An Insider Spills the Beans on Offshore Banking Centers
The oil industry created the practice of countries (SHIPS?) flying "flags of convenience" as a means of avoiding income taxes nearly a century ago. Since the 1960s the U.S. Government itself has encouraged American banks to set up branches in Caribbean hot-money centers and more distant islands as a means of attracting foreign money into the dollar. The initial aim was to help finance the Vietnam War by turning America into a new Switzerland for the world’s hot money.
This policy succeeded in turning the United States into a flight-capital center for third-world dictators, Mexican presidents and Russian oligarchs. The former Soviet Union now finances a substantial portion of the U.S. balance-of-payments deficit with the flight capital that neoliberal "reformers" facilitated by backing the kleptocrats. The result has grown into a full-blown system enabling multinational corporations to evade taxes everywhere, including the United States itself. It enables domestic investors to globalize their operations by setting up offshore affiliates Enron-style in the Cayman Islands, Dutch West Indies or some small and newly notorious Pacific Island of their choice.
The permissive regulatory system relating to these offshore beachheads of tax avoidance has evolved to a point that enables U.S. and European investors to shed taxes simply by hiring a lawyer to set up a boiler-place office and finding an accounting firm willing to take its records at face value–which is good enough for the tax authorities to accept in these days of downsized fiscal operations. The resulting plunge in the ratio of corporate tax obligations to national income has been a major factor in America’s soaring federal budget deficit. Businesses–and especially the financial sector–establish dummy companies and adjust their transfer pricing (e.g. on sales of raw materials to refineries, and of refined or semi-manufactured products to their final distributors in the industrial nations) so as to take all their profits in these tax-free enclaves.
Flight capital would not leave countries without having somewhere safe to go. A rising number of tax-avoidance islands have made use of the fact that they are small enough to adopt whatever tax code they wish. Lawyers acting on behalf of financial and business lobbies in North America and Europe have drawn up laws to turn these banking centers into what Prof. Hudson calls anti-states.
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SS: In earlier interviews you described how the economy has been "financialized" in ways that free companies from taxation. What role do offshore tax havens play in this?
MH:Companies set up trading companies in tax-avoidance islands and declare whatever income or capital gains they earn on real estate, stocks or other investments to be made by these shells. This has led to the quip that taxes have become purely voluntary for modern businesses.
SS:How does this affect the domestic U.S. economy?
MH:Un-taxing business income–and financial income in particular–leaves individual taxpayers to bear the fiscal burden through wage withholding for Social Security, Medicare and pension-fund contributions. Consumers also bear a rising burden through the sales tax and other local taxes.
SS:Do the statistics confirm this?
MH:Offshore tax havens enable multinational companies to give an impression that they do not earn any income on business done in countries where taxes are levied at European and North American rates. The reality is that U.S. companies make a lot more money than they report. However, offshore banking centers free them from having to pay taxes on this income, or on capital gains. That’s why we’re running such high budget deficits today.
SS: I understand you have had a forty-year experience with these offshore banking centers and tax-free enclaves.
MH: I was taught the ropes in the course of my work as a balance-of-payments economist, and later as a mutual-fund manager. My first clue to how these enclaves were set up came when I worked for the Chase Manhattan Bank in 1965-66 and was assigned the task of writing a report on the oil industry’s impact on the U.S balance of payments. After reading the usual books about how the cartel operated worldwide, I still had difficulty making my way through the oil industry’s income-and-expense statements and the statistics published by the Department of Commerce.
My main problem was to find just where oil companies made their profits. Was it at the production end where crude oil was drilled out of the ground, at the processing stage where the oil was refined, or at the distribution end where it was sold to its end-users to heat buildings, run cars, fly airplanes and make into petrochemicals and plastics?
David Rockefeller arranged for me to meet one afternoon with Jack Bennett, the treasurer of Standard Oil of New Jersey (the old Esso before it changed its name to Exxon). "The profits are made right here in the Treasurer’s office," he explained, "wherever I decide." He showed me the broad leeway a vertically organized global conglomerate enjoyed in being able to assign "transfer prices" do as to report the overall profit at whatever point taxes were lowest on oil’s statistically labyrinthine journey from wellhead to gas station.
Taxes were lowest (in fact, non-existent) in Panama and Liberia, where the oil industry’s tankers duly registered their flags of convenience. Standard Oil priced its crude oil low to these shipping affiliates, and sold it at a high, nearly retail price to refineries and marketing outlets in the industrial oil-consuming nations.
SS:How can someone use the statistics to trace what is happening?
MH:It is not easy to find transactions with these flag-of-convenience countries in the U.S. balance-of-payments statistics. Instead of being listed as bona fide countries in Africa or Latin America, they appear under a rather obscure column heading called "international." Cursory viewers tend to overlook it, as it does not indicate a specific country or region. Some people may imagine that it even refers to venerable international organizations such as the United Nations, IMF or World Bank. But what "international" means is, quite simply, "international shipping" registered under flags of convenience. Quite properly, it doesn’t really belong to a foreign nation’s economy at all, because it is a legal fiction that U.S. companies simply make use of to produce tax filings on an unrealistic "as if" basis.
