Thank you and good morning.
My name is James Hines, and I'm the Richard A. Musgrave collegiate professor at the University of Michigan.
There are roughly 45 major tax havens in the world today. Tax havens are widely used by international investors. In 1999, 59% of American multinational firms with significant foreign operations had affiliates in one or more tax havens.
American firms exhibit unusual activity levels and income production in foreign tax havens. Of the property, plant, and equipment held abroad by American firms in 1999, 8.4% was located in tax havens. Employment abroad by American firms was likewise concentrated in foreign tax havens, with 6.1% of total foreign employee compensation located in tax haven affiliates. American firms located 15.7% of their gross foreign assets in the major tax havens in 1999, and affiliates in these countries accounted for 30% of total foreign income in 1999. Much of reported tax haven income, of course, consists of financial flows from other foreign affiliates that parent companies own indirectly through their tax haven affiliates.
Tax havens are viewed with alarm in parts of the high-tax world, where there are concerns that their use may divert economic activity from countries with higher tax rates and erode their tax bases.
Alternatively, tax havens could encourage investment in other countries, if the ability to relocate taxable income into tax havens improves the desirability of investing in high-tax locations, or if low tax rates reduce the cost of goods and services that are inputs to production or sales in high-tax countries.
In fact, evidence compiled by Mihir Desai and Fritz Foley of Harvard University and by me indicates that the use of foreign tax havens appears to stimulate activity in nearby high-tax countries, a one percent greater likelihood of establishing a tax haven affiliate being associated with two-thirds of a percent greater investment and sales in nearby non-haven countries.
Should capital exporting countries such as Canada be concerned by rising home-country investment in tax havens? No, they should not: this growth simply reflects the growing scope and financial sophistication of multinational enterprises. Much of the use of foreign tax havens is designed to avoid foreign taxes or to avoid the need for costly financial transactions that would otherwise be required to prevent triggering avoidable tax obligations. Neither of these should be causes of concern to capital exporting countries; on the contrary, the use of tax havens by Canadian firms likely stimulates business activity in Canada.
Does the availability of foreign tax havens offer unfair tax advantages for sophisticated international investors? It might at first appear so, but on further reflection, matters are not so simple, since multinational firms from one country compete with each other and compete with firms from around the world who also use tax havens.
This international competition ultimately drives pretax returns available from investments in tax havens down to break-even levels, much as the market for tax-exempt debt drives down returns and largely removes the benefits of acquiring such debt. As a result, those who invest in tax havens cannot earn supranormal returns from doing so. This competitive process implies that there is no unfair advantage to be had by investing in tax havens.
Would it be wise to limit the deductibility of domestic expenses, such as interest, for firms with significant foreign investments? Certainly it makes no sense to single out investments in tax havens for this purpose, since the use of tax havens is part of the ordinary international investment process. One might limit interest deductibility for all foreign investment, but doing so has the effect in practice of distorting the ownership of capital assets away from their most productive uses.
The problem is that foreign countries do not permit deductions for interest expenses that home countries deny. As a result, denying home country deductibility of interest expenses incurred for foreign investment would discourage foreign investment relative to domestic investment and thereby reduce the productivity of business enterprises in Canada.
The fact that a rising share of Canadian foreign investment is going through foreign tax havens is not actually relevant to the issue of interest deductibility. There are two reasons why not.
First, this is largely a holding company phenomenon; the vast bulk of what is called tax haven income is earned and taxed in countries other than tax havens.
Second, the competitive process implies that even income that is earned in tax havens is implicitly taxed by foreign competition that lowers pretax returns available there. As long as you tax purely passive foreign income on financial assets that are parked in tax havens, there is no need to limit domestic interest deductibility.
International business is a critical component of any wealthy economy in the world today. Limiting the interest deduction for foreign investment has the unfortunate effect of distorting investment patterns. Ultimately, the cost of imposing heavy tax penalties on foreign investment is borne by domestic workers in the form of lower wages as their economies become less productive.