by Valeria Pellegrini, Alessandra Sanelli, and Enrico Tosti
Offshore financial centers and tax havens remain a popular means for businesses and wealthy individuals to reduce their domestic tax burdens by keeping money abroad. This issue has attracted significant attention from policy makers, who have attempted to eliminate the “international tax gap” — lost domestic tax revenue due to undeclared assets held abroad — by enhancing information exchange among national tax authorities. The value of undeclared assets held abroad has been estimated to be in the range of $5-$7 trillion. But due to the inherent nature of tax evasion — non-reporting and concealment of assets — there is a lack of specific information about the size of the international tax gap and the role that offshore financial centers and tax havens have played in widening that gap.
In a recent study published by the Bank of Italy, we have tried to provide new insight on the magnitude of the international tax gap by analyzing investment position and balance of payments statistics. The paper provides an overview of how tax havens are used as hubs in international financial transactions. It then estimates the value of underreported foreign assets held by individual investors — both globally and for the specific case of Italy. Using these data, we estimate an order of magnitude for the potential tax evasion linked to undeclared assets. Finally, the paper assesses the recent policy responses adopted to address the problem of international tax evasion.
Tax havens are countries that lure in foreign capital by providing investors with low taxation, easy access to their capital through advanced communication facilities, stable political and legal systems, and confidential treatment of financial data. Unreported transfers can be made through cash deposits, intentional misinvoicing for goods and services, or direct payments to offshore entities and accounts. Tax evasion — or the illegal non-payment of taxes — is most commonly carried out by individuals, while corporations, due to higher levels of regulation, typically engage in tax avoidance — that is, legal attempts to exploit loopholes in tax law.
Our methodology estimates the value of underreported portfolio assets by analyzing the discrepancy between global assets and liabilities reported for statistical purposes.[1] This methodology reveals that the total global difference between the reported assets and liabilities in 2013 was $4.9 trillion — approximately 8.5% of total global assets. To account for the other main component of unreported financial investments held abroad by households (directly or through interposed entities), a portion of the cross-border deposits of non-banks[2] — between $1.1-$2.3 trillion — is added to this number to give a total estimate of unreported external financial assets.
Regarding tax evasion, we first consider that the unreported financial assets give rise to capital income which – in most cases – is not declared to the tax authorities and not taxed. Hence, we estimate the possible order of magnitude of the capital income tax evasion on a global level. We also consider that one could assume that the whole amount of unreported assets held abroad at the end of a given year (e.g. 2013) arises from personal income that went untaxed in a given point in time. On the basis of this latter hypothesis, we estimate the potential amount of personal income tax evasion at a global level.
Our estimates are based on four methodological assumptions. First, it is assumed that unreported assets held abroad belong chiefly to individual investors, rather than to business entities. This assumption is based on the fact that business entities typically engage in legal tax avoidance and, when business entities do engage in tax evasion, their income is eventually distributed to individuals investors. Second, the share of tax evasion — the rate of “non-compliance” — is estimated as 90% for portfolio assets, because it is unlikely that capital income from unreported assets will be reported, and between 60%-80% for cross-border deposits. These percentages have been estimated taking into account the data on the EU-Switzerland savings tax agreement published by the Swiss tax administration. Third, tax evasion is estimated by applying top capital income tax rates for capital income tax evasion and top personal income tax rates for personal income tax evasion. And fourth, average annual returns for each type of asset — bank deposits, equity securities, and debt securities — are considered in determining the total annual amount of capital income arising from undeclared assets.
The results of the tax evasion estimate are $20–$42 billion yearly (in the period 2001–2013), or 0.03%–0.06% of World GDP, for global capital income taxes, and between $2.1–$2.8 trillion at the end of 2013, equivalent to 2.9%–3.8% of World GDP, for global personal income taxes.
In spite of the lack of data on the quantitative dimension of the international tax gap, the abundant anecdotal evidence on the phenomenon of unreported assets and the related tax evasion has led to a number of policy initiatives since the early 1990s, when the OECD and the European Commission began promoting exchange of tax information among countries. In 2005, through the EU Savings Directive and related agreements, the EU sought to create a system of automatic information exchange, but it was limited both in the type of income covered (only capital income in the form of interest) and in geographical scope. In the early 2000s, national governments began prosecuting tax evasion with a focus on Swiss banks, leading to a change in bank secrecy rules in Switzerland. By 2016, 101 countries had committed to implement the new Common Reporting Standard on automatic exchange of tax information released by the OECD in 2014.
Whether these initiatives are actually effective at reducing the international tax gap remains to be seen. To some extent, the EU Savings Directive seems to have acted as a deterrent to capital income tax evasion, but its overall effectiveness has been limited by its narrow objective and geographical scope. Automatic information exchange is believed to have the highest potential for reducing tax evasion. But its effectiveness is crucially conditioned by its concomitant adoption by a large number of countries in a short period of time, in order to prevent uncooperative countries being able to benefit from becoming tax havens. Given the reliance of the OECD’s automatic information exchange standard on anti-money-laundering rules, namely as regards the “look-through” approach in the case of entities, its adoption can be adversely affected by a lack of compliance with those rules in some countries. Other possible limits may arise from the amount of leeway given to national legislators for implementation, loopholes in the United States implementing legislation (the FATCA), and non-reciprocity of information exchange between the United States and other nations.
To sum up, by analyzing balance of payments and other external statistics, the study reveals the current magnitude of international tax evasion. Its dimension suggests that automatic information exchange, if implemented properly, may provide a significant contribution in closing the overall tax gap. Future assessment of policy initiatives would benefit from measures aimed at increasing consistency and comprehensiveness of data on unreported assets.
Footnotes
[1] The source for declared assets is the IMF Coordinated Portfolio Investment Survey. The source for declared liabilities is the international investment position data for countries reporting to the IMF. A third data source, the External Wealth of Nations II, was used to fill in gaps for countries that do not report to the IMF.
[2] Cross-border deposit data were drawn from BIS Banking Locational Statistics.
Valeria Pellegrini is with the Bank of Italy, Statistical Data Collection and Processing Directorate in Rome. Alessandra Sanelli is with the Bank of Italy, Tax Directorate in Rome. Enrico Tosti is with the Bank of Italy, Statistical Analysis Directorate in Rome