• Strategy
  • The Economist

What It Takes to Succeed

For offshore financial centres, not only low taxes but a great deal besides.

The Jersey cow, a small, honey-brown bovine that is prized by farmers for the abundance of buttery, high-fat milk it produces, is one of the fastest-growing breeds in the world. From its origins in Jersey, a rocky island 14 miles (22km) off of the western coast of France, it now wanders fields in over 100 countries from South Africa to Latin America. It is Jersey’s most famous export. But the island’s real cash cow is financial services. Jersey’s 46 banks, 1,055 investment funds and over 200 trusts administer over £700 billion in assets on the island. In St Helier, Jersey’s capital, they compete for office space with more than two dozen law firms, 50 accountancy outfits and 20 insurance companies.

Jersey’s transformation into an OFC was not part of a grand plan. After the second world war Jersey’s low taxes attracted the bank deposits of British expatriates living in the former colonies. The island’s maximum rate of income tax of 20% had remained untouched since 1940 when it was set by the German occupiers.

But tax was only the beginning. Jersey used its role as a low-tax repository of cash to build up a sophisticated private-banking and trust business. More recently it has moved into the corporate business — structured finance, the administration of investment funds, the management of company share plans and the like.

Other OFCs developed in similar ways. Many of them are small territories that were once part of Britain (a number of them are still dependencies). Often they had a history of low or no taxes long before they began to attract the deposits of British expatriates and others. As money flowed in, the cleverer ones began to diversify into more sophisticated businesses. They also began to promote themselves as broad financial centres, not just banking ones. This suited Britain, because it meant its protectorates could become self-sufficient. It also suited the jurisdictions themselves. Financial services are lucrative and provide a much more stable income than crops and fickle tourists. Mauritius hoped to diversify away from sugar, textiles and tourism and attract skilled labour when it launched itself as a financial centre in 1992. Barbados, a poor country reliant on sugar, received help from the IMF and other agencies when it established its financial industry in the 1970s.

Given the attractions, why are there not even more OFCs? After all, cutting taxes to attract foreign capital seems an easy way out of poverty. A study published last December by Mr Hines and Dhammika Dharmapala of the University of Michigan looked at 209 countries and territories, including 33 tax havens, to see why some jurisdictions become tax havens and others do not. Those that do, they found, are overwhelmingly small, wealthy and, especially, well governed, with sound legal institutions, low levels of corruption and checks and balances on government. Badly run jurisdictions cannot attract or retain foreign capital, so many do not even try. Slashing tax rates is not nearly enough.

This may explain why the British empire spawned so many successful OFCs. These jurisdictions inherited strong legal and governmental institutions that reassured investors. Lingering ties to Britain probably helped, too. The appeals process in the BVI and Jersey, among other OFCs, ends up in Britain. Other jurisdictions that have tight cultural or linguistic ties to nearby large financial centres also benefit from a ready clientele happy to do business in a familiar place. Liechtenstein, for instance, does well out of being perched next to Switzerland and using the Swiss franc as its currency.

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