It is commonly believed that tackling tax evasion/avoidance is crucial to the viability of the welfare state and to the sustainability of public finances in Europe. A correct understanding of economics, however, tells a different story.

Money does not grow on trees – or does it?

Following the recent disclosure of the so-called Paradise Papers – millions of leaked documents revealing the complex schemes used by the world’s wealthiest individuals and corporations, ranging from the Queen of England to Facebook, to avoid paying taxes – the English-speaking Twittersphere was flooded with messages along the lines of ‘we’ve found the magic money tree, it is in Bermuda!’ (or some other tax haven related to the leak). This was a reference to a controversial statement by British Prime Minister Theresa May a few months earlier on BBC’s Leaders Question Time, when she told a nurse who hadn’t had a pay rise for eight years that “there is no magic money tree” – a variation on the classic ‘there is no money’ argument used since the financial crisis to justify austerity.

May’s comment provoked strong criticisms. Most of these were directed at the Tories’ blatant hypocrisy: i.e., the fact that they were denying wage increases to public sector workers and cutting back on social welfare while giving away billions in tax cuts to high-income-earners and corporations. In this sense, May’s ‘there is no money’ claim was rightly seen by many as an obvious denial of reality: the government was simply refusing to take the money from those who have it. Denying nurses a pay rise was therefore a political choice. Few people, however, challenged the basic premise of May’s statement: that money does not grow on trees.

The reason is, quite simply, that most people share this view. It is one of many deeply-rooted myths about how modern monetary systems operate, which relates to the wider belief that governments, like households, are financially constrained and have to ‘fund’ their expenses through taxes or debt. The pervasiveness of this economic misconception is testified by the reaction to the Paradise Papers scandal – and more generally by how the debate about tax havens is framed, especially on the left. Progressives tend to couch the argument about the offshoring of wealth first and foremost in terms of its impact on the domestic tax base (the tax or revenue loss) – and therefore on the budget balance – of ‘source’ countries. A few years back, for example, Richard Murphy, director of Tax Research UK, estimated that tax evasion and tax avoidance together ‘cost’ EU Member States around 1 trillion euros a year in lost revenues, equal to around 105 per cent of total healthcare spending.

The implication of such analyses is obvious: if only governments could find a way of tackling tax evasion/avoidance and could get their hands on some of that offshore cash, they could afford to spend more – on nurses, for example – and bring their fiscal deficits and public debt under control. As the progressive Twittersphere proclaimed: tax havens are the magic money tree. In his report, Murphy even went as far as writing that ‘tax evasion and tax avoidance undermine the viability of the economies of Europe and have without doubt helped create the … debt crisis that threatens the well-being of hundreds of millions of people across Europe for years to come’ – thus establishing a causal link between offshoring, the European debt crisis, and the related economic and social crisis.

The magic money tree does exist, but it’s located much closer to home than we think

The idea that the savings and tax receipts of the rich are crucial to the viability of the welfare state, and to the ‘sustainability’ of public finances more generally, is a corollary of the aforementioned ‘household budget’ analogy: This idea – peddled by politicians and the media on a constant basis – holds that governments face the same financial constraints as households. As individuals and households, we are painfully aware that we have to earn income before we can spend. Sure, we may borrow to temporarily spend more than we earn, run down savings, or sell assets, but eventually we will have to sacrifice spending to pay back our debts. We intuitively understand that we cannot indefinitely live beyond our means. We have to ‘finance’ every penny we spend and we can quite literally ‘run out of money’. However, the idea that governments face similar limitations is false at the most elemental level.

Modern currencies are often called fiat currencies – from the Latin word fiat (‘it shall be’) – because their value is not underpinned by a government promise to redeem them for precious metal. Their value is proclaimed by faith: the government merely announces that a coin is worth, let’s say, a half dollar without holding a reserve of precious metal equal in value to a half dollar. A consequence of the fiat system is that governments that issue their own currencies no longer have to ‘fund’ their spending. Technically, they don’t need to raise money through taxes before they can spend, neither do they need to offset deficits that may arise by issuing debt to the private sector. They can simply create the necessary money ‘out of thin air’. Moreover, flexible exchange rates mean that governments no longer have to constrain their expenditures to meet the central bank requirements to sustain a fixed parity against a foreign currency. This, of course, does not apply to countries that are part of the European Monetary Union – a point we will return to.

