The price of offshore havens

In this analysis of the global tax haven industry, James S Henry attempts a reassessment of the size and worth of the private wealth that is being held in these havens.

SINCE the late 1970s, investigative journalists, tax authorities, drug enforcement officials, terrorist trackers and national security experts - and a few economists - have gradually become aware that there is indeed a 'vast deal of money' - a large and growing chunk of the world's private wealth and income - hidden out there, not so much 'in the land', but 'offshore', protected by an industrious, highly paid bevy of professional enablers in the private banking, legal, accounting and investment industries, taking advantage of the increasingly borderless, frictionless global economy.

Grade-school geography conditions us to think of 'offshore' as a physical location. Indeed, some 'residential havens' like Singapore and Switzerland do specialise in providing secure low-tax physical residences to the world's wealthiest people, along with expensive private schools, hospitals and resorts to enhance the family dynasties' human capital; and highly secure storage facilities for private collections of art, gold, jewels, classic cars, yachts, planes, weapons and other trinkets.

However, private banking has long since become virtual. So the term 'offshore' refers not so much to the actual physical location of private assets or liabilities, but to nominal, hyper-portable, multi-jurisdictional, often quite temporary locations of networks of legal and quasi-legal entities and arrangements that manage and control private wealth - always in the interests of those who manage it, supposedly in the interests of its beneficial owners, and often in indifference or outright defiance of the interests and laws of multiple nation states. A painting or a bank account may be located inside Switzerland's borders, but the all-important legal structure that owns it is likely to be fragmented in many pieces around the globe. Typically that asset would be owned by an anonymous offshore company in one jurisdiction, which is in turn owned by a trust in another jurisdiction, whose trustees are in yet another jurisdiction (and that is one of the simplest offshore structures).

Core capabilities

Ultimately, then, the term 'offshore' refers to a set of capabilities. The key clients for the offshore system include the world's wealthiest individuals and companies, as well as its worst villains. Numbering just a few million of the world's 6.5 billion people, they are an incredibly diverse group, from 30-year-old Chinese real estate speculators and Silicon Valley software tycoons to Dubai oil sheiks, Russian presidents, mineral-rich African dictators and Mexican drug lords.

From a slight distance, all these players share the same basic needs: (1) anonymity for them, their families, and their business and political dealings; (2) the ability to minimise the net present value of future taxes, net of tax avoidance costs; (3) investment management, for those who still believe in it; (4) ability to easily access and manage their wealth from anywhere on the planet; (5) secure places to hang out, hide out and enjoy life; and (6) iron-clad financial security for their huge stocks of anonymously owned, largely untaxed private assets, against the continuing threats posed not only by taxmen and prosecutors, but also by kidnappers, extortionists, spies, hitmen, conmen, hackers, paparazzi, political opponents, disgruntled family members, ex-spouses, ex-lovers, and each other.

It is these core capabilities - secrecy, tax minimisation, access, asset management, and security - that our modern offshore system offers. In the last 30 years a sophisticated transnational private infrastructure of service providers has grown up to deliver these services on an unprecedented scale. This 'pirate banking' system now launders, shelters, manages and, if necessary, re-domiciles the riches of many of the world's worst villains, as well as the tangible and intangible assets and liabilities of many of our wealthiest individuals, alongside our most successful mainstream banks, corporations, shipping companies, insurance companies, accounting firms and law firms.

All these players have become, as it were, citizens of a brave new virtual country - one that lacks physical boundaries but can still offer escape routes from many of the taxes, financial regulations, human rights standards and moral restraints that the rest of us take for granted: the responsibilities of society. One set of rules for a tiny minority of rich and powerful people; another set for everyone else.

The global haven industry

Given this 'virtual geography' perspective, it is important to emphasise several structural facts about the offshore industry.

First, it is important to distinguish between the 'intermediary havens' which act as conduits for wealth and 'destination havens' where private wealth ultimately ends up.

