Morriss: The Impact Of International Financial Centers

Andrew P. Morriss (Texas A&M; Google Scholar), The Impact of International Financial Centers (Aug. 27, 2024), in Defending Globalization: Economics (Cato Institute):

Just as there is a global market for cell phones and wheat, there is also a global market for law. That may seem strange to many people, since they don’t think about buying law the same way they think about buying goods and other types of services, but law is as much the subject of a global market as those are. Indeed, many things we do in day-to-day life include laws from outside the communities where we live and work. If you have a credit card, you’ve likely agreed that the law of a state other than the one you live in governs any disputes that you have with the bank that issued it (often South Dakota). If you own stock in a Fortune 500 company, your rights as a shareholder are likely governed by Delaware law, where most large US public companies are incorporated. If your 401(k) plan includes a fund that invests in corporate bonds, the fund’s rights (and so yours) are likely governed by New York law.

Foreign legal systems probably affect your life as well. Many hospitals in the United States are insured through insurance companies incorporated in the Cayman Islands, a British Overseas Territory in the Caribbean that is better known to most people for its beaches and scuba diving than for providing insurance to health care providers. The extended warranty you bought on an appliance could be funded through a Turks & Caicos Islands company, another British Overseas Territory. And any insurance policy you buy from a US insurer is likely reinsured through a Bermuda-based (yet another British Overseas Territory!) reinsurer.

All of these are examples of the results of jurisdictional competition, which is the competition among jurisdictions to persuade people to bring legal business to them. The international version of this competition is little different from the domestic American version. In our federal system, states compete for economic activities by offering legal and business environments to attract entrepreneurs. Attractions include business courts (to speed resolution of disputes), business entities laws that cut the transaction costs of creating new businesses, low taxes, better infrastructure, and dozens more features of a business climate that are calculated to appeal to entrepreneurs. The main difference between the international competition for business and the domestic one is that in the former case, jurisdictions are primarily competing through their legal systems for the legal residence of businesses, while in the latter, states are trying to secure a physical presence of employers.

Many of the jurisdictions that are internationally successful in this the law market are small ones with some affiliation (past or present) with the United Kingdom. These jurisdictions are variously called “tax havens” (a term that was originally meant to conjure up a refuge from taxes, but became a slur intended to suggest they were cheating other places out of tax revenue); “offshore financial centers” (since many are islands); and, now, “international financial centers.” Depending on how you count, there are two to four dozen successful IFCs around the world, including independent countries such as the Bahamas, Liechtenstein, Malta, and Mauritius; territories affiliated with Britain, such as Bermuda, the Cayman Islands, Gibraltar, Guernsey, Jersey, and the Isle of Man; and the Cook Islands, which are in free association with New Zealand. As this partial list suggests, IFCs are present around the globe. What exactly do they do?

What Is an IFC?
Liechtenstein was arguably the first intentional IFC. In the 1920s it took advantage of its geographical position near the successor countries to the former Austro-Hungarian Empire to pass a groundbreaking business entities law (the Law on Persons and Companies, or “the PGR,” from its German initials [Personen- und Gesellschaftsrecht]). Wilhelm Beck, an entrepreneurial lawyer and politician, saw an opportunity for the tiny country to offer a neutral home for the many business organizations that the dissolution of the empire had turned from single-country firms into multinationals, with their operations now spread across multiple new countries. The PGR turned what had been an economic backwater into a successful financial center. In the Western Hemisphere, during the 1920s and 1930s, the Bahamas, Bermuda, and Panama each took tentative steps to develop businesses built around persuading foreigners to use business entities and trusts formed under their laws to organize international businesses. It was not until the 1950s and the 1960s, however, that the IFC business really took off, with Barbados, Bermuda, the Cayman Islands, and Curaçao joining the pioneers in the Western Hemisphere and Guernsey, the Isle of Man, and Jersey joining Liechtenstein in Europe in taking explicit steps to develop into IFCs.