In short, currency-issuing governments such as those of Australia, Britain, Japan and the US can never ‘run out of money’ or become insolvent. They face no solvency constraint precisely because they face no revenue constraint. These governments always have an unlimited capacity to spend in their own currencies: that is, they can purchase whatever they like, as long as there are goods and services for sale in the currency they issue. This includes the capacity to purchase all idle labour (or to offer a raise to those that are already employed in the public sector). In other words, the magic money tree does exist, but it’s located much closer to home than we think: in each country’s central bank, not on some faraway tropical island.

Do we need the rich’s money?

Once we understand how modern currency-issuing states operate, we can also appreciate that the widespread belief that tackling offshoring is necessary to allow governments to provide high-quality services, public infrastructure, and jobs is largely unfounded. “Every pound avoided in tax by the super-rich is a pound desperately needed by our National Health Service, our schools and our caring services” declared the British shadow chancellor John McDonnell in the wake of the Paradise Papers leak. Indeed, in the USA “we find that when tax payments are made to the government in actual cash, the Federal Reserve generally burns the ‘money’. If it really needed the money per se surely it would not destroy it”.[1] Ultimately, this is a dangerous and misguided narrative for progressives to engage in. Not only because it fuels damaging myths about how the economy works, but also because it unwittingly provides governments with the perfect excuse not to meet their obligations to society, by legitimising the premise that this is largely predicated on their ability to tackle tax evasion/avoidance (giving them even more reason not to address the issue). It also elevates the rich and high-income earners to an indispensable status that is unwarranted. Progressives should come to terms with the fact that the incomes and taxes paid by the rich are largely irrelevant to the capacity of a currency-issuing government to provide first-class public services and infrastructure (though this does not in any way mean that taxes are not important, as well shall see).

This does not apply to countries that are part of Eurozone, they effectively use a foreign currency (the euro). Much like a state government in, say, the US or Australia, Eurozone countries borrow in a currency which they don’t control (they can’t set interest rates nor can they roll over the debt with newly issued money and thus, unlike currency-issuing countries that issue debt in their own currency, they are subject to risk of default). As a recent European Central Bank (ECB) report reads “although the euro is a fiat currency, the fiscal authorities of the member states of the euro have given up the ability to issue non-defaultable debt”. Thus, the spending capacity of euro area countries is indeed largely reliant on tax revenues (and on the goodwill of the ECB) and their ability to issue debt to the private markets. This situation “is reminiscent of the situation of emerging economies that have to borrow in a foreign currency”, Paul De Grauwe noted a few years back.

Private spending is just as inflationary as (if not more inflationary than) government spending

However, this is not because of some intrinsic economic law but because of a purely self-imposed constraint: Eurozone membership. Any serious discussion concerning the tackling of tax evasion/avoidance for fiscal reasons necessarily needs to be framed within a wider debate on the monetary union. Supporters of such a course of action should bear the onus of explaining why this is a better option for countries aiming to improve their public services rather than, say, regaining their monetary sovereignty and thus the capacity to spend irrespective of revenues. However, the taxes-do-not-fund-spending logic does apply to the Eurozone as a whole. The ECB, like any other central bank, does not face financial constraints of any sort, and could easily support the spending requirements of Eurozone countries – or of a yet-to-be-created ‘European treasury’ – by creating the necessary funds out of thin air (as it already does in the context of quantitative easing, to the tune of 30 billion euro per month). The obstacles to reforming the ECB’s role in relation to public spending are political, not technical, as discussed elsewhere.

