 bills, built 25-room mansions, and abandoned their families in favor of trophy wives and frivolous activities. This negative image was far from harmless. It created an age of envy and censure—and inevitably high income-tax and estate-tax rates, and attacks on big business.

My purpose in writing my column was to alert the readers to the growing evidence favoring a better image for the rich and for capitalism, and to diffuse the anti-capitalist agenda of the politicians and the media. Recent evidence from Professor Thomas Stanley and others confirms an unusual statement made by Nassau Senior, the first professor of political economy, who said in his inaugural address at Oxford in 1825, “the pursuit of wealth . . . is, to the mass of mankind, the great source of moral improvement.” Finally, in the year 2000, Professor Senior’s statement is coming true.

This is all good news, and we need to spread the word rather than to accentuate some extreme laissez-faire tenet. If indeed the wealthy are today more actively pursuing the old-fashioned virtues of frugality, modesty, and faithfulness, then the public and our legislators need to know it. They are less likely to attack the rich and engage in anti-capitalist policies. They may even encourage wealth accumulation. I’m happy to report, by the way, that my column has been reprinted around the country and been translated recently into Spanish and published in several Latin American newspapers.

Economist Paul Krugman has joined the chorus clamoring for closing the e-tax loophole. Writing in the February 12 New York Times, he likens today’s tax-free Internet to a kind of default “industrial policy” for the Digital Age. He ought to know better.

That new taxes on e-commerce are being pushed when the economy is booming, sales tax receipts have swollen, and most state government budgets are awash in black ink undercuts most of what passes for serious analysis of Internet tax policy. Indeed, the palpable absence of a budgetary justification for taxing electronic commerce suggests that the moratorium was enacted, not on the basis of principle, but rather because the tax writers in Congress have not yet figured out how to structure and administer e-taxes so as to maximize the Internet tax take—or found a politically acceptable way for the federal government to share in the loot.

Of course, the pro-tax forces contend that closing the loophole would not impose a new tax but simply eliminate existing distortions in the sales-tax code, that is, ensure that the tax laws do not favor one segment of the retail trade over another. Consumers buying products online currently enjoy the same immunity from state and local sales taxes the U.S. Supreme Court has carved out for mail-order catalog sales. The Court ruled earlier this decade that requiring retailers located in one state to collect sales taxes from consumers in another unconstitutionally burdens interstate commerce. Hence, sales taxes are due on mail-order and Internet purchases only if the retailer has a substantial “physical presence” in the customer’s state of residence. Although buyers in every state with a sales tax are obliged to report and pay “use” taxes on items purchased elsewhere, few consumers voluntarily comply.

As a result, local retailers are supposedly placed at an unfair competitive advantage relative to Internet and mail-order retailers, and including such purchases in the tax code would merely restore a level retail playing field. But the economists who support taxing the Internet to eliminate perceived distortions are living in a fiscal fantasyland. Except insofar as “reform” generates more revenue or confers benefits on key electoral constituencies, government has no interest in designing a neutral tax code, nor in benevolently broadening the tax base so that tax rates can be lowered. Rather, the flesh-and-blood politicians who function in a world light years distant from the policy prescriptions of public-finance textbooks are motivated by more narrowly self-interested objectives.

Barrier to Tax Abuse

Fiscal federalism is a stubborn constitutional barrier to the parochial politics of taxing and spending. As is the case in ordinary markets, competition among the nation’s 30,000 separate state and local tax jurisdictions helps hold tax rates down to their cost-effective minimum. If one jurisdiction imposes a sales-tax rate that is too high compared with the quantity and quality of public services those taxes help finance, its tax base will tend to shrink as businesses and consumers relocate to other jurisdictions with lower taxes, better roads and schools, or both. But moving is costly. The ability to avoid high local taxes by making purchases over the Internet or through mail-order catalogs supplies an alternative margin of competition that forces governments to be more fiscally responsible.

Access to the Internet allows every consumer to live on a “virtual border,” thereby making it economical to exploit even small differences in price. The ability to avoid high local taxes by making purchases online is particularly beneficial to low-income consumers because sales taxes are among the most regressive ways of raising revenue: poor people consume greater percentages of their incomes than those who are financially better off.

Opposition to e-taxes is not, as Krugman puts it, based on a “slash-taxes-to-starve-the-bureaucrats theory.” Tax competition instead promotes a situation in which taxes will tend to mirror interjurisdictional differences in the demands for government services. Policies that promote tax rate “harmony” make it easier for governments to ignore these heterogeneous taxpayer preferences and to levy taxes that are excessively high.

Retailer Response

Local bricks-and-mortar retailers that are placed at a competitive disadvantage by high local sales taxes do not have to stand idly by. They can get business lost to catalog sales or to the Internet back by providing services consumers value—and are willing to pay for. The opportunity to see and touch items on display, to try them on, to take advantage of product demonstrations and other point-of-sale assistance in making their selections, and to accept immediate delivery are options not available to online shoppers. Traditional retailers can also respond to Internet competition by lowering their prices so that, inclusive of sales tax, the prices they charge are equal to or less than those charged by out-of-state retailers, which normally add hefty shipping and handling charges to their customers’ orders.

