The Hidden Wealth of Nations

by Gabriel Zucman

  Trade tariffs are also realistic because, even though the main offshore centers are financial giants, they are not great commercial powers. Granted, there are two risks in this approach. First, that of escalation: Switzerland might react to French tariffs, for example, by increasing its own customs duties or by closing its borders to tourists or cross-border workers. No one would gain from such a commercial war. But there is a way to avoid this: create a coalition of countries strong enough so that Bern would have no interest in playing that game. It is conceivable that Switzerland might want to retaliate against France, but certainly not against the main European powers combined, because that would certainly mean its ruin.26

  The second risk is that commercial sanctions might not be enough. Hong Kong, for example, might prefer to endure French tariffs—even prohibitive ones—rather than abandon its financial secrecy. The solution, again, is to create an international coalition that includes countries that weigh heavily in Hong Kong’s foreign trade.

  This, then, is the essential difference with the Monaco episode of 1962: alone, countries like France cannot achieve very much. Only combined international pressure can truly have an impact. The solution exists nevertheless: coalitions of countries can make the principal tax havens bend by imposing trade tariffs equal to the cost of financial secrecy.

  A Plan for Customs Tariffs

  Concretely, what do winning coalitions look like? There is a trade-off: small coalitions are easier to form, but there is a higher risk that tax havens will play the escalation game. By contrast, in a large coalition the risk of commercial war is small, but alliances of this type are more difficult to form. In practice, exports from the main offshore centers are quite concentrated on a limited number of partners, so that it would be enough for a handful of countries to join together for uncooperative territories to endure very high losses, without, however, daring to launch retaliations. The optimal coalitions are thus small and therefore easy to form.

  Let’s take the example of Switzerland—the argument applies similarly to Dubai, Macau, or any other country that might be tempted to do in the twenty-first century what Switzerland pioneered in the twentieth, namely, helping defrauders evade their home countries’ laws. Germany, France, and Italy represent about 35% of Switzerland’s exports, but for them Switzerland is only a small client (scarcely 5% of their exports): any commercial war would mathematically end up with the defeat of Bern. Thus this would be a coalition against which Switzerland would have no interest in putting up resistance.

  What customs duties should be imposed? By definition, the only justifiable tariff from the point of view of the WTO is the one that enables the recovery of the costs of financial secrecy. Following this logic, and according to my calculations, Germany, France, and Italy have the right to impose a tariff of 30% on the goods they import from Switzerland. As we saw in chapter 1, these three countries have a total of around €500 billion in Swiss banks, of which about 80% still evades taxes today. This represents a loss of fiscal revenue of around €15 billion (tax on income, on inheritance, and, in the case of France, wealth tax). And €15 billion is the sum it is possible to recover with a tariff of 30% on goods coming from Switzerland.

  There are two remarks to be made on these figures. First, the loss of revenue due to financial secrecy is estimated a minima, because it doesn’t include the cost of tax reductions that governments have had to agree to for fear that their taxpayers will hide their wealth in Switzerland. Now, these costs are significant, especially in Italy, the country that has gone the farthest in lowering taxes on financial capital. Dividends there today are taxed at only 20% (much lower than labor income), inheritances are almost exonerated, and the belief that it is impossible to tax financial wealth is so widespread that only real estate holdings have been affected by the latest tax increase—a policy that, moreover, led to the defeat of Mario Monti in the 2013 elections. Let’s prefer cautious calculations of loss, however, because then there can be no reason for them to be contested before the WTO.

  A second remark: in any calculation of optimal customs duties, there is a margin of error, because we never know what exactly will be the reaction of exporters and importers, as it depends on many parameters. But a likely scenario might look like this: should a tariff be imposed, French customers would stop purchasing Swiss products unless the after-tax prices of these products remain unchanged, those prices being determined on a global level. So Swiss producers would have to sell less and cut their pretax price: instead of exporting, as they currently do, €60 billion worth of goods to France, Germany, and Italy—primarily chemical products, machines, and watches—they would sell no more than €45 billion worth, which, after paying the tariff of 30%, would correspond to an unchanged invoice of around €60 billion for the importers. And so there would be a decrease of €15 billion in national income for Switzerland and a corresponding increase for the three border countries.

  In all likelihood, a loss of €15 billion would be enough to force Switzerland to cooperate truthfully, because it is a sum comparable to what it earns in total by managing the wealth of tax evaders. According to official statistics, the financial sector represents around 11% of Switzerland’s GDP. But private wealth-management activities strictly speaking account for only 4%. The rest corresponds to the activity of insurers and other banking businesses, loans, proprietary trading, and so on. Furthermore, the wealth managed by Swiss banks is not all hidden—that of the Swiss is for the most part indeed declared—so that tax evasion scarcely brings in more than 3% of the GDP (around 1% of the total amount of undeclared assets managed by the banks), or €15 billion per year. This is an appreciable, but not vital, contribution: contrary to a common notion, Switzerland does not live off of financial opacity (unlike some microstates), and it would do very well if it completely disappeared.

