The Impact of International Financial Centers

Foreign legal systems probably affect your life as well. Many hospitals in the United States are insured through insurance companies incorporated in the Cayman Islands, a British Overseas Territory in the Caribbean that is better known to most people for its beaches and scuba diving than for providing insurance to health care providers. The extended warranty you bought on an appliance could be funded through a Turks & Caicos Islands company, another British Overseas Territory. And any insurance policy you buy from a US insurer is likely reinsured through a Bermuda-based (yet another British Overseas Territory!) reinsurer.

All of these are examples of the results of jurisdictional competition, which is the competition among jurisdictions to persuade people to bring legal business to them. The international version of this competition is little different from the domestic American version. In our federal system, states compete for economic activities by offering legal and business environments to attract entrepreneurs. Attractions include business courts (to speed resolution of disputes), business entities laws that cut the transaction costs of creating new businesses, low taxes, better infrastructure, and dozens more features of a business climate that are calculated to appeal to entrepreneurs. The main difference between the international competition for business and the domestic one is that in the former case, jurisdictions are primarily competing through their legal systems for the legal residence of businesses, while in the latter, states are trying to secure a physical presence of employers.

Many of the jurisdictions that are internationally successful in this the law market are small ones with some affiliation (past or present) with the United Kingdom. These jurisdictions are variously called “tax havens” (a term that was originally meant to conjure up a refuge from taxes, but became a slur intended to suggest they were cheating other places out of tax revenue); “offshore financial centers” (since many are islands); and, now, “international financial centers.” Depending on how you count, there are two to four dozen successful IFCs around the world, including independent countries such as the Bahamas, Liechtenstein, Malta, and Mauritius; territories affiliated with Britain, such as Bermuda, the Cayman Islands, Gibraltar, Guernsey, Jersey, and the Isle of Man; and the Cook Islands, which are in free association with New Zealand. As this partial list suggests, IFCs are present around the globe. What exactly do they do?

Liechtenstein was arguably the first intentional IFC. In the 1920s it took advantage of its geographical position near the successor countries to the former Austro-Hungarian Empire to pass a groundbreaking business entities law (the Law on Persons and Companies, or “the PGR,” from its German initials [Personen- und Gesellschaftsrecht]). Wilhelm Beck, an entrepreneurial lawyer and politician, saw an opportunity for the tiny country to offer a neutral home for the many business organizations that the dissolution of the empire had turned from single-country firms into multinationals, with their operations now spread across multiple new countries. The PGR turned what had been an economic backwater into a successful financial center. In the Western Hemisphere, during the 1920s and 1930s, the Bahamas, Bermuda, and Panama each took tentative steps to develop businesses built around persuading foreigners to use business entities and trusts formed under their laws to organize international businesses. It was not until the 1950s and the 1960s, however, that the IFC business really took off, with Barbados, Bermuda, the Cayman Islands, and Curaçao joining the pioneers in the Western Hemisphere and Guernsey, the Isle of Man, and Jersey joining Liechtenstein in Europe in taking explicit steps to develop into IFCs.

At its most basic, an IFC is a jurisdiction that provides laws and regulations to govern individuals and businesses that operate outside the jurisdiction. Indeed, many early IFC were explicit that to make use of their laws without complying with all the rules and regulations (and taxes) applicable to local businesses, no business could be done within the IFC’s borders. Curaçao, for example, applied its normal business tax rates (24 percent to 30 percent) to only 10 percent of an international business’ profits, reducing the effective rate to 2.4 percent to 3 percent. IFCs have grown with post–World War II globalization. Not only did rapidly falling communications and transportation costs enable these small jurisdictions to serve customers around the world, but increasing capital flows and the development of global capital markets such as the Eurodollar market that took off in the 1960s created an increasing demand for their services.

At first, IFCs did little more than provide legal frameworks for registering businesses that wanted to take advantage of special deals. Jurisdictions related to Britain had an advantage in that they all had laws similar to Britain’s that governed the formation of companies and trusts, thus enabling their customers to be confident that they understood the rules when they made use of these jurisdictions. Curaçao, a Dutch territory, had the advantage of the Netherlands–United States tax treaty, which exempted interest payments made to Curaçao entities from the US-imposed 30 percent “withholding” tax on payments to foreigners, enabling American businesses to tap into the growing Eurodollar market to fund their overseas operations at a time when the United States restricted the export of capital.