SS:You’re saying that the statistics are translated into a language of unreality.
MH:A carefully structured unreality–and one that has real-world consequences, to be sure. The essence of this game is that Esso and other oil majors were able to "game" the world’s tax systems by selling their crude oil at so low a price to their tanker companies as to leave little income for Saudi Arabia, Venezuela or other oil producing countries. This discouraged them from taking control of their mineral wealth, especially as they had no tanker fleets to move this oil. The corporate shipping affiliates turned around and sold their oil to their downstream refineries. These generally were located safely offshore in different political jurisdictions (e.g., Trinidad for Venezuelan oil). The oil was transferred at so high a price that despite the heavy capital investment in these facilities, the refiners and distributors reported losses year after year, decade after decade.
SS:How could the tax authorities in Europe and America not catch on to what was happening?
MH:That’s where the political lobbying power of major vested interests came into play. Their ability to avoid having to declare earnings on which taxes would be due reflected the passivity of tax collectors in Europe and North America where most downstream facilities were located. One might think that such governments would have imputed a minimum tax, on the principle that any investment must expect to earn at least a normal rate of return; otherwise it would not be made or kept in place. Turning a blind eye to this logic, governments accepted the profit-and-loss statements as company accountants submitted them. They permitted the profits from oil drilling, refining and marketing to disappear down the statistical black hole of international shipping.
Mining companies followed a similar accounting practice with their shipping fleets and refineries. These oil and mineral companies were among the largest multinationals.
SS:You are saying that profits fell statistically, but not really. What does this mean for the theory that market prices allocate resources efficiently by reflecting supply costs and demand?
MH:The development of tax shelters in flag-of-convenience countries to record corporate profits hardly can be viewed as a merely marginal phenomenon. For nearly a century it has played a central role in the U.S. and European economies. But the prices are fictitious rather than a result of being based on actual costs or on supply and demand. Only the immense political power of these extractive sectors could have induced their governments to remain so passive in the face of the fiscal drain they entail–a favorable tax treatment denied to other taxpayers.
Gradually, however, other sectors learned to emulate the strategy of avoiding taxes by using offshore banking centers.
SS:Apart from transfer pricing, were other accounting gimmicks used?
MH:Parent companies consolidated their oil fields in the Near East, Africa and South America into their domestic U.S. balance sheets by organizing them not as corporately distinct foreign affiliates but as "branches." This technicality allowed them to take the full U.S. depletion tax credit against their income. Depleting the resources of other countries was treated as if they were part of the American economy–except that the profits were taken in Liberia and Panama.
SS:Did you have any conflicts working for Chase and the oil companies to produce this report?
MH:I was given free rein. I was told to come up with the best statistics possible. They made it clear that if the answers were not what they and the oil industry expected, they would not publish my report, but at least they wanted to know what the statistical situation was. I accepted the assignment on these terms.
How the Russian and U.S. Governments nurtured offshore capital-flight dollar centers
SS: How did these flag-of-convenience tax havens evolve into offshore financial centers independent of corporate shipping operations?
MH:The common denominator is tax avoidance, but the proliferation of offshore banking centers has taken on a life of its own, based on flight capital and hot money.
SS:Did this also occur as a result of corporate tax maneuvering?
MH:That was not the main motivation. Switzerland and Liechtenstein would have sufficed for the level of flight capital and criminal savings that characterized the 1950s. In order for modern-type hot-money havens to emerge, an institutional set-up had to be created to hold dollars or other hard currencies outside their countries of origin–somewhere that would provide the same degree of "privacy," "confidentiality" and hence immunity from the authorities that Switzerland provided with its notorious bank secrecy laws.
The oil and mineral companies did not break the laws or do anything illegal, and hence did not need this kind of privacy. They simply wrote and amended the tax laws to insert loopholes in their own favor. The actual money was kept in their home offices. But offshore banking centers aimed at a different source of deposits–those which needed to be kept outside the reach of U.S. or European authorities.
SS:So how did the offshore vehicles for dollar deposits develop?
MH:Actually, the great catalysts were the Soviet and U.S. Governments themselves. The story starts with the creation of the Eurodollar market during the Cold War years.
In the late 1950s the Soviet Union had a problem. It needed bank accounts denominated in U.S. dollars to defray its various spending programs in the West. But as the Cold War heated up, it feared that the U.S. Government might confiscate its U.S. bank accounts (much as Chase Manhattan would do to Iran after the Shah was overthrown). Russia therefore approached a number of British banks and suggested that they establish accounts enabling Soviet agencies to keep their dollar receipts denominated in U.S. dollars (rather than converting them into sterling), and to use these dollar accounts to pay dollars various suppliers in the West (not to mention more nefarious agents). British banks agreed, and the Eurodollar market was born–a market for dollar deposits held outside of the United States.
