What’s the Matter with Luxembourg?


Review of The Hidden Wealth of Nations: The Scourge of Tax Havens, by Gabriel Zucman

Chicago: University of Chicago Press, 2015

The Grand Duchy of Luxembourg is rarely the subject of international attention, much less the target of international opprobrium. With fewer than 600,000 inhabitants, it is less populous than the City of Milwaukee. With an area of under 1,000 square miles, it is smaller than the State of Rhode Island. Conquered twice by Germany and thrice by France, it is much more accustomed to the role of victim than villain. In the words of one New York Times writer, “Luxembourg is about as cuddly as countries come.”

But in the view of economist Gabriel Zucman, Luxembourg is the enfant terrible of the European Union. “If we wish to prevent the Irish and Cypriot catastrophes from happening again,” Zucman writes near the end of his new book, “it is essential that Luxembourg go backward” (p. 91). Back to where is not clear, but what is clear is that Zucman wants Luxembourg to change its ways. And if the tiny state refuses to cooperate, Zucman says, Luxembourg should be excluded from the EU and blockaded by its neighbors.

Why does Zucman place so much blame on little Luxembourg? The answer has to do with a statistical quirk—an inconsistency in international economic data. As Zucman notes, Luxembourg’s official statistics show that shares of mutual funds domiciled in the Grand Duchy are worth $3.5 trillion. But when Zucman looks at official data from other countries on their international investment positions, he can account for only $2 trillion of Luxembourgish mutual fund shares recorded as assets. To whom does the remaining $1.5 trillion belong? We don’t know. “This,” says Zucman, “is a big problem” (p. 38).

The big problem has a name: tax evasion. And thanks to Zucman, we can now have a better sense of just how big a problem it is. In 2014, according to Zucman, liabilities on national balance sheets exceeded assets by $6.1 trillion. In other words, $6.1 trillion of the world’s wealth has gone missing. Zucman hypothesizes that this missing $6.1 trillion has been stashed in offshore bank accounts, hiding out of tax authorities’ sight. And while we can’t be sure that’s the case, Zucman persuasively argues that the $6.1 trillion figure is “a reasonable estimate of the amount of offshore portfolios owned by households all over the world” (p. 39).

Key to this $6.1 trillion estimate is the fact that, as Zucman pithily observes, “money in tax havens doesn’t sleep” (pp. 36-37). And most of the money doesn’t stay in tax havens either. Instead, evaders open bank accounts in offshore tax havens and use the money to buy stocks, bonds, and mutual fund shares traded elsewhere. These investments are recorded as liabilities by statisticians in the country of the securities issuer, but not as assets in the bank’s home country or the evader’s. Meanwhile, any income on the investment goes into the offshore account, which authorities in the tax haven don’t tax and which authorities in the evader’s home country can’t tax because they don’t know about it. So the amount in the offshore bank account grows over time as the investments yield income that escapes taxation (assuming, of course, that the investments generate gains rather than losses and that the evader doesn’t withdraw the funds).

Zucman, an assistant professor of economics at UC Berkeley, has drawn deserved praise for his innovative approach to calculating the world’s offshore wealth. Some of his other estimates are less elegant. For example, Zucman posits that the nations of the world lose $190 billion in tax revenue each year due to offshore tax evasion.

To arrive at his $190 billion figure, Zucman calculates revenue losses country by country and continent by continent. The United States, for example, loses $35 billion in tax revenue each year due to offshore evasion by households, according to Zucman.

How does he come up with that number? To start with, Zucman estimates that offshore holdings of U.S. households amount to about $1.2 trillion. This $1.2 trillion number is little more than a guess, based on limited data from Switzerland and Zucman’s supposition that Switzerland is probably a more popular banking destination for European tax evaders than for their American counterparts. Next, Zucman estimates that U.S. households declare 20% of offshore assets and hide the rest from tax authorities. The 20% figure is again based on Swiss data: specifically, the 20% of Europeans who earn interest on Swiss bank accounts and chose to declare their assets after the European Union implemented its 2005 Savings Directive. So, using the $1.2 trillion guesstimate of U.S. households’ offshore wealth and extrapolating from the EU’s experience under the 2005 Savings Directive, Zucman figures that U.S. households hold approximately $960 billion in undeclared offshore wealth. Yet even if we accept all of the assumptions upon which the $960 billion number is based, Zucman’s revenue loss estimate still seems implausible.

