“We’ve left principles behind and gone for regulation”

February 2014

Conversation with Don Johnston, former secretary general, Organisation for Economic Co-operation and Development, on – tax accountability – managing OECD membership – the distinction between rules and principles

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Here is the transcript of the video.

Emmanuel Daniel (ED): I’m speaking to Don Johnson, former secretary general of the Organisation for Economic Cooperation and Development (OECD). You were secretary general until 2006.

That gives you a good view of what you’ve achieved and where the organisation is today, as well as a number of global structural issues that the world is faced with today. One of your big initiatives was Foreign Account Tax Compliance Act, the tax evasion platform, right?

What was your intention at the time when you were putting in place this global tax accountability regime?

1. OECD’s anti-tax evasion initiative

Don Johnston (DJ): Let me respond this way. We started that program in the late ’90s, and initially we called it Harmful Tax Competition, and that got a lot of resistance because it was a bad way to describe it, because there’s nothing wrong with having competitive taxes. That’s been one of the criticisms that the Heritage Foundation and others in the States have said about the OECD. So we made it Harmful Tax Practices because we knew there was an enormous amount of tax evasion going on, that the so-called underground or black economies were very large in certain countries.

We basically went to work under the leadership of Jeffrey Owens, who was then the person I had in charge of this programme. He developed many ways of measuring the black economy – of trying to get countries to adhere to principles of transparency, to get rid of bank secrecy and so on, to put things out in the open. I know it becomes a cliché, but transparency is terribly important in terms of governance. Now why was it not taken up sooner? I think the reason for that is because people didn’t appreciate how widespread it was and how serious it was. I went to Washington, I remember, the first time, and to meet Colin Powell, just after he had been named Secretary of State. We talked about a whole lot of issues.

Then he looked at me and said “Now, Mr. Johnson, tell me about taxes and what the OECD is doing sort of to persecute all these jurisdictions in the Caribbean.” Now in the US, there is a group called the Black Caucus, and they are approached by various islands that basically depended upon tax haven status for much of their livelihood. There was a lot of pressure in Congress, and we had people like the senator from New Hampshire, which is considered a bit of a tax haven because they have no sales tax – they completely misunderstood the programme.

They were totally against it, and they even tried to stop funding the OECD. Can you imagine that? But we had a lot of support, too. People like Senator John McCain and others realised the extent of the problem. So we were able to proceed.

ED: Where was the corporate pushback coming from? Was it from US multi-nationals?

DJ: I don’t think there was as much corporate pushback as there was political pushback from people like the Heritage Foundation. Probably a lot of individuals had money stashed away in Switzerland and so on. The Internal Revenue Service was aware because they knew the structures that were there. For example, when Enron went down, you may recall there were several hundred offshore corporations which became visible and so on, but they were probably quite visible to the IRS. But the tax code had not been really adapted to address these issues.

ED: Do you think that the tax code now is swinging all the way to the other end because there is tax competitiveness that even the US can benefit from. But by swinging all the way to the other end, you’re unable to see certain efficiencies.

DJ: There’re really two distinct issues here. One is illegal tax evasion, which is what we were after. If the US want to create laws that allows its corporations to accumulate funds offshore, outside of the immediate tax jurisdiction, and then only tax on dividends or repatriation, that’s fine. That’s an act of sovereignty. Canada has that kind of arrangement with Barbados for example. That’s not what we’re talking about; basically undeclared income offshore, whether it be corporate, individual, or foundations – well, foundations aren’t taxable.

So this was what we essentially set about to attack. I think that what has made it happen with G20, which the OECD had been invited to join. This was the principle subject of the last G20 meeting because they now realise that they’re all going through financial difficulty. There’s no country in the world, essentially, that’s not concerned about the state of public finances. They see that they have not been collecting billions and billions of dollars because of tax evasion. I don’t think they realised the magnitude of the problem before. When they were running surpluses, they weren’t that concerned, but now they’re very concerned.

ED: But they’re also going after jurisdictions like Ireland, which gives favorable tax advantages to become a fund management and manufacturing centres. So where is the place for legitimate tax advantage?

