Disappearing Act: The Problem With American Tax Havens

Graphic by Arola Oluwehinmi

If someone asked you to picture a tax haven, you might think about the sunny Caribbean beaches of the Cayman Islands, where the world’s richest politicians and oligarchs have long hidden their ill-gotten funds. Next time, however, you might want to think a bit closer to home. The United States is the second largest tax haven in the world, with states like South Dakota and Nevada leading the pack. With the release of the Pandora Papers, a massive leak of nearly 12 million records unveiled by the International Consortium of Investigative Journalists (ICIJ), the world now has a window into the financial secrets of the wealthy. The current lack of regulation and transparency in the American financial sector is what allows the wealthy to hide money in shell companies and trusts half a world away. The problem is not that they are hiding money in illegal ways, but that these practices are legal in the first place. Not only does this protect oligarchs and politicians from equal taxation and oversight, but it also shields resources that could instead be used for the betterment of society. Tax havens anywhere create a problem everywhere, and the United States (and its allies) must enact reforms to prevent these abuses. The first section will detail how the wealthy hide their money, and why they choose to do it in the United States. This section will also clarify key terms that will be used in the remainder of the article. The next section will explain why this is a problem, and explore the negative consequences that are levied against the American people. It will look at the issues of inequality and resource extraction through tax evasion. The third and final section will provide specific policy prescriptions that are best equipped to resolve this problem.

PART I. DISAPPEARING ACT

So how do the wealthy hide their money? While there are a number of ways to shield wealth from taxation, this article will focus on two legal options: shell companies and trusts. A shell corporation is a company with no active operation, no notable assets, and no employees. These companies allow their owners to shirk tax responsibilities or store money with a high degree of secrecy. A trust is a legal structure that allows one person (a trustee) to hold assets transferred to her (by a trustor) and to manage those funds to the benefit of the beneficiaries. The benefit of trusts is that they provide a great deal of secrecy, as most countries do not require trusts to register nor to disclose their trustors or assets. Despite the convenience of structures such as these, shell companies and trusts are useless without a legal system that is both friendly to tax sheltering and strong enough to protect the hidden funds. This is what makes the United States such an appealing place to hide money.

The best place to hide money is a tax haven: countries or jurisdictions that have very low corporate tax rates and that limit public disclosure requirements. These conditions are perfect for the wealthy because they are able to hide their money from higher taxation without having to disclose where the money is and how much is hidden. Increasingly, the wealthy are concealing assets in American tax havens, which benefit from friendly legislation, as well as established rule of law and a stable currency, which protects the assets from crime and instability. In South Dakota, for instance, trust laws provide strong protections for the wealthy, shielding them from transparency and allowing trusts to operate without regulation. Limited legal oversight is essential to a tax haven because a tax haven would not be nearly as valuable without assurances of anonymity. Remaining anonymous is what allows the wealthy to shield their money from taxation without any threat of investigation or interference. These types of laws are not exclusive to South Dakota, and without national transparency laws or a national corporate tax rate, any American state can become a tax haven.

PART II: THE PROBLEM WITH TAX HAVENS

The Pandora Papers leak leaves little doubt that the world’s wealthiest are hiding their assets in tax havens like the United States, but one question remains: what makes this so significant? There is, of course, a foreign policy aspect to this dilemma. Many of those identified in the Pandora Papers are world leaders—figures such as King Abdullah II of Jordan and Guillermo Lasso, the president of Ecuador—who must face investigations into their potential abuses of power. Trusts and shell companies are also integral to international drug-trafficking and the global arms trade, as well as an array of other crimes. The lack of oversight in the American financial system enables these abuses and impedes law enforcement efforts by obscuring the money trails integral to law enforcement investigations. Without knowing the “beneficial owner” behind a trust or a shell corporation, law enforcement agencies are left with a virtual dead end. The result is a thriving global criminal enterprise and startling corruption amongst world leaders and their associates.

