Offshore Tax Havens and U.S. Companies: Causes and Policy Fixes

Introduction: Defining Tax Havens

A tax haven can be defined as a country, province, or city where certain taxes are either not applied at all, applied with very little force, or levied at extremely low rates. Governments all over the world have been busy attracting global investors through these tax havens. Corporations, on the other hand, have been actively shifting their operations to parts of the world where government regulations are minimal and can be easily overlooked. This in turn has pressured the governments of the developed world to lower their tax rates as well as their standard regulatory protocols. This paper reviews why U.S. companies are locating their activities or businesses in tax haven countries, and what changes could be made to U.S. tax law from a tax policy perspective to make such tax shelters less attractive.

Financial Savings and Labor Cost Advantages

One of the primary reasons U.S. companies locate their businesses in tax haven countries is the significant financial savings they can achieve. Developing countries throughout the world have some of the cheapest labor rates, and the cost savings that companies can realize by launching businesses in these countries can be as high as 90%, with individual hiring costs up to four times lower than what they would pay domestically. This difference in salaries alone can save these companies up to 75% of their labor costs. As OXFAM (2000) writes:

"Tax havens, and tax competition in general, can provide big business and wealthy individuals with opportunities to escape their tax obligations. This limits the capacity of countries to raise revenue through taxation on both their own residents and foreign-owned capital. Tax competition and the implied threat of relocation has forced developing countries to progressively lower corporate tax rates on foreign investors. Ten years ago, these rates were typically in the range of 30 to 35 per cent — broadly equivalent to the prevailing rate in most OECD countries. Today, few developing countries apply corporate tax rates in excess of 20 per cent. Tax competition also extends to efforts to attract foreign portfolio investment. Earlier this year, India was forced to reverse efforts to clamp down on the use of tax havens by foreign institutional investors for channelling funds into the country, for fear that future foreign investment would stay away."

The reason behind such a vast supply of cheap labor in these countries is the abundant and rising level of population combined with high poverty levels, which result in a decreased standard of living. This decreased standard of living allows U.S.-based companies to offer lower salary rates for all of the labor employed in their outsourced operations, and to use the percentage of costs saved on resources and infrastructure. It is important to note that cost savings vary by country and by vocation (the Economist, 2004). This means that the cost of hiring an accountant in India, for example, differs from hiring an engineer in India, and similarly differs from hiring an accountant in Pakistan.

There is, of course, one downside to outsourcing businesses to developing countries: the language barrier. The communication barrier is a major challenge, as laborers in developing countries often have little to no command of English. Even though this problem is significant, it can be addressed with additional investment in language training. This reduces the overall cost savings by at least 30%; however, the remaining savings are still sufficient to attract companies to invest in these tax haven countries (the Economist, 2004).

Tactical Outsourcing Strategies

One of the major reasons companies invest in tax haven or developing countries is the time-tested strategy of diversifying sources and suppliers. Companies believe it is generally better to rely on suppliers who provide the resources and infrastructure they need rather than building that infrastructure themselves. This approach allows companies to direct their internal focus on strategies that help them advance within the market. However, this is not always the full picture, as Duncan (2007) writes:

"Billions of pounds, enough to pay for the entire primary health and education needs of the world's developing countries, are being siphoned off through offshore companies and tax havens, according to a body formed to expose the offenders. Aid organizations are alarmed that money which should be used for building the infrastructure of the poorest countries is being hidden in havens by corrupt politicians and multinationals exploiting tax loopholes. Offshore companies are being formed at the rate of about 150,000 a year. While in the 1970s there were just 25 tax havens, there are at least 63 now, about half of them British protectorates or former colonies. Tax avoidance in Britain alone is estimated at between £25bn and £85bn."

There are also multiple reasons behind the use of tactical outsourcing that differ from one country or industry to another. For example, the automotive industry outsources to suppliers because most of those suppliers are smaller companies that pose no competitive threat to the manufacturer's core product. For other industries, outsourcing is primarily aimed at increasing the overall quality of production by fostering greater competition among smaller companies (Mark, 2004).

Overall costs decrease considerably when outsourcing — whether domestic or international — is conducted. The concept of specialization drives this cost reduction, since a specialized company can generally perform a specific task at a lower cost than an internal team hired to do the same work. Another rationale for outsourcing is the reduction of total staff employed within the company. Many advertising agencies today outsource for precisely this reason, as it significantly reduces overall costs while increasing competition among smaller vendors. One of the most well-known examples of outsourcing is in the public sector, where the government contracts out common or district-level tasks to companies and civil servants who receive added benefits such as pensions, health insurance, and government grants (Mark, 2004).

References

"Poor Payers to a Degree." The Economist. June 10, 2004.

David Cay Johnston. "How Offshore Havens Helped Enron Escape Taxes." New York Times. January 18, 2002.

David Cay Johnston. "Tax Inquiries Fall as Cheating Increases." New York Times. April 14, 2003.

Duncan Campbell. "Havens that Have Become a Tax on the World's Poor." Guardian. September 21, 2004.

Jeffrey P. Owens. "Offshore Tax Evasion." Globalist. June 20, 2007.

Mark Horvit. "Exporting Jobs: Offshoring Transforms the Global Workplace." Fort Worth Star-Telegram. June 19, 2004.

Matt Marshall. "VC's Offshoring Push Goes into Overdrive: Everett Prods Start-ups to Turn Labor Abroad as Cost Strategy." San Jose Mercury News. May 16, 2004.

OXFAM. "Tax Competition and Tax Havens." OXFAM's Presentation for UN Financing for Development NGO Hearings. November 7, 2000.

Paul Blustein. "Implored to 'Offshore' More: U.S. Firms are Too Reluctant to Outsource Jobs, Report Says." Washington Post. July 2, 2004.

Paul Kostek. "Can You Compete with an $800-a-Month Engineer?" Puget Sound Business Journal. August 29, 2003.

Robyn Meredith. "China Wants Brain, Not Just Brawn." Forbes.com. June 30, 2004.

Ron Hira and Anil Hira. Outsourcing America: What's Behind Our National Crisis and How We Can Reclaim American Jobs. AMACOM. New York. 2005.

Ryan Chittum. "Call Centers Phone Home: Small Town Economies Lure More Companies to Outsource in Remote Corners of the U.S." Wall Street Journal. June 9, 2004. p. B1.