We typically associate offshore legal entities like shell companies, asset protection trusts, captive insurance companies and haven banks with the conventional list of 'offshore havens' (or 'Treasure Islands'): sultry, dodgy tropical islands like Bermuda, the Cayman Islands, Nauru, St. Kitts, Antigua, and Tortola; or the European bolt holes such as Switzerland, the Channel Islands, Monaco, Cyprus, Gibraltar, and Liechtenstein. These 80-odd frontline havens, most of which are 'offshore' by anyone's definition, collectively provide a home to over 60 million people, and over 3.5 million paper companies, thousands of shell banks and insurance companies, more than half of the world's registered commercial ships above 100 tons, and tens of thousands of shell subsidiaries for the world's largest banks, accounting firms, and energy, software, drug and defence companies.

In the 1970s-90s, as multinational corporations (MNCs), banks, investors and a variety of First and Third World scalawags demanded haven services, the elites in these tiny ersatz states discovered they could make a darn good living simply by turning a blind eye. Their numbers roughly tripled during these years.

However, as the Tax Justice Network has recently emphasised in its work on its Financial Secrecy Index since 2009, this conventional list of havens is misleading, if we're interested in 'finding the money'. For while there are millions of companies and thousands of thinly capitalised banks in these fiscal paradises, few wealthy people want to depend on them to manage and secure their wealth. These stealthy investors ultimately need access to all the primary benefits of 'high-cost' First World capital markets - relatively efficient, regulated securities markets, banks backstopped by large populations of taxpayers, and insurance companies; well-developed legal codes, competent attorneys, independent judiciaries, and the rule of law. Generally, these can only be found in a handful of so-called First World countries like the US, the UK, Switzerland, the Netherlands, Belgium/Luxembourg, and Germany. So we have to look to these 'destination havens' in order to get a handle on the size and growth of unrecorded cross-border private wealth.

Second, the private 'enablers' play a critical role in this market, one that cuts across individual havens. Investing and securing large amounts of private wealth across borders is complex, requiring specialised skills in tax, financial planning, banking, entity structuring and estate planning. This is not something that most wealthy people undertake on their own. As noted, therefore, a global services industry of law firms, accountants, insurance companies and especially private banks has grown up to cater to this cross-border market.

While it has thousands of players, the room at the top is surprisingly limited - global accounting is still dominated by the 'Big Four', while a small number of 'capital city' and haven-based law firms dominate the lawyering, and global private banking is dominated by fewer than 50 multinational banks.

Third, another key development since the late 1990s is the growth of the 'onshore-offshore' market for secrecy and tax avoidance, especially in the United States. From Delaware to Alaska, Nevada and South Dakota, a growing number of states in the US are offering inexpensive legal entities like 'limited liability companies' (LLCs) and 'asset protection trusts' whose levels of secrecy, protection against creditors, and tax advantages rival those of the world's traditional secretive offshore havens. The widespread use of the likes of the Nevada LLC or the Delaware asset protection trust, in the supposedly 'onshore' United States, further undermines the traditional association of 'offshore' with particular physical locations, and underscores the fact that the cross-border flows examined in this article may be just the tip of the iceberg.

Key findings

Overall size

A significant fraction of global private financial wealth - by our estimates, at least $21-32 trillion as of 2010 - has been invested virtually tax-free through the world's still-expanding black hole of more than 80 offshore secrecy jurisdictions. We believe this range to be conservative (see box).

Remember: this is just financial wealth. A big share of the real estate, yachts, racehorses, gold bricks - and many other things that count as non-financial wealth - are also owned via offshore structures where it is impossible to identify the owners. These are outside the scope of this report.

On this scale, this 'offshore economy' is large enough to have a major impact on estimates of inequality of wealth and income; on estimates of national income and debt ratios; and - most importantly - to have very significant negative impacts on the domestic tax bases of key 'source' countries (that is, countries that have seen net unrecorded private capital outflows over time).

Who are the real debtors?

We have focused on a sub-group of 139 mainly low-middle income source countries for which the World Bank and the International Monetary Fund (IMF) have sufficient external debt data.

Our estimates for this group underscore how misleading it is to regard countries as 'debtors' only by looking at one side of their balance sheets.

Since the 1970s, with eager (and often aggressive and illegal) assistance from the international private banking industry, it appears that private elites in this sub-group of 139 countries had accumulated $7.3-9.3 trillion of unrecorded offshore wealth in 2010, conservatively estimated, even while many of their public sectors were borrowing themselves into bankruptcy, enduring agonising 'structural adjustment' and low growth, and holding firesales of public assets.