SS:So a great finance-capital innovation was established by the Soviets themselves. Did they realize what they were dong? And by trying to evade U.S. control, did they end up helping or hurting U.S. global interests?
MH:Nobody grasped the implications at first. As so often happens, this financial innovation bred a train of unanticipated consequences. U.S. multinationals found it helpful to hold dollars offshore to facilitate their own transactions, especially as they began to buy European and other foreign firms and establish their own overseas branches.
U.S. banks set up branches in London and other money centers to serve these companies. When monetary policy was tightened during the Vietnam War years, these banks found the easiest supply of money to come from their foreign branches. Bank regulatory agencies had not foreseen this development, and had not imposed any requirement that head offices set aside reserves against the deposits that came from these foreign branches. So Eurodollar deposits became a great source of deposits for the large international U.S. banks to lend out when money was getting tight as a result of the Vietnam War’s balance-of-payments drain.
How the U.S. Government urged Chase to set up branches in hot-money centers
SS: What was the most remarkable experience you had with these institutions?
MH:The Vietnam War was pushing the balance of payments into deficit, draining the gold supply that backed the currency. Gold had been America’s lever of international financial power since World War I, and now it was flowing out to pay for the war in Southeast Asia.
The Johnson and Nixon administrations knew that if fighting the war meant less consumption at home, voters would oppose the war. So they pursued a guns-and-butter policy, promoting heavy domestic consumption and deficit spending, leaving little to sell abroad. The United States was not willing to permit key economic sectors to be sold to foreigners to balance its international payments, although this is what it directed other debtor countries to do after 1980.
U.S. officials sought to attract foreign exchange in any way they could, but their options were limited. One great possibility remained: attract foreign flight capital. This could be done without raising interest rates at home, but providing a safe haven for foreign hot money. Therefore, what U.S. geopolitical strategists were willing to accept were foreign bank deposits, regardless of where they came from.
In balance-of-payments terms, foreign money being converted into dollars and kept in foreign branches of U.S. banks would do just as well as money in U.S. banks, as long as these deposits were held in dollars rather than in foreign currency.
SS:Was this an explicit policy?
MH:Pretty explicit. This was at a time when so much hot money was going to Switzerland that its franc was becoming the world’s hardest currency. American financial strategists sought a policy to support the dollar in much the same way. The State Dept. and Treasury approached the nation’s leading international banks with a proposal to do something that they would have feared to do without official inducement. They were to establish and expand their own branches in the world’s major capital-flight centers–and perhaps to help establish some new ones. Not only would this attract foreign flight money, it would keep at home the substantial sums were being sent abroad by U.S. tax evaders.
In 1996 a former State Dept. employee who had become a Chase officer asked for my opinion of a memorandum outlining the common interest between U.S. economic diplomacy and the nation’s international banks with regard to establishing offshore branches aimed at attracting some of the world’s hot money away from Switzerland and other flight-capital centers.
The US is probably the second major flight center in the world, but with little probability of rivaling Switzerland for the foreseeable future. Like Switzerland, flight money probably flows to the US from every country in the world. It is handled almost exclusively by the major New York and Miami brokers, lawyers, and leading commercial banks. Officers of CMB International Department and Trust Department confirm that CMB Home Office itself handles a reasonable amount of foreign flight money. However this is insignificant relative to the total potentially available.
There is general consensus among CMB officers and both US and European experts in the field that US-based and US-controlled entities are badly penalized in competing for flight money with the Swiss or other foreign flight-money centers over the long run. This is because of the following interrelated factors:
(a) The demonstrated ability of the US Treasury, Justice Department, CIA, and FBI to subpoena client records, attach client accounts, and force testimony from US officers of US-controlled entities, with proper US court back-up.
(b) The restrictive US investment and brokerage regulations and policies, which limit the flexibility and secrecy of investment activity.
(c) The US estate tax and US withholding tax on foreign investments.
(d) The role of the US as a major contestant in the Cold War, and resulting likelihood that investments through a US entity may be exposed to any hostility or freeze of assets occurring as a result of the Cold War.
(e) The generally held (and partly unwarranted) view of many sophisticated foreigners that US investment managers are naïve and inexperienced in manipulation of foreign funds, especially in foreign markets.
Despite the above limitations, the US has brought appeal to flight money holders in other respects. These include: The largest and most active securities markets in the world, assuring both liquidity and diversification. Ease of transfer and mechanical handling of investments, partly through US banks’ worldwide network. The world’s leading reserve currency, the US dollar. In recent years, the unmatched financial stability and one of the highest levels of economic growth of any major industrial nation. Finally, negligible probability of revolution or confiscation, and low probability of inconvertibility.
