Transparency and the Location of Assets: Evidence from FATCA

Lisa De SimoneStanford Graduate School of Business

Becky LesterStanford Graduate School of Business

Kevin MarkleUniversity of Iowa

September 2017

Motivation

If U.S. citizen compliant with U.S. tax rules:$100M of wealth invested in U.S. equities

Earn $5 million in investment income(dividends and gains)

Pay U.S. tax at 23.8% = $1.19M in U.S. tax

If non-compliant with U.S. tax rules$100M of wealth invested in U.S. equities

Earn $5 million in investment income(dividends and gains)

*REQUIRED to report this income to the U.S. and pay tax, but

*Choose not to report (evade); pay $0 in tax

Approximately 8% of global personal wealth is hidden in tax havens (Zucman, QJE, 2013).

The US has a large annual “tax gap” of which $40-$125 billion is estimated to be from individual offshore tax evasion (TIGTA).

A simplified example:

Moves $ Offshore

Research Question

RQ: What is the effect of increased reporting on the worldwide location of

investment assets?

Foreign Account Tax Compliance Act (FATCA)

► Several reasons (legal and illegal) to have an offshore account.

► Prior to FATCA, U.S. citizens had to self-report:• Foreign income on U.S. tax return• Foreign bank account (U.S. tax return and Treasury form).

► Prior literature demonstrates:• Low evasion on third-party-reported income• Higher evasion (lower detection risk) on self-reported income (Kaplow,

1990; Slemrod, 2007; Kleven et al., 2011)

► “Voluntary compliance rates are the highest where there is third-party reporting, but this reporting was largely absent for U.S. owned offshore accounts…” - Emily McMahon, former Asst. Secretary of the Treasury for Tax Policy (2012)

► “…Moreover, identifying U.S. taxpayers who earn foreign source income through offshore accounts would require the cooperation of foreign financial institutions.”

Foreign Account Tax Compliance Act (FATCA)

► To address the growing tax gap, Congress passed the Foreign Account Tax Compliance Act in 2010.

► Primarily a reporting regime – FATCA requires:• Automatic exchange of information (“AEOI”)• By Foreign Financial Institutions (“FFIs”)• To U.S. tax authorities• Of payments from the U.S. (i.e., dividends, proceeds from sales of

stock)

► Compels foreign banks to register with the IRS and comply with FATCA by imposing punitive withholding taxes for non-compliance.

► As of August 2017, over 290,000 entities registered as FFIs.

► Over 100 countries have agreed to cooperate with FATCA information exchange by signing “Intergovernmental Agreements” with the U.S.

Foreign Account Tax Compliance Act (FATCA)

“To paint an extreme case, when a farmer in Sichuan province walks into the bank office near his home to open an account for the proceeds from sale of his crop, the bank will have to take steps to ensure that he is not an American citizen or resident. On the amazing coincidence that he is, the bank will have to provide regular information to the IRS about his account activity. On a careful and considered view, this seems a bit extreme.”

- Michel and Rosenbloom (2011)

Prior Evidence on Offshore Evasion

► Optimal tax evasion = f(detection risk, size of penalty, and risk aversion) (Allingham and Sandmo, 1972)

► FATCA is intended to increase detection:• Converts self-reported income into third-party-reported income• Analytically predicted to lead to a lower level of U.S. offshore tax

evasion (Dharmapala, 2016)• Observed reduction in the number of offshore shell incorporations

post-FATCA (Omartian 2017)• Observed increases in the number of individuals filing under IRS

amnesty programs (Johannesen 2017)

Prior Evidence on Offshore Evasion

However:

► Cost of relocating assets or shifting to alternative investment classes may be lower than paying back taxes and incurring penalties (Langenmayr, 2015)

► Individuals engaging in evasion likely have different risk preferences and view tax compliance process differently (Slemrod et al., 2001; Alstadsaeter et al., 2017)

► Prior programs (EU Savings Directive; TIEAs) have had limited success in reducing evasion (Caruana-Galizia and Caruana-Galizia, 2016; Huizinga and Nicodeme, 2004; Johannesen, 2014; Johannesen and Zucman, 2014; Omartian, 2017)

Hypothesis: The level of offshore tax evasion by U.S. individuals does not change after FATCA.

Research Design#1: Test of Change in FPI into US

1. Exploit the round-tripping phenomenon (following Hanlon et al., 2015):Does the amount of foreign portfolio investment (FPI) into the United States from tax haven countries change, post-FATCA?

Foreign Portfolio Investment (FPI)

into U.S.

Implicit assumption: Non-U.S. investors in other countries should be unaffected by and indifferent to FATCA regulation, to which they are not subject.

