In 2016, in The Hidden Wealth of Nations, UC Berkeley Associate Professor of Economics Gabriel Zucman quantified the amount of the world’s assets held in tax havens, clarified the ways large-scale tax evasion undermined global markets, and explained the connection between tax evasion and financial, budgetary and democratic crises occurring throughout the world. He argued that tax evasion can be stopped, but only if we have statistics to measure it, if we implement policies and penalties to address it, and if we monitor our progress. In his recent research, Michael Love has made important progress in measuring the flow of partnership income to tax havens and monitoring the effects of the Foreign Account Tax Compliance Act (FATCA) in improving reporting and compliance by U.S. investors.
While a number of scholars, including Ed Kleinbard, have catalogued efforts to exploit gaps and mismatches between different countries' tax systems, and others, such as Kim Clausing, have quantified the tax base erosion effects of profit-shifting by multinational corporations, Love’s article is the first to trace empirically the flows of partnership income to tax havens. U.S. partnerships and most foreign partnerships with U.S. source income or income from U.S. trades or businesses are required to file an information return for the partnership (Form 1065) and for each partner (Schedule K-1) that reflects each partner's distributive share of partnership income, gain, loss, deduction and credit. Love builds on the prior work of Michael Cooper, with the U.S. Department of Treasury, to match data from partnership information returns to other federal tax and information returns using masked Taxpayer Identification Numbers (TINs) for the period from 2009 to 2019. He also developed algorithms to infer, from the non-identifying information on the K-1, whether the partner is an individual or a business entity and the type of entity, whether the partner is domestic or foreign, and the country of the partner’s address. Error testing suggests that the inferences are extremely accurate. Together these techniques allow Love to describe the recipients of over 99% of the partnership income flows by type, U.S. domestic or foreign status, and country.
Love concludes that the amount of partnership income flowing to foreign investors between 2011 and 2019 is 17%, twice the level of previous estimates. Most of this income, $1.2 trillion (approximately 10% of all income flowing to owners of partnerships), is flowing to tax havens. Most of the income flows to “zero corporate tax” jurisdictions, such as the Cayman Islands ($500 billion), the British Virgin Islands, and Channel Islands ($240 billion). Other low-tax jurisdictions, such as the Netherlands and Switzerland, that help move profits from low and zero-tax jurisdictions back to larger economies, account for $250 billion in partnership income for this period. Finally, jurisdictions whose main distinction is their secrecy have received $180 billion. While most of this income was generated in the United States, very little of it has been subject to U.S. tax.
Love’s research also confirms that the expansion of reporting and withholding requirements in 2010 under FATCA have been effective In boosting reporting of income and reducing tax evasion by U.S. investors. FATCA imposed new reporting requirements for “foreign financial institutions,” which includes banks, broker-dealers, retirement fund custodians, and investment, private equity and venture capital funds, on pain of a 30% withholding tax on a range of payments. Love indicates that FATCA has been effective not only in improving information on outbound flows and foreign financial assets, but in increasing the likelihood that tax authorities may identify when taxpayers are underreporting their incomes. He also confirms that new rules on the taxation of dividend equivalent payments, under IRC §871(m), have prompted a sharp increase in reporting and a reduction in the use of swap agreements to trade U.S. dividends that are subject to tax, for foreign payments that are not subject to tax.
Love finds that financial investment firms are driving these flows. Investment firms use partnerships to allocate different types of income to different partners and corporate blocker entities to limit reporting requirements, to shield foreign investors from the estate tax, and to shield tax-exempt entities from unrelated business taxable income. The firms also structure investments to generate the types of passive income that can avoid U.S. withholding on outbound flows.
Love argues that more empirical research and policy analysis are needed to determine whether the appropriate response would be to terminate the tax exclusions that make these tax haven arrangements possible, such as the trading safe harbor and the portfolio interest exemption. These provisions were enacted with the goal of encouraging foreign investments within the U.S. While the rules may reduce borrowing costs for American households, businesses, and government and provide capital for new enterprise, they have also facilitated the shift of tax burdens to American taxpayers.
Love’s research also adds to the body of evidence that, at this stage, the financial sector is not so much creating value as extracting value. In The Value of Everything, University College London Professor of Economics Mariana Mazzucato details several pathways by which the financial sector has been engaged in rent-seeking rather than value creation: (i) through high charges relative to risk (which is largely borne by U.S. taxpayers), (ii) through the exercise of monopoly power (via patent extensions among other things), and (iii) through the insertion of a transaction cost wedge between those who receive finance and those who provide it. To that list we should probably add facilitation of tax avoidance and evasion that generate deadweight loss to the economy and increase burdens for American taxpayers.