The memo cited Beirut, Panama, Switzerland and other centers from which the U.S. Government invited Chase to attract international flight capital by placing its services at the disposal of the existing and prospective patrons of dictators, drug dealers, criminals and even Cold War adversaries.
Chase and other major U.S. money-center banks responded by setting up a network of offshore centers to turn America into a high-level Switzerland.
SS: Did this actually occur, and did the government go along with it?
MH:The government and banks were well aware of the fact that crooks are the most liquid people in the world, for the simple reason that they fear to hold property in plain sight of the authorities–except in cases where their actual ownership can be laundered through a maze of dummy companies and name-plates on legal folders in the offices of the offshore lawyers who make their livelihood by managing such financial stratagems. The major American accounting firms, law firms and investment advisors soon got into the business of advising corporations and wealthy clients how to set up offshore bank accounts in the name of paper companies.
SS:This would seem to be a bombshell. Have you ever published this?
MH:I showed it to the Canadian economics professor and journalist Tom Naylor, who reproduced it in 1987 in his book Hot Money, pp. 33-34. The book has been translated into many languages and reprinted numerous times. It is about to be reprinted again this year by McGill-Queens University Press up in Canada, and in fact I’m writing an introduction to the newest edition. But there hasn’t really been much discussion, because the topic of hot money remains outside the concerns of most academic economists.
SS:Was there any debate over whether this was the right thing to do?
MH: Yes, a series of Congressional hearings were held, and many excellent reports were included. But right-or-wrong morality didn’t play much of a role. One of the main policy issues was simply whether the government should impose a 15 percent withholding tax on foreign holdings of Treasury securities, on the ground that this would probably be the only tax revenue it would recover. Government spokesmen (WHO, WHAT DEPARTMENTS?) convinced Congress not to impose the tax, on the ground that this would discourage foreign hot money–and also U.S. hot money, for that matter–from holding Treasury bonds. The United States needed every market it could create for its bonds at this time, to stem the gold outflow. So the foreign withholding tax was abolished.
SS:In other words, the Treasury permitted domestic U.S. tax avoidance to occur in order to get a balance-of-payments inflow into the dollar, and to hold down domestic interest rates.
MH:Yes. The I.R.S. already had permitted tax avoidance to occur under pressure from the large multinationals such as the oil and mining companies. Vertical integration enabled them to administer transfer pricing in a way that minimized their global tax liability. Refraining from taxing the interest paid on U.S. Treasury bonds favored U.S. hot money.
By the late 1960s the United States was well on the way to making America the leading haven for the world’s flight capital. Citibank, Chase and others established or expanded operations for their "private banking" subsidiaries offering "confidentiality" to clients ranging from Mexico’s leading politicians to Russia’s kleptocrats in the 1990s.
SS:But the price was to give international law-breakers a better tax treatment than law-abiding and tax-paying citizens.
MH:Yes, and there’s a reason for that. The striking thing is that the most liquid savers in today’s society are criminals and tax evaders. They have a good reason to avoid real estate or other tangible property. It is too visible to prosecutors and tax authorities. That is why balance-of-payments statistics classify capital movements as "invisibles." Prestigious accounting firms and law partnerships busy themselves devising tax-avoidance ploys and creating a "veil of tiers" to provide a cloak of invisibility for the wealth built up by embezzlers, tax evaders, a few drug dealers, arms dealers and government intelligence agencies to use for their covert operations.
SS:So all this made finance capital more cosmopolitan and less subject to national regulation and government control.
MH:Yes, and by the late 1980s U.S. money managers were incorporating offshore mutual funds to tap global capital markets.
How hot-money centers turn capital flight into a market for government debts
SS: What was the effect of these tax havens and banking centers on the economies of other countries?
MH: Just as the U.S. authorities hoped, the world’s hot money found it most convenient to go into dollarized offshore banking centers.
SS:Can you give an example of how this worked?
MH:In 1989 I was hired by the Boston money-management firm of Scudder, Stevens and Clark to spend a few months of my life organizing a sovereign-debt fund, that is, a fund investing in the bonds of third world governments. This was the world’s first such fund, and it started what would become a torrent of issues in the 1990s. But at that early stage Scudder was unable to find American clients willing to put $75 million into a region where they had been burned badly in the aftermath of Mexico’s 1982 insolvency.
On the other hand, that traumatic event had pushed borrowing rates up to nearly 45 percent annually for Argentine and Brazilian dollar-denominated government bonds, and about 25 percent for Mexico’s dollar-denominated medium-term tesobonos. These rates enabled the fund to be more successful in finding foreign buyers. Incorporated in the Netherlands Antilles (Dutch West Indies) as the Sovereign High -Yield Investment Co. N.V., its shares were listed on the London Stock Exchange. The underwriter, Merrill Lynch, sold them mostly to well-connected Argentine families through its Buenos Aires office, with the balance taken mainly by Brazilian and other Latin American buyers.