How does Zucman get from his $960 billion estimate for U.S. households’ offshore wealth to his bottom line that offshore tax evasion costs the U.S. government $35 billion in annual revenue? He proceeds in several steps (though some of these steps require logical leaps).

First, Zucman estimates that households earn an 8% nominal rate of return on their offshore assets. That figure strikes me as high—especially if, as Zucman appears to assume, some of this money is invested in bonds and short-term deposits.

Second, Zucman assumes that U.S. households would pay an average tax rate on investment income of 30.3%. That number is based on a blend of the top tax rates on dividends and interest, but any tax-savvy investor could achieve a much lower rate by investing in stocks with low dividend yields and minimizing turnover. (An investor who follows a simple buy-and-hold approach and picks low-dividend stocks will pay an effective tax rate well below 20%, and potentially close to 0%.)

Finally, Zucman estimates that 3% of household wealth each year will be transferred across generations and subject to an inheritance tax of 40%. The last figure might be the most unrealistic: while it’s technically true that estates above $5.4 million pay a 40% federal tax, households can reduce their estate tax liabilities significantly through family limited partnerships, grantor-retained annuity trusts, and a host of other strategies. Today, only about 1 in 500 U.S. estates are taxed at all, and the effective tax rate for those estates is less than 17%. If U.S. households with offshore accounts were forced to declare all of their assets, they still presumably would use available tax-minimization strategies to reduce their final bill. It strains credulity to think that they would end up paying the statutory rate of 40% when virtually no one else does.

Even if Zucman’s revenue estimates are accurate, it’s important to put them in perspective. U.S. federal government revenues exceeded $3 trillion in fiscal year 2014. So if Zucman is right that the federal government lost $35 billion to offshore tax evasion, that would still amount to less than 1.2% of all federal revenues (or 0.2% of gross domestic product). The percentages for other countries are slightly higher: the United Kingdom’s losses to offshore tax evasion ($8 billion, according to Zucman) represent roughly 0.3% of GDP; Greece’s losses ($2 billion) are approximately 0.8% of GDP; France’s ($25 billion) approach 0.9% of GDP. Yet even for France, eliminating offshore tax evasion and raising an additional $25 billion in revenue would still leave the country with a government deficit above the Eurozone’s 3% target. Offshore tax evasion is indeed a serious problem, but it’s a stretch to say (as Zucman asserts at the start of the book) that “[t]ax havens are at the heart of financial, budgetary, and democratic crises” (p. 1).

Looking Beyond Luxembourg

My disagreements with Zucman’s revenue loss estimates might seem to some like quibbles, but they relate to a more important point: By overstating the loss of tax revenues for the United States and United Kingdom in particular, Zucman is underestimating the challenge facing those of us who want offshore tax evasion to stop. If offshore tax evasion resulted in significant revenue losses for the U.S. and U.K. governments, then leaders of those nations would have a strong incentive to crack down. But it does not, and so they do not. Indeed, it’s not clear whether the United States and United Kingdom are net winners from offshore tax evasion or net losers.

