Tax Reform: Lessons from the Cayman Islands
By Douglas Holtz-Eakin @ National Review (September 19, 2012)
The Cayman Islands have taken a public-relations beating this U.S. electoral season — a poor reward for developing a sensible business model in the complicated world of international finance. Rather than demonizing those who use Cayman subsidiaries, U.S. public policy should be informed by the facts.
Almost everybody with a global business has a Cayman subsidiary, as do many U.S. colleges and universities. Why? First and foremost, any venture interested in having the participation of foreign investors needs a location that has a strong rule of law, well-developed financial services, and is outside the reach of the IRS. International investors need the protections and financial services, and have no desire to have their investments entangled with the IRS. The Caymans, along with Bermuda, the Bahamas, and others fit the bill.
What does this tell us about tax policy? Well, certainly it has nothing to do with tax evasion. The moment an individual has a dollar of earnings in a Cayman venture, the appropriate tax is due on the interest, dividend, or capital gain. So there is no tax advantage for an individual.
For corporations, however, the tax treatment matters. In striking contrast to nearly every other developed country, the United States continues to tax worldwide earnings of corporations. Thus, for example, if an international investment headquartered in the Caymans earns $100 in Brazil, it will first pay the $15 in tax due to Brazil. For other international investors, that is the end of the story.
U.S. investors, however, must then pay a second layer of tax to the U.S. government, bringing their tax rate up to the U.S. level of 35 percent. This additional $20 is owed, however, only when the earnings are brought back to the United States (“repatriated”). If the funds merely flow back to the Cayman-based subsidiary, the tax is not yet due.
This has two major implications. First, the funds may be deployed from the Caymans to a new international opportunity without paying the second layer of tax. Second, the U.S. firm is able — at least temporarily — to compete on an even footing with other countries investing in Brazil.
There is the lesson. The existence, success, and scale of the Cayman financial sector should tell U.S. policymakers to look outward to opportunities around the globe as a way to enlarge the markets for U.S. workers and take advantage of the potential income from the 95 percent of the world’s consumers that live outside U.S. borders.
And second, the U.S. tax system should be configured so that its firms can compete permanently on a level playing field with companies from other countries. In practice, this means that the U.S. should bring itself into alignment with global best practice and adopt a territorial tax system. A territorial system would tax U.S. earnings at the U.S. rate, but not tax international earnings. Instead, those earnings would be subject to a single layer of tax at the host-country rate — allowing for a level playing field for competition. And those earnings should be repatriated tax-free so that the U.S. economy can benefit from global success.