Their money was invested in the high-yielding bonds of their own governments. The irony was that the exorbitant interest payments being made in 1990 were largely due to Argentine flight capital and to Brazilian families operating offshore as a "Yankee fund." The fact that it was set up offshore meant that no U.S. investors were allowed to buy its shares.
The biggest investors were political insiders who had bought into the fund knowing that their central banks would pay their dollar debts despite the high risk premiums. While these local oligarchs appeared in the statistics as exploitative "dollar creditors" to their countries, domestic demagogues blamed the Yankees, the IMF, the World Bank and British bankers for enforcing financial austerity on their countries. Yet the dollar debt of Argentina in the early 1990s was owed mainly to Argentineans operating out of offshore banking centers. The major beneficiaries of foreign-debt service were their own flight-capitalists, not bondholders in North America and Europe.
To Argentina, a "foreigner" was likely to be a local oligarch operating out of an offshore account invisible to their government (which consisted largely of their own families). One finds the same phenomenon in Russia today, where a "foreign investor" tends to be a Russian with an offshore account operating out of Cyprus, Switzerland or Liechtenstein, perhaps in partnership with an American or other foreigner for political camouflage.
SS:How did the fund do?
MH:In its first year of operation it became the second highest-performer worldwide. (An Australian real-estate fund was in first place.) Global investors soon got into the act as they watched Latin America’s financial oligarchy recycle its own dollarized flight capital back to its countries of origin via offshore enclaves.
However, the fund with which I had been associated was limited to only a five-year duration, because in 1989 it seemed to me that this was all the leeway available to keep siphoning off third-world income until a new crisis loomed. By the time this period was up, in 1994, Mexico’s tesobonos had become such an investor favorite that their interest rate fell below 10 percent. The country was selling off its telephone system and other public enterprises whose sale proceeds temporarily were filling the central bank’s foreign-exchange reserves–the PRI dictatorship’s last act in office before it lost the presidency.
But Mexico teetered on the brink of default in that year’s peso crisis, just a dozen years after it had triggered the Latin American "debt bomb" of 1982 by announcing that it could not service its foreign debt. The Clinton administration "rescued" Mexico, or rather, Treasury Secretary Robert Rubin rescued its creditors.
SS:So ultimately, speculators in third world dollar bonds lost.
MH:They weren’t the only ones. The process involved flight capital being turned into a legacy of foreign official debt. Argentina even was convinced to join the ranks of Panama and Liberia by dollarizing its economy. Rather than creating domestic credit itself by running budget deficits as other nations do, its government issued an enormous volume of bonds payable in dollars. Their interest rates fell below the 10 percent level as investors in the creditor nations wanted to believe that the secret of monetary solvency had been found. Foreign dollars were borrowed to finance domestic policies.
Meanwhile, the decline in interest rates resulting from the rise in "confidence" in Argentina’s folly provided rich capital gains for investors who had bought the bonds at so low a price that they yielded four or five times as high a return. But what is confidence, after all, but an opportunity to play the confidence game–a game at which financial underwriters have honed their skill for centuries! The Scudder fund and other early investors sold off their bonds to the new mutual funds and other buyers inexperienced with international risk during the bubbling ’90s when everyone tried to top the returns of others, regardless of where the long run was leading.
This promoted a needless foreign indebtedness, whose collapse today threatens to split Argentina away from other nations. Then in 2001 the debt pyramid collapsed, and the bonds have now plummeted. This wiped out a substantial portion of "bad savings" that were the book-keeping counterparts to these bad debts.
Some policy alternatives
SS:How much money in these centers is illegal flight capital and savings out of tax evasion?
MH:The remarkable thing is the extent to which investors have made the use of these centers legally. In sponsoring the Eurodollar, for instance, the British government encouraged the creation of tax-avoidance entrepôts on some of the islands located in the otherwise inhospitable English Channel and North Sea. By the simple act of registering ownership of their real estate in one of these islands, British property owners are permitted to avoid paying capital gains taxes, as these are not charged on "foreign" investors.
SS:What’s the difference between a tax avoider and a tax evader?
MH: It’s legal to make use of existing laws to minimize one’s tax liability. A tax evader is someone who violates the law by making false statements or engages in complex financial operations that have no economic function except to avoid paying taxes.
SS:So Britain’s logic was much the same as America’s in the 1960s: It needed the money, regardless of where it came from. The cost ended up making it easier to avoid taxes.
MH:The logic was that sterling needed foreign investment to support its exchange rate. The main effect, however, was to provide tax favoritism to large domestic investors as opposed to home owners or small investors who did not establish foreign accounts. A British investor can set up a dummy corporation in these enclaves and avoid paying taxes on resale gains on their land and buildings, stocks and bonds or other assets.
