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TAX HAVENS AND AN EXPANDING ECONOMY

Permanent Link: http://ncf.sobek.ufl.edu/NCFE004847/00001

Material Information

Title: TAX HAVENS AND AN EXPANDING ECONOMY POLICY RECOMMENDATIONS FOR CHINA
Physical Description: Book
Language: English
Creator: Richardson, Timothy
Publisher: New College of Florida
Place of Publication: Sarasota, Fla.
Creation Date: 2013
Publication Date: 2013

Subjects

Subjects / Keywords: China
Tax Havens
Investment Development Path
Tax Morale
Economics
Genre: bibliography   ( marcgt )
theses   ( marcgt )
government publication (state, provincial, terriorial, dependent)   ( marcgt )
born-digital   ( sobekcm )
Electronic Thesis or Dissertation

Notes

Abstract: A very large percentage of Chinese outward FDI is being sent to countries labeled as "tax havens," such as the Cayman Islands, the British Virgin Islands, and Hong Kong, and this has been true since the early 2000s. This paper uses the theory of tax morale to recommend institutional improvements to encourage Chinese corporations and individuals to pay their taxes. Building on the failures of many countries to develop functioning Tax Information Exchange Agreements and the idea of incentive structures this paper recommends China engage in a multilateral TIEA with its two major havens which involves extensive amounts of information sharing and large payouts for the information. This paper also suggests that China imitate the U.S.A.'s new FATCA bill which taxes foreign institutions for non-compliance with information sharing requirements. The Investment Development Path theory is used to support the idea that OFDI flows may increase greatly very soon, and so policy improvements with respect to OFDI should be of a high priority.
Statement of Responsibility: by Timothy Richardson
Thesis: Thesis (B.A.) -- New College of Florida, 2013
Electronic Access: RESTRICTED TO NCF STUDENTS, STAFF, FACULTY, AND ON-CAMPUS USE
Bibliography: Includes bibliographical references.
Source of Description: This bibliographic record is available under the Creative Commons CC0 public domain dedication. The New College of Florida Libraries, as creator of this bibliographic record, has waived all rights to it worldwide under copyright law, including all related and neighboring rights, to the extent allowed by law.
Local: Faculty Sponsor: Coe, Richard

Record Information

Source Institution: New College of Florida
Holding Location: New College of Florida
Rights Management: Applicable rights reserved.
Classification: local - S.T. 2013 R5
System ID: NCFE004847:00001

Permanent Link: http://ncf.sobek.ufl.edu/NCFE004847/00001

Material Information

Title: TAX HAVENS AND AN EXPANDING ECONOMY POLICY RECOMMENDATIONS FOR CHINA
Physical Description: Book
Language: English
Creator: Richardson, Timothy
Publisher: New College of Florida
Place of Publication: Sarasota, Fla.
Creation Date: 2013
Publication Date: 2013

Subjects

Subjects / Keywords: China
Tax Havens
Investment Development Path
Tax Morale
Economics
Genre: bibliography   ( marcgt )
theses   ( marcgt )
government publication (state, provincial, terriorial, dependent)   ( marcgt )
born-digital   ( sobekcm )
Electronic Thesis or Dissertation

Notes

Abstract: A very large percentage of Chinese outward FDI is being sent to countries labeled as "tax havens," such as the Cayman Islands, the British Virgin Islands, and Hong Kong, and this has been true since the early 2000s. This paper uses the theory of tax morale to recommend institutional improvements to encourage Chinese corporations and individuals to pay their taxes. Building on the failures of many countries to develop functioning Tax Information Exchange Agreements and the idea of incentive structures this paper recommends China engage in a multilateral TIEA with its two major havens which involves extensive amounts of information sharing and large payouts for the information. This paper also suggests that China imitate the U.S.A.'s new FATCA bill which taxes foreign institutions for non-compliance with information sharing requirements. The Investment Development Path theory is used to support the idea that OFDI flows may increase greatly very soon, and so policy improvements with respect to OFDI should be of a high priority.
Statement of Responsibility: by Timothy Richardson
Thesis: Thesis (B.A.) -- New College of Florida, 2013
Electronic Access: RESTRICTED TO NCF STUDENTS, STAFF, FACULTY, AND ON-CAMPUS USE
Bibliography: Includes bibliographical references.
Source of Description: This bibliographic record is available under the Creative Commons CC0 public domain dedication. The New College of Florida Libraries, as creator of this bibliographic record, has waived all rights to it worldwide under copyright law, including all related and neighboring rights, to the extent allowed by law.
Local: Faculty Sponsor: Coe, Richard

Record Information

Source Institution: New College of Florida
Holding Location: New College of Florida
Rights Management: Applicable rights reserved.
Classification: local - S.T. 2013 R5
System ID: NCFE004847:00001


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TAX HAVENS AND AN EXPANDING ECONOMY: POLICY RECOMMENDATIONS FOR CHINA BY TIMOTHY RICHARDSON A Thesis Submitted to the Division of Social Sciences New College of Florida in partial fulfillment of the requirements for the degree of Bachelor of the Arts Under the sponsorship of Professor Richard D. Coe

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ii Acknowledgements: I would like to thank my parents for telling me to talk to Professor Coe when I was too confused or stressed about things. I would also like to thank Professor Coe for making me significantly less stressed and confused about these things each time we had a meeting. I would like to thank Hannah Brown for setting a good example by working really hard on her thesis from day one and for being a generally awesome friend and co chef. I would like to thank Mar Echevarria for all the chilling, co oking, and homework we did together and for the dope hip hop, dub, and reggae which accompanied all three of those activities. I would like to thank Alejandra Martino for reminding me to take o ut my trash on Sundays and for having my back at all times. I would like to thank William Kocsis, Phillip Pope, and Elliott Countess for making my house so much fun I never attempted to do any thesis work there. I would also like to thank Duff Cooper for k eeping watch over the Social Science Research Lab, and for the music he routinely bumps through his office wall. I would like to thank my Thesis Tutorial of Willis Schueler, Matt Cutler, and Reese Crispen, for sitting through me talk about this stuff for a long time. I would like to thank Henry Smyth of Granville Cooper Asset Management for accepting me as an intern and for giving me numerous helpful comments on my thesis as it progressed. I would like to tha nk lattes, coffee and rooibos tea for giv ing me regular study breaks.

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iii I would like to thank my thesis committee of Professor Coe, Professor Khemraj, and Professor Van Horn for reading my thesis and grilling me appropriately. I do not thank AlJazeera.co m, TinyMixT apes.com, Pitchfork.com, Jezebel.c om, Feministing.com, or any of the other websites I used to procrastinate. Lastly I would like to thank Rebecca Borton for inspiring me to finish this paper so I can move on with my life and l ive with her somewhere awesome.

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iv Table of Contents: Acknowledge ments ii Table of Contents iv Abstract v Chapter 1: Introduction 1 Chapter 2: Literature Review 7 Chapter 3: Theoretical Model 24 Chapter 4: Policy Recommendations 36 Chapter 5: Conclusion 49 Bibl iography 53

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v TAX HAVENS AND AN EXPANDING ECONOMY: POLICY RECOMMENDATIONS FOR CHINA Timothy Richardson New College of Florida, 2013 ABSTRACT A very large percentage of Chinese outward FDI is bein h avens, suc h as the Cayman Islands, the British Virgin Islands, and Hong Kong, and this has been true since the early 2000s. This paper uses the theory of tax morale to recommend institutional improvements to encourage Chinese corporations and individuals to pay thei r taxes Building on the failures of many countries to develop functioning Tax Information Exchange Agreements and the idea of incentive structures this paper recommends China engage in a multilateral TIEA with its two major havens which involves extensive amounts of information sharing and large payouts for the which taxes foreign institutions for non compliance with information sharing requirements. The Investment Develop ment Path theory is used to support the idea that OFDI flows may increase greatly very soon, and so policy improvements with respect to OFDI should be of a high priority. Professor Richard Coe Division of Social Sciences

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1 Chapter 1: Introduction ax have meanings according to a myriad of different sources. Given its slippery definition, the academic community does not agree on a definitive list of countries which qualify as tax havens It is definitely a loaded term, a pejorative term, and at the same time a buzzword used by j ournalists and academics alike. So what does it mean in the most common parlance ? individuals a nd businesses little or no tax liability in a politically and economically stable environment. Tax havens also provide little or no financial information to foreign tax This general definition is pretty effective, but there still exist proced ural problems in identifying which countries fit this model and which countries do not. In American culture, associated with Switzerland and money flowing out o f Western countries and into a European microstate However, th second largest economy in GDP terms and what China can do to manage its relationship with tax havens. China was selected as a good country f or analysis for several reas ons. I t is a country with a large tax base and a lot of private wealth but it has not been that way for very many decades ilization of these offshore centers is a relative new phenomenon that took hold quickly compared w ith the Western powers Furthermore, China is not European or dominated by citizens of European origin, causing it to have further reason to branch out to tax havens which do not fit the traditional small European state model or the British Channel Islands model.

