Tax Havens, Growth, and Welfare

• Author: HSUN CHU,CHING‐CHONG LAI,CHU‐CHUAN CHENG
• Published date: 01 December 2015
• Date: 01 December 2015
• DOI: http://doi.org/10.1111/jpet.12118

TAX HAVENS,GROWTH,AND WELFARE

HSUN CHU

Institute of Economics, Tunghai University

CHING-CHONG LAI

Institute of Economics, Academia Sinica. National Cheng Chi University, and Institute of

Economics, National Sun Yat-Sen University

CHU-CHUAN CHENG

Feng Chia University

Abstract

This paper develops an endogenous growth model featur-

ing tax havens, and uses it to examine how the existence of

tax havens affects the economic growth rate and social wel-

fare in high-tax countries. We show that the presence of tax

havens generates two conflicting channels in determining

the growth effect. First, the public investment effect states that

tax havens may erode tax revenues and in turn decrease the

government’s infrastructure expenditure, thereby reducing

growth. Second, the tax planning effect of tax havens reduces

marginal cost of capital and hence encourages capital accu-

mulation so as to spur economic growth. The overall growth

effect is ambiguous and is determined by the extent of

these two effects. The welfare analysis shows that tax havens

are more likely to be welfare-enhancing if the government

expenditure share in production is low, or the initial income

tax rate is high. Moreover, the welfare-maximizing income

tax rate is lower than the growth-maximizing income tax

rate if tax havens are present.

Hsun Chu, Department of Economics, Tunghai University, No. 1727, Sec. 4, Xitun Dist.,

Taiwan Boulevard, Taichung, 40704 Taiwan (hchu0824@gmail.com).

We are deeply indebted to the editor John Conley as well as three anonymous refer-

ees for their insightful comments which substantially improved the paper. We also thank

Cheng-wei Chang and Chih-hsing Liao for helpful suggestions. The usual disclaimer ap-

plies.

Received December 30, 2013; Accepted January 14, 2014.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (6), 2015, pp. 802–823.

802

Tax Havens, Growth, and Welfare 803

1. Introduction

Tax havens have attracted increasing attention from policy-makers in re-

cent years. By definition, the term “tax haven” refers to a jurisdiction that

imposes little or no taxes and offers itself as a place to be used by nonresident

firms or individuals to escape the tax burden in their home country (OECD,

1998). The empirical evidence reveals that in 2006, U.S. foreign direct

investment in tax havens amounted to around 5% of GDP.1With the

presence of tax havens, multinational firms can engage in interest stripping pa-

perwork; more specifically, they can generate interest deductions in a high-

tax host country by directing interest payments to low-tax haven countries.

In practice, however, tax havens are usually regarded as “harmful” and need

to be eliminated by the high-tax countries. As stressed in the 1998 OECD

report, “governments cannot stand back while their tax bases are eroded

through the actions of countries which offer taxpayers ways to exploit havens

to reduce the tax that would otherwise be payable to them.”

This traditional “negative” viewpoint of tax havens is theoretically mod-

eled by Slemrod and Wilson (2009), in which tax havens are viewed as “par-

asites” on the tax bases of high-tax countries and thus decrease public good

provision. Therefore, the elimination of tax haven activities can certainly

increase tax revenues and improve social welfare. This negative view is also

supported by Krautheim and Schmidt- Eisenlohr (2011), who consider tax

competition between a tax haven and a large country with heterogeneous

firms. As for campaigning against tax havens, Elsayyad and Konrad (2012)

argue that the current OECD process against tax havens, which is to reduce

the number of tax havens instead of eliminating them altogether, can be

harmful to welfare in OECD countries.

However, whether the existence of tax havens is unfavorable to high-tax

countries becomes more controversial due to the fact that a growing num-

ber of studies propose some new “beneficial” viewpoints of tax havens. For

example, in their empirical study, Desai, Foley, and Hines (2006a) find that

multinational firms benefit from tax haven operations by paying significantly

lower taxes compared to non-multinational firms. Hong and Smart (2010)

show that tax havens can provide firms with opportunities for international

tax planning, which makes the firms more willing to invest and thus benefits

the workers in the home country. As a result, Hong and Smart (2010) find

that an increase in tax planning stemming from tax havens is associated with

a higher level of social welfare. Johannesen (2010) proposes that tax havens

make it less attractive for countries to set a low tax rate and thus have the

1In 2006, U.S. direct foreign investment amounted to US$2,477 billion and US GDP

amounted to US$13,399 billion (U.S. Bureau of Economic Analysis; http://www.bea.gov).

Moreover, according to Dharmapala (2008), a fraction of about 25% of U.S. direct for-

eign investment is located in tax havens, which would have been US$619 billion in 2006.

Therefore, it can be roughly inferred that U.S. foreign direct investment in tax havens

account for around 4.6% of GDP.