Occupying a damp 1,000 square miles where the French, German and Belgian borders meet, the Grand Duchy of Luxembourg is a far cry from the palm-fringed tropical island tax haven of popular imagination.

In fact the country owes its status as the world’s premier corporate tax haven to its position at the heart of Europe. A founding member of the European Economic Community in 1957, Luxembourg enjoys all the freedoms governing investment in what is now the European Union. These and a network of taxation agreements with all the world’s leading economies ensure the Grand Duchy is accepted in a club of leading nations that share basic principles on how to tax corporations operating across national borders.

Such a privilege would never be afforded to island-in-the-sun tax havens. Large economies, such as the US and UK, typically block multinationals from shifting profits to low-tax territories by imposing ‘withholding taxes’ on payments leaving their borders. Luxembourg, by contrast, is a respected member of the international economic club, and assumed therefore to tax its companies fully; it even has a corporate income tax system with a 29% rate that is now relatively high by international standards. So money flows into the country tax-free.

Secretly, however, Luxembourg is a tax haven, offering a range of ways in which payments that reduce a multinational’s taxable profits in a country such as the UK or US can escape tax when received in the Grand Duchy. These include: exempting income diverted to foreign branches of Luxembourg companies in places like Switzerland and Ireland, tax relief for paper investment losses, and the approval of complex ‘hybrid’ financial instruments and corporate structures within its borders. Top FTSE 100 firms like Vodafone and GlaxoSmithKline are known to have exploited these opportunities to channel billions through Luxembourg companies.

When a multinational approaches the Luxembourg tax authorities with a scheme employing one of these tactics, after a meeting or two to chew over the details a senior official rubber-stamps the plan and the company walks away with a big tax break. In this way the Grand Duchy behaves like the club member who enjoys all the benefits of membership while quietly pilfering from the kitty.

It might be an underhand way to run a tax system, but it serves Luxembourg well. The country has the highest levels of foreign investment inflows and outflows in the EU, taking a small but valuable tax levy as the money washes through. Corporate income taxes, at 5% of GDP, consequently form a far greater share of Luxembourg’s finances than they do in other EU countries.

As the world cottons on to Luxembourg’s tax poaching, pressure for reform grows. So does embarrassment for the new president of the European Commission, Jean-Claude Juncker, who as prime minister of the Grand Duchy for 18 years until 2013 presided over the activity. Revelations of precisely how its corporate tax avoidance factory works give the lie to Juncker’s repeated protestations that the country is not a tax haven.

Investigations by the European Commission into deals offered by Juncker’s government to Amazon and Fiat might or might not conclude that they constituted anti-competitive ‘state aid’. But these inquiries concern the possibility of ‘sweetheart deals’ for favoured companies, when the bigger problem is that Luxembourg offers major tax breaks to all companies – as long as they have enough money.

Neutering Luxembourg as a tax haven at the heart of Europe requires an overhaul of its corporate tax law and administration. A concerted effort coordinated by the OECD aims to bring many of the tax structures facilitated by Luxembourg to an end. But, even if its proposals are technically sufficient, it will take intense political pressure to force Luxembourg to implement them.

In the meantime, despite his claims to be spearheading the OECD’s work, George Osborne has enhanced the allure of Luxembourg’s tax breaks. In 2012 he drastically scaled back anti-tax avoidance laws targeted at multinationals’ so-called ‘controlled foreign companies’. These are tax laws that since 1984 have caught profits diverted by UK multinationals into tax havens. In a move specifically aimed at favouring finance companies established in Luxembourg, Osborne reduced the tax on their profits to no more than 5%.

Osborne’s changes are designed to make the UK an attractive place for multinationals to base themselves. They do so by accommodating predatory tax practices, in response to opportunities provided by countries like the Netherlands and Luxembourg. Other widely publicised tax breaks such as the ‘patent box’ special tax rate for income from intellectual property mimic concessions elsewhere.

This is the real harm that tax havens like Luxembourg cause. They turn ‘tax competition’ into a global race to the bottom, depleting the contributions of major corporations and leaving citizens to pick up the tab.

Richard Brooks is the author of The Great Tax Robbery - How Britain became a tax haven for fat cats and big business.