The Hidden Wealth of Nations

by Gabriel Zucman

  The fundamental problem is that authorities have no means to verify that offshore bankers are respecting the spirit—or the letter—of international regulations. All the steps being taken today and the plans devised for the future are based on the idea that we can trust bankers to carry out their obligations. However, this belief is, to say the least, problematic. Many financiers in Switzerland and the Cayman Islands—a majority perhaps?—are honest people and will abide by the new law. But some may not. For decades, after all, bankers in Switzerland and elsewhere have been hiding their clients behind shell companies, smuggling diamonds in toothpaste tubes, handing bank statements concealed in sports magazine, all of this in violation of the law and the banks’ stated policies. More than a handful rogue employees were involved: in 2008 over 1,800 Credit Suisse bankers were servicing Swiss accounts for US customers.23 Some became enormously wealthy by doing so.

  To ensure that bankers apply FATCA in practice, the American tax authorities rely on the denunciations of informers, to whom they promise fortunes. The IRS, for example, signed a check for $104 million to the ex-banker of the UBS, Bradley Birkenfeld, who revealed the practices of his former employer. But one may well doubt the effectiveness of this strategy. True, large organizations are today more than ever before at the mercy of information leaks, but whistle-blowing by rational (or moral) employees is less likely to occur in small firms than in big ones. If tax-evasion activities move to small boutique banks, shielded from US outreach, then enforcement might prove increasingly hard. To rely exclusively on whistle-blowers to fight against tax havens is not strong policy.

  Even some large banks may straggle in a way that hinders enforcement, if they believe they are “too big to indict”—that is, they believe that regulators will hesitate to charge them because it might pose a danger to financial stability. In 2012 US authorities decided against indicting HSBC despite evidence that the bank enabled Mexican drug cartels to move money through its American subsidiaries, in violation of basic anti-money-laundering regulations. Instead, the bank was fined $1.92 billion, which pales in comparison to HSBC’s pretax profits of $22.6 billion in 2013. And despite its guilty plea, Credit Suisse was able to keep its US banking license.

  The final source of concern is that the largest international experiment in an automatic exchange of information most similar to FATCA, the EU savings tax directive, was a fiasco because it didn’t include any measures for constraint, for fighting against opacity, or for verification. If we don’t learn from all these lessons derived from experience, there is every reason to fear that the disaster will be repeated in the same way. This EU experiment therefore deserves a closer look.

  The Lessons of the Savings Tax Directive

  The savings tax directive was the star initiative of the European Union to fight against offshore tax evasion. By virtue of this directive, which has been applied since July 1, 2005, when a French resident, for example, earns interest on his English account, the United Kingdom automatically informs the French tax authority. In principle, this should make all fraud impossible. The savings tax directive could have been a great success, and in its time, it raised many hopes; but, in fact, it has been a great disappointment, due to three core mistakes.

  First, although the directive is an EU-wide policy, not all European countries participate in it on an equal footing: Luxembourg and Austria were granted favorable terms. Those countries—the two EU tax havens for wealth management—do not have to automatically send information to the other member states (although this will hopefully change by 2018). This was the original sin: the exemptions accorded to Luxembourg and Austria have paralyzed the European struggle against tax havens for close to a decade. The EU had no credibility for imposing automatic exchanges on Switzerland and other non-European havens, since it is was not even capable of applying them to its own countries; in return, Luxembourg could give as justification the persistence of banking secrecy in Switzerland to block any revision of the savings tax directive. Seeing the large EU countries capitulate before such obvious maneuvering for years and years is the tragedy of the European construction.

  Instead of an exchange of information, Luxembourg and Austria apply a withholding tax: Luxembourg banks must tax at 35% the interest earned by French residents on their accounts there. Three-quarters of this tax is then sent to France. Thirty-five percent is less than the top marginal income tax rate in force in France: oddly enough, the holders of hidden accounts thus find themselves having the “right” to pay less tax than honest taxpayers. An identical tax is applied in most of the tax havens outside the European Union—with the exception of Singapore and Hong Kong, but including Switzerland—who have signed agreements with the EU to have the same rules as Austria and Luxembourg applied.

  The fixed tax (35% regardless of the income or the wealth of the taxpayer) makes little sense. There is no reason to tax at the same rate income from a million Euros and that from a few hundred. And it violates the fiscal sovereignty of EU countries that can no longer choose the rate at which they wish to tax the interest of their residents. Tax havens, primarily Luxembourg, are the first to defend the right of each country to choose its tax rate; they are also the first to flout this principle on a daily basis.

  The second defect of the EU savings tax directive is the most serious: the concession of a fixed tax of 35% doesn’t even work. The directive in fact applies only to accounts held in the name of the owners, not to those held through the intermediary of shell corporations, trusts, or foundations. The Swiss tax administration explained this candidly to Swiss banks, in a memo regarding the agreement passed with the EU for the application of the directive on its territory: “Interest payments to legal entities do not fall within the scope of the agreement” (paragraph 29).24 But what is a “legal entity”? The response is in paragraph 31, which provides a “partial” inventory of them: companies in the Cayman Islands, those of the Virgin Islands, trusts and companies in the Bahamas, companies and foundations in Panama, trusts, holdings, and foundations in Liechtenstein, and so on.

