The release of the so-called ‘Paradise Papers’ last year did not come as a major surprise to anyone. The leaks, which came from Appleby – a Bermuda based offshore law firm – implicated many, from leading politicians to businessmen and celebrities, in shadowy (though perfectly legal) financial activities. The previous year’s ‘Panama Papers’ had primed everyone for the latest leak. Though the scale of the operations and the sheer range of people involved may have been striking, the existence of tax havens was no secret. So how exactly did modern tax havens come about?

Tax avoidance is not a new phenomenon; tax havens are as old as tax itself. In ancient Greece some traders would deposit their goods on special islands to avoid Athenian import duties. The first elements of the recognisably modern tax haven emerged in the United States in the late nineteenth century. Delaware and New Jersey pioneered the use of ‘easy-incorporation’ regulations to attract corporate headquarters. This practice, which is central to the establishment of tiny island havens with hundreds of thousands of registered companies, was later copied in Europe in the 1920s and 1930s.

Wartime and capital security

In the early 20th century, taxes were increased to fund the foundations of the modern welfare state – chiefly the old age pension. It was the Great War, however, that was the real turning point in the history of tax avoidance. In most countries, taxes skyrocketed to feed the demands of total war. Britain borrowed heavily, necessitating increases in taxation (a top rate of 30% by 1919) to prop up a newly enlarged state apparatus. In the US, the war made the federal income tax permanent, and the top rate went from 15% to 67%, and then to 77% (for incomes above $1,000,000).  All over Europe belts were tightened to pay for reconstruction and taxes increased across the board.

Switzerland, however, which stayed neutral during the conflict, did not have to increase taxes to pay for reconstruction after 1918 because there was nothing to reconstruct. So capital flocked to the country where it was sheltered from the reach of the new, bigger treasuries seeking ever larger revenues.

Switzerland’s status soon put the country in a difficult position. In the 1930s, the Nazi regime pressured Swiss banks into cooperating with investigations into the assets of German Jews. Switzerland’s reputation as a safe place to put capital beyond the reach of the taxman was at risk. The result was the Federal Act on Banks and Savings Banks (1934) which established another central practice of modern tax havens: secrecy. Banks were forbidden to reveal the name of an account holder. As the German war machine rolled across the continent after 1939, more and more people from occupied Europe turned to Switzerland to keep their assets safe from the prying eyes of the Nazis.

Although it was Switzerland that pioneered the modern tax haven as a refuge from personal taxes, corporate tax avoidance, which was at the heart of the Panama and Paradise Papers, emerged from the British Empire tax havens and the City of London. A key court case in 1929 put the British Empire on the path to become the backbone of the global tax haven network. In Egyptian Delta Land and Investment Co. Ltd. V. Todd, the court ruled that a company which did not have any significant operations in the United Kingdom was not subject to British taxation, even if it was registered in the UK. From this emerged the principle that the actual location of a company’s operations and the place where it legally existed need not be the same.

As the Second World War drew to a close, the Allies met at Bretton Woods in the United States to create an international financial system for the post-war world. Learning from the mistakes of the past, when speculation had caused sudden, damaging capital flight when the threat of financial crisis loomed, the Allies agreed to create a system in which speculative movements of capital between countries would be curbed so as to not exacerbate future crises. The result of this was that if a company wanted to invest a lot of money abroad, they would have to obtain approval from financial regulators.

Until 1957, this was not usually a problem. But during the Suez Crisis, in which Britain, France and Israel attempted to wrest back control of the Suez Canal from Egypt, the Treasury stopped authorizing large foreign investments. The implication of this for City bankers was easy to see; if foreign investments were prohibited, they would lose a huge portion of their business. They turned to the Bank of England to see what could be done. In a crucial ruling, the Bank decided that transactions undertaken in a currency other than sterling by banks in London on behalf of clients overseas were not to be subject to UK financial regulations.

Following the 1957 ruling, the City of London revived its fortunes as a global financial centre, and the network of colonies, former colonies, and dependencies emerged as one of the two poles of global tax avoidance. The ruling meant that it was more profitable to trade US dollars in London banks than in US banks, where they would be subject to US tax; the US dollars being traded internationally became known as the ‘Eurodollar’. 

The Crown Dependencies (the Isle of Man, Jersey and Guernsey), British Overseas Territories (namely Gibraltar, Bermuda, the Cayman Islands, British Virgin Islands, and the Turks and Caicos Islands), and former colonies (such as the Bahamas and Bahrain) saw an opportunity to fill a gap in the market. And so while dollars were traded in London, the actual borrowers and lenders were able to register their addresses in these low tax jurisdictions.

The poorest bear the brunt 

But what exactly do the offshore islands centres get out of being tax havens? Other than departure taxes from tourists, offshore tax havens make their living primarily off corporate registration and renewal fees. The fee to register a company in an offshore tax haven is far less than what it would be to pay full taxes in a high-tax jurisdiction, so most are willing to pay the fee to avoid a far heavier tax burden. The registration fee, along with an annual renewal fee, is relatively small, but when they number in the hundreds of thousands, even millions (these ‘companies’ are merely files in a folder in an offshore office), they add up.

Due to the secrecy that surrounds it, the scale of offshore finance is tricky to gauge. Some estimates suggest that up to $32 trillion of assets are held in offshore havens. In a time of seemingly permanent austerity, offshore havens and those who make use of them to reduce their tax burdens have received a great deal of flak.

Though Western treasuries fight tooth and nail to levy taxes on assets that are shielded in offshore havens, it is worth putting it into proportion. The absolute value of revenue lost is greater in rich countries but, proportionally, developing countries are the real losers in the system of global capital hypermobility. Often, company ‘subsidiaries’ are set up in developing countries where natural resources or cheaply manufactured goods are sold at artificially low prices to shell companies registered in tax havens. The amount lost to tax avoidance far outstrips the amount that they receive in development aid.

In a world of sovereign states, there is little that can be done to prevent some countries offering better tax arrangements than others. After all, it is not only tiny offshore islands that seek to attract business through competitive tax rates. Though many reasonably feel frustrated at the setup, the issue must be looked at in its wider context. The problem is a real one, but instead of angrily pointing a finger at a few of the most well-known figures named in high-profile leaks and expecting people to voluntarily abstain from tax planning, a more productive approach would be to understand that developed countries lose a relatively small amount of their wealth to tax avoidance, compared to poorer countries.

Instead of pouring development aid into Africa and Asia, only to have it whisked away to faraway Caribbean islands and Swiss bank vaults, we would do better to think creatively about how poorer countries can shield themselves against the excesses of modern hypermobile capital.