Should Bhutan be a tax haven for India?

Several years ago, while defending India's Mauritius tax treaty, a prominent government economist told me that "every country needs a teat to suckle from". He then went on to give several examples of tax havens and such like that "facilitate" capital flows.

It was therefore pleasant to come across a paper that discussed tax havens. In a recent paper,*Dhammika Dharmapala and James R Hines Jr of the University of Michigan say that "roughly 15 per cent of countries are tax havens". That means around 30 countries service the needs of both other countries and global capital.

Panama, Bermuda, the Caribbean countries, Ireland, Luxembourg, Switzerland, Hong Kong and Singapore earned $7.4 billion in 2002 as a result of just American individuals doing the high-fives. "In contrast, the controlled foreign divisions of American corporations reported $57.3 billion of after-tax earnings and profits in these countries in 2002," the paper states.

The authors say that it is mostly small and affluent countries that become tax havens. The smallness part is easy to understand. After all, if you don't have a large domestic market, you may as well do other things to get on with becoming rich.

But the affluent part seems dodgy as far as causality is concerned. That is, could it be that they become affluent because they are tax havens and not the other way around?

Likewise, the authors say that "better-governed countries are much more likely than others to become tax havens. For a country with a population under one million, the likelihood of it becoming a tax haven rises from 24 per cent to 63 per cent as governance quality improves from the level of Brazil to that of Portugal."

Or is it that if you want to be a successful tax haven, you'd better ensure good governance? Who would trust, say, Haiti as a tax haven?

Indeed, say the authors, low tax rates are by themselves not enough. A country could drop tax rates to as close to zero as possible and yet be unsuccessful as a tax haven if it is poorly governed.

There has been considerable research on tax havens. The authors provide us an excellent sampling of the literature. One of the key findings pertains to the effect of tax cuts on investment. "A 10 per cent tax reduction (for instance, reducing the corporate tax rate from 35 per cent to 31.5 per cent) is typically associated with a 6 per cent greater inbound foreign investment." Is that a takeaway for Chidambaram for the 2007 Budget?

Indeed, say the authors, FDI may be even more sensitive. Recent evidence also points to this finding. This is because there a hundred other tax dodges that depend on tax regimes and combinations thereof.

As the authors put it, "It is entirely possible for firms to adjust transfer prices in a tax-sensitive fashion without violating any laws", which was the point of the Mauritius Treaty.

From the point of view of the host country, which would suffer some tax loss as a result of reducing its rates, the reduced revenue can be made up by taxing other things. Thus, if you treat international capital as a necessary intermediate input, which you well might, following the classic study of Peter Diamond and James Mirrlees, we can say that a country would be better off by not taxing internationally mobile capital.

Looking to it all, it strikes me that Bhutan could well become a nice little tax haven for India. Perhaps that is one way of viewing India's new approach towards it?

*Available on the website of the Social Science Research Network: http://papers.ssrn.com/ sol3/ papers.cfm? abstract_id=952721