That is how competition is supposed to work. When the playing field is instead leveled by forcing Internet companies to raise their prices by collecting sales taxes and remitting them to the treasury of the state where the purchaser resides, the competitive market process is short-circuited and taxpayers become more vulnerable to exploitation by big government. Paul Krugman apparently thinks that a tax-free Internet has a harmful effect on retail competition, but he ought to be more concerned with the damage done to intergovernmental competition if the loophole is closed.

—William F. Shughart II
University of Mississippi

One would expect that within a country the same pattern would be evident. Indeed it is, and now we have a comprehensive analysis that proves it: Economic Freedom in America’s 50 States by economists John Byars, Robert McCormick, and Bruce Yandle. Commissioned by the State Policy Network, an association of some three dozen state-based free-market think tanks, the report argues that “states with relatively more economic freedom enjoy higher rates of growth . . . because individuals in those states are allowed to keep more of their income, and thus the marketplace can more efficiently determine the allocation of resources.”

There are profound lessons here for state governments. Their actions and policies do make a difference in the material welfare of their citizens. People respond to incentives and disincentives, and they tend to migrate, taking their skills and capital with them, to those locales where those skills and capital are relatively safe from the depredations of high taxes and regulation. Governors and state legislators who want to accumulate power and centralize resources while proclaiming a desire to spur growth are trying to have their cake and eat it too.

Economic Freedom Defined

From the start, the report assumes a definition of “economic freedom” that comports with the ideas of classical-liberal thinkers. The individual is a sovereign entity that the state respects by minimizing its intrusions and providing for a common defense. Economic freedom is expanded when governments limit “encroachments on opportunities for individuals to engage in voluntary exchange.” It is contracted when states interfere with voluntary exchange through an array of costly impositions.

Every state provides its own “bundle” of costs and benefits. The tax burden may be low in a state at the same time the regulatory burden is high. A state may have low tax and regulatory burdens that are at least partially offset by a judicial system that encourages frivolous lawsuits or bestows abnormally large damage awards that overcompensate harmed parties and thereby exposes individuals to higher risks of property confiscation and redistribution. A relatively high level of welfare spending indicates a state is engaged in more income redistribution than others, a violation of economic freedom, and this may offset an otherwise friendly regulatory environment. In any event, the report agglomerates all this information in about as scientific a fashion as is possible.

It assembles data on more than 200 indicators, grouping the resulting measurements under five key categories: fiscal, regulatory, judicial, government size, and welfare spending. Each state is then assigned a rank, from 1 to 50. Idaho turned in the best score as the state with the greatest degree of economic freedom, while New York came in dead last. The five states with the most economic freedom (Idaho, Virginia, Utah, Wyoming, and South Dakota) boasted growth in personal income from 1990 to 1997 that was a spectacular 59 percent higher on average than the five states with the lowest levels of economic freedom (New York, Rhode Island, New Jersey, Massachusetts, and Connecticut).

Just as the human traffic around the world tends to move from the less free to the more free countries, migration patterns within the United States show similar movement. The report confirms that “people are moving into states with high levels of freedom and out of states with low freedom.” Birth rates are not markedly different from state to state, so changes in population are heavily influenced by the movement of people. The difference in population growth between the top and bottom of the freedom scale is especially dramatic: Idaho—the freest state—saw its population soar by 16.8 percent from 1990 to 1997, while New York—the least free state—barely held its own with a paltry growth rate of just 0.8 percent.

Per capita personal income in Idaho in 1996 was a low $19,539 when compared to New York’s $28,732—a fact which by itself might suggest a conclusion diametrically opposite of the report’s general finding. Having lived in Idaho in the mid-1980s, however, I can certify that $19,539 goes a lot further than the same amount of income in a high-cost-of-living state like New York. Indeed, Byars and colleagues show that residents of New York pay twice the state and local taxes than residents of Idaho: $3,858 versus $1,955.

You’re also more likely to be working if you live in Idaho rather than in New York. The unemployment rate in Idaho was 3.7 percent below the national average in 1996, while New York’s was 15 percent above. In the 1990s, both per capita income and gross state product boomed in Idaho at almost twice the respective rates of New York.

Business Incentives

The strong, positive correlation between economic freedom and economic growth that the report demonstrates has implications for the states in an increasingly controversial area of policy: “incentive” packages designed to lure businesses. Almost every state is now engaged in a tit-for-tat war of selective tax abatements and direct subsidies. For example: To attract a new factory for Ohio and prevent it from locating in neighboring Michigan, Ohio politicians may offer to forgive several years of taxes due and even give the company millions of dollars for job training and infrastructure.

The report does not directly address this form of competition among the states, but its bottom line certainly points in one particular direction. If states want to cultivate growth and prosperity, they should focus on the forest and the trees will take care of themselves. To the extent that these incentives are targeted at a few at the expense of the many, they rearrange wealth and politicize it—which works against an improvement in overall economic freedom. State governments would be better advised to reduce burdens on everyone and foster a policy of “a fair field and no favor.” Economic freedom, not political redistribution, is what makes a state—and indeed, a nation—prosper.

Byars, McCormick, and Yandle have done us a favor by proving beyond a shadow of a doubt what we all should have instinctively known. Freedom works, and more of it works even better.