You’ve probably heard of the Panama Papers by now. These are the millions of pages of confidential documents from a firm in Panama that an anonymous hacker sent to the German newspaper Süddeutsche Zeitung. This firm, Mossack Fonseca, specializes in setting up shell corporations so that their clients could avoid taxes. Through these corporations, which are little more than a legal address, wealthy individuals and government leaders are able to channel money and in this way hide profits from government authorities and the public. Often the purpose is to avoid taxes, but these shell companies are also used for drug trafficking and weapons smuggling. Profits from these illicit activities are then hidden, again using shell companies. Dirty money is made “clean,” at least as far as the government authorities can see. Mossack Fonseca is just one firm that sets up shell companies; they alone created over 200,000. The Global Financial Integrity organization estimates that over a trillion dollars is siphoned out of poor and emerging market countries every year, in large part by using shell corporations. And by avoiding taxes, those who rely the most on government for education, health care, roads, security, and protection from unsafe working conditions are the ones being hurt the most. In short, the poor are the ones who pay.
The Global Financial Integrity organization attempts to track illicit flows of money from developing countries and produces an annual report on their analyses. The latest report, Illicit Financial Flows from Developing Countries 2004 – 2013, was released in December 2015. They admit they are probably seeing only a fraction of the illegal flows of money. By far the biggest portion they see is from “misinvoicing” where the true value of the goods imported and exported are falsely declared. In short, if country A – let’s call it Freedonia – exports a million dollars’ worth of shirts to the United States, then the United States should have received a million dollars’ worth of shirts from Freedonia. It is far too difficult to match up individual cargoes, but many countries report the sum totals of the values to and from each country that is imported and exported. So at the end of the year if Freedonia exports $10 million dollars’ worth of goods to the United States but the United States reports that it imported $40 million dollars’ worth of goods from Freedonia, and this sort of thing happens year after year, there is a problem. At least one side is lying and possibly both.
Using Freedonia as an example, the fictional country made famous in the Marx Brothers movie Duck Soup, is appropriate because the scheme is worthy of the plot for one of their movies. Let’s go back to the million dollars’ worth of shirts exported by Freedonia. But in this case the Fredonian exporter says that the shirts are only worth half a million dollars and that is all they received for them. When the Freedonian profits are calculated, the company says that since a half a million dollars is about what it cost to make the shirts, then there is little or no profit on which to pay the taxes. The country and people of Freedonia lose out on the tax revenue for the half million dollars’ additional profit that was, in fact, made.
And the importer in the United States can play a similar game. The million dollars’ worth of shirts will be sold for $2 million. But instead of paying $1 million, the importer says they actually cost $1.5 million. By the time the shirts are shipped to the stores and all the cost for running the stores is paid, the total cost is almost $2 million. In the end, the importer says that very little profit was made and pays the taxes accordingly. The country and people of the United States lose out on the half million dollars’ extra profit that was, in fact, made.
Free trade is important for this scheme to work at its most effective level. Most countries traditionally levied import duties on goods. The taxes the importer avoids by falsely declaring the value of the goods to be too high will be offset by the increase in tariff duties. As Global Financial Integrity pointed out, “[i]f the marginal duty rate on imports is lower than the corporate tax rate, private businesses can still profit by over-invoicing imports as long as the higher import costs reduce taxes more than they increase the additional duties payable.” Reduce the duties to zero and the scheme can become profitable regardless of the corporate tax rate, something that is never addressed by proponents of free trade.
It may be difficult, but the authorities in Freedonia and the United States might be able to compare invoices and shipping declarations. Then they will find that the two don’t match. Shirts that were worth a half million dollars when they left Freedonia were worth a million and a half when they arrived in the United States. There is a total profit of a million dollars on which no taxes were paid. Corrupt officials aside, and bribes are a business expense that companies would rather avoid in any event, this poses a problem. And here is a place where shell companies are useful.
Let’s say the Freedonian exporter did not sell the shirts directly to the American importer. Instead, the Freedonian exporter sold them for a half million dollars to a shell company that was based in a country that has no corporate income tax, like the Cayman Islands. And the Cayman Islands shell company was the one that sold them to the American importer for a million and a half dollars. The shirts went from Freedonia to the United States, just as before. But now it is this Cayman Islands company that, on paper, made the million dollars’ profit. Since there is no corporate income tax there, it doesn’t matter how much profit was made. In fact, there is virtually no reporting necessary. So it’s all legal in the Cayman Islands and, on the surface, appears to be legal in Freedonia and the United States. There is almost no way for government authorities to track down what really happened. If one uses shell companies to own other shell companies, it becomes even more difficult. The Freedonian exporter may own a shell company that has a partial interest in the Cayman Islands shell company, for example. With nesting and interlocking shell companies, there is almost no chance of finding out what happened to the profit. And no chance that the proper taxes will be paid.
The European Union released a list of 30 countries and territories last year that it called tax havens. Some may have a small income tax, but allow certain income to be tax free. Others are used as way stations while moving money around. Their list of 30 is: Andorra, Liechtenstein, Guernsey, Monaco, Mauritius, Liberia, Seychelles, Brunei, Hong Kong, Maldives, Cook Islands, Nauru, Niue, Marshall Islands, Vanuatu, Anguilla, Antigua and Barbuda, Bahamas, Barbados, Belize, Bermuda, British Virgin Islands, Cayman Islands, Grenada, Montserrat, Panama, St Vincent and the Grenadines, St Kitts and Nevis, Turks and Caicos, and the US Virgin Islands. Note that the Panama Papers come from just one firm located in just one of these 30 countries and jurisdictions.
By some measures the United States should be on that list. In early February Bloomberg BusinessWeek had an “Opening Remarks” article on how money from Switzerland is finding its way to an “unlikely haven,” the U.S. Yes, the U.S. has a federal income tax, but certain states such as Nevada and South Dakota have very tight secrecy laws. And the tax does not apply to income earned abroad by foreigners. This is ideal for foreigners who want to hide income from their home countries, such as China, Russia, and countries in the Mid-East. Creating shell companies which hide these assets from the home countries is a growing business for a few states.
The irony is that the U.S. had been in the forefront of going after Swiss banks that were helping Americans from sheltering income. More than 80 Swiss banks have paid a total of $5 billion to the U.S. in fines, penalties, and restitution. Now a lot of money that had been in Switzerland is coming here. In theory, those foreigners have already paid the taxes due to their home countries, but there is no way of checking. The German newspaper Die Zeit, in an article explaining how the poorest wind up paying the costs for tax evasion through schemes as illustrated by the Panama Papers (Auf Kosten der Ӓrmsten), pointed out that while the U.S. is aggressive in demanding information from other countries, it is much less willing to reciprocate.
All this hurts the poor, through such things as lousy schools and poor health care. Oxfam estimates that the richest 1% own half the wealth in the world. The bottom half, on the other hand, own just 0.6% of the wealth. It should be obvious that this system is not sustainable in the long run. As technology advances and competition increases, we need the brightest and the best to receive the appropriate education. Right now the idea seems to be that if your family is wealthy, then of course you are one of the brightest and best. Uh-huh. The children of the wealthy get the best education even though there might be millions of people who would be more suited and could make better use of it. But they are the poor, so they never get the chance. Even good vocational training is often difficult to obtain. The countries that give all their citizens a fair chance to get a good education suited for their abilities will, I believe, prevail.