Daniel J Mitchell assesses the options for Bermuda as it seeks to protect its interests

It is hard to feel sorry for the people of Bermuda. They bask in a generally pleasant climate and have more per capita income than any place else on the globe, according to the World Bank. Perhaps best of all, they get to keep all the money they earn. There is no personal or corporate income tax to penalise the creation of jobs, wealth and prosperity in Bermuda.

But sometimes there is a downside to success. Bermuda's achievements have aroused envy and resentment, particularly among politicians from high-tax jurisdictions and the international bureaucracies that act on their behalf. Bermuda has been harassed by the Organisation for Economic Co-operation and Development (OECD) and vilified by US politicians.

Bermuda's 'sin' is that it has a pro-growth tax system based on free market principles. This is something that policymakers in other nations should emulate rather than persecute, but that would mean reducing the size and power of government - reforms that usually run contrary to the self-interest of the political elite.

The Bermuda threat

Politicians from high-tax nations see Bermuda as a threat for two reasons, one general and one specific. The general threat is that Bermuda's economy demonstrates the link between low tax rates and prosperity, a fact that is rather inconvenient to statist officials who assert that no such relationship exists. Politicians from uncompetitive, high-tax nations do not want their people to see that there is a better approach. This is why Ireland has been condemned by many of its European neighbours, and it also explains why there is growing hostility in 'Old Europe' to the tax reforms in 'New Europe'.

Needless to say, if high-tax nations are upset that other nations are growing fast and creating jobs because of lower tax rates, one can only imagine how irked they are when jurisdictions with zero tax rates are the richest places in the world. Even worse (at least from the perspective of Europe's paternalistic welfare states), Bermuda is a reasonably tranquil multiracial society. The political left would be much happier if Bermuda was a strife-torn, basketcase economy relying on periodic handouts from colonial masters.

The specific threat is that Bermuda has a very attractive business climate.

Pro-growth tax laws, combined with the rule of law and a market-friendly regulatory structure, have fostered the creation of a dynamic business community. Bermuda is home to some of the world's most competitive companies and it is an attractive location for companies that wish to escape repressive tax regimes.

But this is why Bermuda is being attacked, especially in the US. Some American politicians whine that it is unfair when over-taxed US-based companies have to compete against zero-taxed Bermuda-based companies.

Indeed, two members of Congress - Richard Neal of Massachusetts and Nancy Johnson of Connecticut - have proposed legislation that indirectly would impose US tax on the non-US income of Bermuda reinsurance companies. Other American politicians have made demagogic attacks against companies that have re-chartered in Bermuda. This has led to both federal and state legislation imposing discriminatory burdens on selected Bermuda companies.

Bad tax theory

Unfortunately, the hostility against Bermuda is not limited to politicians.

Many of the world's tax bureaucrats are advocates of Capital Export Neutrality (CEN), a theory that individuals should not be able to lower their tax burdens by shifting labour and/or capital across borders. Supporters of CEN argue that countries should impose similar tax rates, which is why the theory is often cited in OECD and European Union (EU) publications.

Proponents of this approach genuinely believe places like Bermuda cause economic damage.

This seems preposterous, but the underlying hypothesis is not without merit. The CEN theory starts with a very reasonable assumption. Supporters assume a world with no taxes, and they postulate that resources will be efficiently allocated in that world based on economic criteria. In the real world, however, taxes are an unpleasant reality and they often differ from one jurisdiction to another. Advocates of CEN point out, quite correctly, that these differences affect the allocation of resources and they assert that these deviations from the theoretical no-tax world cause world output to suffer. The European Commission, for instance, has written that "some harmonisation of business taxation (both corporation tax and the personal taxation of dividends) may be required to prevent distortions of competition, particularly of investment decisions. Where tax systems are non-neutral - i.e. where relative post-tax rates of return do not correspond to relative pre-tax rates of return - resources will be misallocated."

The CEN has a certain consistency and logic, and it was the predominant view among public finance experts for much of the postwar era. In the last 20 years, however, it has lost favour among economists, largely as a result of real-world considerations. Supporters of economic liberalisation, for instance, point out that tax competition puts downward pressure on tax rates, and these lower tax rates enhance economic efficiency. The economic benefit of lower rates - particularly stemming from the reduction of punitive tax rates on savings, investments and entrepreneurship - easily exceeds the theoretical economic cost of the resource misallocation associated with different tax rates.