These same source countries had aggregate gross external debt of $4.08 trillion in 2010. However, once we subtract these countries' foreign reserves, most of which are invested in First World securities, their aggregate net external debts were minus $2.8 trillion in 2010. (This dramatic picture has been increasing steadily since 1998, the year when the external debts minus foreign reserves was at its peak for these 139 countries, at +$1.43 trillion.)

So in total, by way of the offshore system, these supposedly indebted source countries - including all key developing countries - are not debtors at all: they are net lenders, to the tune of $10.1-12.1 trillion at end-2010.

The problem here is that the assets of these countries are held by a small number of wealthy individuals while the debts are shouldered by the ordinary people of these countries through their governments. As a US Federal Reserve official observed back in the 1980s: 'The real problem is not that these countries don't have any assets. The problem is, they're all in Miami.' And, he might have added, New York, London, Geneva, Zurich, Luxembourg, Singapore and Hong Kong.

These private unrecorded offshore assets and the public debts are intimately linked, historically speaking: the dramatic increase in unrecorded capital outflows (and the private demand for First World currency and other assets) in the 1970s and 1980s was positively correlated with a surge in First World loans to developing countries: much of this borrowing left these countries under the table within months, and even weeks, of being disbursed.

Today, local elites continue to 'vote with their financial feet' while their public sectors borrow heavily abroad - but it is First World countries that are doing most of the borrowing. It is the frequently heavily indebted source countries and their elites that have become their financiers.

In terms of tackling poverty, it is hard to imagine a more pressing global issue to address.

How this wealth is concentrated

Much of this wealth appears to be concentrated in the hands of private elites that reside in a handful of source countries - many of which are still regarded officially as 'debtors'.

By our estimates, of the $7.3-9.3 trillion of offshore wealth belonging to residents of these 139 countries, the top 10 countries account for 61% and the top 20 for 81%.

Untaxed offshore earnings start to swamp outflows

Our estimates also correct the sanguine view that since new outflows of capital appear to have recently declined from countries like Mexico and Brazil, capital flight is no longer a problem for these countries.

Once we take into account the growth of large untaxed earnings on accumulated offshore wealth, it turns out that from 1970 to 2010 the real value (in $2000) of these earnings alone may be as much as $3.7 trillion - equivalent to about 60% of the global total unrecorded capital outflows during this period. For Latin America, sub-Saharan Africa and the Middle East that have long histories of accumulating offshore wealth and unreported earnings abroad, the ratio is close to 100% or more.

By shifting attention from flows to accumulated stocks of foreign wealth, we call attention to the fact that retention of investment earnings abroad can easily become so significant that initial outflows are eventually replaced by 'hidden flight', with the hidden stock of unrecorded private wealth generating enough unreported income to keep it growing long after the initial outflows have dried up.

Offshore earnings swamp foreign investment

Another key finding is that once we fully account for capital outflows and the lost stream of future earnings on the associated offshore investments, foreign direct and equity investment flows are almost entirely offset - even for some of the world's largest recipients of foreign investment.

Wide open and 'efficient' capital markets: how traditional theories failed

Standard development economics assumes that financial capital will flow predominantly from 'capital-rich' high-saving rich countries to 'capital-scarce' countries where returns on investment are higher.

But for many countries the global financial system seems to have enabled private investor motives - understandable ones like asset diversification along with less admirable ones like tax evasion - to swamp the conventional theory. Reducing frictions in global finance, which was supposed to help capital flow into capital-starved developing countries more easily and efficiently, seems to have encouraged capital to flow out. This raises new questions about how 'efficient' frictionless global capital markets are.

The active role of private banks

Our analysis refocuses attention on the critical, often unsavoury role that global private banks play. A detailed analysis of the top 50 international private banks reveals that at the end of 2010 these 50 collectively managed more than $12.1 trillion in cross-border invested assets from private clients, including via trusts and foundations. Consider the role of smaller banks, investment houses, insurance companies, and non-bank intermediaries like hedge funds and independent money managers in the offshore cross-border market, plus self-managed funds, and this figure seems consistent with our overall offshore asset estimates of $21-32 trillion.

A disproportionate share of these assets was managed by major global banks that are well known for their role in the 2008 financial crisis, their generous government bailouts and bountiful executive compensation packages. We can now add this to their list of distinctions: they are key players in many havens around the globe, and key enablers of the global tax injustice system.

