Tax havens bending to the will of soft law
Tax havens bending to the will of soft law : a case study of the Cayman Islands’ response to the OECD and FATF blacklists
Title: Tax havens bending to the will of soft law : a case study of the Cayman Islands’ response to the OECD and FATF blacklists
Author: Driscoll, Matthew Brian
In 2000, two international organizations—the Financial Action Task Force (FATF) and the Organization for Economic Development (OECD)—attempted to attack the problems of money laundering and tax evasion through coercive soft law. Both organizations attempted to induce state compliance with international standards by placing noncompliant states on publicly available blacklists.
The FATF blacklist, Non-Cooperative Countries or Territories, documented states that failed to implement international anti-money laundering standards and the OECD blacklist, Uncooperative Tax Havens, documented states that failed to implement international tax information-sharing agreements.
This report examines the Cayman Islands’ quick compliance with these two international efforts. The report hypothesizes that the Cayman Islands’ complied quickly with both the FATF and OECD initiatives because the Cayman Islands’ had a strong financial institutional capacity and a high level of reputational risk from not complying.
The report develops a methodology for testing this theory against other jurisdictions placed on both of the original FATF and OECD blacklists. The testing reveals that while financial institutional capacity and reputational risk may have contributed to the Cayman Islands’ and other states’ compliance with the FATF and OECD initiatives, these factors were not determinative.
The report concludes that better metrics for state institutional capacity and reputational risk are needed to accurately measure states’ compliance with the FATF and OECD regimes.
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Abstract
Tax Havens Bending to the Will of Soft Law: A Case Study of the Cayman Islands’ Response to the OECD and FATF Blacklists
Matthew Brian Driscoll, MGPS; JD The University of Texas at Austin, 2013
Supervisor: Catherine Weaver
In 2000, two international organizations—the Financial Action Task Force (FATF) and the Organization for Economic Development (OECD)—attempted to attack the problems of money laundering and tax evasion through coercive soft law. Both organizations attempted to induce state compliance with international standards by placing noncompliant states on publicly available blacklists. The FATF blacklist, Non- Cooperative Countries or Territories, documented states that failed to implement international anti-money laundering standards and the OECD blacklist, Uncooperative Tax Havens, documented states that failed to implement international tax information- sharing agreements. This report examines the Cayman Islands’ quick compliance with these two international efforts. The report hypothesizes that the Cayman Islands’ complied quickly with both the FATF and OECD initiatives because the Cayman Islands’ had a strong financial institutional capacity and a high level of reputational risk from not complying. The report develops a methodology for testing this theory against other jurisdictions placed on both of the original FATF and OECD blacklists. The testing reveals that while financial institutional capacity and reputational risk may have contributed to the Cayman Islands’ and other states’ compliance with the FATF and OECD initiatives, these factors were not determinative. The report concludes that better metrics for state institutional capacity and reputational risk are needed to accurately measure states’ compliance with the FATF and OECD regimes.
Conclusions
The argument that institutional capacity and reputational risk were determinative in the Cayman Islands’ quick compliance with the OECD and FATF initiatives has been neither falsified nor verified. However, it is clear that this thesis cannot be extrapolated to apply more broadly to the other ten jurisdictions appearing on both lists. While institutional capacity and reputational risk may be contributing variables in determining why and when states complied with the FATF and OECD regimes, they are far from the only variables affecting a state’s decision to comply. The following section identifies problems encountered during this study and briefly suggests a path forward for further study regarding states’ compliance with the FATF and OECD regimes.
PROBLEMS OF MEASUREMENT
The absence of data regarding OFCs is inherently problematic, making cross- jurisdictional comparisons all the more difficult (Palan et al. 2010, 46–47). The gathering and publication of data has been aided by international governance initiatives, such as the FATF and OECD blacklists, and the rapid development of information technology. Nonetheless, statistical reporting is often clouded by variation across jurisdictions. While some countries such as the Cayman’s may report extensively on most elements of their financial sector—including IBCs, insurance companies, and hedge funds—other countries, such as Panama, may report only data regarding registered banks (IMF 2006). Cross-jurisdictional comparisons are challenging because of these variations in the availability and types of data reported.
Moreover, when approaching the two variables—institutional capacity and reputational risk—one cannot find a ready definition of either in the academic literature.
Institutional capacity is often defined using the World Governance Indicators (WGIs). In fact, my approach borrowed from that of Murray et al. in an IMF evaluation of Pacific Islands (2009). However, there are severe limitations with the WGIs, particularly when used in conjunction with assessing reputational risk. Since the WGIs measure perceptions rather than reality, they may be more appropriate for assessing reputation. Moreover, the WGIs are aggregated from multiple sources; these sources vary across jurisdictions, making comparisons using the WGIs far from perfect (see footnote 6). Nevertheless, if one were to use the WGIs for measuring reputational risk, then measuring institutional capacity would be very difficult as there are no truly independent metrics for institutional strength.