Sadly, tax policy in most nations is dominated by lawyers, the vast majority of whom are not familiar with these developments in economic theory. And as long as the CEN theory has adherents, politicians continue to get bad advice from their Treasury Departments and Finance Ministries - guidance that the lawmakers will gladly follow since it conveniently reinforces their bias against low-tax jurisdictions.

Protecting Bermuda

So what can Bermuda do to defend itself? There are a number of options, ranging from independence to surrender.

- Capitulation - Bermuda can forestall any future attacks and avoid all blacklists by imposing a US-style or European-style income tax regime. But since this strategy would decimate the economy, officials presumably will shun this option.

- WTO membership - This is an interesting notion, and is predicated on the assumption that joining the international trade body will give Bermuda the ability to successfully challenge protectionist measures imposed by either the federal government or various state governments. The good news is that the World Trade Organisation (WTO) probably would rule in favour of Bermuda (in part because the restrictions proposed by US politicians are contrary to WTO rules and in part because other nations enjoy siding against the US). The bad news is that such an outcome might take several years. There are two downsides to WTO membership. The first is that it costs money. The second is that there is a long-term risk that the WTO will be co-opted by supporters of the CEN theory and will begin to rule that low tax rates are an unfair trade practice. The left already is making this argument in the EU and hopes that the European Court of Justice will use the CEN theory as an excuse to rule harmonisation is necessary for proper functioning of the internal market.

- Independence - This is the nuclear option, one that carries the greatest risk but also may offer the greatest reward. An independent Bermuda no longer would have to worry about being sacrificed in Brussels as part of a sordid deal between the UK and the EU. The current UK government has been unwilling to defend its territories from European bullying, and things will get much worse if an unreconstructed socialist like Gordon Brown becomes Prime Minister. On the other hand, declaring independence presumably would have an unsettling impact on global investors. Jurisdictions like Bermuda and the Cayman Islands have prospered in part because the UK is perceived to be the guarantor of the rule of law. And even though Bermuda presumably would become part of the Commonwealth and retain strong links to the UK legal system, independence would be accompanied by a perception of greater risk.

- Quiet resistance - The final option is to maintain the status quo, which is to work behind the scenes to defend Bermuda's interests. The hard part, of course, is defining what this means. Does this require high-priced lobbyists in Washington, DC? And, if so, what are they supposed to do? Does this always necessitate a passive approach, based on the assumption that Bermuda should avoid the headlines and steer clear of controversy?

There are no answers to these questions, largely because Bermuda is not in a position to dictate the course of events. Instead, it must react to external pressures and the best strategy will always depend on the particular circumstances of each issue.

Sadly, the pressures on Bermuda are likely to grow with the passage of time. The increasing integration of the world economy has put welfare states under significant pressure, and this creates an additional incentive for high-tax nations to persecute Bermuda and other low-tax jurisdictions.

The OECD and EU almost surely will continue to push for tax harmonisation, and the United Nations, World Bank and International Monetary Fund are being conscripted as well to carry water for uncompetitive nations like France and Germany.

In the final analysis, though, the international bureaucracies may be fighting an uphill battle. For all intents and purposes, the OECD and EU are trying to create a cartel - an OPEC for politicians. Yet economic theory explains that a cartel is unstable and unworkable unless all participants in a market agree to join the conspiracy, and it is difficult to imagine that high-tax nations will convince all the world's low-tax jurisdictions to surrender their competitive advantage.

This is not an easy task, in part because places like Bermuda have a self-survival incentive to resist bullying - whether from international bureaucracies or from the UK and/or US. And even if smaller jurisdictions like Bermuda get steamrollered by pro-tax harmonisation forces, it is difficult to imagine that more powerful jurisdictions will acquiesce to such schemes. Switzerland, Ireland, Hong Kong and Panama are all nations that benefit from international capital flows and have considerable ability to stand up to pressure from high-tax countries.

All governments make economic policy mistakes, but Bermuda politicians have avoided one of the biggest mistakes - imposing direct taxes on income.

This gives Bermuda a competitive advantage in the global economy and helps generate prosperity. Public sector and private sector leaders should not be ashamed for having a pro-growth tax system.

- Daniel J Mitchell is the McKenna Senior Fellow in Political Economy at The Heritage Foundation in Washington, DC.