DJ: Well, that has to be a decision that’s made by each country. In other words, where do you decide you’re going to use taxation or lack thereof as an advantage – as a comparative advantage? That’s quite legitimate, provided it’s transparent and up front. That’s not a problem. The sanction on that will be the international community saying “Well, wait, if you do it, we’re going to do it, too.” Then if everybody starts to do it, well, then you have – then you create competition, but perhaps too much competition. Governments will gradually start to lose money.

There was an article in The Economist which talked about escaping taxes. It looked at the kind of structures that one could put in place and who is being criticized. Firms were not evading taxes. They’re taking advantage of some call loopholes. Others might say they’re incentives. I was a tax lawyer at one time, so I used to do that. I mean that’s what you do. You try to minimise your tax – the tax burden, but it’s all on the table.

ED: Future financial centres, I mean the Singapores and the Hong Kongs of the world operate somewhat differently from the Barbados and the Bermudas of the world, right? Barbados and Bermudas are booking centers, and the tax element is an element in the booking centre model. Compared to financial centres of Singapore and Hong Kong, is there a difference that you would make?

DJ: These financial centers have a role to play. There’s no question about that. They’re used by intelligent tax planners and business effectively, to preserve capital essentially, and to deploy capital on behalf of shareholders and others in effective ways. As long as it’s transparent, as long as everybody agrees that that’s fine, there’s no problem. Insurance companies and so on have been doing that for years.

ED: What would you say about the argument that what’s lost in taxes is actually paid in dividends anyway?

DJ: I don’t know that you can make a direct correlation. It’s also a timing problem. The dividends may be paid ten years from now. People may want to defer taxation. Corporations may wish to defer taxation. They may wish to use funds offshore for other purposes in their global operations. But of course, the globalisation of the industry and services also plays into this. I mean we’re living in a different world now than we were back in the say 50s’, 60s’ or 70s’. When I started practicing law in tax, we had a thing called foreign business corporations.

You could have a Canadian corporation. As long as its activities and income were generated offshore, it’s not taxed in Canada. That would not be the case today. There used to be all kinds of activities internationally, and more exceptions to the rule. But now it’s different. Now we’re in a truly globalised world, and one of the most important issues, which governments have to deal with is the issue of the distribution of transfer payments; in other words, between corporations.

Most international trade, as you know, is intra-corporation. Corporations will seek to maximise profits in that chain, in the country of least taxation. So you have to have some very elaborate rules in terms of dealing with these transfers, which the OECD has done. You’ll find that probably more tax is lost in that regard, than in any other tax evasion scheme.

ED: Well, that’s intra-organisation, but if you look at it in a broader sense, the supply chain is changing today. You get end products which are made in seven countries, before it reaches where it’s supposed to.

If you put the tax element in there, that they need to be mindful of, you’ll actually kill this whole idea of globalisation as it is intended to be.

DJ: Well, it should be fair. In other words, if you take a Boeing aircraft, or even an automobile, almost any sophisticated product today, their parts are sourced in different countries. Each country that the parts are sourced from should receive a fair share of the ultimate profit. That can only be done by taxing the transfer payments because there’s actually no real transfer if you like, in terms of a sale. This is a very sophisticated area, and it has to be very carefully calibrated to ensure that it’s fair. It must be fair because otherwise, the countries that may be making a real contribution, but have a low tax-rate will not benefit as much as corporations.

ED: Right, so G20 ends up trying to solve the problem with a sledge hammer rather than taking a nuanced approach. Will OECD take into account the variations between countries and their specific needs? Do you think a more nuanced approach should be adopted?

DJ: I’ve not been at the OECD for some years, but I follow its work more or less. Certainly, I don’t think that the culture will have changed. The OECD would not recommend a sledge hammer. The OECD would do its best to recommend effectively a fair system. And of course, there will be a lot of support also from the Business Industry Advisory Council at the OECD, as to how these kinds of issues should be dealt with in a fair and transparent way. I think you ultimately emerge with the best of what one can reasonably do. It’ll never be exact, and there’s no question about that.

2. Corruption in China

One of the areas that I find fascinating in China – I spoke there in January on corruption, which I was hesitant to do. Corruption in China is one of the major challenges that they face; I was surprised at the level of concern. The ten things that concerned the Chinese the most – number one was food safety. Number two was corruption.