These straightforward transactional businesses brought revenue to the IFCs, both directly through fees paid to local governments in return for corporate charters, and indirectly as lawyers, accountants, and other professionals moved to IFCs to work in the growing financial industries and spent their salaries and paid taxes locally. In his 2005 study that examined data from 1982–1999, economist James Hines, Jr. found that tax havens flourished, with average annual per capita GDP growth of 3.3 percent for that period compared to the global average of just 1.4 percent. IFCs also benefited from the influx of businesspeople coming for meetings, who not only spent money while visiting but who often spotted investment opportunities in infrastructure, such as hotels and office buildings, as well as in other activities, from tourism to agriculture. Indeed, R. W. H. du Boulay, the British official overseeing Britain’s interests in what was then the New Hebrides (now Vanuatu), wrote in a June 18, 1974, letter to the Foreign and Commonwealth Office that the arrival of 150 professionals “has entirely altered the quality of life” and that it would be “hard to exaggerate the importance of this factor,” listing the development of a pig farm and slaughterhouse, the rehabilitation of dormant plantations, the establishment of cattle ranches, the building of hotels, the financing for the airport’s expansion, the development of a local concrete firm, and the expansion of car hire, garages, and petrol stations to the development of the IFC. Overall, du Boulay reported that the number of businesses had grown from 393 to 595 in three years, despite the country experiencing four damaging tropical cyclones and a disastrous fall in world prices for copra, its major export. He further concluded that “The New Hebrides would have been left destitute from these disasters, had it not been for the building boom which followed the influx of professional people.”

As the number of IFCs grew, competition among them for business grew more intense. At the same time, as the sophistication of their professional communities grew IFCs began to seek to climb the value chain of business offerings, providing something beyond merely registering business entities. For example, in the 1960s Bermuda began to develop a captive insurance industry, in which companies with idiosyncratic risks that could not find adequate coverage in the commercial market, such as those owning oil tankers and offshore drilling rigs, could create their own subsidiary that would provide insurance. Since this “captive insurer” was a separate legal entity, the parent could still deduct the premiums. Because Bermuda did not tax the captive’s investment income, it could quickly build reserves to pay future claims. And since the parent owned the captive, it could write the terms of the policy without including the many exclusions that a commercial insurer might insist on. Moreover, the captive insurer could access the reinsurance market for catastrophe level coverage at lower rates than the insured company itself could have done.

Similar developments occurred elsewhere: Guernsey became a hub for European captives; the Cayman Islands, Guernsey, and Jersey became major destinations for investment funds; and IFCs began to offer sophisticated laws governing particular lines of business, thus reducing costs for their customers. They also developed regulatory regimes that successfully kept out scammers and criminals, which protected the jurisdictions’ reputations and reassured their legitimate customers that their own reputations were not at risk from being associated with an IFC.

All of the jurisdictions we’ve discussed are small jurisdictions with limited economic opportunities. This is crucial to their successful development. Financial services, broadly defined, often provides half or more of IFCs’ economies. When you also consider the additional tourism that develops when businesspeople make regular trips to an island with lovely beaches and weather, bringing their families along when they attend meetings and extending their stays to add a vacation to a business trip, the finance sector’s impact looms even larger. Jurisdictions become IFCs for the simple reason that the revenue they earn from the direct and indirect economic impact of being an IFC funds much of their education, health care, and other public services. Anyone comparing photographs of the crushed coral roads (and not many of them) and clouds of mosquitos that sometimes suffocated cattle in the Cayman Islands in the early 1960s with the virtually mosquito-free, highly developed Cayman Islands today can instantly see the positive economic development impact.

Not only do IFCs provide public revenue, but they also provide good jobs. For example, I calculated that the Cayman Islands have more Caymanian accountants per capita (that is, not counting the foreigners working as accountants) than New York has accountants per capita. Those are high-wage, skilled jobs that would not exist in the Cayman Islands if it were not for the IFC sector. Every successful IFC has a similar economic development story—and these are dramatic development stories. It took the Cayman Islands just 20 years to go from what was essentially a barter economy in 1960, in which many young men left to become merchant marine sailors on US ships, to passing Britain in GDP per capita in 1980.

Why are countries IFCs? Because it enables their people to live happier and more productive lives at a higher standard of living than anything else that could be done in small places with tiny domestic markets, high transportation costs, and little or no natural resources. There’s no question that those jurisdictions that have successfully become IFCs have improved the living standards of their people and have grown their economies by a substantial amount.