The United States and United Kingdom stand to benefit from offshore tax evasion because much of the world’s offshore wealth ends up, in a roundabout way, passing through New York or London. Consider the case of a French resident who wants to avoid home country taxes on investment income. The French resident might set up a shell company in the British Virgin Islands and open a Swiss bank account in the company’s name. The French resident might then have the company purchase shares of a Luxembourg-based mutual fund. The fund, in turn, might hold a portfolio of stocks traded on the New York Stock Exchange, NASDAQ, and London Stock Exchange, as well as bonds issued in the United States and United Kingdom. When a U.S. corporation pays a dividend to a Luxembourg mutual fund, the dividend will generally be subject to a 15% withholding tax under the U.S.-Luxembourg tax treaty. (The United Kingdom imposes no tax on outbound dividends.) When a U.S. bond issuer pays interest, the interest is exempt from withholding tax as long as it qualifies for the “portfolio interest exception.” (The United Kingdom imposes a 20% withholding tax on outbound interest, but debt issuers can avoid the withholding tax through Eurobonds.) Luxembourg, for its part, imposes a subscription tax of 0.05% on the net asset value of mutual funds. And the British Virgin Islands levies no tax on corporations. So as long as the French resident can keep her arrangement a secret from home country tax authorities, she can avoid France’s high taxes on dividends (36.5%) and interest (39.5%) as well as its wealth tax on worldwide assets (1.5% for the wealthiest households).

Who wins from this web of transactions? Obviously the French resident does, at least as long as she can escape detection. And so too do the Luxembourg-based fund, the Swiss bank, and the shell corporation’s registered agent in the British Virgin Islands—all of whom gain a client. Quite likely, the arrangement also redounds to the benefit of U.S. and U.K. securities issuers: the French resident may be willing to supply capital on more generous terms because she can avoid home country taxes on her U.S. and U.K. investment income. This notion was certainly in the minds of members of Congress when they enacted the portfolio interest exception in 1984: supporters of the exception argued that investors would be attracted to U.S. debt securities by the opportunity to avoid withholding tax on outbound interest. And the United Kingdom, for its part, uses the lack of any withholding tax on outbound dividends as a selling point to draw corporations to the British Isles.

This is not to say that offshore tax evasion necessarily yields a net benefit for the United States and United Kingdom. To make that claim, one would have to weigh the welfare gains for U.S. and U.K. firms, who benefit from a lower cost of capital, against the welfare losses due to evasion by U.S. and U.K. taxpayers. What we can say, though, is that the United States and United Kingdom face a complicated set of incentives when it comes to cracking down on offshore tax evasion. And it is not obvious that they have reason to upset the status quo.

Not only is it difficult to know who wins and who loses from offshore tax evasion, but it is also difficult to distinguish the villains from the innocents. Luxembourg is far from faultless, especially when it comes to facilitating corporate tax avoidance. Zucman’s main focus, though, is on tax evasion by individuals—he devotes only a dozen pages to corporate tax issues. Luxembourg also abets tax evasion by individuals, who can invest anonymously in Luxembourg-based mutual funds and thereby benefit from the reduced treaty rate on dividends from U.S. sources. But investors in any country can earn interest on U.S. bonds and dividends on U.K. stock without facing a withholding tax: those exemptions are not at all dependent on the existence of tax treaties. So if Luxembourg fell out of the picture, the French resident in the example above could still start a shell company in the British Virgin Islands, open a Swiss bank account in the company’s name, and load up on bonds issued in New York and stocks traded in London—without incurring any tax liabilities along the way. The United States and United Kingdom, not Luxembourg, are the irreplaceable links in the chain.

All this makes Zucman’s crusade against Luxembourg seem quixotic. While Zucman calls for a “financial and trade embargo” on the tiny Grand Duchy, he never explains why Luxembourg deserves any more blame than the United States and United Kingdom. At least on first glance, the conduct of all three countries looks comparable: Luxembourg, like the United States and United Kingdom, lets foreign investors earn income on securities without any withholding tax, and without information on beneficial ownership being shared with the investors’ home countries. Perhaps Zucman would say that Luxembourg should try to determine the ultimate owners of shares in Luxembourg-based mutual funds and should notify the tax authorities in those owners’ home states. But why doesn’t the obligation lie with the United States and United Kingdom to identify the ultimate destination of outbound payments? Zucman leaves this question unanswered.