ED: Now they can talk about it because they have Twitter. The moment they hear something, they’re latch onto it on social media. Even if the government wanted to control the conversation, it’s all out there already, so they can’t pull it back in. That’s the thing that gives the people power to talk about it.

Then again, when you look at corruption in China, and in every other country, India, Africa and so on, roads and railways get built. The accountability element is there. It’s the “what can I take on the side” thing that is an issue.

DJ: On the Transparency International scale, China is far from being the worst. The likes of Kazakhstan and Russia are worse. But we all have corruption, Emanuel, all of us. Canada has corruption. Korea has corruption. The US has it. Look at what’s happened on Wall Street, and look at the insider trading going on today.

ED: Capitalist corruption is up front. Someone getting a salary of $165 million a year, that’s up front.

DJ: Well, of course, that may or may not be corruption. That may just be the system not working, but the point is though, that in our countries, it is not enough to have a macro-economic impact. It’s not systemic. But it is systemic in China. Everybody’s corrupt there, I’m told.

ED: But again, roads get built, the hospitals run.

DJ: That’s true.

ED: So, there’s an element by which it gets delivered. You want to see corruption, you go to India, where there are no roads. It’s blatant. Money gets stolen long before it reaches the people it’s intended for. The Indian Olympic participants can’t compete because the money goes to the Olympic Council and the council members take the money before it goes to the sportsmen, so that’s how pathetic it is. In China, the structure is a hierarchical society. There’s a different sort of democracy at work, in that people validate each other up the hierarchical chain.

Money also gets churned out that way in that network. But there are ways around that, which is top-down, things work. For example, when we invite top people to speak at our conferences, we don’t go to the middle directors and so on, we go to the governor or the central bank. If you went down the line, people ask us for money and for favors and stuff like that. That’s partly because people don’t know where they stand relative to each other. They need validation.

The structure is hardwired, and that’s why corruption is the way in which you let some money through. “I work very hard to build this city, so I need to be rewarded better than a civil servant’s salary”, so they pay themselves that way. That sort of reward system, you get around it by creating statutory boards, non-state-owned enterprises, that kind of thing, which they don’t want to because they want everything to be owned by the state.

DJ: You’re right, the roads get built and so on. But we have to be very concerned about corruption, not just in China, but it’s a real disease of humanity. A person’s individual greed, which is unbelievable – you have to be able to control it. The reason I’m on this subject and the reason I’m interested to speak about China is that I have views as to how you have to tackle it. And we’ve never done it. Transparency International has done a great job in terms of doing surveys. Their rankings are probably pretty accurate because they’re consistent. You don’t jump from fourth place to 20th place. It’s usually within a range.

ED: When I was studying the OECD that you built, it had a very strong investment focus. It looked at countries in terms of their investment flows and how they can be part of the global economy that way. Today, there’s a whole stream of countries that are being built on trade rather than investment. Trade seems to be the first phase, followed by the investment part in the second phase. Is that an element that was missing in the OECD, and how does the OECD see its own role, given multilateral trade agreements such as the TPP and other similar platforms?

DJ: We ran into a real obstacle when we tried to implement the Multilateral Agreement on Investment (MAI). That negotiation had started before I came to the OECD, but I was there for the unfortunate failure of it. There was a lot of good work done there though, in terms of rules and regulations that could be fed into the World Trade Organisation and elsewhere in terms of investment. But both trade and investment flows are absolutely critical – go hand in hand.

After all, much of the foreign direct investment from OECD countries going into the developing world is for purposes of establishing factories, facilities, and in some cases, real estate. But the reality is that there will be productive companies that are in China for example, so you’ve got strong investment in order to develop trade – in order to develop product sourcing and so on.

I don’t think you can separate the two, and in any given time, if there’s a fluctuation, it could be due to general economic conditions, which is what we’ve seen in the last five, six, seven years. There have been aberrations in probably both trade and investment. We still are struggling with that problem. So I don’t think there’s been any change in philosophy. I don’t think that there’re any rules or regulations that have been put in place that would affect that change per se.

ED: At the same time, OECD should take a view, in terms of multilateralism.

DJ: OECD’s basic mission is multilateral trade and investment, not bilateral trade. The US does a lot of bilateral trade, and what we call regional trade agreements (RTA).