It is all perfectly legal, as any country has the right to levy–or not to levy–taxes on wealth, capital gains or income. Inasmuch as capital gains tend to outstrip the growth of earned income, the economic role of such offshore centers is central to global wealth accumulation. As global asset-price inflation gained momentum during the 1980s and ’90s, the attractiveness of such centers has increased proportionally. This means that economists hardly can analyze the growth and polarization of national and global wealth without taking into account the web of financial claims and liabilities associated with these centers.
SS:But there is a growing overlayer of illegality, isn’t there?
MH:Certainly, but it’s been merged into "invisibles" as far as economic statistics are concerned, and economic theory too for that matter. Crime is one of the key sectors for which no estimates are made. Yet it is perhaps the most liquid, as dictators and kleptocrats, embezzlers and drug dealers fear to tie down their assets in visible form. The newest additions to the world’s rentier class, they have become a fount of liquidity for today’s economies.
Russia has suffered $25 billion in flight capital annually since 1990. Its IMF bailout loan of August 1997 disappeared into an obscure bank in Britain’s Channel Islands, from whence it was forwarded to Cyprus, Switzerland and the United States. Most IMF lending to Africa and Latin America has been fully absorbed by capital flight, subsidizing it under the euphemism of "currency stabilization." What is being stabilized is mainly the rate at which this flight capital is exchanged for hard currency (if one still can call dollars a hard currency).
SS: How might governments counter this ploy to tax this money?
MH: That is what is being debated in Russia these days. It seems that the only kind of tax that can be collected from multinationals today is to tax what is visible, not what is invisible–that is, invisible to the national economic statistician and tax-collecting office. Russians are discussing a rent tax levied in the form of an excess profits tax on oil and mining exporters.
SS: If we look at the balance sheets as they stand, the offshore banking centers appear as net creditors, and the rest of the world’s countries are net debtors?
MH:Not quite. The "savers" who have accounts in these offshore banking centers have claims on them that, in turn, represent the liabilities of these enclaves that offset their claims on the rest of the world. But the financial claims held by these havens are owed in turn to their offshore "savers."
What is missing from the data that should be there are the claims by these "savers"–the tax avoiders, criminals and so forth–on these offshore havens, classified in terms of their country of origin. These surreptitious savings get lost in the IMF’s "errors and omissions" line. This is because the Dutch West Indies, for example, may owe money to a Panamanian shell, which owes money to an Isle of Man shell, and so on. The ultimate hot-money claimants are hard to identify. Deposit inflows to these enclaves find their balance-sheet counterpart in their own rising indebtedness to tax avoiders and dodgers in Europe, North and South America, Asia and Africa. But the statistics are silent as to just who these invisible savers actually are and where they really reside.
An Argentinean or Russian exporter sells at a fictitiously low invoice price, asking the buyer to deposit the difference in an offshore bank account. Needless to say, the Argentinean or Russian will not declare this holding, so it doesn’t appear in the official accounts. But it exists in reality. This is why the world’s reported debts exceed the locatable savings by an "errors and omissions" margin.
SS:How exactly does this false invoicing work?
MH:In two ways. The simplest is for importers to claim to pay more for imports than their true economic price. This is what the oil companies do when they price crude oil so high to their refineries that the refineries have no room to report a profit, decade after decade.
The mirror image of this fraud occurs when exporters claim to receive less than they actually are paid. The margin is what they are able to embezzle. The buyer typically pays the difference to a "private" account in one of the offshore banking centers, facilitated by one of the U.S. or British or Canadian banks set up for this helpful purpose. This is the meaning of bank "privacy." It is how Russian exporters of oil, aluminum and other raw materials conceal their actual income from the Russian government. It explains the emergence of so many post-Soviet multi-billionaires benefiting from "unexplained enrichment."
SS:Doesn’t the Russian government still raise most of its taxes from oil and other raw-materials exports?
MH:Yes, but it fails to tax the actual income. If it did, Mr. Khodorkovsky and other kleptocrats would not have suddenly risen to join the ranks of the world’s wealthiest individuals in merely a single decade, and would not now be under prosecution for criminal tax evasion. It is significant that the financial press in the West writes anguished editorials accusing this of representing nothing less than brown-shirted fascism, nationalism and totalitarianism. Bush administration hacks such as Secretary of State Powell publicly express their worry that this threatens the very foundations of "private enterprise." This show how little they think of punishing tax evasion in their own countries.
SS:I assume that we’ll get to cover these machinations in greater detail in our up-coming interview on Russia after its March 14 presidential election. Returning to the topic of offshore banking centers, are you describing a technique that has been developed simply by individuals, or has it been institutionalized on a higher, economy-wide plane?
MH:The largest accounting and law firms of North America and Europe have got a rising proportion of their income for providing advice to companies seeking to make use of these tactics. The primary users are money managers and leading corporations to conceal their profits (or losses, in the case of Enron and Parmalat) from oversight by the authorities in their own countries. By the 1990s, Enron, Parmalat and other giant corporate criminals were able to organize the largest financial frauds in history by using structured finance involving hot-money havens.