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2 little flow to these nations before this period. Since then, trillions of dollars of foreign direct investment (FDI) have flown to the British Virgin Islands, the Cayma n Islands, and Hong Kong, a special administrative region of China which operates with its own laws, its own political system, and its own judiciary. For this reason, though Hong Kong is part of China, Chinese industries and constituents may still utilize financial system in ways not fully disclosed to Chinese tax authorities. Both state owned and private Chinese firms have been sending money to these offshore centers but their incentive structures are quite different. State owned firms (SOEs), given preferential access to Chinese capital markets, utilize tax havens to finance large scale mergers and acquisitions, often for political reasons or for the profit of SOE insiders. Private firms extend to these tax havens so they may gai n access to capital markets, as they are largely unable to access the Chinese capital markets due to crowding out which occurs by the large SOEs and an unfair regulatory environment. Though now distinctly less popular than in 2006, firms also send investme nt to tax havens to have it come directly back to China so that these firms may receive various benefits for bein g a foreign domiciled industry, in a process known as capital round tripping. Roughly, there are two types of reasons why money flows to these tax havens, regulation escape and for value added services. Firms may send money to the Cayman Islands to obscure the ownership of capital so that they may pay less money in taxes, in financial services because there is an actual profitable motive to do so, such as gaining access to capital markets as mentioned earlier. In crafting policy for China, it is necessary to try to

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3 minimize the first kind of flows but not necessarily the latt er. Though China does need to repair its capital markets for the benefit of its own private firms, there is nothing inherently damaging to the Chinese economy when Chinese firms make a profit by accessing American stock markets and Hong Kong stock markets at the same time, a benefit allowed to subsidiaries which incorporate in the Cayman Islands. For the reasons mentioned above, these flows have both positive and negative impacts for the China, and there is much theoretical disagreement on the net effect of offshore financial centers on the host country. Some author s suggest that offshore centers allow firms a greater ability to avoid distortionary investment taxes and thus make greater elfare. Other authors suggest that tax havens are fully parasitic upon the source country and thus any step towards their elimination may be a welfare enhancing one. Even though these offshore centers have some benefits for Chinese firms, allowing the rich est firms to evade their taxes while smaller domestic firms are totally unable to do so is not a justifiable move. For this reason, China needs to craft policy such that they gain more complete control of their tax base and they can stop tax leakage to the Cayman Islands, the British Virgin Islands, and Hong Kong. The investment Development Path theory, which outlines a common pattern of the Inward FDI and Outward FDI ratio compared with GDP per capita, suggests several conclusions hip with these centers. Outward foreign direct investment is growing faster than i nward foreign direct investment and if the IDP theory is correct OFDI flows may soon become greater than IFDI flows in total F or this reason China needs to ensure that the se funds leaving the country are doing so for the benefit of

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4 the Chinese economy before the volume of the outward funds reaches its peak. Prior the IDP theory is a st some information on what the future holds for Chinese investments. This thesis recommends a variety of potential policy changes that China may utilize to limit its tax base leakage and improve its tax policy. Tax information exchange agreements (TIEAs), as they have been commonly used by other countries, have been shown to be ineffective as they do not provide much information and they do not provide incentives for tax havens to share i nformation. In order to craft an effectual TIEA, there needs to be a large payoff for the tax haven in exchange for absolutely all relevant information. Given that China has two large foreign tax havens, t he Cayman Islands and the British Virgin Islands, t hey should engage in a treaty in which these countries give information to China in exchange for a payment, but only if both countries have signed the agreement. The reason for this is that if the BVI effectively ends it s haven activities, the Cayman I slan d s stands to gain through a shift in funds. An effective TIEA for China would require signature from all the major havens, would provide substantial payments to compensate them for their losses, and would ensure full information sharing. As for the Chines e citizens and corporations who are avoiding taxes by using these havens, China may find that tax evasion is less prevale nt if the Chinese government foster s seeks to explain why people in general e vade taxes less than is expected through theories of profit maximization even in countries where the probability of being caught for tax evasion is low. The personal belief that taxes should be paid and therefore the motivation to do so is

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5 called tax mora le. This attitude of choosing to pay taxes even though one may easily avoid detection can be supported when people believe that the government is spending its money on the proper things, and when people receive a say in what the government spends through d irect democracy opportunities. Tax morale was also found to be applicable to firms, in a study which measured how tax compliant firms are versus how survey In the stu were more likely to pay their taxes correctly. For this reason, China may find itself with fewer problems with tax evasion if they facilitated greater direct democracy opportunities for their citizens and improved their legal and financial institutions to be considered more trustworthy by the Chinese people. The above policy suggestion s however, method s which attempts to coax cooperation with a r eward. It is entirely possible that these island nations would not agree to the kind of TIEA outlined above China may also U.S. in 2012. The U.S. implement ed a policy known as FATCA, in which foreign financial institutions must provide full tax information to the U.S. about U.S. citizens or S sourced assets. China should imitate this policy, and threaten t o tax foreign assets unless full tax information is provided to the Chinese authorities. The reason why this method may work is that it stands to make b ank secrecy unprofitable. It is a truly drastic measure but implementations of this law over 50 countries have begun negotiations to craft a treaty for its implementation. Given the fact that China is a host to trillions of dollars of foreign

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6 investment, this measure may intimidate the holders of the funds enough to bring about change in th e offshore financial system. As for Hong Kong, China does not need to financial center for Western businesses to enter China and thus should avoid attempting to take full co extensively in Hong Kong. The amount of money leaving China in the form of Foreign Direct Investment was over 65 billion USD (UNCTAD STAT) in 2011 and it appears that this amount is only going to increase in the coming years. Money may leave the country for many reasons, but the Chinese government and the Chinese people would stand to benefit extensively if they can prevent the money from leaving for reasons of unprofitable SOE mergers, ta x evasion, funding of unknown enterprises, and money laundering. This thesis seeks to suggest methods that may limit the abuse of tax havens or offshore financial centers by Chinese firms and Chinese nationals.

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7 Chapter 2: Literature Review The State of T ax Havens in 2013 Tax Havens have existed for centuries now, but recently there has been increasing government in an attempt to erase the influence of tax havens. In April 2009 at a G20 conference, tax havens were encouraged to sign at least 12 information sharing treaties with other countries or else face economic sanctions. (Johannesen and Zucman, 201 2) The G20 achieved its goal of mass treaty signing, as over 300 treaties were signed before the end of 2009. However, does this mean that tax havens are actually going away? Johannesen and Zucman (2012) have studied the way that these treaties have impact ed wealth kept in havens, through the use of cross border bank deposit data collected from the Bank of International Settlements. Comparing the flow of money between country haven pairs that did and did not sign a treaty, the study found that as the G20 co untries hoped, signing a tax information sharing treaty did cause some money to flow out of that particular tax generally not repatriated, but instead transferred to a differ ent haven with which the country does not have a treaty. The result of this treaty is that the G20 crackdown on tax tax transparency. Below is a graph depicting how m banking systems versus non

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8 Graph originally from Johannesen and Zucman (2012) It appears from this data that tax havens are alive and well, and bilateral tax treaties are not a good method for solving the problem. Naturally, a treaty signature between a country and a haven would make it more risky to keep assets in this haven, but it would not impact the risk of keeping the funds in another country. It appears that tax havens are not going away yet, at least not as a result of treaty signature. In order to understand how the relationship between China and tax havens will evolve, it is first necessary to measure and understand how the relationship between the two has evol ved up until this point, and to see what research has already been carried out that may be relevant to this prediction. Unfortunately flows of money to tax havens for