  At least this is clear! Owners of Swiss or Luxembourg accounts have only to transfer their assets to any shell structure to escape the fixed tax of 35%. Creating shell companies costs a few hundred dollars and is done in just a few minutes.

  But there is a final loophole. The directive only applies to interest income, not to dividends. Why? This is a mystery. There is no valid economic reason to treat these two categories of income differently. As we have seen, wealthy households do not turn to tax havens to let their money sleep in accounts that earn little interest. Close to two-thirds of their assets are invested in stocks and shares of mutual funds that pay dividends. In other words, from the onset, the directive arbitrarily excludes most dissimulated wealth from its realm of influence. Fortunately, FATCA and similar laws that will enter into force by the end of this decade are much broader in scope: they include all types of capital-income payments, including dividends, capital gains, and insurance payments. One should not, however, underestimate the ingenuity of bankers when it comes to dodging regulations: using derivatives, some might be well able to generate income falling outside the scope of FATCA. Only time will tell.

  Fifteen years of negotiations in Europe—the first discussions began at the beginning of the 1990s—to end with this: a directive filled with holes that shows absolutely no serious will to fight against financial dissimulation. Was it from lethargy that the European authorities agreed to exclude shell corporations from the perimeter of the savings tax directive? Was it incompetence? Complicity? We don’t know. The sociology of this embarrassing episode remains to be written. In the meantime, we can at least investigate its economic effects.

  Not surprisingly, the main effect of the savings tax directive has been to encourage Europeans who hadn’t already done so to transfer their wealth to shell corporations, trusts, and foundations. This occurred on a massive scale in Switzerland, the country for which we have the best statistics (see fig. 5). At the
end of 2004, right before the directive was put into effect, 50% of the accounts in Switzerland already “belonged” on paper to shell companies and 25% to Europeans in their own names. At the end of 2005, six months after the introduction of the 35% withholding tax, Europeans “possessed” only 15% of the accounts (−10%), and shell corporations 60% (+10%). It only took a few mouse clicks, a few pieces of paper printed in Geneva and Zurich, to transfer the ownership of tens of billions of dollars to trusts in the Virgin Islands or to Liechtenstein foundations. The creation of these structures takes place right in Switzerland, in the banks, trusts, and wealth-management offices. Nothing happens in the Virgin Islands. Swiss bankers have deliberately, and on a large scale, torpedoed the savings tax directive.

  Figure 5: Who holds accounts in Switzerland? The effect of the 2005 savings tax directive.

  Source: BNS (see online appendix to chapter 3, www.gabriel-zucman.eu).

  If all the interest and dividends earned in Switzerland by residents of the European Union were indeed subject to a tax of 35%, this tax would earn on the order of €20 billion per year. In 2012 Switzerland paid €300 million to the EU, about sixty times less. This theft goes on and on, year after year, apparently without really troubling either Swiss bankers, who today depict themselves as paragons of virtue, or European politicians, who like to congratulate themselves on their great determination in fighting tax evasion.

  The lack of sanctions for nonparticipating havens, dissimulation through shell corporations, and the blind faith in bankers made the directive fail. Without heeding the lessons from this episode, there is a real chance that they will do the same with the FATCA and similar laws. Most tax havens have promised to proceed to automatic information exchanges in 2017–18, but as the former prime minister of Luxembourg (now president of the European Commission) Jean-Claude Juncker candidly admitted: “The lights are not going to go out in banks” of offshore centers like the Grand Duchy for all that; defrauders may remain protected by their trusts and other empty shells.25 Sanctions are not mentioned anywhere nor is verification. How can we think today—in light of what happened in 2005 and the UBS and Credit Suisse cases in the United States—that Swiss bankers will cooperate of their own free will, in good faith? It is high time we wake up to reality.

  FOUR

  What to Do?: A New Approach

  To fight offshore tax evasion effectively, we need a set of coherent and focused measures: concrete sanctions proportional to the costs imposed by uncooperative tax havens to other countries and an international financial register.

  Financial and Commercial Sanctions

  First, there must be constraints. The tax havens that assist defrauders themselves derive substantial, sometimes huge profit from their activities. In some microstates, most of government revenue derives from fees levied on the incorporation of shell companies, trusts, and similar arrangements. Thanks to financial secrecy, others manage to attract real activity—such as bank offices, audit firms, and law firms—generating employment, profits, and taxes at the expense of their neighbors. For the most successful havens, the profits are political. Luxembourg is a case in point: the outsize role played by the tiny Grand Duchy in world financial markets has directly benefited its political elite for decades, enabling some of its members to occupy key positions in European institutions. If they have nothing to lose by continuing to attract tax dodgers, it is likely at least some tax havens and their elite will continue this lucrative business. Concrete threats, on the other hand, have the potential to make them bend.