 It is interesting to note that despite choppy markets the rank order at the top of the private banking world has been remarkably stable - key recent trends have been for an increased role for independent boutique money managers and hedge funds, and a shift towards banks with a strong Asian presence.

New revenue sources for global needs

Finally, if we could figure out how to tax all this offshore wealth without killing the proverbial Golden Goose, or at least entice its owners to reinvest it back home, this sector of the global underground is also easily large enough to make a significant contribution to tax justice, investment, and paying the costs of global problems like climate change.                       

James S Henry is a Senior Advisor and Global Board Member of the Tax Justice Network (TJN). The above is an edited extract from his paper 'The Price of Offshore Revisited', which was published in 2012 by TJN. The full paper is available on TJN's website

Scope of the estimates

OUR core focus is on measuring long-term unrecorded cross-border private financial capital flows and stocks that have contributed significantly to the erosion of the domestic tax base, especially in developing countries.

There are several very different sources for these flows and stocks - that is one reason I prefer to call them 'unrecorded capital flows and stocks' rather than 'capital flight'.

One key source is underreported capital flows that have been secreted offshore and invested abroad beyond the reach of domestic tax authorities.

This broad definition focuses on unrecorded capital flows without prejudging the motives for it. Among the possible motives are: (1) short-term speculation ('hot money'), (2) longer-term portfolio diversification, (3) asset protection (including protection against political risks and illegality), and (4) more dubious motives, like money laundering, income tax evasion, 'round-tripping' (taking money offshore, dressing up in secrecy structures then pretending to be 'foreign' investors in order to take advantage of tax breaks and exchange rates only available to 'foreigners'), back-to-back lending games, export subsidy fraud, avoidance of import duties, corruption and more.

All these motives have been at work through the period we are considering, so the best explanation is 'all of the above'.

However, since net outflows from developing countries have continued over sustained periods of time, and since little offshore wealth or the earnings that it produces have been repatriated, the most important factors driving it are not those that drive 'hot money', but long-term de-capitalisation.

Our best estimate is that at least 25-30% of these funds, averaging several hundred billion per year since the 1970s, have come from developing countries.

Another key source is under-taxed corporate profits and royalties that have been parked offshore in low-tax havens by way of rigged transfer pricing schemes. While estimates for the value of such transfer pricing abuses are more problematic, they are likely to be significant.

A third source is a myriad of illicit activities in the global underground economy - corruption, fraud, insider trading, drug trafficking, 'blood diamonds', and innumerable other for-profit crimes. Even for source countries with zero or very low income taxes, like Russia, Saudi Arabia and most other Middle Eastern oil producers, havens provide a convenient way to launder all this illicit loot. While banks and other financial intermediaries are supposed to follow 'know your customer' rules that prevent this kind of chicanery, in practice the regulations are full of loopholes - rather like, appropriately enough, Swiss cheese.

Narrow scope, conservative estimates

Despite including all these sources, our focus so far is still much narrower than the full scope of 'the price of offshore'. There is a long laundry list of economic 'bads' enabled by haven jurisdictions: not only tax evasion but also fraud, bribery, illegal gambling, money laundering, and traffic in contraband: drugs, sweatshops, human and sex trafficking, arms, toxic waste, conflict diamonds, endangered species, bootlegged software . the list is virtually endless.

In principle, all these 'bads' deserve to be included on the social balance sheet in any overall assessment of the offshore industry. In practice, however, we focus here on what we can get a handle on. And given the sheer scale of tax evasion facilitated by offshore havens, it is clearly one of the main anchors for the system, which underpins all these other dubious activities.

We also omit several important types of non-financial wealth that are collectively quite sizeable, as well as important for tax justice and development policy - notably human capital, net claims on real property (including land and natural resources), and 'intangibles' like claims to patents, trademarks, brands, technical know-how, and other intellectual property. In all these cases the role of cross-border flows and offshore havens appears to have been increasing: for example, recent exposes concerning re-domicilations of intellectual property to low-tax jurisdictions by leading US pharmaceutical and computer companies, or continuing concerns about 'Third World brain drain'.                                    

*Third World Resurgence No. 309, May 2016, pp 17-20