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9 the purpose of hiding wealth from the tax authorities are often measured by the governme nt as a type of Outward Foreign Direct Investment, or OFDI. This is unfortunate because it then becomes difficult to distinguish the real cause and purpose of the OFDI spike that has occurred and to distinguish the more standard type of FDI from tax haven activity. To give a summary of recent OFDI that is relevant to haven activity, Outward FDI Flows by Destination Unit: $1,000,000 U.S. Source: Chinese Mi nistry of Commerce Hong Kong, The Cayman Islands, and the British Virgin Islands are all known offshore centers. Morck et al. ( 2007 ) suggests several factors to be taken into consideration when studying these numbers to distinguish tax haven activity from actual investment: 1. FDI into these countries may be put there so it is beyond the view of tax

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10 2. Chinese subsidiaries in these locales may be holding these funds here to be reinvested later, to another unknown loca le or back into China. ( UNCTAD World Investment Report 2006 suggests that between 25 % and 50% of Inward FDI in China is actually just round tripped.) 3. Insiders in Chinese firms may be moving the money to accounts under their personal control. The money can not be easily traced from these jurisdictions once it enters them, as Hong Kong, The Cayman Islands, and the British Virgin Islands all abide by tight bank secrecy laws. For these reasons, OFDI figures, which are necessary to measure the flows of Chinese m oney into tax havens, may not be viewed as reflecting the true amount of investment in this country which results in actual production of goods, services, industry, research and development, or any of the other components of real investment. It may be nec and the reason why Chinese money began flowing into these jurisdictions in the first place. Although Chinese economic history is quite lengthy, foreign direct investment is for Chin a a very recent phenomenon. Angus Maddison suggests that during the Mao era from 1949 intersta after Deng Xiaoping took control of the Chinese economy, an economic reform began to take shape. Here is what outward and inward FDI looked like in the post Mao era:

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11 Source: UNCTAD STAT 2011 Unit: $1,000,000 Inward FDI started to grow very quickly, and to a much greater extent in the 1990s than did outward FDI, however, outward FDI is now presently quickly catching up. The Investment Development Path theory of FDI (to be disc ussed in more detail later) suggests that inward FDI is a prerequisite for outward FDI, so inward FDI of the 1990s should be examined as it may give information relevant to the OFDI boom of 2000s Yasheng Huang frames this growth in Inward FDI with the fol lowing heuristic equation: In the 1990s, domestic firms lacked competitiveness with foreign firms for a variety of reasons, which encourages rapid inward FDI growth due to the prevalence of profit resources were allocated based on a political pecking order, which gave greater preference to the inefficient State Owned

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12 Enterprises (SOEs). Even though SOEs received much more capital than either the Township Village Enterprises (TVEs) or the private sec tor, it was the private sector where the truly effective domestic firms existed. Between 1990 and 1999, SOEs eliminated 17.7 million jobs, while urban collective firms (subsidiaries of SOEs) phased e sector created 59.9 million jobs. (Huang) There is no good way to create an estimate of how effective these private firms would have been had they had ready access to domestic capital, but it is clear that the capital allocated to the failing SOEs could have been a better investment if it had gone to the high performing private firms. Also, the lack of proper funding increased the relative foreign competitiveness, and helped produce such a high level of inward FDI. The Chinese government further shackled its domestic firms by preventing firms from engaging in projects across multiple regions i.e. each domestic firm could only operate in one region. Foreign firms did not have any of these limitations, and for this reason these firms could capitalize on pr ofitable opportunities all over China at once. (Huang) The economic importance of this large amount of inward FDI has both positive and negative aspects. FDI worked against some of the inefficiencies of the Chinese institutions and capital markets, and f inanced some firms starving for capital. However, h igh levels of FDI dependency on almost entirely foreign investors mean that enormous profits were being made by foreigners which could have been made by Chinese entrepreneurs. This also limits the ability of Chinese firms to develop independently and become globally competitive. However, this inward FDI laid the economic background from which outward FDI was able to grow so extensively.

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13 According to Lian (2011), Chinese Outward FDI can be classified into t wo stages. The first stage, from 1982 to 2000, is the spontaneous stage, in which outward FDI is very volatile and inconsistent. From 2000 present is the new stage, the government oriented stage, in which outward FDI is promoted by the government heavily through their policies, and in which OFDI growth has been more consistent to reach great heights. The Importance of Tax Havens to Chinese Industry in the Preceding Decade What are the reasons that so much Chinese outward FDI has been directed towards these secrecy jurisdictions, if so much of the money is subsequently returning to China? Xiao (2004) produced one of the most definitive studies on the relationship between China and offshore financial centers. Although this study is now quite dated due to some prominent it remains useful for its clear description of the four incentives which cause Chinese FDI to round trip so extensively. 1. Tax Advantages and Fiscal Incentives preferential treatment (until 2006) of foreign owned enterprises which operated in China. These included superior land use rights, favorable financial services, and lower taxes. The extent of the final advantage is given by Deng et al. (2012) who suggest t hat foreign firms had to pay a de facto rate of 15% during their first 7 years of operation, while domestic firms would have to pay up to 33% in corporate income tax. 2. Property Rights Protection The private sector in China sees many advantages in putting w ealth in Hong Kong or another offshore center, because the property law clarity and enforcement in China is weak comparatively. An incentive also exists to turn profits into FDI and

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14 subsequently bring them back into China, as the Chinese governmental insti 3. Expectations of Exchange Rate This element means that Chinese investor may round trip their capital so as to collect an advantageous exchange rate when the money comes back into China. Xiao cites this as an element whose role is increasing as China relaxes its controls on capital accounts. 4. Competitiveness of Overseas Financial Services (specifically Hong Kong) Many companies in Hong Kong mostly engage in business with China. Companies w hich have close ties in the two areas become the best intermediaries for round trip FDI flows, which permit the flow of capital with the least associated transaction cost. Another important contribution of Xiao (2004) is the subdivision of round tripping F DI tripping purposefully confusing trail of capital to get around administrative weaknesses, taxes, or la ck of property rights in China. Xiao cites this reason as an implicit assump tion about all round tripping present in many prior studies of the round tripping phenomenon. The a flow which creates value. For example, firms may be creating value by r eceiving loans banks or sending capital to firms listed on a stock market in Hong

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15 Kong. Xiao also suggests that most international mergers and acquisitions transactions involve round tripping to Hong Kong to receive adequate financial support. Since round tripping fundamentally involves transaction costs, it may be necessary to distinguish between the above two types of round tripping for the purpose of normative policy prescription. If most round tripping is just a complicated paper trail used to befuddle the authorities and evade taxes then this may be seen as a needless cost to businesses, fueled by regulatory incentives from the Chinese government such as high taxes, poor legal protection of business, etc. A needless cost to busin esses should be eliminated in an ideal and efficient business environment. However, if round tripping is largely used for creating value, than these techniques will continue if they exceed the transaction costs associated with them even in the absence of r egulatory incentives. appears even more important today because in 2006, China harmonized its tax rates for domestic and foreign businesses, while including new taxes on assets sent to offshore vehicles. (Sutherland et al, 2010) If regulations, one might have expected the FDI to the Caribbean tax havens to drop to almost z ero, but this was not the case. Source: Chinese Minis try of Commerce

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16 Evidently, a very large shift in Chinese FDI flows occurred between 2006 and 2007, with the Cayman Islands taking a major loss in relative importance and the other jurisdictions increasing in proportion. Sutherland et al. (2010) examines th e amount of FDI shifting between China and the big three tax havens, attempting to measure empirically which applying them in the post 2006 context, Sutherland used a s urvey of all Chinese firms which were operating in a US based stock exchange to determine how these firms raised capital, using the 20 F form all firms must give to the U.S. Securities Exchange Commission, which requires detailed information on capital rai sing activities. Sutherland agrees with Xiao that capital round tripping may be done to exploit differences in the economic environments of countries, the so tripping for escaping for adding value. Sutherland further subdivides the motivations for this capital round tripping for SOEs and private sector firms. SOEs have privileged access to capital due to the government controlled capital markets, at favorable rates. SOEs are also d ividend adverse, and pay much less to their shareholders (mostly consisting of government groups) than private sector firms. For this reason, stock in SOEs would be more valuable in the Chinese capital market than ng. Private firms, excluding a few mega firms, are largely crowded out of the capital market and must look for capital on the international market and through international listings to receive support. Additional main goals of the Sutherland study include determining which aspects of the Chinese economic system cause FDI to flow so heavily to these tax havens, and to determine the specific advantages of sending capital to the Cayman Islands and British