Ostracizing Luxembourg and other tax havens is only one piece of Zucman’s anti-evasion strategy; a second element is the creation of a global financial register. Zucman’s idea is to establish a central database recording the beneficial owners of all stocks, bonds, and shares of mutual funds in circulation. As Zucman notes, partial registers already exist in the United States (run by the Depository Trust Company) and in Europe (Clearstream and Euroclear). But Zucman’s proposal would involve a lot more than just scaling up and combining these existing registers, because neither the DTC nor Clearstream nor Euroclear contains the sort of detailed information on beneficial ownership that Zucman desires.

The idea of a global financial register raises obvious concerns about privacy, which Zucman acknowledges and addresses. But a more serious defect with the proposal is its futility: a comprehensive securities register probably would not accomplish very much. That is because savvy investors still could use derivatives to circumvent the register’s requirements. To see how, take the example of a French resident who wants to invest in a U.S. stock without paying home country tax. Imagine, moreover, that Zucman’s register proposal is adopted and that it becomes possible to identify the ultimate owner of each and every stock traded on a U.S. exchange. Instead of buying the stock outright, the French resident could enter into an equity swap with a counterparty: the French resident would make fixed payments to the counterparty; the counterparty would buy and hold the stock; and the counterparty would make periodic payments to the French resident based on the stock’s performance. The swap would allow the French resident to replicate the opportunity available today through offshore tax havens—i.e., the opportunity to earn a tax-free return from onshore investments. So unless the keepers of the register had some way of detecting every derivative transaction anywhere in the world, the register still wouldn’t prevent investors from using swaps to evade taxation in their home countries.

Zucman’s final proposal is his most ambitious: a global wealth tax of 0.1% a year levied at the source. Zucman is hazy on the details, but as best I can tell, here is how the proposal would work: Let’s say that a U.S. corporation—call it General Electric—has issued stock now worth $300 billion and bonds now worth $300 billion. (These figures aren’t too far off from GE’s actual financials.) At the end of the year, the U.S. Internal Revenue Service would collect $600 million from GE (0.1% of $600 billion). GE’s stockholders and bondholders would then declare their holdings to home country tax authorities. If France chooses to impose an 0.1% wealth tax, then a French taxpayer who owns $1,000 of GE stock would declare her holding to French tax authorities, and the United States would then transfer $1 (0.1% of $1,000) to the French government. If the United Kingdom chooses not to impose a wealth tax, then a British taxpayer who owns a $1,000 GE bond would declare his holding to British authorities, the United States would transfer $1 to the UK government, and the British taxpayer would receive a $1 refund.

Such a system would reduce the British taxpayer’s incentive to hide his assets from home country tax authorities: only by declaring his holdings could he qualify for a refund. To deter the French taxpayer from engaging in evasion, though, the United States would have to collect much more than 0.1% a year. The top wealth tax rate in France right now is 1.5%, so unless the United States collected more than that from GE, the French taxpayer would have no hope that declaring her holdings to home country authorities would qualify her for a reimbursement.

Zucman acknowledges as much in the book, but he floats the global wealth tax proposal to illustrate a more fundamental point: “Taxation on capital at the source is the ultimate weapon against financial opacity” (p. 101). While that statement strikes me as correct, it also suggests that Zucman’s call for a crackdown on offshore tax havens is superfluous. Zucman says that “[a]t the heart of offshore tax evasion is the sinister trio of the Virgin Islands, Luxembourg, and Switzerland” (p. 34), but really, at the heart of offshore tax evasion are the U.S. portfolio interest exception and the U.K. exemption of outbound dividends. Offshore tax havens come and go—the sinister trio might be replaced by, say, Lebanon, Bahrain, and Panama—but New York and London remain integral players in the evasion game. As long as individuals retain the opportunity to earn investment income tax-free in the United States and United Kingdom without revealing their identities, the fight against offshore tax havens will remain a game of whack-a-mole.

The fight against offshore tax evasion, then, need not involve a trade war against Luxembourg, Switzerland, and the British Virgin Islands. The United States and United Kingdom could significantly reduce evasion by imposing a withholding tax on outbound dividends and interest. Reuven Avi-Yonah has suggested a mechanism whereby the withholding tax would be refundable: if a foreign individual could prove to the satisfaction of U.S. or U.K. authorities that she has reported her income to authorities in her own country, then the U.S. or U.K. authorities would release the withheld funds to the foreign investor. And if the withholding tax rate were high enough, investors would have an incentive to identify themselves so that they could qualify for a refund.