Setting aside the global implications of the Pandora Papers, the current financial system in the United States contributes to inequality and resource extraction at the domestic level. In South Dakota today, assets in trusts constitute $360 billion, a number which has ballooned over the past decade. This figure points to a startling reality that helps to explain the rise of income inequality in the United States in the past four decades. When the wealthy hide their money in tax havens like South Dakota, they are cheating the system—and doing so by working within the system. Instead of paying their fair share of taxes, the wealthy push responsibility for funding essential projects (like infrastructure or climate reform) onto the shoulders of average citizens. Instead of acting with transparency and integrity, the wealthy use trusts to develop fortunes across generations, deepening the divide between rich and poor. The American financial services sector is plagued by corruption and secrecy, and national legislation should be enacted to seek greater transparency and regulation. This argument should not be taken as a demand to strip the wealthy of all of their money, in some vindictive agenda against the rich. Except where money has been illegally obtained, there are no grounds on which this is a viable option. However, there is a clear problem with the American financial sector as it stands today: it serves the rich, to the detriment of the poor. This does not live up to the American ideals of equality and justice for all. This article recommends concrete legislation that will reform the financial system so that it better aligns with these principles and no longer allows the wealthy to hide from liabilities.

PART III: POLICY PRESCRIPTIONS

Given the massive problem of tax-sheltering in the United States, Congress should enact or expand legislation to increase transparency, set a national corporate tax rate, and allow for meaningful enforcement and oversight. On January 1, 2021, Congress passed legislation—over the veto of then President Trump—called the Corporate Transparency Act (CTA) that forces entities registered within the United States to disclose the identities of their owners. This move essentially limited the use of shell corporations to anonymously hide assets, and constituted the first major step toward financial transparency. However, this legislation is insufficient to address the greater problem because it does not apply to trusts. Trusts are still not obligated to disclose their trustors or beneficiaries, and are not subject to extensive regulation in many states. So long as trusts are not covered by transparency laws, they continue to be a tool of the wealthy to hide money from equitable taxation. Therefore, the United States must expand this transparency obligation by amending the CTA so that it covers trusts. 

Additionally, the United States should set a national corporate tax rate that is high enough to ensure that no American states are tax havens. At the Group of 20 (G20) Conference in October 2020, world leaders signed off on a global pact to end profit-shifting. One of the central tenets of the agreement is a global corporate tax rate of 15 percent, which should help to curb abuse of tax havens. This is clearly not a perfect strategy: countries that have not signed the agreement are unlikely to follow suit, and it will be difficult to pass a 15 percent tax rate even in countries that did sign the agreement. However, this is an important step, and the United States should follow through on the agreement by passing a 15 percent corporate tax rate before the 2022 midterm elections. 

Finally, the United States should better fund the Internal Revenue Service (IRS) in the next budget and prioritize punishment of corporations or individuals that violate federal tax code or engage in strategies to hide wealth. This is an essential component because it both bolsters the previous two recommendations, and acts as a deterrent against tax evasion and an enforcement mechanism to reduce criminal activity. When the IRS is well-funded and free to pursue tax evaders, it will be a far more effective law enforcement service; able to help agencies like the Drug Enforcement Administration and the Federal Bureau of Investigation to pursue criminals who use trusts and shell corporations to hide illicit activity. This is backed up by research: the Congressional Budget Office (CBO) found that a 2021 proposal to increase IRS funding would result in greater tax compliance overall. The CBO also found that the proposal would increase the audit rate for high-income taxpayers and allow the IRS to focus its enforcement efforts on “high-wealth taxpayers, large corporations, and partnerships.” This final policy recommendation will be beneficial for American law and order as a whole.

PART IV: CONCLUSION

The United States is the world’s second largest tax haven, and it is a problem that must be addressed at the national level. Tax-avoidance and wealth-sheltering activities in states such as South Dakota and Nevada create sweeping consequences for average citizens. Not only is the United States acting as a bank for dictators and oligarchs, but it is also allowing wealthy individuals to avoid paying a fair share of taxes. This contributes to ever-rising inequality and prevents the American government from tackling important issues, such as welfare reforms or climate change. The recommendations proposed in this article provide some initial steps to curb this behavior by making lucrative anonymity illegal, by setting a national corporate tax rate, and by enforcing these policies. However, even if the government is successful in implementing these policies, there is still a long road ahead in curbing abuses at the global level.