They are spread across the world, a good number of which are tiny islands and political lightweights in themselves. Yet they hold so much financial and political muscle that for more than a decade of intense global spotlight on them, following the 2007-08 financial crisis which exposed their role in precipitating it, little harm has come to them.
Their role is critical for global financial and political stability, including India, more than what is commonly realised or understood. But before getting into some of the important whys and hows, here is about who they are.
Tax havens: Refuge for global wealth
In one of the early studies on the subject, Tax Havens: How Globalization Really Works (2010), Prof Ronen Palan of the University of Birmingham and his co-authors, Richard Murphy and Christian Chavagneux, described tax havens as "jurisdictions that deliberately create legislation to ease transactions undertaken by people who are not resident in their domains with a purpose of avoiding taxation and/or regulations, which they facilitate by providing a legally backed veil of secrecy to obscure the beneficiaries of those transactions".
The Organisation for Economic Co-operation and Development (OECD) defines a tax haven in a classical sense as "a country which imposes a low or no tax and is used by corporations to avoid tax which otherwise would be payable in a high-tax country". It lists three essential characteristics of a tax haven: (a) no or only nominal taxes (b) lack of effective exchange of information and (c) lack of transparency in their legislative, legal or administrative provisions.
How many tax havens exist in the world?
Palan et al presented "a list of lists" prepared over the previous 30 years, including those of the OECD and International Monetary Fund (IMF). It contained the names of 91 jurisdictions.
Another authority on the subject, former McKinsey & Co chief economist James Henry put the number at more than 90 in 2016. When he first started looking at secret jurisdictions (another term for tax havens) in 1985, there were just 10-15 significant ones: in the Channel Islands, Caribbean and Switzerland - reflecting "the sheer, exuberant growth" of such jurisdictions.
Some of the tax havens are familiar names: Switzerland, the Netherlands, Ireland, Singapore, Hong Kong, Luxembourg, Cayman Islands, British Virgin Islands, Bermuda, Cyprus, Mauritius, Panama, etc.
On February 18, 2020, the Tax Justice Network (TJN), an international network which has done pioneering work and remains the most credible body in the field of research and advocacy regarding tax havens, released its latest Financial Secrecy Index (FSI2020). It contains the names of 133 jurisdictions.
The Cayman Islands top the list, followed by the US, Switzerland, Hong Kong, Singapore and others.
The FSI ranks countries/jurisdictions according to how their legal and financial regulations allow wealthy individuals and entities to "hide and launder money extracted from around the world" for more than a decade. It uses 'secrecy jurisdiction' as an alternate term for a tax haven to describe those "who use secrecy to attract illicit and illegitimate or abusive financial flows" by using a methodology developed by the IMF in 2007.
Financial secrecy holds the key because tax advantage or arbitrage (since tax havens offer no-tax or low-tax) would not be available to individuals and corporations if secrecy does not protect them from being discovered.
A caveat is called for. A higher rank on the FSI does not necessarily mean a jurisdiction is more secretive, rather "that the jurisdiction plays a bigger role globally in enabling secretive banking, anonymous shell company ownership, anonymous real estate ownership or other forms of financial secrecy, which in turn enable money laundering, tax evasion and huge offshore concentrations of untaxed wealth".
Also Read: Taxing the untaxed II: Why India's smaller taxpayers bear heavier burden
Financial secrecy up in US, UK and Cayman Islands
The good news is that the FSI2020 saw an overall improvement in secrecy score over the FSI2018 because of "recent transparency reforms". On average, countries on the index reduced their contribution to global financial secrecy by 7%. Switzerland reduced its secrecy score by 12% and dropped to number 3, from number 1 in FSI2018.
The bad news is that the US, the UK and Cayman Islands increased theirs: the US by 15% and retained its position at number 2; the UK by a whopping 26% and went up from number 23 to number 12 and Cayman Islands by 24% and went up from number 3 to number 1.
From India's perspective, Singapore (rank 5), Mauritius (rank 51) and the Netherland (rank 8) are the top three destinations through which more than 50% of the country's FDI equity inflows and outflows (OFDI/ODI) are routed.
Also Read: Taxing the untaxed III: Is govt oblivious to leakages in direct tax collection?
How much wealth tax havens hide?
Given the secrecy involved, it is tough to estimate. Nevertheless, one credible estimate exists.
James Henry's 2010 study, The Price of Offshore Revisited, (written for the TJN), said about $21 to 31 trillion (or Rs 1,554-Rs 2,368 lakh crore at exchange rate of Rs 74) of unreported private financial wealth is located in various tax havens at the end of 2010.
This estimation did not include real estate, yachts and other non-financial assets owned via offshore structures. Henry described the private wealth held in tax havens represented "a huge black hole in the world economy" at the time.
The same estimate has been retained in the FSI2020 report.
In 2019, the IMF-University of Copenhagen published a study, The Rise of Phantom Investment, saying that $15 trillion of the total $40 trillion FDI channelling around the globe was 'phantom' FDI structured to avoid corporation tax. The 'phantom' FDI is 37% of the total FDI and equals to the combined annual GDP of the economic powerhouses China and Germany.
It further said that despite the OECD-G20 anti-tax avoidance action plan on Base Erosion and Profit Shifting (BEPS) the "phantom FDI keeps soaring, outpacing the growth of genuine FDI". A year earlier, in 2018, the same team had estimated 'phantom' FDI at $12 trillion.
It identified 10 tax havens hosting the 'phantom' FDI - reproduced below. Luxembourg and the Netherlands accounted for about 50% and all of them put together more than 85%.
Three of these tax havens figure prominently in India's FDI inflows and outflows - Singapore, the Netherlands and Mauritius.
Also Read: Taxing the untaxed IV: All that's wrong with India's tax system, GST
India's deep connections with tax havens
An analysis of the data released by the Department for Promotion of Industry and Internal Trade (DIPP) on FDI inflows, from April 2000 to December 2019, and the RBI on FDI outflows, from April 2012 to Mach 2018, show that the top three tax havens account for 59% of cumulative FDI inflows and 55% cumulative FDI outflows or Outward Direct Investment (ODI).
Both FDI inflows and outflows relate to equity participation.
If other tax havens are added to the list, their contribution to the total FDI flows to India will go up substantially.
In fact, the top 10 jurisdictions from which India receives FDI inflows account for 87% of the total inflows between April 2000 and December 2019.
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