  There is, of course, uncertainty about what exactly Switzerland earns, and 3% of the GDP is conservative, in particular because the wealth of defrauders involves activity in places other than in banks’ departments of wealth management. But the important point is that tax evasion earns Switzerland much less than what it costs the countries that are victims of it. If Swiss banks were the only ones in the world to provide services of tax evasion, they could in principle raise their commissions and earn the equivalent of all, or almost all, of the tax evaded by their clients. But they are no longer a monopoly and cannot charge the exorbitant commissions they did in the 1960s.

  If the customs duties of 30% proved ineffective (for example, due to the political influence of Swiss bankers), it would be enough to enlarge the coalition to other countries: by including the United Kingdom, Spain, and Belgium, losses for Switzerland would reach 4% of the GDP; with the entire European Union, 5%. The more governments in the coalition, the greater are the chances for success. But the good news is that all it would take is a small group (France, Germany, and Italy, or the United Kingdom) to force the full cooperation of Swiss banks and authorities.

  This must be stated clearly: the goal of commercial sanctions is to force tax havens to cooperate, not to establish protectionism. We’re talking about threats to agitate, which ideally will never have to be applied. Customs duties of 30% have never lastingly profited anyone. In the long term, free exchange benefits all nations and protectionism is to be avoided. But quite simply, we can no longer continue to liberalize trade while completely ignoring the problems of fiscal dissimulation. Those problems must be placed at the heart of discussions on trade. Since tariffs/sanctions are realistic and proportional, they are credible and, therefore, in principle they will not need to be applied. But if discussions aren’t enough, they should be put into effect.

  In any event, there is no progress possible without specific threats. The great majority of Swiss citizens and Swiss companies have nothing to lose with full financial transparency and would certainly prefer that offshore tax evasion disappears rather than see their country regularly singled out. But bankers have a political influence th
at far exceeds their true economic weight, so that, without threats of reprisals, there is good reason to fear that they will succeed in maintaining a form of status quo—for instance, abandoning a portion of their clientele, those who do not have the means to hide assets in trusts, while at the same time concentrating on the greatest wealth.

  The same approach would lead to the cooperation of other large centers. In all cases, the large countries can legally make the giants of offshore banking bend, using relatively small coalitions.

  The Case of Luxembourg

  One country poses a problem, however, because it is protected from trade tariffs through European treaties: Luxembourg. Should it be excluded from the EU? The question deserves to be asked, because the Luxembourg that cofounded the Union in 1957 has nothing to do with the Luxembourg of today. Steel was everything back then; finance was nothing. Today, without its financial industry, the Grand Duchy would be nothing; tomorrow, offshore finance may be everything (see fig. 6). It is the tax haven of all tax havens, present in all stages of the circuit of international wealth management, used by all other financial centers.

  Figure 6: Luxembourg: From steel to Clearstream (% of GDP).

  Source: Statec (see online appendix to chapter 4, www.gabriel-zucman.eu).

  The signatories of the Treaty of Rome could not have envisioned the possibility of such an upheaval when they established the bases of European institutions. For them, Luxembourg was an old nation, the heir of a member state of the Germanic Holy Roman Empire since 1000, which had been a resolute proponent of the European dream. Today the trap has shut. An economic colony of the international financial industry, Luxembourg is at the heart of European tax evasion and has paralyzed the struggle against this scourge for decades.

  This great transformation deserves to be recounted, if we wish to find a rational way to remedy it. First, it is important to understand that Luxembourg does not owe the success of its conversion to its so-called stability or its highly qualified labor force, as its proponents claim. In reality, inflation there has been almost as high as in France since the 1970s and much higher than in Germany. Economic activity fluctuates violently depending on the jolts of international finance: between 2007 and 2009, the GDP per worker was lowered by 10% (as opposed to 2% in France); it has not gone up much since. The only stability is that of power: since 1783 the reigning family, the Nassaus, has transferred from one branch of the family to another the title of grand duke; the Christian Social People’s Party has provided the prime minister since the end of the Second World War, with the exception of a short period of five years at the end of the 1970s and of the government elected in 2013. As for the national labor force, it is aging and has nothing unique to sell: not steel, not ancestral tradition for wealth management as in Switzerland, nor prestigious university diplomas as in Great Britain.

  If Luxembourg has succeeded in becoming one of the foremost financial centers in the world, it has been by commercializing its own sovereignty.27 Starting in the 1970s, the government initiated an unheard-of enterprise: the sale to multinationals throughout the world of the right to decide their own rate of taxation, regulatory constraints, and legal obligations for themselves. There were many who saw the advantage of this new type of trade. Does a large bank want to create an investment fund for its clients? Let it set it up in the Grand Duchy; the government imposes no taxes. Does the same bank wish to sell new stocks to strengthen its capital and satisfy the demands of regulators? In Luxembourg it can issue “hybrid” securities: stocks for the supervisors but bonds for the tax authority—the income paid will be deductible from the corporate income tax. In the fall of 2014, a consortium of investigative journalists revealed a large number of discretionary deals signed by the Luxembourg tax authority with multinational companies from all over the world, granting them low or zero effective tax rates on their profits.

