Which countries become tax havens?

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jpubeco.2009.07.005 Byline: Dhammika Dharmapala (a), James R. Hines (b) Keywords: Tax havens; Foreign direct investment; Governance quality Abstract: This paper analyzes the factors influencing whether countries become tax havens. Roughly 15% of countries are tax havens; as has been widely observed, these countries tend to be small and affluent. This paper documents another robust empirical regularity: better-governed countries are much more likely than others to become tax havens. Controlling for other relevant factors, governance quality has a statistically significant and quantitatively large association with the probability of being a tax haven. For a typical country with a population under one million, the likelihood of a becoming a tax haven rises from 26% to 61% as governance quality improves from the level of Brazil to that of Portugal. Evidence from US firms suggests that low tax rates offer much more powerful inducements to foreign investment in well-governed countries than do low tax rates elsewhere. This may explain why poorly-governed countries do not generally attempt to become tax havens, and suggests that the range of sensible tax policy options is constrained by the quality of governance. Author Affiliation: (a) Department of Economics, University of Connecticut, 341 Mansfield Rd., U-1063, Storrs, CT 06269-1063, United States (b) Department of Economics, University of Michigan, 343 Lorch Hall, 611 Tappan Street, Ann Arbor, MI 48109-1220, United States Article History: Received 18 November 2008; Revised 20 May 2009; Accepted 8 July 2009 Article Note: (footnote) [star] We thank the Editor (Amy Finkelstein), three anonymous referees, Alan Auerbach, Charles Brown, Mihir Desai, Daniel Feenberg, Ray Fisman, Fritz Foley, James Sallee, Joel Slemrod, Jeff Smith, Stanley Winer, and various seminar and conference participants for helpful comments on earlier drafts. We also thank Mary Ceccanese for assistance with the OTPR data, and Sebastien Bradley and Owen Kearney for excellent research assistance.