The deepening scandal initiated by a massive leak of financial documents from a Panama-based law firm, Mossack Fonseca and Co. has once again highlighted the glaring loopholes in the global financial system – which is at once big news and tediously familiar. One may concur with the shock at corruption in Russia, involvement of political leaders from various countries, and the fact that the leaks have prompted a political crisis in Iceland.
However, the Panama Papers only point towards what has always been in plain sight – crime, violence, corruption and inequality are directly aided by financial secrecy offered to the rich and powerful through tax havens and enablers (institutions or individuals like lawyers and accountants) of such secrecy and illicit wealth. While Mossack Fonseca offers a range of services, its specialty lies in helping foreigners set up shell companies in Panama, and in a range of notorious tax havens around the world.
Mechanisms of secrecy
A shell company or an anonymous company (though not all shell companies are anonymous) are entities used to disguise the identity of their true human owner — the person(s) who ultimately control or profit from the company. These people are also known as the ‘beneficial owners’. Anonymous companies often have very few or no employees at all, and most don’t conduct any real business. However, they are legally eligible to make financial transactions, shift capital globally, buy a million-dollar yacht or a penthouse in Monaco. The problem gets further complicated when a company is owned by an anonymous company – looking a little like Russian Matryoshka dolls of different sizes placed one inside another – making it close to impossible to trace the profits back to the true beneficial owner.
The picture becomes even more intriguing when tax havens or secrecy jurisdictions come into play. Tax havens are countries or jurisdictions that offer extremely low tax rates, secrecy in various forms, avoidance of financial regulations and criminal laws, and escape from corporate governance rules. Tax havens also change their laws for wealthy individuals and organizations located elsewhere, thus making them ‘offshore’ secrecy jurisdictions. They are thus the perfect place to go if an individual or company does not want to want to declare their income, wealth or assets. 98 percent of the companies listed on the London Stock Exchange have subsidiaries located in tax havens.
In 2009, Barack Obama had pointed towards Ugland House in Cayman Islands being home to 12,000 US-based corporations; while overlooking the fact that there are 217,000 companies housed at 1209 Orange Street, Wilmington, in the American state of Delaware. Tax havens are therefore not palm-fringed island nations alone – such financial havens range from small island jurisdictions to financial centres such as the City of London and New York.
Estimates and consequences of secrecy
Tax havens and the use of anonymous companies have complex and wide-ranging effects. Offshore bank accounts are not used by drug dealers and money launderers alone – they are also used by the rich who do not want to pay their fair share of taxes. According to Gabriel Zucman, an economist at University of California, Berkeley, 8 percent of global wealth or $7.6 trillion sits in offshore tax havens – half of which belongs to developing countries. A 2012 study by James S. Henry of the Tax Justice Network (an independent think tank striving to achieve fair tax systems) had estimated that at least $21–$32 trillion have been invested ‘virtually tax-free’ through secrecy jurisdictions. There are many who believe that both these estimates could be very conservative.
A recent report by Oxfam, a global confederation of affiliated organizations working to alleviate poverty and inequality, reveals that in 2015, 62 individuals had as much wealth as 3.6 billion people – the bottom half of humanity. Between 2010 and 2015, the wealth of the poorer half of the world’s population fell by over $1 trillion. The people benefitting from the global economy are those at the top, simply because our economic system is heavily skewed in their favour – and maybe increasingly so. Clearly, wealth is not trickling downwards; it is instead being sucked upwards. Such stark economic inequality undermines growth and social cohesion, while further aggravating gender inequality and other social inequalities.
At the heart of such gross inequality lie tax havens or secrecy jurisdictions. The rich are not getting richer merely by way of increased economic activity – they are getting richer by avoiding taxes through the vast network of tax havens and intermediary institutions that enable flows of illicit wealth and facilitate sweetheart deals for them. There are different estimates regarding global GDP that goes untaxed, due to schemes outlined in the Panama Papers, and the figure could be anywhere between 10 to 25 per cent of global GDP.
A study by Washington-based think tank, Global Financial Integrity (GFI) reveals that in 2013 alone, developing countries worldwide lost over $1 trillion to illicit financial flows – money that is illegally earned, utilized or transferred. That’s trillion with a T. India lost over $510 billion to illicit financial flows between 2004 and 2013, averaging $51 billion every year over the decade for which data is available. While crimes such as drug trafficking, smuggling and money laundering definitely contribute to the illicit or shadow economy, the study concludes that 83.4 per cent of illicit financial flows result from trade mis-invoicing.
However, contrary to popular imagination, these illicit flows don’t always result in fat bank accounts sitting in tax havens – a significant portion of offshore wealth makes its way back into the country through reinvestment and conversion into different forms of assets, such as securities, real estate or bullions, through a process called ‘round-tripping’.
The dominant market fundamentalist view holds that low taxes (or tax incentives) for wealthy individuals and multinational corporations are necessary for economic growth. It is in fact the richest individuals and companies who should be paying higher taxes than the rest of the populace. This leads governments of developing nations to lower taxes on businesses and rich individuals in what has been termed a ‘race to the bottom’. However, research shows that lower taxes and tax incentives are not necessarily the only driving factor for foreign investment in an economy.
Tax dodging and stowing away of untaxed and unaccounted for income by wealthy individuals and big businesses pinch government budgets, in turn leading to cuts in crucial public services. Governments also turn to greater indirect taxation (like the Value Added Tax or Goods and Services Tax) to compensate for the shrinking revenue, disproportionately affecting poorer sections of the population. The effects of tax competition and tax avoidance alone cost developing countries across the world around $50 billion a year – and this estimate does not even include transfer mispricing or under-reporting of profits.
What can be done?
The stir caused by the Panama Papers is staggering. However, these documents have been leaked from a single law firm in only one secrecy jurisdiction. The Panama Papers are not the tip of the iceberg – they are a mere speck of ice in the entire iceberg.
There are solutions though. Countries across the world should invest in staffing their tax departments adequately and increasing capacity. It’s only going to mean more efficient collection of revenue.
Jurisdictions could create black-lists which would refuse company registration where an entity,
shareholder or partners are based in secrecy jurisdictions such as Panama. The EU has gone a step ahead and is contemplating a withholding tax (on the lines of the United States federal law FATCA, or the Foreign Account Tax Compliance Act) on jurisdictions which do not share information reciprocally. Finally, all countries should implement a register of beneficial owners of firms and entities in their respective jurisdictions, which should be available in the public domain.
Getting it right in India
A proposal for registering ‘significant beneficial owners’ – persons with beneficial interests of not less than 25 percent in the shares of a company or significant control or influence over the company – by way of a declaration to the company, has been included in The Companies (Amendment) Bill, 2016 introduced in the Lok Sabha on March 16, 2016. However, the amendment does not include public registries for beneficial owners. It remains to be seen if the political will of the government to clamp down on the shadow economy is going to spell into meaningful measures. We could get it right the first time, by implementing registries of beneficial owners available in the public domain.
The author works with Centre for Budget and Governance Accountability (CBGA), New Delhi. She can be reached at firstname.lastname@example.org. Views are personal.