It’s terrific that being an IFC makes people living in the IFCs better off, but what about the rest of us? Pro-high-tax groups, such as the Tax Justice Network and Oxfam, and the rich country club of the Organisation for Economic Co-operation and Development (OECD), argue that IFCs hurt big countries by allowing businesses and individuals from those countries to avoid paying their fair share of taxes at home. Other than lower taxes for those businesses and individuals who figure out how to make use of them, are there benefits of IFCs for ordinary Americans?

Yes! For example, starting with Harvard’s hospital network, US health care facilities have been making use of the Cayman Islands as the home of captive insurers for medical malpractice. This originated in the late 1970s and early 1980s during the US liability crisis, when many doctors and hospitals found that sometimes they either could not buy malpractice coverage or else get the level and type of coverage that they wanted. Harvard led the way, and the Cayman Islands built an insurance regulatory environment to ensure that Harvard did not have reputational risk from being in a jurisdiction with fly-by-night captives. So IFC-based captive insurers save US health care providers money, thus lowering the cost of medical care in the United States. (Note that this saving isn’t driven by taxes—many offshore medical captives are owned by nonprofit medical facilities, which are already exempt from US income taxes—and virtually all such captives aren’t organized to earn profits but are instead organized to lower costs for their parents).

That’s not the only benefit, however. Captive insurers have evolved into important risk-management tools because they provide health care facilities with direct access to data on their risks. This is true for captives in many industries, from trucking to nursing homes to any business that is facing idiosyncratic risks. Educational institutions such as the University of California System operate multiple captives, which reduces their costs of supporting research and education. (The University of California captives are licensed in Washington, DC, which is not a jurisdiction that many Americans would associate with innovation or good regulatory policy, but it is one of several US jurisdictions that entered the captive market in response to offshore jurisdictions’ successes.) Not only do captives such as the University of California System’s enable their owners to design their own coverage, including creating new types of coverage that is unavailable in the commercial market, but the captives give insureds control over their investment strategies for the reserves and access to reinsurance markets for catastrophe-level coverage at a substantial discount to rates that are available in the commercial market.

There are further benefits from having jurisdictions that offer legal systems that encourage innovation. One result is that captives have led in the development of coverage for new risks. For example, captives’ greater control over policy terms, such as exclusions, and control over claims management enable them to provide coverage where risk models are less fully developed. Over time, that develops the data necessary for commercial insurers to offer more standardized policies as well.

Offshore insurance products have expanded beyond the straightforward captive model to include catastrophe (or “cat”) bonds, which enable insurers to tap into the equity market for funding for, as the name suggests, catastrophic occurrences. Earthquakes, fires, and hurricanes are all risks that are partly insured through cat bonds, expanding the amount of coverage available to, and lowering the price for, Americans seeking such insurance. Further, these innovations allow pension funds and other investors to diversify their risks by giving them liquid, tradable assets that are not correlated with the risks of their typical investments in stocks and corporate and government debt.

Ordinary Americans thus benefit from lower medical costs, higher pension returns, reduced insurance costs, lower transportation costs, cheaper education, more investment in important research, and access to broader categories of risk transfer products because of the insurance products developed in IFCs. Moreover, many of the concepts developed by IFCs have come onshore and are now also offered by US-based firms. More than a dozen states (led by Vermont, Utah, Delaware, and North Carolina) and the District of Columbia are homes to significant domestic captive insurance industries.

It’s not just in insurance that IFC-developed innovations have an impact in the United States. Liechtenstein’s PGR included an entity whose English name means “private foundation.” These are not foundations in the philanthropic sense; rather they are legal entities which serve a private economic purpose. A typical use is owning the shares in a business, with the goal of continuing a business after the founder retires so that the business continues to generate income for the founder’s family and provide employment for its employees. In the 1990s, Panama—which shares Liechtenstein’s civil law heritage—copied the concept. A number of Caribbean jurisdictions took note and, despite their quite different common law traditions, passed statutes adapting it to their legal systems. Private foundations have now come onshore, with New Hampshire and Wyoming creating their own versions. Competition from IFCs thus is improving the US legal system.

IFCs also benefit Americans by serving as platforms that funnel money into investments that benefit Americans. For example, many commercial and private aircraft are financed through investment vehicles in IFCs. An aircraft leasing company forms a special purpose vehicle in the IFC; investors around the world can then invest in a share of the ownership of the planes, earning income from the plane’s lease to airlines. Providing the right business entities to enable these transactions requires a range of laws, including an aircraft registry, insolvency laws that persuade the investors that their rights are protected, and regulators why are able to keep out fly-by-night operators. They also require a jurisdiction that is tax neutral, meaning that it will not add an additional layer of tax to that already paid by the investors in their home countries. The result is that IFCs make it easier and cheaper to organize investments in aircraft. IFCs’ role in aircraft financing thus means lower airfares and lower air freight costs for Americans.

