I suspect that these rates came as a response to the “Pay their fair share” crowd of that day.
In other words these high marginal tax rates where always intended more as a way of pleasing peoples emotions than a pragmatic goal of generating more revenue.
The little wiggle is that even central bank types and politicians of that type knew that if it was ever to be fully enforced, the industries providing the factory jobs of it’s day would fall apart.
Read more about the Laffer Curve to understand why higher tax is not necessarily the same as higher revenue.
A Gentleman’s Agreement
So the politicians and the rich people kind of had a gentleman’s agreement to allow certain national loopholes and also happily ignore the offshore centers of their time.
It was for example during this exact time that the UK actively encouraged it’s dependent territories like the Channel Islands, Gibraltar and Bermuda to become the Tax Havens they are today.
You can argue that Panama and definitely Puerto Rico and the USVI’s tax laws were setup under a similar Gentleman’s Agreement in the US.
This was a pragmatic approach. We allow these territories with no natural resources or industries to build up a new industry and pay for themselves, instead of live on large subsidies, which was the case for French overseas territories for example.
The politicians and the rich (sometimes the same people) now had a place where they could shield their family fortunes, while paying lip service to the political rhetoric of the day.
Mossack Fonseca and the offshore world post 9/11
The current details from the Mossack Fonseca leak has to be seen out of this history. While the press is filled with stories of rich people hiding money abroad, in many cases their money is not actually hidden abroad. At least it is more likely to be hidden in London or New York than in Panama.
After 9/11 the OECD’s FATF group started to crack down on offshore financial centers. Tax Evasion and Terrorist Financing were added to the definition of Money Laundering. This mostly eliminated the old school way of flying in to a country and opening a bank account.
Now-a-days it is often easier for people to just hide their assets in plain site by obscuring ownership through clever combinations of on and offshore structures.
This is what Mossack Fonseca does, and what they have apparently historically done very well until their lack of network security expertise got them down.
Territories that relied more on banking like Jersey have had a tough time.
Pragmatic Tax codes
The economic pragmatist would say the best way to deal with this issue is to go after demand and not supply. In other words eliminate the need for offshore centers by simplifying tax codes like what Estonia has had great success with. The good thing about this model is that removes most if not all loop holes only used by the rich (The bad guys) and has a simple flat tax.
This always comes up against the political pragmatist that has to deal with cries of “Pay your fair share” from the voters. Imaginary percentage rates always seem to make better sound bytes than actual tax paid.
There we have the issue that politicians have to deal with. Each country’s political culture deals with this differently.
If the politicians give in too much to the populists you literally end up with Cuba or North Korea, with no real industry to sustain the economy.
In Denmark for example you have high income tax rate and VAT, as Danish culture traditionally dislikes rich people and displays of wealth. At the same time we are quite fond of our jobs so corporate tax rates are low. End result is that many successful Danes leave the country, yet there are still a decent amount of steady jobs.
The US’s complex tax code is also a product of this negotiation, based on the US form of populism. We want the middle class to do well,like upwards mobility and buy cool stuff. That is why we have medium income tax rates and low sales taxes.
The evil corporations still figure in our culture however and get to pay very high corporate taxes on paper. Yet pragmatically thousands of pages of loop holes are negotiated to lower this every year. The LLC and S-Corp also solves the high corporate tax rates for small businesses.
Finally to make the US an attractive place for foreigners to leave their money, the capital gains tax is relatively low.
Pragmatic Anti Money Laundering measures
The interesting fact is that even the FATF rules for Anti Money Laundering also ended up being relatively pragmatic, from a rich person and government point of view.
Companies like Mossack Fonseca has to obtain very detailed information about who there clients and final beneficiaries are no matter where they operate in the world (except very pragmatically the US).
I’m pretty sure that Mossack Fonseca more or less followed the FATF rules as specified or their literally would not have been any juicy information in the leak. In the old days numbered Swiss bank accounts did not have any names on file.
The pragmatic part of it is that yes they have to ask and verify information so it sounds like they are helping in the fight against Money Laundering, but they don’t actually have to share it with anyone, unless subpoenaed through their court system.
Anyone ever interacting with Panama’s court system now knows why Panama is a popular place for someone like Mossack Fonseca. It has to be a very serious investigation (or involve you offending a Panamanian politician).
In other words the FATF’s rules were setup to show the world that they are being tough on Drug dealers, Terrorists, Rich people and other such nastiness, while pragmatically allowing anyone with the money to pay expensive lawyers to continue as before.
In the end money actually stayed onshore, while still hiding from local tax authorities who the beneficial owners are. In particular places like London, New York and Miami are very popular places.
Much of the increase in real estate prices in the last 15 years comes specifically from this.
Is this good? Is it bad? I’m tempted to say it just is.
As a world we need safe havens and escape capsules
Nassim Taleb my favorite author/philosopher explains very well in his amazing book Antifragile how important that we don’t all do the same thing. If the whole world suddenly became Denmark it would be just as dangerous in the long term as if it suddenly became Somalia. Even Denmark has Christiania as a kind of safe haven in the middle of it’s Capital.
The reason being that the largest risks are the ones we can’t see or plan for. Just look at the recent sub-prime crisis. The whole world was affected, because everyone started doing the same thing.
The role of Tax Havens have always been important as an insurance. An insurance against populist politics. Against financial melt down, wars, climate or technological change.
The point is that they are not necessarily as bad as people think. Even if some very bad people still use them. Just remember those same very bad people probably also bank in that same exact bank you use to receive your pay check.
The future of safe havens
Bitcoin, Ethereum, ZCash and OpenBazaar are examples of new kinds of non geographically centric havens. As I’ve argued in The IBC and it’s blockchain alternatives and Trusts without Trustees we may actually end up with a world sooner rather than later, where the safe haven is no longer Panama or Jersey (or even London).
And it might actually be these and future technologies that bring the traditional havens down, not activist journalists and Parisian bureaucrats.
Yet we will continue to see populist stories in the future. How about “Shady Cryptorati not paying their fair share” and yes there will be yet more pragmatic ways for politicians to deal with that without breaking the world. You can argue that the US Financial Regulator FINCEN did just that already.
The bottom billion and how they are affected
A little publicized fact of the FATF’s pragmatic AML rules is that they were designed to be easily followed by citizens and institutions of rich countries.
Not so much so for someone living in a developing country, with no bank statement, credit record, verifiable address etc. etc. I will cover this problem in a future article.