  An illustration of this is the blockade that France imposed on Monaco in 1962. At that time, French citizens who were living in the principality paid no tax on their income. The French government wanted to put an end to this situation, but Prince Rainier was firm: there would be no question of challenging the fiscal sovereignty of Monaco. France could have stopped there and, after endless summit discussions, given in to the demands of the microstate—as the large countries of Europe have done for years with Luxembourg. But de Gaulle would not budge. On the night of October 12–13, 1962, he sent customs officers to rebuild the border between France and Monaco. The message was clear: if it didn’t cooperate, Monaco would be cut off from the world. And the results were immediate—since 1963 French people who live in Monaco are subject to the same fiscal laws as those who live in France proper.

  There are several important differences between the current situation and that of 1962, but what is clear is that the ratio of strength is eminently in favor of the large countries, not of the microstates that have specialized in services of financial opacity and in helping defrauders.

  In concrete terms, how can they be induced to cooperate? A simple solution consists of following and expanding the US approach with FATCA—that is, taxing the interest and dividends paid to those countries, in an effort coordinated between the United States, Europe, and other G20 economies. Some countries have already been imposing taxes similar to those introduced by the recent American legislation, but they are very limited in scope. For example, France currently imposes a tax of 50% on the income that leaves the country in the direction of what it considers to be “noncooperative territories,” meaning Botswana, Brunei, Guatemala, the Marshall Islands, Montserrat, Nauru, the Island of Niue, and the British Virgin Islands. Unfortunately, lists of noncooperative territories (the OECD, the IMF, and the G20 all have had one at some point) always end up including only a number of small, unpopulated havens—like in the French case—disregarding the places where the bulk of tax fraud takes place. It is high time for G20 countries to emulate the US approach and impose systematic penalties for noncompliance.

  As the recent work of the OECD on automatic information exchange shows, sanctions are not always necessary: diplomacy can go a long way in securing formal commitments. But not all tax havens are on board; and in the absence of well-defined penalties, history suggests that formal commitments may not translate into real change: threats may be necessary to foster effective cooperation.

  Although financial sanctions are appealing and simple to implement, they face a potential obstacle: they can be easily circumvented. A bank that does not want to comply with FATCA could use FATCA-compliant intermediaries to continue investing in the United States without facing the 30% US withholding tax. The US law contains provisions to prevent this scenario, but the opacity of financial intermediation chains (largely because of the absence of financial registers) is such that these provisions may well not be enough.

  An alternative approach to withholding taxes consists of acting on the level of the trade of goods and services, which are currently more traceable than financial transactions. Tax havens cannot, in fact, do without commercial avenues. For the United States and Japan, exports represent a total of only 15% of their GDP. But they weigh in at 50% of Switzerland’s GDP and up to 200% in Luxembourg, Singapore, and Hong Kong, the three countries that hold the world record in exports. Granted, these spectacular percentages are artificially inflated by companies’ practices of fiscal optimization, as well as by entrepôt trade in countries such as Hong Kong, a territory through which flows a large part of the imports and exports from China. In spite of all this, the percentages also correspond to a basic reality: the crucial nature of international trade in the economies of small countries. In a small, introverted economy, producers have access only to a restricted market and cannot easily specialize. Only access to world commerce enables them to achieve an increase in profits, to increase a division of labor, and, ultimately, to achieve levels of productivity found in large countries. Without access to foreign markets, tax havens are condemned to die.

  Justified and Realistic Sanctions

  Imposing trade tariffs on uncooperative tax havens is well-founded in economic reasoning. Each year financial secrecy—the lack of effective exchange of information between offshore banks and foreign authorities—deprives governments around the world of about $200 billion. It’s important to understand that we’re not talking ab
out tax competition, but of theft pure and simple: Switzerland, Luxembourg, or the Cayman Islands offer some taxpayers who wish to do so the possibility of stealing from their governments. It is their choice, but there is no reason that the United States, Europe, or developing countries should pay the price for it. Financial secrecy—like greenhouse gas emissions—has a costly impact on the entire world, which tax havens choose to ignore. In economic lingo, it is a matter of negative externality. The solution to this problem was proposed in the work of the English economist Arthur Pigou a century ago: it is a tax equal to the losses incurred by foreign countries.

  In other terms, zero or limited cooperation is a disguised form of subvention. It gives offshore financial institutions a competitive advantage, just as the absence of environmental protections allows polluting companies to be more competitive. Now, these forms of hidden subvention inhibit the good functioning of markets. This is precisely one of the missions of the World Trade Organization, to discourage disloyal practices of this type, by authorizing countries who are victims of it to impose supplemental customs duties to compensate for the losses they incur.

  The problem with this type of approach is that it is difficult to quantify the exact cost of anti-competitive practices. That is why it is important to measure hidden wealth and the loss in tax revenue that it creates. The estimates that this book proposes provide a start, because they are based on official statistics and verifiable calculations. The tax havens that feel wronged are free to produce their own estimates—under the condition, of course, that they are consistent with the available data, in particular with the gaping statistical anomalies in the portfolio positions of countries.