A serious impediment to economic growth in many developing countries is a legal system that cannot support the levels of investment necessary to bring about growth. Corruption, long backlogs in courts, and out-of-date laws are just a few of the problems investors face in making investments in developing countries. IFCs make a difference by supplying the legal platform through which investors from multiple countries can come together to invest in a developing country that lacks a strong legal system. For example, a 2021 study sponsored by Jersey Finance, the industry group for Jersey’s finance industry, found that investment by Jersey entities in Africa supported an average £6 billion of African GDP per year from 2017–2020, and Jersey-intermediated capital supported 916,000 jobs in Africa.

Why do investors want to organize their investments through an IFC like Jersey rather than either in their home countries or in the country where the funds will be invested? Efficiency and neutrality.

IFCs are efficient for investors because they offer specialized, up-to-date legal regimes and sophisticated courts and legal communities. Having the right legal regime matters because it lowers the cost of organization when investors can understand their rights without undertaking expensive custom legal analyses of the investment documents. Leading IFCs have laws governing the rights of investors based on well-understood legal principles. They also have laws with specific provisions for investment funds that provide default legal rules that are acceptable in the global marketplace. Their courts are staffed by expert judges who are familiar with how investment funds operate and so the courts can provide relatively quick resolutions of disputes. Cases are argued by leading lawyers, both from the IFC and from the some of the best lawyers internationally.

The neutrality of IFCs is important in two senses. First, IFCs provide tax neutral platforms for investment, meaning they do not add an additional layer of taxation to the funds organized in them. Investors, of course, owe taxes to their home countries when they receive the returns on their investments, but they will not owe the IFC additional tax. Second, IFCs provide a neutral legal platform, not giving any one investor a home-court advantage. All of this combines to make IFCs important contributors to economic growth around the world.

Groups such as the Tax Justice Network (TJN) often argue that IFCs are responsible for massive losses of tax revenue by governments around the world. For example, in 2023 the TJN claimed that countries lose $480 billion a year due to financial transactions involving IFCs. Most of this ($311 billion) is due to corporate tax losses; the remainder comes from offshore tax abuse by wealthy individuals. And most of the alleged revenue losses ($433 billion) are from developed countries; the US alone is estimated to lose almost $140 billion. The Tax Justice Network is not alone in creating such estimates. The International Monetary Fund and the United Nations make similar claims, although based on different methodologies. How credible are these claims?

Not very. For example, the TJN’s corporate numbers come from allocating companies’ global profits to countries based on the share of global employment and the share of global wages paid by a company in that country, then comparing this to the reported profits for the company there. The difference is the “misalignment” of profits. If the misalignment shows reported profits are lower than the calculated profits, the TJN multiplies the amount by the corporate income tax rate and calls that the tax loss. (In addition, the TJN “cleans” the data through a series of adjustments.) Even aside from the many data issues that the TJN acknowledges, its misalignment method fails to account for the complex reality of corporate tax laws (which differ in thousands of details, not just headline rates); long-term impacts (tax may be merely deferred until funds are brought “home”); and the impact of the more than four thousand of double-tax treaties in allocating the taxation of income among jurisdictions. Moreover, these estimates never consider any positive benefits from IFCs, from the inflow of investment into both developed and developing economies to the beneficial effects of legal innovations offshore influencing onshore jurisdictions and to their provision of rule-of-law services to jurisdictions with weak legal systems.

For decades, developed economies have chased the tax revenue they claim to have lost to IFCs through ever-more-complex tax rules to prevent companies and individuals from shifting income to lower-tax jurisdictions. One way to see if the claims of lost tax revenues are real is to compare the revenue estimates made to justify those rules to the actual revenue received. The results do not support the claims of massive lost revenues. For example, one expert’s 2017 back-of-the-envelope analysis of the 2010 US Foreign Account Tax Compliance Act found that US taxpayers would have had to have hidden 20 percent of all global wealth to generate the amount of lost tax revenue claimed when the legislation was being considered. Moreover, automatic information-sharing provisions contained in the dense web of tax information exchange agreements and double-tax agreements mean that tax authorities already have the data necessary to collect taxes that are actually owed. Of course, politicians in developed countries have every incentive to estimate massive revenue gains from new tax measures, since these predictions are often enough to support additional spending. When actual revenue gains prove illusory, they simply double down on more bureaucracy and regulation.