SS:Isn’t there a U.S. law against arranging a complex business practice solely for the purpose of evading taxes?
MH:The law is indeed on the books, and the IRS has complained specifically that the KPMG firm has organized systematic tax-evasion schemes. But the neoliberals have placed their own ideological administrators in these agencies, men who have bragged to me that they simply refuse to regulate to "kill the beast," that is, government, which is supposed to be the economy’s guiding brain. Their non-action has corrupted the national legal and regulatory system by disabling it. Power is being wielded by campaign contributors whose wealth has convinced politicians to give tax evaders the right to blackball any regulatory agency who shows himself or herself to be too conscientious in applying the law, above all the tax code.
SS:What about New York Attorney General Eliot Spitzer?
MH:He obviously recognizes what is going on, and seems to have been astounded to discover how far the rot has spread. What he found while bringing criminal charges against Arthur Andersen in the Enron case was that every major accounting firm was engaging in the same fraudulent practices. This created a practical problem for him. Was he going to close down every accounting firm by applying the law across the board?
If he had done this, who would have audited the books of America’s companies? It would have crashed the stock market and the entire economy. So he settled for fining the banks and financial and accounting firms a very small portion of their gains, leaving their partners with their comfortable retirement takings and making them promise to stop breaking the law in the future.
On the other hand, I think that even if he closed down these firms–and remember, I used to work for Arthur Andersen and found it thoroughly venal already in the 1960s–the system would have healed itself almost overnight. The existing firms as such would have been wiped out and many of their leading partners would have gone to jail–probably not more than a few hundred–or at least would have lost their retirement payoffs. But most of the remaining accountants would have gotten together to create new firms, free of the taint of corruption that has characterized Deloitte Touche in the Parmalat case, KPMG for its tax-evasion schemes, and the other accounting firms right down the board.
SS:How deeply can the problems be traced?
MH:The path leading to this state of affairs was opened up at the close of World War II. U.S. diplomats brought pressure on the International Monetary Fund to free capital movements, at a time when it was clear enough that most capital flight would be into the dollar, out of economies that were regulated. Euphemized as "economic reform" and "freedom of choice," the move toward financial decontrol cleared the path for the development of offshore havens. That was part of the fatal flaw built into the DNA of the postwar Bretton Woods system.
The U.S. Government remained in control, and as I explained earlier, when the Vietnam War pushed the balance of payments into deficit, the government encouraged the large money-center banks to set up branches in these island enclaves to act as enablers facilitating global theft, fraud and other criminal activity. It has been through their user-friendly operations that the non-criminal world–the world of honest men and women, industry, commerce and even sovereign governments–has become increasingly indebted to lawbreakers, just as taxpayers are increasingly indebted to tax avoiders.
Much of America’s net foreign debt, along with that of countries such as Argentina, is owed to these flight-capital centers. This has become the meaning of "globalization" in its financial dimension.
I pointed out above that deposit inflows to these havens are matched in the official statistics by other countries’ "errors and omissions." The world’s most important economic phenomena that determine exchange rates today have been relegated to the unseen "black" economy–not only crime, but what is becoming the dominant mass of corporate and personal wealth. It is more "invisible" today than ever, in order to avoid the eyes of prosecutors and tax authorities.
What is remarkable is that neoliberals praise rather than denounce this phenomenon. The upshot has been to create a situation in which, if one must own land, other tangible assets, or financial securities, the best way to avoid taxation or seizure is to register them in the name of offshore proxies.
The next step for these offshore entities is to loan this money back to oneself, charging enough interest to absorb the erstwhile taxable revenue. Operators large enough to set up their own insurance company can charge off the remainder of their income as tax-deductible insurance payments to their offshore entity created for this purpose, along with the usual skimming charge for management fees to owners and senior managers.
Financially sophisticated operators send their money offshore and then borrow it back, paying enough interest, insurance and management fees to themselves to absorb their earnings and thus render themselves free of taxes. These payments expensed to oneself appear in national income and tax statistics as a cost of doing business, while balance-of-payments statistics report them as an international outflow for "services" under the rubric of "invisibles." So statistics become increasingly fictitious.
SS: You have described how the rise of these centers has led to economic statistics losing their value. How can the economy be analyzed and quantified under these conditions?
MH:Financial havens help income and capital gains disappear from the statistics of national economies as flight capital, only to reappear as debts owed by victimized economies to "foreigners" operating out of these enclaves. Their balance-of-payments transactions appear as "errors and omissions." Most economists know that this is a euphemism for "short-term capital movements," which itself is a euphemism for capital flight and tax evasion.
