Tax havens are good for economic growth and inevitable

The immediate reaction by some was that we should regulate and close these loopholes. That is the traditional regulatory way of dealing with distortions.

Economists, however, tend to believe in the power of incentives and the invisible hand of markets: closing down existent tax havens and loopholes will only open new ones somewhere else in the system.

As long as there is demand for such services, the supply of these services will take place. Cracking down on small islands that offer tax services may even have unwanted side effects.

Why? Let us explain.

Tax havens curb competition among nations

One argument gaining credence is that the existence of small island tax havens makes it less attractive for larger countries to engage in tax competition.

The widespread use of tax havens alleviates what would otherwise be aggressive competition between big countries to reduce taxes as a way of attracting and maintaining real investment.

Such real investments matter for big countries as, for example, they create jobs where people live. When firms are able to shift their profits to low-tax jurisdictions through financial transactions: for example, thin capitalisation, the location choices for real investments become less responsive to tax rate differentials.

Hence, closing down tax haven islands, without removing the demand for their services, may shift tax competition among large countries with even more adverse effects for the world economy.

Such arguments are part of a new literature on tax havens that tries to make sense of the empirical data that show the high demand by global firms for tax haven services.