The tiny principality of Liechtenstein, nestled between Switzerland and Austria, rarely attracts the attention of the international media. However, a major investigation in Germany into allegations of tax evasion has turned the spotlight on Liechtenstein's strict banking secrecy laws, and heightened tensions between the two countries. The German chancellor, Angela Merkel, has demanded greater financial transparency; Liechtenstein's politicians point the finger at Germany's convoluted tax system. The fallout from the scandal could have wider implications for Germany's political scene, with growing voter discontent at the country's business elite provoking a further shift to the left.

A model of secrecy

Last week German prosecutors launched the country's largest-ever investigation into alleged tax fraud, raiding homes and offices nationwide for evidence of those suspected of avoiding their tax obligations by channelling up to €4bn (US$5.9bn) into secret foundations set up by LGT Group, Liechtenstein's largest bank. The German finance minister, Peer Steinbrück, has accused the tax dodgers of defrauding the state of millions of euros in lost revenue.

The most high-profile casualty so far is Klaus Zumwinkel, a well-known figure among Germany's corporate elite, who resigned as chief executive of Deutsche Post and chairman of Deutsche Telekom on February 15th, amid claims that he had evaded payment of around €1m in taxes due on a Liechtenstein trust. As many as 1,000 members of Germany's social and business elite are now believed to be in the prosecutors' sights.

The scandal has sent shockwaves across Germany and also sparked a heated political row, with the German chancellor, Angela Merkel, accusing Liechtenstein's banks of "encouraging lawbreaking" and demanding an easing of the principality's strict banking secrecy rules so as to provide greater financial transparency. The head of the governing Social Democratic Party (SPD), Kurt Beck, went so far as to charge the Alpine tax haven of employing "robber baron" policies, while Ms Merkel warned that the German parliament could block Liechtenstein's entry into the EU's border-free Schengen zone later this year unless reforms were implemented. Not to be outdone, the principality responded by pointing the finger at Germany's "bullying tactics", with Crown Prince Alois denouncing the "unprovoked attack" on Liechtenstein, and suggesting that Germany should concentrate on doing more to sort out its own flawed tax system.

The growing tensions between the two countries stem in part from revelations that the tax investigation was initiated only after Germany's foreign intelligence agency, BND, had paid €4m to a suspected former employee of LGT for a list of the bank's tax-evading clients. Concerns have been voiced in both countries that the actions taken by BND were outside the agency's national security (and constitutional) remit, with attention also focusing on the wider ethical debate as to whether BND was justified in paying a €4m bribe to a bank official in a foreign country (with financing and approval from both the German chancellery and finance ministry).

A need for transparency

Tight banking secrecy rules have long made Liechtenstein an attractive place for investors seeking to avoid tax, but its continued status as a tax haven has drawn increasing attention and criticism from larger countries seeking to clamp down on alleged tax dodgers. Since 2000 the OECD has achieved some success in its efforts to promote greater banking transparency and more effective information exchange across 35 jurisdictions—mostly small islands and states such as Jersey, the Cayman Islands, San Marino and Bermuda—identified as tax havens. This partly reflects a growing concern in many offshore centres that tight banking secrecy rules could be disproportionately aiding money-laundering, terrorist financing and corporate fraud.

Within the EU, a political agreement was reached in 2003 to introduce a system of information exchange in a bid to reduce savings tax evasion within member states. Countries eager to retain a tax haven tag such as Austria, Luxembourg and Switzerland were allowed to keep their banking secrecy laws, but were required to impose a withholding tax on interest-bearing assets.

However, Liechtenstein is one of three tax havens, along with Monaco and Andorra, that the OECD has blacklisted as being "uncooperative". Indeed, the Alpine principality is regarded as being the most reclusive of all the tax havens monitored by the organisation. In a Financial Times article on February 21st, the secretary-general of the OECD, Angel Gurria, stated that "jurisdictions characterised by strict bank secrecy and a policy or practice of non-cooperation prosper … to the detriment of the integrity of the world financial system and such behaviour is no longer acceptable".

The Liechtenstein prime minister, Otmar Hasler, has sought to dampen the current ill feeling with Berlin, stressing that its standing as a financial centre is currently undergoing a process of reform. A toughening of controls has been promised, although it is unclear what changes, if any, will be made to improve financial transparency. The principality has rejected Ms Merkel's accusations that investing in its system of secret foundations actively encourages tax evasion.

A need for simplicity

The argument in Liechtenstein that Germany should look closer to home in analysing the reasons behind the breaking scandal should not be overlooked. Germany's tax structure remains one of the least attractive feature of the country's business environment. According to OECD data, tax and social security contributions for an average single earner in manufacturing account for over 50% of labour costs, second in the OECD only to Belgium. Top income tax rates were reduced from 53% in 1998 to 42% at the beginning of 2005, but then increased again in 2007 to 45% for those earning above €250,000. The tax burden on companies is also high, even after a reduction of the corporate tax rate in 2001, while the tax base for capital income is set to be broadened next year by the inclusion of capital gains.

The major concern, however, is that German tax laws have become increasingly complex, reflecting politicians' fondness for micro-management. Tricking the taxman is now widely considered a national pastime in Germany, with the number of tax advisers having risen sharply over the past decade, as those on even modest earnings seek to find a potential loophole in the sprawling tax code. According to the national tax collectors' union, DStG, revenue losses amounted to around €30bn last year through tax avoidance measures. Before the last election in 2005, opinion polls had indicated a strong preference among most voters (and business leaders) for simpler tax rules rather than lower rates. However, the government has made little progress in addressing such concerns, and with the momentum for reform in Germany having slowed sharply, any new initiatives are likely to remain on hold until after next year's federal election.

Wider discontent

Ms Merkel will be conscious of the potential domestic fallout from the spiralling tax fraud inquiry, not least with a regional election taking place in Hamburg on February 24th. Traditionally a northern stronghold for the chancellor's Christian Democratic Union (CDU)—the senior partner in Germany's federal "grand coalition"—opinion polls suggest her party is unlikely to gain a majority this time around.

On a broader front, the CDU will be concerned that the scandal could trigger a rise in public dissatisfaction with the business establishment in the midst of a banking crisis and a long-running debate in Germany over executive pay, and in the process drive voter sentiment further to the left. There is a commonly held belief among labour unions and the wider electorate that the benefits of the robust period of economic activity in recent years have not been enjoyed by the majority, at the same time as booming profits have led to excessive "fat cat" pay.

The chancellor will be keenly aware that a protest vote in Hamburg would provide further momentum for parties on the left of the political spectrum. A clear message from recent regional elections in Hesse and Lower Saxony in late January was that reform-weary Germans are moving in greater numbers towards parties who oppose further economic liberalisation, with the small Left Party, a radical left-wing grouping, strengthening its position as a real player in German politics. With this trend seemingly set to continue—polls show a rise in support for the Left Party in Hamburg—the outcome of the federal election next September will remain wide open.