𝐿𝐿𝐿𝐿𝐿𝐿 𝐹𝐹𝐹𝐹𝐹𝐹𝑖𝑖,𝑡𝑡 = 𝛼𝛼𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑡𝑡𝑐𝑐𝑐𝑐 + 𝛼𝛼𝑐𝑐𝑦𝑦𝑦𝑦𝑐𝑐 + 𝛽𝛽1𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝑖𝑖 ∗ 𝐹𝐹𝐿𝐿𝑃𝑃𝑃𝑃𝐹𝐹𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡 + 𝛾𝛾𝑘𝑘𝑃𝑃𝐿𝐿𝐻𝐻𝑃𝑃𝐶𝐶𝐿𝐿𝐶𝐶𝑃𝑃𝑖𝑖,𝑡𝑡 + 𝜀𝜀𝑖𝑖,𝑡𝑡

- Measure inbound FPI using U.S. Treasury International Capital System data- Year and country fixed effects- PostFATCA is an indicator equal to 1 for years 2012 and later

Move $$ Offshore

Table 3: Inbound Investment to the U.S.

Reduction in equity FPI into the U.S. (relative to other FATCA-signing countries) of 22%.

Table 4: Inbound Investment to the U.S.

Table 5B: Falsification Test of FPI after 2010

Research Design#2: Test of Change in Worldwide FPI from Havens

2. Expand the potential investee countries: does the amount of worldwide foreign portfolio investment (FPI) from tax haven countries change, post-FATCA?

𝐿𝐿𝐿𝐿𝐿𝐿 𝐹𝐹𝐹𝐹𝐹𝐹𝑖𝑖,𝑡𝑡 = 𝛼𝛼𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑡𝑡𝑐𝑐𝑐𝑐 + 𝛼𝛼𝑐𝑐𝑦𝑦𝑦𝑦𝑐𝑐 + 𝛽𝛽1𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝑖𝑖 ∗ 𝐹𝐹𝐿𝐿𝑃𝑃𝑃𝑃𝐹𝐹𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡 + 𝛾𝛾𝑘𝑘𝑃𝑃𝐿𝐿𝐻𝐻𝑃𝑃𝐶𝐶𝐿𝐿𝐶𝐶𝑃𝑃𝑖𝑖,𝑡𝑡 + 𝜀𝜀𝑖𝑖,𝑡𝑡

- Measure country-pair data on FPI using IMF data on the Coordinated Portfolio Investment Surveys (CPIS)

Table 6A: Worldwide FPI Data from IMF

► Equity FPI out of FATCA haven countries declined by 30.7%► Effect is not only confined to reduced investment into U.S.: see

significant effect in other countries► Results robust to excluding 2014 and 2015

Research Design#3: Test of Change in Level of Hidden Assets

Directly examine the estimated level of hidden assets following Zucman (2013)

For Example:Amount Other Countries Report is Owned in Switzerland

Less: Amt. Switzerland Reports Reports is Owned by ForeignersEstimated “Gap”

𝐿𝐿𝐿𝐿𝐿𝐿 𝐺𝐺𝐻𝐻𝐺𝐺𝑖𝑖,𝑡𝑡 = 𝛼𝛼𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑡𝑡𝑐𝑐𝑐𝑐 + 𝛼𝛼𝑐𝑐𝑦𝑦𝑦𝑦𝑐𝑐 + 𝛽𝛽1𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝑖𝑖 ∗ 𝐹𝐹𝐿𝐿𝑃𝑃𝑃𝑃𝐹𝐹𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡 + 𝛾𝛾𝑘𝑘𝑃𝑃𝐿𝐿𝐻𝐻𝑃𝑃𝐶𝐶𝐿𝐿𝐶𝐶𝑃𝑃𝑖𝑖,𝑡𝑡 + 𝜀𝜀𝑖𝑖,𝑡𝑡

Table 7: Level of Hidden Assets (“Gap”)

- The gap reported by haven countries declined by 29 percent in 2012.

Where did the money go?

► Did the hidden assets move to a non-signing haven?• Weak evidence of some increase in non-signing

havens

► Additionally, evidence of increases in inbound FPI from non-signing countries (not just havens)• Includes Argentina, Ecuador, Egypt, Guatemala, Lebanon,

Morocco, Russia, and Uruguay

Where did the money go?

► Did the hidden assets move into alternative investments?• Real Estate investments• Art work and other luxury goods• Freeports

Findings

• The reporting regime imposed by FATCA is associated with significant, economic effects on cross-border fund flows, consistent with tax-evasion-motivated investment flows• Reduction in inbound FPI to the U.S. from tax haven countries of 22

percent• Heterogeneity within haven countries: not all FATCA havens are

alike• Reduction in total FPI out of tax havens of 23-30 percent• Reduction in gap (proxy for hidden assets) of 29 percent

• Evidence consistent with assets moving from FATCA-signing tax haven jurisdictions to other jurisdictions that have not signed onto FATCA

Contribution

• Contribute to the literature studying tax evasion• Provide additional evidence on the round-tripping phenomena• Show some of the economic effects of a far-reaching reporting

regime and provide evidence to evaluate regulation• Provide evidence on relative economic significance of FATCA (as

compared to events of 2008 and 2010) and on worldwide cross-border flows

• Contribute to the policy discussions regarding FATCA• Significant opposition to the law• Legislation introduced on April 6 to repeal FATCA• Congressional hearings in April 2017• Current appeal to Supreme Court• Inform expectations about responsiveness to worldwide FATCA –

“Common Reporting Standards”

Thank you!