Thursday, 9 August 2012

The Cayman Islands: A Modern Morton's Fork?

The Cayman Islands has come to stand as the epitome of the offshore tax haven.  Yet, until just the other day, the Cayman Islands had proposed a first of its kind income tax (dubbed a "community enhancement fee") of 10% on the income of expats.  Unsurprisingly, expats were less than pleased about this, even going so far as to claim that the mere discussion of the possibility of an income tax could kill the Cayman Islands as the preferred tax haven destination in the Caribbean.  Also unsurprisingly, the Caymans reversed course, introducing a new proposed tourist tax to replace the expat tax.

So what is going on?  The Cayman Islands has one of the highest GDP per-capita in the world, and thus presumably should have no problem raising the relatively small amounts of money at issue.  The problem is that the tax base of the Caymans is fleeting.  Expats (and capital for that matter) came to the Caymans precisely for their zero income tax rate, and presumably will leave just as quickly without it (in the words of one Cayman expat - "no tax or we leave").

Attracting financial business and the people who support it through tax competition is what made the Caymans wealthy from a GDP per-capita standpoint.  That it also is what makes it trapped from a revenue standpoint: raise taxes and lose this tax base (and business) or don't raise taxes and never fund any new public goods.  In a recent article I identify and analyze this phenomenon in depth (subsequent work by economists has also begun to do so).  In the article, I refer to this as a modern Morton's Fork, providing small tax haven type countries with a choice, of sorts, between two equally unappealing options.  In the article, this was a matter of theory.  But, lo and behold, it appears to have become real life.

From a US tax policy standpoint, this should be particularly troubling.  The United States needs tax havens such as the Cayman Islands to stop engaging in tax competition to collect the billions, or even trillions, of lost tax revenue.  The Cayman Islands, at least as evidenced by recent events, can't.  So the world appears stuck.

Perhaps it is time to start thinking differently about tax competition.  Instead of ignoring the Morton's Fork plaguing the Cayman Islands and continue insisting it just stop being a tax haven, the United States could adopt policies to make it easier for the Cayman Islands to do so.  For example, if US tax law made it easier for capital to invest in the Cayman Islands, there would be less pressure on the Caymans to rely on tax competition.  In turn, it would become easier for the Cayman Islands to impose some income taxes, share information, or otherwise cooperate with the United States on tax matters, the benefits of which should vastly outweigh any costs.  I discuss some specific proposals in detail in the article, but the basic premise remains.  While this may seem counter-intuitive at first, recent events only further support the idea that counter-intuitive may be precisely what the international tax system needs at this time.  Absent some fundamental change, my guess is we will only continue to see skirmishes such as the one over the failed Cayman "community enhancement fee" increase over time.

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