The basic perception is that what one can avoid reporting to national authorities will not be regulated, taxed or prosecuted. Strategy along these lines reflects decades of lobbying by the world’s wealthiest companies and individuals to disable their governments’ ability to tax them. Accounting firms, law firms and global banks help them by using "structured finance" to conceal their income and wealth–as well as their debts and financial fraud. The more crooked the client, the larger the fee that can be charged for the advice being orchestrated to guarantee privacy. In a society where crime pays better than most honest professions, financial and banking expertise is for hire. The experts will happily go to work for Enron and Parlamat, salving their conscience by believing that this is all part of the free market impelling civilization forward and leaving Communism by the wayside in the world economy’s struggle for existence between competing systems.
The symbiosis between offshore banking centers and oligarchic, kleptocratic and criminal wealth can be traced in the lawsuits that have graced the front pages of the international press in recent years. The largest bankruptcies in recent years have involved machinations via such centers. In Parmalat’s bankruptcy the legal defense by the company’s auditors, Deloitte and Touche, is that they had no reasonable way of knowing that the $4 billion in alleged deposits in an offshore Bank of America hot-money account did not really exist. Other poster boys for this predatory universe of flight capital are the offshore entities created by Arthur Andersen and Citibank for Enron, the Swiss banks renowned for serving Idi Amin and other warlords, and the Bank of New York and its brethren that helped Russia’s oligarchs embezzle $250 billion in the 1990s.
Once the fiscal ploys are spelled out in detail, attentive readers may recognize that what is being described is how today’s multinationals typically are structured to extract revenue and minimize (that is, to avoid) taxes. Economists since John Maynard Keynes have used the word "leakage" to describe funds withdrawn internationally from the domestic income stream. The term implies that money is being lost, and of course it is lost to the tax collector. But it does not simply disappear. Placed in the world’s anti-government centers, flight capital takes on a creditor power that is indebting North America, Europe, Asia and Africa, siphoning off their financial surplus in ways that remain invisible to most statisticians and economists, politicians and voters.
SS: You paint a discouraging picture. What is the point in trying to tax corporate and financial income at all, if transactions with these islands are not simply closed down?
MH:A choice is indeed being forced. If these tax-cheating havens are not closed down, the only people left to tax will be the middle class and employees.
Companies now file two sets of annual accounts. One is for their stockholders, and another is for the tax collector. The tax account shows no profit, because companies don’t want to pay taxes. The report to stockholders shows a maximum profit, because companies want to boost the price of their stock. Voters have elected politicians whose electoral campaigns are paid for by lobbies who are hired to mobilize support for this policy, while academic chairs are endowed to hire well-meaning fools or "useful idiots" to teach this anti-government philosophy as representing positive "reform" rather than depicting it as outright parasitism.
The public is being misled in two ways. First of all, governments are given tax returns that show profits as shrinking, through artificial book-keeping that becomes the basis for official statistics. Meanwhile, stockholders are being given stories of fictitiously high profits, at least in the cases of Enron and Parmalat.
The clients of this floating island world use a system that has been put in place by pillars of business integrity representing the global economy’s core, not merely a peripheral underworld constituency. These enclaves belong at the center of economic analysis, yet they usually are treated as an anomaly rather than as an integral organ of modern wealth accumulation.
SS: How might these offshore centers be shut down? The law says that you cannot punish or fine people following the laws that apply in their own day. You cannot lay down penalties retroactively.
MH:You don’t have to. Laws against fraud, embezzlement and tax evasion have been on the books for many years, although many of these laws have not been seriously enforced. One of the easiest laws to enforce is the principle of "unexplained enrichment." This is, by the way, how the world’s great fortunes were created–and what Putin is applying against Mr. Khodorkovsky.
Banks in the United States, Canada, Europe and Asia would agree not to recognize deposit transfers from these centers. Companies and brokerage houses would refuse to pay dividends to addresses in them. Countries would lay down rules for legitimization of ownership of these deposits, corporate shares or other financial claims.
One standard question no doubt would be to ask how one came to obtain holdings in these centers. Was this wealth obtained out of one’s normal income? If not, how?
A broader solution would be simply not to recognize banking and creditor claims from these centers. This would be a start repudiating the world’s bad debts.
SS:This would have to be done suddenly, of course. We’d better leave this broader context for a future interview.
Professor Michael Hudson is an independent Wall Street financial economist. After working as a balance-of-payments economist for the Chase Manhattan Bank and Arthur Anderson in the 1960s, he taught international finance at the New School in New York. Presently, he is Distinguished Professor of Economics at the University of Missouri (Kansas City). He has published widely on the topic of US financial dominance. He has also been an economic adviser to the Canadian, Mexican, Russian and US governments. His books include Trade, Development, and Foreign Debt (Pluto, 1992, 2 vols.). He is the author of Super Imperialism.
STANDARD SCHAEFER is an independent economic journalist, a cultural historian, literary critic, poet and short-story writer. He teaches at Otis College of Art and Design. He is the non-fiction editor of the New Review of Literature. He can be reached at email@example.com.
©2004 Hudson and Schaefer, from book-in-progress.