  The trade of sovereignty knows no limits. Everything is bought; everything is negotiable. It has attracted thousands of investment funds, the holdings of multinational groups, shell companies, and private banks. The installation of companies, in turn, has brought workers in finance, auditing, and consulting. There are currently more than 150,000 people who cross the border twice every day, half from France, a quarter each from Belgium and Germany.

  Luxembourg is not the only country that has sold its sovereignty, far from it. Many microstates have given in to the temptation. But it is the one that has gone the furthest. In 2013 one-third of the production of the Grand Duchy was used to pay the salaries of cross-border workers and, above all, the income owed to the foreign owners of banks, investment funds, and holdings. The GNP thus represents only two-thirds of the GDP: after the deduction of the net primary income paid to the rest of the world—salaries, dividends, and interest—the GDP of Luxembourg is reduced by a third.

  This situation is unique in the world and in history: no independent nation, no matter how small and open to international trade, has ever paid such a share of its income abroad. A single territory today comes close to rivaling the Grand Duchy in this regard: Puerto Rico. The archipelago of the Caribbean, with close to 4 million inhabitants, is a tax haven sought after by multinationals, notably drug companies. All, or almost all, of the capital there is held by Americans, who hire the local population; all profits return to Uncle Sam. The difference with Luxembourg is that Puerto Rico is not an independent nation. The US Congress imposes most of the laws there, but the local population does not have American citizenship. It cannot elect a senator, a representative, or the president of the United States.

  Imagine an ocean platform where the inhabitants would meet during the day to produce and trade, free of any law or any tax, before being teleported in the evening back home to their families on the mainland. No one would dream of considering such a place, where 100% of its production is sent abroad, as a nation. What is a nation, what is a platform? We don’t know where to set the limit, but a threshold of 50% of its production, which Luxembourg is approaching and which it could reach by 2020, is not unreasonable.

  Is Luxembourg In or Out?

  Let’s be clear: if Luxembourg is no longer a nation, it no longer has a place in the European Union. At the Council of the European Union (which gathers together the ministers of the member states) and the European Council (where the heads of state and government determine strategic goals), each country, however small, can make its voice heard. But nothing in the treaties, in the spirit of European construction or in democratic reasoning, justifies allowing an offshore platform for the global financial industry to have a voice equal to that of other countries. And this especially since the Grand Duchy, like every member state, has extensive blocking capabilities. In the Council of the European Union, each country has a right to veto proposals related to taxation, social policy, and foreign affairs. In the European Council, decisions are made unanimously. In both these institutions where most power is exercised, the representative of the 500,000 inhabitants of Luxembourg can impose his will on 500 million Europeans. Will we ever discover all the obstructions and compromises imposed by him? Undoubtedly not, because the deliberations of the European Council (and certain meetings of finance ministers) are held in secret, about which the prime minister from Luxembourg publicly congratulated himself, by the way.

  The other problem raised by Luxembourg in its current form belonging to the EU is the threat that it represents to the financial stability of the Union. Because the economic model of the Grand Duchy is based on a hypertrophic financial sector, it is not viable and risks ending in catastrophe, as happened in Ireland or Cyprus, with a costly bailout as a result. It is also a model that, contrary to popular belief, has not benefited the local population. The GDP per worker has grown by only 1.4% per year since 1970, a very mediocre result that places Luxembourg at the back of the line of developed countries.

  Inequality among the inhabitants, on the other hand, has taken off. Salaries in the offshore sector have exploded, in particular in judicial and bu
siness consulting activities. In the manufacturing industry, construction, or transportation, workers have not benefited from any gain in purchasing power for twenty years and have seen their relative position collapse. Since 1980 the poverty rate has doubled; housing prices have tripled. Luxembourg City—with 100,000 inhabitants, granted, green, and fortified, but of frankly limited attraction—is today as expensive as London. The country is cut in two: bankers, lawyers, and accountants live in opulence, while the rest of the population suffers an accelerated decline. And those excluded from the world of finance should not count very much on school: educational performance, according to PISA (Programme for International Student Assessment) surveys, is among the worst of the countries of the OECD and scholastic inequalities among the highest.

  If we wish to prevent the Irish and Cypriot catastrophes from happening again, it is essential that Luxembourg go backward. The simplest solution is full and complete cooperation with foreign countries to stop fraud and put an end to the fiscal optimization of large companies. This operation of transparency will cost the Grand Duchy a lot (at least 30% of the GDP), because the financial sector in Luxembourg literally lives off of the accounting manipulation of multinationals and the fraud of individuals, not only from financial secrecy, which brings in close to 10% of the GDP, but above all because a large portion of the money held in Switzerland and elsewhere is recycled through its investment funds. Unless Luxembourg cooperates, the threat to be made is clear: exclusion from the EU, followed by a financial and trade embargo by the three bordering countries.