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17 Virgin Islands (CBVI) over other tax havens across the globe. To do this, three theoretic propositions were tested: 1. Chinese OFDI to the havens is a response to Chinese capital market imperfections This proposition was tested to by viewing the amount each company raised in its foreign IPO as a proxy for capita l raising activity. 2. Chinese OFDI to the havens is a response to non capital market institutional factors This proposition was tested by examining if these firms had used the offshore market for property rights to acquire other China based businesses throu gh its offshore holdings. 3. highly time dependent upon changes to Government policies This was tested by viewing changes in FDI immediately following shifts in FDI regulation. Suther land confirms all of these propositions, and notes that firms extensively raised capital through structures both in the Cayman Islands and the British Virgin Islands. (62 of 72 firms were incorporated in the Cayman Islands and 42 had one or more BVI holdin g company held by the CI firm.) It was also quite common for firms to use IPO proceeds to acquire other Chinese companies, which was done by 22 firms. As for responding directly to new regulation, 46 of the firms had established a new Hong Kong subsidiary between 2005 and 2009, reflecting the preferential tax agreement established with Hong Kong in 2006 through a tax treaty. Sutherland establishes that the reason the Cayman Islands is the most popular destination for Chinese firms to establish their listing

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18 vehicles is more than just its zero rate of income and capital gains tax, because many havens worldwide offer these features. The Cayman Islands provides a location for firms to have an IPO in both the Hong Kong and U.S. stock exchanges, though the BVI do es not. Incorporation cost in the Cayman Islands is very low and the incorporation process takes 1 3 days, half the time of Hong Kong. All in all, the Sutherland theory emphasizes that Chinese firms effectively use offshore vehicle to both respond optimall y to Chinese regulations and augment capital greatly through the use of superior capital and institutional markets offered by the CBVI and Hong Kong. Further evidence of the time dependency is offered by Yuan et al. (2012), who looks at how a prominent C income tax law planning to limit the amount of taxes paid, in both legal and illegal ways.) The effects of the law are threef old. First, the corporate tax rate was reduced from 33% to 25%. Second, this rate was applied to all business, including foreign invested enterprises, foreign owned enterprises, and domestic enterprises. Lastly, tax scrutiny would increase and China would make greater efforts to locate and punish corporations participating in illegal tax avoidance. Yuan et al. (2012) attempts to find how this law impacted the book tax gap, which is the difference between the financial pre tax income and the taxable income r eported to the tax authorities as a proxy for tax aggressiveness. The first hypothesis is that this law would cause a decrease in the amount of tax aggressiveness seen in Chinese corporations. Yuan also included two more hypotheses; Hypothesis 2a is that s tate controlled companies would demonstrate a lower level of tax aggressiveness than private firms. Hypothesis 2b is that foreign invested companies would demonstrate a

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19 different level of tax aggressiveness than domestic companies. Using regression analysi s, hypotheses 2a and 2b were not large enough to be statistically significant. He does cite that 2a is supported by prior research by Wang (2010) and Zheng and Han (2 008). Most importantly, it appear that by making tax rates more consistent and more acceptable to business, this policy was able to limit the amount of tax aggressiveness, and potentially lower the amount of resources spent on avoiding taxation. The Pres ent Trends of Chinese OFDI In order to measure and understand how Chinese firms interact with tax havens, FDI must also be understood, as it the most important measure which can gauge tax haven activity. Wang et al. (2012) has found several important trend s of Chinese OFDI which FDI stocks. Secondly, OFDI from the financial industry i ncreased at a faster rate than any other industry, and 90% of OFDI came from the industries of finance, business service, investment went to Asia (with most of it g oing to Hong Kong) and 17.5% went to Latin America (almost entirely to the CI and the BVI.) The last trend of note is that 85% of FDI in non finance fields comes from SOEs. Peng (2012) attempts to determine which factors of the Chinese OFDI boom are and is understood in the largely Western business literature The first factor which makes

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20 Chinese OFDI relatively unique is that the role of the home country government (in this case China) is fundamental in the shaping of the increase in OFDI. Peng suggests that previously most countries which prod uced large amount of OFDI were W estern style developed countries which all have similar market supporting institutions. As a result, these instituti nese institutions are far from W estern style, and now there is a necessity to observe exactly how Chinese policies work to incentivize or hinder FDI. For example, Peng believes that China is taking greater contr flight back to the Caribbean tax havens. The second relatively unique feature of this boom is the lack of superior technology of Chinese firms, which runs contrary to the tra ditional view of FDI from western countries. In the ownership location internationalization framework, Multi National Enterprises (MNEs) use superior managerial and technological resources to find ways to make profits in foreign markets. However, Chinese a Western counterparts. Peng cites a different framework, the Linkage, Leverage, and Learning framework, as more useful for Chinese OFDI. Linkage means that Chinese firms are able to identif y new opportunities through their extensive networking with other professionals. Leverage means that Chinese firms can use comparative advantage in global markets, even if they do not have the most cutting edge technologies. Learning is the factor which mo st differentiates this framework from the OLI; it is the feature which causes Chinese MNEs to enter new markets to learn about them to develop new techniques. The third and final new trait of Chinese OFDI, which agrees with the finding by Wang, is that mer gers and acquisitions have a relatively large role to play in Chinese

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21 market entry. Peng cites two reasons why this technique is so prominent: ur gency of entry into new markets and a desire to acquire existing popular brands (as Chinese MNEs have tradition ally had limited success in creating popular brands.) These three relatively unique factors of Chinese OFDI must be considered alongside any traditional theories of FDI growth when determining the causal mechanisms of Chinese capital flow into tax havens. Further research into Chinese institutional support for business was conducted by Zhu et al. (2011), specifically on Chinese institutional support for small and medium 50% of tax revenues and 70% of import and export trade, but these businesses receive less than 25% of bank credit. These firms also contribute 82% of new products and 74% te chnology when compared with many other rich countries. Zhu engaged in surveys with many managers at Chinese SMEs to find out what they determined were the biggest institutional barriers to their success. The top five barriers were 1. Fairness of Competition 2. Access to Financing 3. Laws and Regulations 4. Tax Burden 5. Public Support Systems Two thirds of these firms in total found that their innovation activities were greatly constrained by an unfair business environment in which large firms attempt to monopolize the m arket. 95% of the interviewees complained that the tax structure does

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22 not incentivize innovation. Because China operates under a value added tax system, firms who have low material costs but high labor costs are unable to deduct most of their production co st from sales income. Thus, knowledge intensive businesses face a barrier that manufacturing firms do not face. Zhu finishes the paper by saying that the environment for SMEs has improved in the past couple years but great strides must still be made to eli minate these institutional hurdles. This tax system and these capital market imperfections do not provide the proper incentives for innovation. Conclusion Pressure upon tax havens to give away their secrets has found some limited success, but with so man y countries and banks willing to take up these secrets anew, there has not been a shift towards eliminating tax havens or ending the age of bank secrecy. Chinese businesses have enthusiastically embraced sending FDI to Hong Kong, the Cayman Islands, and th e British Virgin Islands over the past ten years, as the Chinese nouveau riche are finding ways not only to make profits through international investment but also ways to hide money from Chinese authorities, protect their assets using superior foreign lega l systems, and attract financing from other businesses around the world. These factors have combined into the OFDI explosion from China, but it is not always easy to determine the difference between investment in a real firm and a paper corporation actuall y under the control of the Chinese firm, nor can outward foreign direct investment that returns to China as inward foreign direct investment easily be distinguished from OFDI which actually terminates in a foreign country. Research on Chinese firms has sho wn that the FDI amounts are highly sensitive to changes in policy from Beijing, and that Chinese firms actively use FDI strategies, ofte n in ways not

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23 formerly seen in W estern theories, to increase the value of their capital holdings. This is not surprising given the many weaknesses of Chinese legal and financial institutions. It may be difficult though, for China to actively shape its policy and institutions to limit its loss to these overseas financial institutions, due to the incredible vested interests in ineffective SOEs, entrenched cronyism, and the myriad of creative ways Chinese firms are limiting their tax exposure by utilizing financial, governmental, and banking apparatuses from around the world.

