Under the tax microscope

 Income tax, payroll tax and property tax are off the table – but only for now.

The Cayman Islands government managed to gain a reprieve, but had to concede to the UK Foreign Office that an independent commission will assess Cayman’s ability to generate stable revenues without direct taxes.

What may have been nothing more than a bargaining chip in negotiations with the UK, in order to delay the unwanted and perhaps the inevitable, is actually something that common sense requires: a study into the effects that direct taxes would have for the Cayman Islands.

In a time when most industrialised nations are concerned with reducing direct taxation, the UK government believes direct taxes are just what the Cayman Islands needs.

In an opinion piece in UK newspaper the Guardian on 18 September UK Foreign Office Minister Chris Bryant reiterated his claim that the Cayman government will have little choice but to introduce some form of direct taxation to deal with its financial woes.

“It is clearly in the interests of all the overseas territories to have open, transparent fiscal arrangements and sustainable revenue from a wide and diverse tax base,” he wrote.

“Mere tax haven status will not pay the bills, nor will an over-reliance on indirect taxation.”

It is difficult to find anyone in Cayman who agrees with the UK minister responsible for the overseas territories.

“To now react to pressure from the UK to introduce payroll/income tax would be just short of a crime,” says Kim Lund, Broker/Owner at Re/Max.

Mr Lund believes that the introduction of direct taxation would be an overreaction to a one-time global financial crisis that hit almost every country and is not unique to Cayman.

“Cayman has an incredible and successful business model that works,” he adds.

“It is envied worldwide. Unfortunately, some of the established tax regimes are extremely envious and their solution and hidden agenda is to make us like them, despite their system being dysfunctional and a burden on their citizens.”

Leader of Government Business McKeeva Bush takes the same line and points to different ideologies on taxation in countries like the UK. He argues, with regard to their high tax burden, that it is those countries that “have mismanaged”.

“Money is going to find its way to those jurisdictions that are well managed, like the Cayman Islands”, Mr Bush says, citing the country’s record with international organisation such as IOSCO, the IMF and the OECD.

He contends: “The fact is that, barring any agenda, the UK still has a valid point in that the Cayman Islands needs sustainable revenue streams,” but he maintains that direct taxes are not what is needed.

While the UK is busy shifting revenue income from direct to indirect consumption-based taxes, the Cayman Islands until now does not have direct taxation.

When considering direct taxation, Cayman would have three basic options: a payroll tax paid by an employer on payroll, a similar income tax paid by the employee on salary or a property tax linked to property ownership.

Seismic shift

Each option would present the Cayman government with its individual set of problems.

No matter which tax was introduced, the effect on the economy and Cayman society would be considerable.

The Cayman Islands would become a tax experiment, observed by tax theorists across the world interested in seeing how the introduction of direct taxation would affect the Cayman economy and influence the behaviour of market participants, including employees, consumers and businesses.

“If we introduce direct taxation, it will be the start of the end for Cayman,” says Mr Lund.

“We will lose one of our most important attractions, of being an efficient society who pays fees based on what we personally use or consume,” he says, describing one of the fundamental benefits of a system of indirect taxation.

Direct corporate taxes have decreased world-wide owing to the competitive pressures between different tax regimes. In many European countries, including the UK, direct taxes are being reduced, whereas indirect taxes are increased in the hope that these will provide more stable revenues.

It is currently a key advantage that the indirect taxes in the Cayman Islands are not directly exposed to international competition. Direct income or corporate taxes, in contrast, would be very susceptible to businesses and individuals relocating abroad.

Anthony Travers, chairman of the Cayman Islands Financial Services Association, argues: “The move from an indirect to a direct system of taxation is a seismic shift which has not been thought through and which is not justified on the facts.”

The argument that the introduction of direct taxes would not have been thought through is an understatement.

In the wake of the arrangement with the UK Foreign Office, the Cayman Islands government has now time to study the effect of such a move.

Any tax will create incentives and disincentives for tax payers. Irrespective of the type of tax introduced, it will have repercussions for the economy and in the medium and longer term for the society of a country.

When a new tax is contemplated, tax revenue is therefore an important but by no means the only factor that should be analysed.

One of the most important things to remember is that tax rates and tax revenue are not positively correlated.

This means that higher taxes do not automatically mean more revenue, because tax payers, whether businesses or individuals, adapt and find ways of reducing the amount of tax they have to pay.

This change in behaviour in turn has an effect on the economy, on businesses, jobs and living conditions.

“I have canvassed senior business players in Cayman and they have indicated that at the first sign of a payroll tax they will have to consider their options,” says Mr Travers.

“I believe this will inevitably lead to job losses and it will affect both the highly paid and more junior members of staff and lead not to a revenue increase, but a decrease.”

Taxes in general are assumed to have a negative effect on the economy, because they create disincentives for those who have to pay them.  A sales tax discourages retail purchases, taxing income or payroll reduces the incentive to work or create jobs and a tax on savings reduces the incentive to save.