It is commonly believed that financing government spending through a fiscal deficit rather than through taxes is inherently inflationary – even more so if the deficit is financed directly by the central bank rather than by the private sector. In reality, fiscal deficits do not carry any intrinsic inflationary risk. Instead, it is government spending itself that carries such a risk, regardless of how such spending is financed – by raising taxes, issuing debt to the private sector, or issuing debt to the central bank. Indeed, all spending (private or public) is inflationary if it drives nominal aggregate spending faster than the real capacity of the economy to absorb it. In other words, the government taking money sitting idle under someone’s mattress and spending it in the economy carries exactly the same inflationary risk as the central bank creating that money out of thin air and giving it to the government to spend. What matters, from an inflationary perspective, is the government’s capacity to spend responsibly, without overheating the economy.

However, it is often overlooked that private spending is just as inflationary as (if not more inflationary than) government spending. The current system allows private banks to create (out of thin air, just like central banks) most of the digital money in circulation through loans, which create deposits and liquidity that can be spent. This freedom gives banks the power to engineer credit-driven booms at will, which in turn leads to soaring prices (especially in the housing market), as we saw in the run-up to the financial crisis.[2]

So should we close down tax havens? Yes!

Of course, none of means that the offshoring of wealth is not serious problem and shouldn’t be urgently addressed. There are very good reasons for tackling tax evasion/avoidance and closing down tax havens, and for collecting more taxes in general; however, these have little to do with the financing of public expenditure (with the possible exception of the Eurozone). They largely have to do with social justice, inequality and the distribution of political power. It is a well-established fact that today’s soaring levels of inequality – which have returned to levels of over a century ago – represent a grave economic and social problem. As acknowledged even by the International Monetary Fund (here and here), inequality hampers growth (“when the rich get richer, benefits do not trickle down”, one IMF study notes, consigning decades of trickle-down propaganda to the dustbin of history), exacerbates financial instability, erodes social cohesion, and leads to political polarisation. Even more importantly, various studies show that extreme inequality represents a threat to democracy itself. Allowing a small minority to amass obscene amounts of wealth leads them to wield disproportionate influence and power, and allows them to capture to legislative process and push through laws that further cement their power and influence. As Branko Milanovic writes, the “higher the inequality, the more likely we are to move away from democracy toward plutocracy”. Tax havens and offshoring, by facilitating the concentration of wealth, exacerbate the problem of inequality. For this reason they should be shut down.

Extreme inequality represents a threat to democracy itself

If that is the aim, however, progressives should be clear about the fact that this does not require some all-encompassing international agreement. This is just another smokescreen. A cursory glance at the world’s leading tax havens shows many lie within the direct legislative jurisdiction of nations such as the US and the UK (which themselves are tax havens). Bermuda, the Cayman Islands, Guernsey, Jersey and, the Isle of Man – all major tax havens – are all British dependencies or overseas territories. Moreover, according to the Tax Justice Network, many of the world’s largest and most secretive tax havens – Switzerland, Luxembourg, Germany, the UK, Belgium, Austria, Cyprus – are located in Europe (and, with the exception of Switzerland, are part of the European Union).[3] The conclusion is obvious: if politicians were serious about the issue of tax evasion/avoidance and offshoring they could do something about it with a stroke of their legislative pens.

It is often argued that the EU, by establishing free capital mobility among its members, has forced countries to engage in tax competition with each other, since these have little choice but to lower their corporate tax rates if they want to attract foreign direct investment. This argument prompts the conclusion that the only viable solution to tax avoidance and declining corporate tax rates is to ‘harmonise’ tax rates across Europe. However, various studies (see here and here) have found a negligible relationship between foreign direct investment and low(er) corporate tax rates, finding a much more significant relationship to things like labour costs, skill levels, infrastructure quality, and political stability. This would appear to disprove the oft-heard claim that there is little individual countries can do to tackle tax avoidance.

Gaining a greater control over the tax base would also allow governments to tax high incomes and wealth more efficiently – not with the aim of ‘raising more money’ but of creating a more equitable society. This underscores how, for currency-issuing governments, taxation is first and foremost a way to redistribute economic (and therefore political) power between classes, as well as a means to alter the allocation of resources away, for example by encouraging or discouraging certain industries and/or products (think taxes on alcohol or carbon taxes). To conclude: there are very good reasons for closing down tax havens. Financing government spending, however, is not one of them.