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24 Chapter 3: Theoretical Model To determine how tax haven flows between China and its preferred tax havens will change over the next several years, and to make policy recommendations, it is necessary to understand the theory behind how tax havens impact the capital host state (defined as the country fro m which capital is coming which goes to tax havens) and the people that live within them. There is not a consensus as to whether tax havens help or harm the welfare of citizens in high tax countries. There is also not a consensus on whether tax havens incr ease the amount of financial activity in the world economy, or reduce it. In the section, I will present some of the recent debate going on with respect to the theoretical foundations of tax havens, and attempt to use empirical evidence from China to suppo rt the models whose theories are the most relevant. Furthermore, I will lay the theoretical foundations for the investment development path theory, which may provide some evidence about the volume of Chinese FDI flows both inward an d outward in the comin g years. The Influence of Tax Havens on Other Actors within the Global Economy: Current Debate There exist several theoretical models that attempt to weigh the influence of tax havens on other nations, and they do not all draw the same conclusions. Desai et al. (2006) is a commonly cited paper which suggests that money being directed to tax havens in fact does not limit the amount of financial activity in non haven countries. Their argument works by suggesting that investors are freed from the burdens of taxes in their own country, and may thus maintain levels of foreign investment unattainable if tax

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25 havens were more costly. Desai et al. further support their argument with an appeal to the to the many high tax countries continue to attract significant foreign direct investment. In this model, tax rate diversity promotes the growth of investment without causing countries to attempt to all lower their taxes to be able to collect dividends. Hong and Smart (2010) further provide theoretical support for tax havens as an advantage for the world economy rather than a problem. Hong and Smart base their theory on the standard analysis (supported by Gordon, 1986) that small governments with open economies s hould not tax mobile factors such as international capital because such taxes are distortionary and will be paid by domestic immobile capital holders anyway. Despite these distortionary affects, Hong and Smart suggest that capital taxes can be a welfare in creasing measure as they can redistribute rents from domestic entrepreneurs to domestic workers. They further use their model to conclude that an increase in income shifting causes effect ive tax rates on capital to rise instead of fall (if the initial tax rate is below 50 percent.) Given that tax rates in G7 countries have a median value of 52 percent, the authors suggest that there will not exist any considerable lowering of tax rates even in high tax countries. Hong and Smart declare the normative impli cations of their somewhat surprising model to be as follows: borne by domestic agents in equilibrium anyway, then the rise of tax planning can increase domestic redistribut Furthermore, our qualitative results hold even when tax planning entails

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26 deadweight costs in the host country and when governments may use investment tax credits to limit the distortionary effects of the cor (84) The implications of such a model are quite radical. Tax planning increasing social welfare suggests tax havens only harm domestic entrepreneurs and high tax rate governments, but that in general tax havens perform a service for s ociety. However, this The most influential model which declares tax havens to be detrimental to other non haven states is by Joel Slemrod and John D. Wilson (2009). Slemrod and Wilson expand considerable resources to limit their revenue losses to tax havens, and corporations and people also spend large amounts of resources in transaction costs to get this capital to these jurisdictions. A notable normative conclusion from this model is that welfare would all be increased if tax havens were eliminated completely. Slemrod and Wilson support this idea with raises the equilibrium level and Wilson, 1265). This argument makes int uitive sense. The public good is assumed to be a normal good for the purposes of this model. C apital flight to tax havens lowers the amount of taxable cap ital in the country, which subsequently lowers the amount of tax revenue collected such that the government cannot afford to provide Q*, the amount of

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27 the public good which would be provided in equilibrium Underproduction of the public good results in dea dweight loss as illustrated in the following graph. Source: Dumas Slemrod and Wilson also argue that even a partial elimination of tax havens, as in causing one tax haven to cease haven activity, would be welfare increasing. Limi ting the choice of tax h avens w ould reduce the competition in the tax haven business, and thus increase the transaction costs. This increase in transaction cost should subsequently cause less money to flow out of the country and allow for more public good provision. A further c ontribution of the theory is a potential explanation for the reason why capita benefit of being a tax haven falls with country size. With many people living and doing business in a country, it becomes less attractive to tax these people minimally while still providing public goods for them than to have a more traditional tax regime.

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28 Elsay yad and Konrad (2010) further the idea of tax havens as harmful, and utilize a three player game theory approach to determine how non haven governments should negotiate with tax haven countries S, a capital owning country that attempts to combat the influ ence of tax havens, and H1 and H2, which are tax havens. Elsayyad and Konrad describe a multiple stage game. In stage 1, S makes offers to pay the tax havens compensation in exchange for ceasing the tax haven business. In this phase, there are two types of offers. Country S can offer payments to H1 and H2 simultaneously and thus is able to pay either both havens, one, or neither. Alternatively, country S may first offer a payment to one of the tax havens, and then after that tax haven accepts or rejects, ma ke an offer to the other one. This alternative would be referred to as the sequential offer. In the sequential offer, the second haven to be negotiated with will know the outcome of the prior negotiation. The second phase is the competition phase, in whic h S chooses a tax rate, and the tax havens who have not received a payment from S select user fees for keeping a function of the tax rate chosen and the user fees charged. (Investors are not a separa te player in this game, and are assumed to move their money to wherever they would receive the most returns.) In this model, there is no equilibrium in which a deal is struck with only one tax haven. If only one tax haven makes an agreement with S, the other tax haven is able to can also be no equilibrium with sequential negotiation. Once one tax haven is deactivated, the other will not accept a payment that is equal to any less than the full amount of the capital investment. For this reason, s imultaneous negotiation will always

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29 be less costly for S in scenarios where both tax havens are deactivated. This paper further supports the notion that tax haven countries see improved returns when their competition is limited, and for this reason it is impossible to shut down the last tax haven, when they parasitic on the capital of other nation s, they disagree with the stance taken by Slemrod and Wilson with respect to the advantage of shutting down several tax havens while many others still exist. Elsayyad and Konrad argue that if the OECD expends to shuts down several havens, OECD citizens may find themselves worse off from a welfare negotiation approach of reaching agreements with all the tax havens at once is not feasible, and the sub optimal sequenti al approach can be used, countries would maximize their welfare by negotiating with the primary tax havens first, as opposed to tax havens which do not have a large relationship with the country. The Investment Development Path The theory of the investme nt development path is a theory first proposed by FDI. In the first stage, the country has very low IFDI and OFDI, but IFDI begins to pick up. In enlarging domestic market brings market seeking I FDI and resource seeking I FDI. From here, in stage 3, local businesses become stronger and develop the ability to compete internationally, and the Net Outward Investment position goes from negative to closer to zero, but in stage 3 the country is still a net recipient of FDI. In stage 4, OFDI takes off and becomes much larger than IFDI. Stage 5 is the stage

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30 of highly technologically advanced nations, where the net investment position of the country is predict ed to hover around zero. (Liu et al. 2005) Note: this chart is not to scale, and is merely illustrative of the theory. Liu et al. (2005) examined how this theory applied to China in 2005, and found that the theory did appear dated and insufficiently abl e to describe the modern role of China. However, Liu et al. added three variables to their regression analysis to represent some easily measured features of Chinese development. These three variables were: Exports, Human Capital (represented in this study by average years of schooling), and OFDI flows, without including any model modifications for simulating the peculiarities or unique features of Chinese institutions. T hese data are relevant for creating policy recommendations, because this demonstrates the way that FDI develops in a way that is being $123 billion (UNCTAD Data), China may safely be considered to be in stage 2 or 3 depending on the future trajectory