The withholding proposal is not foolproof. For one, if the United States and United Kingdom imposed a withholding tax but other onshore financial centers did not, then securities issuers might—over time—migrate from New York and London to, say, Brussels and Tokyo. In order to avoid this result, the United States and United Kingdom might need cooperation from other EU countries and Japan (and perhaps China and Singapore too). But the focus would be on onshore financial centers—not the members of the “sinister trio,” who are replaceable cogs in the evasion wheel.

A second potential infirmity in the proposal is the same one that ails Zucman’s global financial register: evaders and their abettors might use derivatives to get around the withholding tax. A French resident who wanted to invest in U.S. or U.K. securities but didn’t want to face a withholding tax would just need to find a counterparty in a low-tax jurisdiction. The French resident and the counterparty would enter into a swap agreement; the counterparty would buy and hold the stock or bond; and the counterparty would claim a refund from the United States or United Kingdom for whatever tax was withheld. To be sure, the United States and United Kingdom could try to crack down on derivatives-based evasion: they could, for instance, deny refunds to residents of low-tax jurisdictions that allowed their own residents to facilitate this type of evasion. But while this patch might work, it suggests a more fundamental flaw in the withholding plan.

The flaw—potentially a fatal flaw—is that it requires the United States and United Kingdom to play along. In effect, it requires U.S. and U.K. tax authorities to serve as collection agents for governments in investors’ home countries. U.S. policymakers, in particular, might rationally decide to opt out of the refundable withholding tax regime. The United States already has a powerful tool for ferretting out U.S. taxpayers who try to evade U.S. taxes through offshore evasion: the Foreign Account Tax Compliance Act (FATCA). Under FATCA, foreign financial institutions must report to the IRS the identities and investment income of all account holders who are U.S. citizens or residents; otherwise, interest and dividend payments to the financial institution will be subject to a 30% withholding tax. Foreign financial institutions are reluctant to relinquish the benefits of the portfolio interest exception, and the IRS reports that more than 177,000 financial institutions and branches have chosen to comply.

It’s too early to say whether FATCA has been a success—key provisions didn’t take effect until July 2014. But if FATCA fares well, then the United States will have even less incentive to cooperate with other countries in the fight against tax evasion. The United States would be quite happy if U.S. citizens and residents pay U.S. tax on their worldwide investment income while foreign investors can escape home-country taxation on their U.S.-source interest and dividends. FATCA may allow the United States to arrive at this outcome unilaterally. And at that point, the United States has little reason to want to help foreign countries collect tax from foreigners who hold U.S. stocks and bonds.

In sum, onshore financial centers appear to be the nations in the best position to stop offshore tax evasion. But onshore financial centers—in particular, the United States after FATCA—have much to gain from offshore tax evasion and perhaps not all that much to lose (especially if they can use unilateral measures to prevent their own citizens and residents from escaping tax). The challenge, then, is convincing politicians and voters in the onshore financial centers that the global welfare losses from offshore tax evasion offset any domestic gains. Put differently, the challenge is convincing onshore financial centers that they should place altruism above self-interest (or, perhaps, constructing a scheme whereby the countries that lose most from offshore evasion compensate the United States and United Kingdom for serving as their collection agents).

Zucman powerfully argues that offshore tax evasion is an outrage. It is unfair that some households can escape their obligation to pay for public services. But it is also unfair to place the blame entirely on offshore tax havens; onshore financial centers—including the United States and United Kingdom—are at the heart of the problem and are an essential part of any solution. To his credit, Zucman has done more than anyone else in recent years to draw attention to the scourge of household tax evasion. In his zeal to shine a light on the misdeeds of offshore havens, though, he lets the real culprits off the hook.

Posted on 13 January 2016

DANIEL HEMEL is Assistant Professor of Law at the University of Chicago Law School.