The less a tax distorts economic activity, the better. But many taxes have unwanted effects.

No window tax please

Taxes tend to impose an excess burden on consumers and producers by creating what economists call a “deadweight loss”.

In 1696, King William III introduced a levy in Great Britain, based on the number of windows a house featured, in a crude effort to measure the wealth of the owner. The “window tax” led in some cases to windows being blocked up with bricks to reduce the tax charge. Some allege it coined the term daylight robbery. The lack of sunlight and revenue constituted the deadweight loss of the tax.

Modern taxes face the same problem. To determine the effect of taxes theorists analyse the price elasticity of supply and demand.

For example, the more elastic the demand, in other words the more demand is able to respond to a tax on supply, the higher the deadweight loss of the tax. The more inelastic the demand is, the higher the tax revenue.

Applying tax to a base that has little or zero elasticity is therefore preferable, as the overall burden is lower and the tax revenue higher.

Income and sales taxes for instance vary considerably, whereas property taxes are highly stable regardless of the economic situation.

Tax fairness

Another concern, when deciding on taxation, is whether people in similar circumstances will carry a similar tax burden. This includes the question whether the more affluent tax payers carry more of the tax burden than less well-off tax payers.

In order to make taxes fairer, different structures such as proportional, progressive or regressive can be applied. A progressive tax would for example be an income tax that applies higher tax rates with increasing income. In a proportional tax the ratio remains constant and in a regressive tax the ratio declines with income.

A major criticism of indirect taxes is that they are regressive. It is argued that indirect taxes, affect the poor more than the rich. One example would be a fixed tax on tobacco, which will be more of a burden to someone with less disposable income.

However, indirect taxes such as sales taxes are less complex.

Complexity is an important factor, because a simple tax will also appear fairer to the tax payer, than a complex direct tax with many exemptions that can only be reduced by wealthier tax payers with the resources to do so.

How to collect?

A tax also needs to be collected effectively. The ease with which a tax can be collected will directly affect the kinds of structures that have to be put in place to be able to collect the revenue quickly and in full.

A tax may be expensive to administer depending on how easily it can be avoided, evaded, audited and policed.

Direct taxes would have the disadvantage that they require a system for tax assessment and collection that Cayman so far does not have. Such a system would take time and money to implement.

Shadow economy

If the costs are high enough, a tax on income or payroll will immediately create a market for tax evasion.

High tax countries are familiar with shadow economies that reduce tax revenue and affect employees.

Employers able and willing not to pay taxes for certain employees will also not pay pension contributions and healthcare, with all the social and financial ramifications this has for employees.

To prevent the creation of a shadow economy, it will be necessary to create an authority that supervises and polices tax payments.

This all comes at a cost. In terms of timing and with regard to the volume of tax revenue that can be generated in the short term, it means that direct taxes are not likely to be suitable to address Cayman’s immediate financial difficulties.

No taxation without representation

The imposition of direct taxes will also require a much higher degree of accountability and transparency from government.

It is doubtful that tax payers will tolerate ever increasing tax rates in the face of unaudited budgets, wrong economic forecasts and excessive government spending.

Social change may be another consequence. A direct tax imposed on expats may mean that they would have to be granted more rights.

Can for example state schools in the future refuse expat children, when they are financed by direct taxes?

Taxes that apply only to tax payers above a certain salary level to protect low wage workers could at the same time lead to an influx of workers that earn wages below this threshold.

All these issues and potential effects have to considered and balanced with the actual objective of diversifying and stabilising the revenue base, before any tax, direct or indirect, could be introduced.

Are direct taxes in Caymans best interests?

While it may be justified and easy to demand a diversification of the revenue base, it is clear that it will be much more difficult to implement.

McKeeva Bush believes that with the right management and the right attitude towards business the crisis can be resolved.

“Fees will increase, we will broaden our revenue base and we will make it more sustainable,” he says.

Mr Travers meanwhile asks, what is in the best interest of the Cayman Islands?

“It is not, in the view of CIFSA, in those best interests to seek to introduce any form of new or increased taxation without at the same time bringing expenditure under control.”

He adds: “Failure to bring expenditure under control means that tax rates can only rise inexorably over time.  That in turn will fundamentally and negatively affect the attraction of all sectors of the Cayman economy in terms of essential inward investment and that in turn means that increasing levels of revenue will have to be found from a smaller and smaller cross section of the community.”

He states, other countries, including the UK, have discovered that this is not a sustainable model for fiscal management.

Mr Lund agrees, saying if direct taxation was introduced, “future government budgets will simply be balanced by raising the tax rate and/or introducing new direct taxes, as history has shown us in these other countries.  

“The overseas investors, who help support our economy, will find we are really not any different or better than other locations and choices they have for investment and domicile,” he says.

“The bottom line is we will lose our allure and appeal, with the result being that even more money will be needed, through direct taxation, because we will not be getting it from overseas investment.

“It will become a vicious circle.”