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31 of the Net Outward Investment Position (IFDI OFDI). It may be useful to predict the arrival of stage 4, because this is the stage in which OFDI begins to dwarf IFDI, which will certainly impact flows to tax havens. A Brief Note on Guanxi Guanxi (pronounced gwan shee) is a word for the relationship network used by Chinese people. This social network has no easy analogue in Western soci ety, but its presence in China is undeniable. Chinese businessmen frequently use guanxi by giving gifts to other businessmen, including those that they did not previously know, as a sign of goodwill and respect (Xin and Pearce, 1996) These relationships ar e often reciprocal, but they are distinct from bribery or kickbacks as they are not tit for tat, and are never done to bring about only one desired outcome (to give a gift to a government official just because one want s him to give company a contract would be frowned upon, but to give a common practice.) Xin and Pearce (1996) have put forth the hypothesis that owners of private Chinese businesses utilize these s ocial networks as a substitute for formal institutional protection. By using interview data from both government officials and private business, they have shown that businessmen in the private sector rank networking ability more highly as a cause for their success. They also report that private businessmen report guanxi connections as more useful for defense against threats of government seizure of assets than businessmen in the state sector. They show that private businessmen give more unreciprocated gifts than do officials in SOEs, indicating potentially that the use of guanxi gifts is more vital to private business survival. The connections made through guanxi are often lifelong, and not easily revocable. When

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32 considering the reasons for tax haven flows, it may be necessary to consider the interpersonal connections of the businessmen involved with them. It could be that to cut ties entirely with a Chinese business partner who manages a BVI firm would be unacceptable to many Chinese businessmen, and for thi s reason, many business es maintain partnership s for a very long time. Furthermore, the use of guanxi by Chinese businessmen could help explain why so many Chinese firms are using the same tax havens. Two businessmen who know each other are likely to recomm end people from their own social networks to the other, as a way to expand the social network and do favors. Overall, guanxi is simply a good thing to keep in mind when studying China in general, as it is not easily understood by Western economic models of self interest and exchange. Tax Morale In 1972, Allingham and Sandmo put forth one of the first theoretical models on why people pay their taxes. They attempted to use a utility maximization approach to determine how people decide whether paying taxes is worthwhile or not. They decided that tax evasion is negatively correlated with the probability of detection and the degree of punishment for tax evaders. (Torgler, 2003) However, in many critiques of this research, other researches have pointed out that t his theory predicts too much tax evasion. In other words, many people pay their taxes despite the fact that the countries they live in may have some combination of low evasion detection and minor punishment for the crime. From this point then, it becomes necessary to ask a different question: why do people pay their taxes, sometimes in systems where it may not appear to be utility maximizing to do so? Torgler (2003) suggests the answers lies with a concept called tax

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33 that paying taxes is a worthwhile thing to do. To attempt to find some factors which impact tax morale levels, Torg ler the country that each has a distinct form of taxation and government. He compared strong the direct democracy is in each district. He found that the greater the strength of direct democracy in the district, and the greater the sense of local autonomy in the respondent, the greater the sense of tax morale. The study also showed that tru st in the courts and the legal system correlated with higher tax morale. Extending the findings into China with a further study, Torgler found that China has high tax morale compared with other countries in Asia such as the Philippines, but lower tax mora le than the OECD average. He goes on to say that fostering trust in the government and legal system and its representatives can improve tax morale. He concludes: constitutional leve l as well as at the current politico economic level. In all the different cultural settings such a strategy has a positive effect on tax morale. If taxpayers trust the government, the legal system, and the national officers, they are more willing to pay ta

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34 Although the author does not go much into the justification of how this correlation can be extended into causation, his suggestion that greater trust leads to greater tax payments makes intuitive sense. People who believe they can positively shape the activities of the government and who believe the government is pursuing worthwhile activities with the money it collects would see a greater positive economic benefit from giving their money to the tax authorities that those who s ee the government as corrupt and controlling. This idea suggests that by improving direct democracy practices in China and improving the China. However, given the fact tax evasion themselves beyond the activities of high net worth individuals; can this theory of tax morale extend to firms too? According to Alm and McClellan (2012) the theory of tax morale can be e asily extended to explain firm behavior. They performed a study on over 8,000 firms spanning 34 countries, and used data from the Business Environment and Enterprise Performance Survey and the World Enterprise Survey. They used responses to these surveys t o capture some relevant information on the intrinsic tax morale of these firms, such as a quest ion which asked these firms to what extent taxation was an obstacle to the ir firm running successfully. They found that across these countries, state owned firms and foreign firms were both significantly less likely to find taxes to be a burden than domestic firms. Furthe rmore, the larger firms were more likely to find taxes burdensome to them. They also found that firms whose survey responses hinted at them havin g higher tax morale did indeed pay more taxes, and that suggests that

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35 authors conclude by suggesting that since corporations have tax morale values as well, the same polic y recommendations may be useful to increase firm level tax morale, such avoiding pol icies that suggest that cheating is morally ac McClellan, 2012 )

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36 Chapter 4: Policy Recommendations In 11 years since the OECD has attempted to limit the flows to tax haven nations, many source countries have tried different methods to prevent tax base leakage to thes e offshore financial centers, with varying degrees of success. China is and definitely should be interested in having greater knowledge of where its OFDI is headed and a greater ability to tax these flows effectively. This section will address which policies will most Islands, the British Virgin Islands, and Hong Kong. Furthermore, the ongoing trends of these relationships will be evaluated to see how Chinese tax haven interactions are likely to function over the next several years in the absence of significant policy changes. Tax Information Exchange Agreements: To Sign or Not to Sign? A popular way to tackle this problem is to sign Tax In formation Exchange Agreements (TIEAs) with other countries as a means to prevent tax leakage. As noted in Chapter 2, the G20 summit of 2009 saw a coordinated ultimatum for countries considered to be tax havens: all tax havens must sign at least 12 TIEAs or face economic sanctions from the G20 countries Since then, China has signed several TIEAs with countries such largest tax haven, Hong Kong, is not eligible to sign TIEAs wit h any country. It has been recommended at the 2011 Global Economic Forum for Transparency and Exchange of Information for Tax Purposes that Hong Kong should put forth the legal framework permitting the territory to participate in TIEAs with other nations, though this has not yet that China could pressure Hong Kong to develop these frameworks and participate in this

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37 type of treaty, or it could be possible that the threat of i nternational sanctions could cause Hong Kong to participate. However, it would be unwise for China to push for a TIEA with Hong Kong which mirrors the other TIEAs that have been signed by many other countries for two primary reasons. The TIEAs which have b een signed have not been proven to cause fund repatriation. There are also insufficient incentives present for Hong Kong to compromise its bank secrecy by signing such an agreement with China. Fund Repatriation is the ultimate goal of Tax Information Ex change Agreements, but this is not the end result of them. As referenced in Chapter 2, Johannesen and decrease in the amount of money kept in the particular signee haven, but it caused the funds to flow to a different country which has not signed an agreement. China may also learn that the TIEAs signed (but not yet ratified) with the Cayman and British Virgin Islands recently have not caused these OFCs to decrease in import ance. This graphic from The Economist depicts the staying power of the relationship between China and the CBVI and Bermuda even in 2011 when the flows from these countries have decreased in size from their peaks: With almost $10 trillion of FDI stock in Ch ina, it is very difficult to believe that the British

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38 Virgin Islands has ceased its capital round tripping operations after the TIEA signature. Other economic superpowers such as the U.S. have experienced that the TIEA signature and ratification did not ca use much information to be exchanged or many tax evaders to be detected either. The U.S. signed a TIEA with the Cayman Islands in 2001 which went into effect for criminal matters in 2004 and civil matters in 2005. However, the mechanism of the agreement m eans that the potential for mass information exchange is very limited. In order for the U.S. to receive information from the Cayman Islands, it must make a prima facie case that the information it seeks is about individuals or corporations engaging in tax evasion. (Addison, 2009) With only 1% of income tax returns audited in the US, it can be very difficult to detect suspicious behavior which would provide enough of a case for the U.S. government to request the relevant authorities. Addison suggests that signing the TIEA with the U.S. accomplishes little: industries if they effectively gave up their favorable banking and tax laws? The answer is simple: the Cayman Islands did not radically change its favorable taxation policies or remove the veil of secrecy. The country still caters to (720) flows to the tax havens even in the presence of a tax information exchange agreement, and the historical failure of tax information exchange agreements to repatriate funds or cause significant flows away from such jurisdictions, it is not recommended for C hina to pursue this sort of agreement with Hong Kong.

