Some investors avoid paying taxes in a move called round-tripping sending money offshore, then investing it in U.S. stocks or bonds. A study estimates it costs the U.S. billions in lost revenues.
Recently, MIT professor Michelle Hanlon and two colleagues set out to find out all they could about round-tripping.
"I think it's a big problem in the U.S. tax system that individuals can evade taxes and that they try to do so offshore," Hanlon says. "So we just felt like it was a big policy issue actually to try to get a handle on how much this occurs and whether we could track this down with data."
In round-tripping, American citizens open bank accounts in tax havens such as the Cayman Islands. They funnel money into the accounts and then use it to buy stocks and bonds back in the U.S.
"A U.S. individual would pretend essentially to be a foreign investor," Hanlon says. "So they would set up, say, a bank account or a shell corporation offshore and from that offshore location they would invest back in the U.S."
Normally, she says, American citizens who invest in the United States are supposed to pay taxes on any profits they make. "But if they pretend they're foreign and don't report that they're U.S. [residents] and don't report that income then it's very hard for the tax authorities to catch them," Hanlon says.
For a long time it's been nearly impossible to quantify round-tripping. E.J. Fagan of Global Financial Integrity, a nonprofit research and advocacy group, says a lot of countries refuse to tell the Internal Revenue Service anything about their U.S. customers.
"Very often a lot of these jurisdictions places like, for example, Mauritius or the British Virgin Islands they make the Cayman Islands look open and transparent. So, very often it's hard to know where the assets are," Fagan says.
But in a study in the Journal of Finance, Hanlon and her co-authors, Edward Maydew of the University of North Carolina and Jacob Thornock of the University of Washington, took a look at how much money has come into the country from places such as the Cayman Islands since 1984. The flow of money into the U.S. has always been erratic and can be affected by a lot of different factors. But the researchers decided to look at what happened to the flow when the U.S. tax rate went up.
"So when the U.S. tax rate goes up, we would expect that there'd be more tax evasion because the benefits to evading tax are greater," Hanlon says.
At the same time the researchers looked at what happened to the flow of money in periods when the U.S. government was especially aggressive about catching tax evaders.
"And we tested those two types of variables and we find pretty much exactly what you'd expect, that part of this data is due to tax evasion," Hanlon says. When U.S. taxes go up by 1 percentage point, the amount of money flowing into the U.S. from foreign tax havens increases by as much as 2.8 percentage points. And the flow of money into the U.S. slows down when the IRS cracks down on tax cheats like it's doing now.
Tax attorney Jeff Kolodny of the Cozen O'Connor law firm says that isn't surprising. "It would make sense, I think, that as tax rates go up people are trying to find ways to shelter their income and maybe they're doing it in illegal ways," he says.
The study's authors say it's pretty hard to calculate how much this is costing the Treasury. But they say if their numbers are right, the U.S. has lost as much as $27 billion in tax revenue since 2008.