Aside from alleged tax revenue losses, IFCs are often criticized for enabling financial crimes, such as money laundering. Books and movies, such as John Grisham’s The Firm or the 2004 movie National Treasure, often use IFCs as the destination for criminals seeking to hide money. The truth is that IFCs have stronger anti-money laundering laws and better records on preventing financial crime that most large jurisdictions. For example, the Financial Action Task Force, a multinational agency that inspects and rates countries for compliance with a series of standards, found the United States to be noncompliant on 3 standards and partly compliant on 5 of the 40 substantive standards. By contrast, the Bahamas and the Cayman Islands were found to be largely compliant or compliant on all 40 and a number of other IFCs exceeded the US score. Similarly, a commercial ranking of jurisdictions’ anti-money-laundering risk puts several IFCs ahead of the United States (74.78), including San Marino (80.90); Brunei Darussalam (78.60); Bermuda (78.15); Andorra (77.45); Liechtenstein (76.77); Luxembourg (76.59); and Switzerland (75.49), even though its ranking is partly dependent on US government assessments of money laundering risk.

The reason IFCs are better at preventing financial crime than large jurisdictions such as the United States is that their survival depends on their success. It will only take one major financial crime involving a small jurisdiction to destroy its reputation and make the business it depends on flee to scandal-free jurisdictions. By contrast, the seemingly endless string of financial crimes uncovered in the United States have little effect on foreigners’ interest in investing here because our economy is so large.

As a result, IFCs invest heavily in the regulatory infrastructure necessary to prevent such crimes. For example, in 2022 the primary regulators in Bermuda (the Bermuda Monetary Authority), the Cayman Islands (the Cayman Islands Monetary Authority), and Jersey (the Jersey Financial Services Commission) spent more than US $74 million, US $52 million, and US $32 million, respectively. For jurisdictions with populations of between 64,000 and 111,000, that is a massive investment. Substantively, IFCs pioneered the regulation of trust and corporate service providers. More generally, their focus on regulating who is engaged in financial activities rather than dictating the details of how transactions are conducted has given them an enviable record in avoiding the kind of financial scandals that plague large economies, such as Bernie Madoff’s $64 billion Ponzi scheme.

Having IFCs in the world economy makes Americans’ lives better in three important ways. First, IFCs lower transaction costs and so enable transactions that would not otherwise occur that, in turn, make our economy more productive. Everything from health care to goods carried by trucks is cheaper because of IFCs just through their impact on insurance costs. They also lower the cost of investment vehicles that funnel billions of dollars into US businesses through IFC entities, creating jobs and economic growth in the United States. And many Americans’ pensions are invested in funds housed in an IFC and so the pensions earn higher returns as a result. Their retirement is thus made more secure because of IFCs’ existence.

Second, the competition from IFCs pushes US jurisdictions to improve their legal systems. Vermont is a significant competitor in the captive insurance market because it responded to competition from IFCs. More than a dozen other states have followed Vermont’s lead and entered the captive market. New Hampshire and Wyoming have adopted private foundation laws based on IFC laws, which they hope will bring estate-planning business to their economies. Ohio revamped its trust law in hopes of luring Americans who are considering offshore trusts to use it instead, thus boosting the local economy. The improved and innovative laws created as a result of this competition are available to, and improve the legal environment for, all Americans, not just those who make direct use of IFCs.

Third, IFCs enable economic growth around the world, helping developing countries improve their economies. This directly benefits the people in those developing countries: economist Edward Miguel noted that “the correlation between low per capita incomes and higher propensities for internal war is one of the most robust empirical relationships in the economic literature.” But growth in developing countries also benefits Americans by building a more prosperous, and so more peaceful, world.

The global market for law is as significant and dynamic as the markets for tangible goods such as cell phones and wheat. Jurisdictional competition, whether domestic or international, plays a crucial role in shaping the legal and business environments that attract economic activities. IFCs, which are small jurisdictions with strategic legal frameworks, exemplify how tailored legal and regulatory environments can drive economic growth and innovation. These jurisdictions provide specialized services that lower transaction costs, support investment, and foster economic development both locally and globally. The competition that IFCs give big jurisdictions such as the United States not only enhances our legal system but also contributes to a more interconnected and prosperous world economy. Understanding and engaging with the global market for law is essential if we are to avoid falling for politicians’ efforts to build legal barriers that cut us off from the beneficial effects of that competition.