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39 If this standardized agreement between countries has proved ineffectual, what might a successful agreement between countries with respect to tax information sharing look like? The key aspect of a succe ssful agreement is that it would align the interests of China and its tax havens in such a way that both countries actively seek to prevent Chinese tax evasion. (Addison, 2009) Building on the game theory approach of Elsayyad and Konrad (2010), it is nece ssary for China to negotiate with the tax havens in a way which makes both parties better off. There is no reason countries should be willing to sign an agreement which limits their ability to make their own livelihood absent some type of coercion or tangi ble sequential payoffs, as each tax haven which is shut down will decrease the competition and make more profits possible for other tax havens. So if China attempts sequent ial shutdown of tax havens, the price for each successive treaty will increase until China has no more tax revenue available. Addison suggests that a potential way to prevent this problem is to set up a new multinational type of TIEA, which provides paymen t for the countries who agree to give over all Chinese national tax information to China, but does not provide payment until a minimum number of tax havens sign on. This incentive structure would prevent a tax haven from waiting until other countries sign on in hopes of receiving a higher payment. Addison also says this scheme would not necessitate every single tax haven to sign on to be successful. The reason for this is that if just a few tax havens are remaining, China could coordinate all of its tax eva sion enforcement efforts in these remaining locales. The payments to each individual country should be equal to or slightly greater than the estimated amount lost to each haven through missing tax

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40 revenue. The rationale for this is that if country X receiv es 10 million in tax revenue from Chinese nationals, it would not accept less than a 10 million dollar payment to disclose these identities. This also provides evidence as to why so many countries are willing to sign the present form of TIEA. The common ty pe of agreement does not accomplish much, and thus countries lose very little profit from signing it. The ideal type of TIEA would involve steep penalties for havens who fail to enforce their end of the bargain, would provide large and sufficient payments for tax havens to join, and would only go At the very least, China should seek full cooperation from both the Cayman Islands and the Virgin Islands before giving any payoff to either of them. The United States has recently put forward a bill known as the Foreign Account Taxpayer Compliance Act. This bill, incredibly broad in scope, requires every foreign financial institution to provid e the IRS with information on every American account holder or else the U.S. government will apply a withholding tax of 30% on all U S source investments held by the financial institution. This bill has proven influential across the globe as other large c ountries, such as the U K prep similar bills in their own legislative branches. Would a similar technique work for China? FATCA, although large and unilateral, cannot work without the help of foreign governments. (Harvey, 2012) Shortly after passing FAT CA, the United State government negotiated treaties with France, Switzerland, the U K and Germany in which these countries promised to uphold the FATCA requirements. Now the U.S. is negotiating with

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41 over 50 countries on a bilateral promise to implement F ATCA. ( Wood, 2012 ) However, that FATCA directly contradicts Chinese law and thus is unenforceable in China. ( Flaherty, 2012 ) For this reason, it seems very unlikely that China would want to participate in the U S A U.S. refuse to participate in tax information sharing because it would put them at a competitive disadvantage with the other superpowers. Effectively they operate as tax institutions. For this reason, Chinese participation in FATCA is exceedingly unlikely. However, the American method for convincing 50 count ries to participate in bilateral agreements promising to engage in their scheme has proven to be effective, and China could use the same method. Essentially, the U.S. has used its economic clout to threaten all the other countries to provide it with inform ation or face a drastic reduction in the value of their U.S. assets, which are extensive for many countries. China may benefit by a similar policy. If promising to pay tax havens to participate in their information sharing scheme does not work, perhaps thr would work. This would certainly intimidate the owners of the 9.7 trillion dollars of capital currently in China domiciled in the British Virgin Islands. lationship to China, it would probably be best for China to coordinate a treaty exclusively with Hong Kong, but Hong Kong would be very unlikely to sign a treaty with China which compromises its bank secrecy. Evidence from Garca Herrero (2011) suggests th secrecy regime (contrasted with Shanghai) is one of its primary advantages as an offshore

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42 center. Garca Herrero further suggests that Hong Kong needs to diversify its investments and fully assert its independence from China so it may possess advantages over Shanghai Chinese tax haven abuse in Hong Kong it is necessary to initiate domestic policy which could limit the abuses, rather than att empt to remove the barrier between Hong Kong and the mainland with respect to tax rates and banking secrecy, currently making Hong Kong an attractive avenue for capital to enter China. According to Garca Herrero (2011, 369), ser Economic Partnership Agreements with Hong Kong Chinese tax laws de facto in Hon g Kong would harm both Hong Kong and China. It seems the best way for China to institutions is to discourage tax evasion through domestic policy shifts. In order for China to boost the tax morale of its inh abitants and thus also of its corporations, it is necessary to improve the fairness and trustworthiness of its institutions. According to Michelsen and Read (2011), Chinese citizens as a whole have a fairly positive opinion of official justice, including t he police system and the legal system, but this is not true of the citizens who had actually engaged in a legal trial before. They system and the satisfaction with national officials have a significant positive effect on tax morale. Thus, trust seems to be key determinant for maintaining and increasing tax

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43 it is necessary for China to increase the public perception that its courts are trustworthy such that tax evasion may be less likely to occur. The legal institutions are not the only ones that may be holding back tax morale. The capital markets have also been shown to be not considered trustworthy by business owners. In the study previously mentioned by Zhu, Wittmann and Peng (2011), in which small and medium sized business owners were interview ed, almost 80% of the interviewees mentioned that they felt the business environment was unfair, with preferential treatment given to large businesses who have more contacts within the e adequate financing through the Chinese banking system. Less than 10% of private Chinese enterprises can obtain bank loans and less than 1% can obtain non bank financing from the capital markets. (Zhu et al. 2011) This lack of support from the government and the government controlled banking system may explain why tax morale among business owners is not as high as it could be. In addition, as Sutherland et al. (2010) have suggested ic legislation and to imperfections in the domestic capital markets from which they have China which provide paltry amounts of financing to SMEs and starve private firms for capital are encouraging usage of offshore financial centers both by lowering tax morale of the business owners and by necessitating the usage of foreign capital by a form of domestic capital starvation. These problems can be addressed at the same time by providing more capital to private businesses and less capital to the SOEs.

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44 A further problem with the funding of SOEs is that SOE managers do not have the proper ince ntive structure for efficient and profitable business tactics. This is because of the way in which state owned enterprises are owned. With over 65.9% of shares of Chi tradable shares either owned by the government or other st ate controlled groups, the Chinese government ensures that it maintains majority control of almost all of the largest firms in the country. (Morck et al. 2007) Chinese SOEs pay very small amounts of dividends to shareholders and often none at all, because the state loses control of the profits if they are distributed but maintains control if they are retained in bank accounts. For this reason, corporate managers of SOEs are very unlikely to encourage retained cash to be disbursed to shareholders, as they ar e not accountable to private shareholders. Instead, they are likely to send out large amounts of FDI, either to politically important pet projects of the government or perhaps to tax havens where the funds may be put into the private benefit of SOE insider s. Although these SOEs are providing the majority of the funds which flow into these tax havens, it is questionable how much these flows from SOEs are actually in pursuit of economic profit for the firm or whether they are merely for the personal profit of the SOE managers. This does not suggest, however, that Chinese institutions need to be replaced entirely with westernized models of proper institutions. As Michelsen and Read (2011) point out, Chinese citizens have alternatives to the formal legal system s for dealing with only more frequently sought local help from informal relations and community and workplace leaders, but they also evaluated their experiences with the se sources of help far

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45 (Michelsen and Read, 193) These relationships with community leaders used to solve disputes, related to the use of Guanxi, allow Chinese citizens t o find proper solutions to disputes without contacting the courts. Although it is necessary for China to make its legal system more trustworthy to the people who use it, there is not a need to stimulate its use for an increased percentage of Chinese citize appear much more favorable to all involved. Furthermore, as Torgler (2003) notes, both significantly impact tax morale is no need to treat only official ins titutions as potential enhancers of tax morale. The IDP Model largely consistent with the IDP model, once a couple of extra factors neglected by Dunning originally have be en added to the analysis. The authors found that over half of the variance of ODFI could be explained using their modified IDP framework. The