Measuring institutional capacity is made more difficult by the broad reach of the term. When studying OFCs, the concern is with only one sliver of a state’s economy and its institutional apparatus. Thus, the focus of institutional capacity should really be redefined, as attempted here, to mean “financial institutional capacity”. Is the state capable of implementing legislation and enforcement mechanisms to support and monitor the stability of its financial system? Such a question has become all the more relevant after the fallout from the global financial crisis of 2008–09.
Reputational risk is even harder to define; the literature provides no clear definition. This is made more problematic by conflicting views on how to define reputation. Most political scientists and economists treat reputation as an objective form of social capital, developed over time in something resembling an iterated game. This view holds that states have a high degree of control over their reputations and can monitor and control it simply by altering their behavior with regards to other states (Sharman 2006, 110). This view is best stated by Downs and Jones:
According to the standard argument, a major—if not the major—reason why states keep commitments, even those that produce a lower level of return than expected, is because they fear that any evidence of unreliability will damage their current cooperative relationships and lead other states to reduce their willingness to enter into future agreements. (2002, 95–96)
However, as Sharman points out reputation may be more intersubjective than objective; i.e., the role of third party perceptions may play a larger role in determining reputations rather than the state’s actual behavior (2006, 109–12). Thus, reputation may be far removed from objective reality (Eccles et al. 2007). The case of Nauru, as detailed above, seems to highlight this point. Despite complying with the FATF and OECD initiatives and having virtually no OFC sector, Nauru continues to suffer from a poor reputation.
The risk associated with a reputational downgrade is also difficult to assess. As the comparison between Liechtenstein and the Cayman Islands highlights, states may be facing different consequences from compliance or noncompliance. Liechtenstein may have made a rational choice in choosing not to comply with the OECD initiative, whereas the Cayman Islands may have also made a rational choice by complying. This is not to say that the FATF and OECD blacklists did not create risks for all the named jurisdictions, merely that the risks faced by each jurisdiction for compliance versus noncompliance were likely different.
Unfortunately, most of the economic literature regarding OFCs suggests that there is one global OFC market and that jurisdictions are homogenous in their desire to attract foreign capital (Desai et al. 2004, 2006a, 2006b; Dharmapala 2008). This line of thinking tends to ignore specialization and variation across OFC jurisdictions. OFC jurisdictions may specialize in a particular OFC product, such as the Cayman Islands’ focus on hedge funds. Moreover, such products may be strengthened and or determined by local law. For example, the Liechtenstein Anstalt is a financial and legal instrument that can only be found within Liechtenstein.
These variations across jurisdictions are likely to mean that each jurisdiction is servicing a different client base with different preferences. Each client base may be more or less sensitive to a reputational downgrade. A criminal attempting to launder money may care very little about an OFC’s reputation so long as the reputation does not hinder the ability to move money into the global economy. On the other hand, New York investors and corporations engaged in tax planning are likely to be very sensitive to an OFC’s reputation as stable and law-abiding. To obtain a better grasp of each jurisdiction’s reputational risk, one would need a deeper understanding of each jurisdiction’s specialization and the corresponding preferences of their client base.
MOVING FORWARD: A DEEPER UNDERSTANDING OF STATE COMPLIANCE WITH SOFT LAW
The hypothesis of this paper should not readily be abandoned. Institutional capacity and reputational risk may have been contributing variables to each state’s decision to comply with the OECD and FATF initiatives. Moreover, while difficulties in data collection and defining contributing variables may continue, cross-jurisdictional comparisons between OFCs, though strained, should not be wholly discarded. Even if cross-jurisdictional comparisons do not reveal a predictive theory, they tend to reveal a more nuanced understanding of individual state behavior, as was the case with this study.
Moving forward, to better grapple with institutional capacity and reputational risk, a broader empirical study across jurisdictions can be conducted. More empirical data regarding states’ financial sectors, legal regimes, and government institutions are understanding of reputation can be garnered through interviews of persons involved in both the supply and demand side of OFC services. Interviews, where and if available, are likely to be limited in their scope of information, as the FATF and OECD regimes are nearly fifteen years old, and participants may be unwilling to admit true interests or motives. To supplement these gaps, information regarding jurisdictions’ reputations should be gleaned from public statements both from the jurisdiction and by third parties about the jurisdiction. A more robust understanding of state compliance with the FATF and OECD initiatives will not only service the literature regarding OFCs, but will also aid in understanding state compliance with other types of soft law regimes. Presumably, a better understanding of state motivations to comply or not comply may lead to improvement in the design of future soft law regimes. likely to lead to more conclusive outcomes. Where empirical data are not available a more robust understanding of reputation can be garnered through interviews of persons involved in both the supply and demand side of OFC services. Interviews, where and if available, are likely to be limited in their scope of information, as the FATF and OECD regimes are nearly fifteen years old, and participants may be unwilling to admit true interests or motives. To supplement these gaps, information regarding jurisdictions’ reputations should be gleaned from public statements both from the jurisdiction and by third parties about the jurisdiction. A more robust understanding of state compliance with the FATF and OECD initiatives will not only service the literature regarding OFCs, but will also aid in understanding state compliance with other types of soft law regimes. Presumably, a better understanding of state motivations to comply or not comply may lead to improvement in the design of future soft law regimes.
