The basic dilemma faced by such an economy is that to attract IBC activity, the economy needs to choose between either becoming a tax haven, a safety haven or both for investors from large economy. In other words, the SOE is required to establish a competitive advantage relative to a large economy in terms of two possible instruments: taxation and institutional infrastructure.
The problem is that in reality, the same SOE will not be able to provide both - quality institutions and tax haven protection, since the latter contradicts the former. One can argue that in the past some tax havens were institutionally extremely robust, but in the current globalization-altered world, good institutions require compliance across the borders, not just within the country.
What the paper shows is that in such a setting, the tax haven can act as a catalyst to induce institutional reforms despite the fact that it cannot create institutional competitive advantage. The reason is that competition amongst tax havens drives institutional improvements in these IBCs.
As surveyed in the paper, a recent study by Dharmapala and Hines (2009) "investigated 209 countries and territories to determine which jurisdictions become tax havens and why. They found that successful jurisdictions are overwhelmingly small, but that they are especially well governed, with sound legal institutions and low levels of corruption. Poorly run jurisdictions fail to attract or retain foreign capital, and many do not even try. Thus, the quality of governance seems to matter for the existence of tax havens. According to Gonzalez and Schipke (2011), there is some empirical evidence that countries that apply stronger regulation rules have benefited from higher portfolio investments."
The CEPR study largely confirms this. The core conclusions are:
- "...whether the small country becomes a tax haven depends on the integration of financial markets and the intensity of the small country's comparative advantage."
- "The nature of government matters too to the extent that benevolent governments never build a tax haven. They prefer to erect an IBC through the provision of better institutional infrastructure."
- "By contrast, tax havens may emerge under Leviathan governments. This may explain why tax havens are developed in microstates where there is almost no conflict between social welfare and tax revenues because the local population benefits from the taxes which are mainly levied on foreign investors."
- "Our analysis also reveals that the presence of heterogeneous investors matters for the viability of the IBC and the nature of the policy mix."
- "IBCs need not be as bad as claimed in the media because they foster institutional competition which is beneficial to all investors."
- "Our results provide evidence that safe havens have a place in the global financial environment and provide benefits to governments, firms and households."