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46 hypothesis suggests that policies specifical ly directed at OFDI may be unnecessary, since OFDI even with its variety of non western institutions and non standard business practices, is able to closely match the augm ented IDP model, and that OFDI seems to follow naturally was only influenced by pe rverse incentives put forth by the government, it might be above capita and GDP per capita do bear a resemblance to the beginning stages of the IDP diagram (on page 30 .) with the exception of the increase in NOIP and subsequent decrease following the financial crisis. However, instead of suggesting that the decrease in NOIP following the crisis is an anomaly, it may make more sense that the increase during the crisis was not due to China advancing to stage 3 but actually to the collapse of world markets causing an IDFI drop. Based on this model, it may seem that China is primed to enter stage 3 ver was lower than its IFDI from a year earlier, the 11 th such relative decrease in 12 months, while outward FDI rose by 25% over the first 10 months of 2012. These trends suggest that stage 3 is app OFDI will soon rise to be greater than IFDI. China needs to establish proper relations with tax havens as soon as possible, because the capital is flowing out of China in greater

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47 numbers a nd in greater proportion than ever before. The negative impacts of tax havens Conclusion havens. U nfortunately, though many other countries are and have been interested in the same goal there are few successful models from which to build Many tax information exchange agreements appear to be only slightly useful and have achieved no detectable fund re patriation to the host country. However, there are ways in which a more optimal agreement may be designed. China should pursue a multilateral agreement with its largest sovereign tax havens, The British Virgin Islands, the Cayman Islands, Samoa, among othe rs, which would pay these countries to provide full disclosure of all Chinese sourced assets in their financial institutions. Payments would only be provided to these parties once the Cayman and British Virgin Islands both sign on and perhaps a number of s maller other havens as well. There would be steep penalties for noncompliance. This sort of agreement represents a workable and mutually beneficial agreement for both China and the smaller countries. However, if such a multilateral agreement cannot work, d ue to hesitance to relax its bank secrecy, China China could threaten all foreign financial institutions with steep withholding fees of all China based assets unless the institution provides full information to the government. Though this method is unlikely to work without foreign consent the U.S. is in the process of negotiating over 50 treaties with other nations, demonstrating that th is approach can actually cause mass

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48 and also largest tax haven, there is no reason China should attempt to strong arm Hong shore center also helps China through facilitating western investment in China, so China should not enforcement policies in the mainland. very efficient, and also the capital markets which funds these enterprises cause extensive crowding out of private businesses, furthering the need for foreign capital markets accessible through tax havens. T he capital favoritism for inefficient state owne d enterprises should be eliminated to stop the capital starvation of private firms. To further decrease the amount of money flowing to tax havens, the Chinese government must seek to increase the trust between the constituents and the institutions. Furthe ring direct democracy possibilities and causing a more predictable and popular legal system may increase the tax morale of Chinese citizens and also Chinese businesses, as both people and businesses around the world evade taxes less often when tax morale i s high. become positive, as do the numbers for these figures for 2012, and for this reason it is especially important for China to solidify its relationship with offshore ce nters. Money will continue to go offshore, and if China is unable to minimize the negative impacts of such flows, the tax base leakage is only going to be more of a problem for China and its people.

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49 Chapter 5: Conclusion get stronger and more dominant, the wealth of Chinese citizens and firms will only continue to grow. However, not all increase in wealth is good for the country in welfare terms. Allowing the most successful businesses and people to send their money to tax havens and avoid proper taxation limits the effectiveness of progressive taxation to begin with, and can result in a totally unfair and growingly unequal tax environment. The optimal level of tax for a country to charge its residents is beyond the scope of this paper and up to debate, but it must be ensured that as many people as possible comply with the tax code or else an efficient and equitable tax code cannot exist. For this reason, it is necessary for China to craft some new policy to limit the flow s of Foreign Direct Investment that go to tax havens. It can approach this problem by having new policies which influence its firms, its citizens, and the other countries themselves. China needs to provide a better business environment for its private fi rms, and it needs to stop coddling the SOEs in the domestic markets A better tax, regulatory, and legal environment for small enterprises would encourage Chinese SMEs to gain their financing through domestic markets rather than crowding them out so that t hey must seek foreign financing or use personal savings. The SOEs do not have the proper incentive structure for profitable activity, and it is these enterprises which are sending the majority of money to these tax havens. The SOEs should be allowed to com pete more fairly with private firms, and if they are unable to compete they should either be privatized or

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50 restructured, not kept afloat through a financial market artificially allowing them to operate continuously. Chinese citizens would be more likely to pay their taxes if they felt that the government was spending its proceeds in ways deemed acceptable to the citizenry. This feeling of trust for the government can bo ost tax morale and ultimately bring in tax proceeds in ways which exceed heightening of t ax avoidance detection schemes. Furthermore, a more trustworthy government can increase the tax morale of firms as well, by making business owners more invested in the goods paid for through taxes. As for the relations between China and the tax haven nati ons themselves, China must craft new policy for its relations with foreign tax havens, but it may not be China should first see if the Cayman and British Virgin Islands (CBVI) can both agree to a tax information exchange agreement (TIEA) with extensive payouts to the countries, compensating them for their losses, complete and total tax information sharing, and no payout authorized unless both large havens agree. This prevents any potential hold out incentive and can attempt to get these countries to engage in negotiation of an actual effective TIEA. However, if this does not work, China may threaten these countries with heavy withholding taxes of their China sourced assets unless such information is shared. Realistically, the only way to get such negotiations to happen is for China to make these countries better off by sharing the information than not sharing, and they can do it with a coaxing payment or an aggressive tax. As for Hong Kong, China stands to lose too much

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51 continue to be a doorway for investment into China and if the tax haven flows get to o out of hand engage in further evasion detection methods. As the IDP theory suggests, Chinese outw ard foreign direct investment is going to reach some unprecedented levels in the coming years, and without a proper regulatory framework fo r Chinese tax policy, negative impacts of tax leakage will only exaggerate themselves. Chinese firms have been shown to respond quickly to new regulatory frameworks, which means that China should also move fast to keep wealth from being hidden away in tax havens rather than have its owners pay their fair share. Future studies in this area should look at how FATCA has actually been implemented by the U.S. and through its numerous bilateral agreements, as this policy benefits are of yet unproven but promising Potential problems with such a policy include an overabundance of information shared, which may be costly to effectively sort through, a continued tax haven problem due to shifting assets to different countries, and privacy or leak concerns. FATCA requir es an immense amount of information to be shared, which theoretically could be leaked to people who could engage in malicious actions with that information. A further promising area for study in this field is the exact causal methods, if any, which can cau se firms in countries with developing economies and institutions to pay more taxes in a voluntary way. Tax havens seem to be unlikely to go away, as there are not very many methods to effectively discipline a small, privileged country which holds the perso nal accounts of

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52 methods. The American tax authorities were able to shut (Wegelin & Co, a bank which predated the American Revolution) in 2012 for this banks assistance in helping tax evaders. China should learn from this method, improve domestic policies which incentivize such behavior, make tax evasion stoppage a seri ous priority, and they should be able to minimize the negative effects these offshore centers can have while still growing their businesses and their outward foreign direct investment.

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54 Flaherty, Michael. "China Central Bank Official Slams U.S. Tax Dodging Law." Reuters 28 Nov. 2012. Web. Garca Herrero, Alicia. "Hong Ko ng as an International Bankin g Center: Present and Future." Journal of the Asia Pacific Economy 16.3 (2011): 361 71. Web. "The Good, the Bad and the Ugland; the OFCs' Economic Role." The Economist (US) 16 Feb. 2013: Web. 6 Mar. 2013. < http://www.economist.com/news/special report/21571551 havens serve clean well dirty money good bad and ugland > Gordon, R.H., 1986. Taxation of inves tment and savings in a world economy. American Economic Review 76, 1086 1102. Web. Harvey, Richard, Jr. "FATCA and Schedule UTP." Villanova Publi c Law and Legal Theory Working Paper Series (2012) Web. Hong, Qing, and Michael Smart. "In Praise of Tax Ha vens: International Tax Planning and Foreign Direct Investment." European Economic Review 54 (2009): 82 95 Web. Huang, Yasheng, (2003) "Chapter 7" from Huang, Yasheng, Selling China, Foreign Direct Investment during the Reform Era pp.308 350, Cambridge: Cambridge University Press Web. "Inward and Outward Foreign Direct Investment Flows 1970 2011." UNCTAD STAT United Nations 16 Apr. 2013. Web. Johannesen, Niels, and Gabriel Zucman. "The End of Bank Sec recy? An Evaluation of the G20 Tax Haven Crackdown ." Paris School of Economics Working Papers 4. (2012) Web.

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