At its most basic, an IFC is a jurisdiction that provides laws and regulations to govern individuals and businesses that operate outside the jurisdiction. Indeed, many early IFC were explicit that to make use of their laws without complying with all the rules and regulations (and taxes) applicable to local businesses, no business could be done within the IFC’s borders. Curaçao, for example, applied its normal business tax rates (24 percent to 30 percent) to only 10 percent of an international business’ profits, reducing the effective rate to 2.4 percent to 3 percent. IFCs have grown with post–World War II globalization. Not only did rapidly falling communications and transportation costs enable these small jurisdictions to serve customers around the world, but increasing capital flows and the development of global capital markets such as the Eurodollar market that took off in the 1960s created an increasing demand for their services. ...

Are IFCs Stealing American Tax Revenue?
Groups such as the Tax Justice Network (TJN) often argue that IFCs are responsible for massive losses of tax revenue by governments around the world. For example, in 2023 the TJN claimed that countries lose $480 billion a year due to financial transactions involving IFCs. Most of this ($311 billion) is due to corporate tax losses; the remainder comes from offshore tax abuse by wealthy individuals. And most of the alleged revenue losses ($433 billion) are from developed countries; the US alone is estimated to lose almost $140 billion. The Tax Justice Network is not alone in creating such estimates. The International Monetary Fund and the United Nations make similar claims, although based on different methodologies. How credible are these claims?

Not very. For example, the TJN’s corporate numbers come from allocating companies’ global profits to countries based on the share of global employment and the share of global wages paid by a company in that country, then comparing this to the reported profits for the company there. The difference is the “misalignment” of profits. If the misalignment shows reported profits are lower than the calculated profits, the TJN multiplies the amount by the corporate income tax rate and calls that the tax loss. (In addition, the TJN “cleans” the data through a series of adjustments.) Even aside from the many data issues that the TJN acknowledges, its misalignment method fails to account for the complex reality of corporate tax laws (which differ in thousands of details, not just headline rates); long-term impacts (tax may be merely deferred until funds are brought “home”); and the impact of the more than four thousand of double-tax treaties in allocating the taxation of income among jurisdictions. Moreover, these estimates never consider any positive benefits from IFCs, from the inflow of investment into both developed and developing economies to the beneficial effects of legal innovations offshore influencing onshore jurisdictions and to their provision of rule-of-law services to jurisdictions with weak legal systems.

For decades, developed economies have chased the tax revenue they claim to have lost to IFCs through ever-more-complex tax rules to prevent companies and individuals from shifting income to lower-tax jurisdictions. One way to see if the claims of lost tax revenues are real is to compare the revenue estimates made to justify those rules to the actual revenue received. The results do not support the claims of massive lost revenues. For example, one expert’s 2017 back-of-the-envelope analysis of the 2010 US Foreign Account Tax Compliance Act found that US taxpayers would have had to have hidden 20 percent of all global wealth to generate the amount of lost tax revenue claimed when the legislation was being considered. Moreover, automatic information-sharing provisions contained in the dense web of tax information exchange agreements and double-tax agreements mean that tax authorities already have the data necessary to collect taxes that are actually owed. Of course, politicians in developed countries have every incentive to estimate massive revenue gains from new tax measures, since these predictions are often enough to support additional spending. When actual revenue gains prove illusory, they simply double down on more bureaucracy and regulation. ...

Conclusion
The global market for law is as significant and dynamic as the markets for tangible goods such as cell phones and wheat. Jurisdictional competition, whether domestic or international, plays a crucial role in shaping the legal and business environments that attract economic activities. IFCs, which are small jurisdictions with strategic legal frameworks, exemplify how tailored legal and regulatory environments can drive economic growth and innovation. These jurisdictions provide specialized services that lower transaction costs, support investment, and foster economic development both locally and globally. The competition that IFCs give big jurisdictions such as the United States not only enhances our legal system but also contributes to a more interconnected and prosperous world economy. Understanding and engaging with the global market for law is essential if we are to avoid falling for politicians’ efforts to build legal barriers that cut us off from the beneficial effects of that competition.

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