The country claims it wants to participate in multilateral trade, but when you think about it, if you’re the 800-pound gorilla, why would you want to take on 200-pound gorillas in the same negotiation, when you can basically deal individually with states like NAFTA with Canada, with Australia, and more recently with Korea? I don’t favor that. I can see it as one of the unfortunate necessities of the world that we’re in. But multilateralism is by far the best way to go, so that small countries are not marginalised.

ED: Is OECD by definition, exclusive of emerging countries that want to enter the next growth phase? When Korea became an OECD member, everything became more expensive because it’s seen as a developed country rather than a developing country.

There are several Asian countries that should be maturing into an OECD type role, but they keep themselves in a developing paradigm because they get the development aid and funding that is available.

DJ: I must say I have really not looked at that specifically, when I was at the OECD because most of these countries would not qualify for OECD membership on other grounds. In other words, the OECD has an awful lot of instruments that one has to comply with in order to bring it up to the standard – whether it’s the application of the rule of law, the anti-bribery convention, the environmental basically regulatory regime and so on. All these issues have to be taken into account, including the taxation system. So I don’t know that any country would want to stay out of the OECD. It probably wouldn’t need development aid if it reached OECD standards. I mean Korea does not development aid.

ED: I’m also thinking of countries like Singapore, which would technically qualify, but not on all grounds, particularly in terms of governance. But would you invite a country like Singapore to the OECD today?

DJ: I can’t answer that question because I’m not there, and I don’t know whether Singapore wants to be an OECD country. I think back to China for example. I say China should be an OECD country. Of course, democracy is another principle of the OECD. That’s what all the ambassadors would say to me around the table, as reasons for example, to exclude certain countries, and I would point out that after all, we had Greece, who is a member of the OECD being run by colonels. We had Portugal as a member of the OECD, run under a dictatorship. So this does not stand up to historical inspection.

Today, you see this major expansion of the OECD. Since I left, there are now 34 more countries that have come in. Russia is on the waiting list, as well as Israel, Latvia, and Slovenia.

This is going to change the nature of the organization, with membership management becoming more difficult. From 30 country representatives – ministers – you have a session of two hours, which is 120 minutes. How much time does each minister get? And ministers don’t travel around the globe to make a five minute speech. You know? They want to have a real dialogue.

This is one of the problems for an establishment like the OECD, and I put forward a whole lot of formulae when I was there to try and address that problem.

Back to China, I don’t know that China wants to join the OECD because China has the advantage of being at the OECD. For example, we had to deal with steel. Well, how do you deal with steel unless you have China at the table, which is the largest producer in the world? So you invite China in for that purpose.

I don’t say this in a derogatory way, but China is basically able to cherry pick and say, “We’d like to work with you on environment. We’d like to work with you on our statistical series. We’d like to work with you on our technology transfer at our universities.”

We’re very happy to do that but in reality, China has benefited a great deal from the OECD.

ED: Given how the global economies have had to deal with economic doubt over the last two years, do you think there’s been a retreat in terms of the market economy?

3. Over-regulation stifles creativity

DJ: I don’t know that there’s been a retreat. The major interventions, of course, have been, for example, in the United States with the Troubled Asset Relief Program (TARP). And this was seen, of course, as an emergency bailout situation. In my mind, it is that we all recognise there has to be a better regulatory regime.

And the danger of that is will it affect the flexibility, for example, in financial markets? It very well could. This is because there’s now a tendency to think that you have to regulate everything. And when you do that, you destroy creativity to some degree.

The issue is you come in with a sledge hammer, and basically over-regulate to the point of chalking off some of the creativity which has driven the success of the American economy for generations. That’s a worrisome aspect.

I’ve been concerned about that because we’ve left principles behind and gone for regulation.

ED: Regulation. Lots of it.

DJ: When we did our principles for corporate governance at the OECD, we did adhering to certain key principles. It was very interesting to see how much we adhered to principles.

ED: Risk. That’s the big divide between the US and the European approach.

DJ: US is big on rules. I think this is a big mistake because what happens is when you have a rule, if you can bring yourself outside the rule, it’s okay. If you have a principle and there’s a rule, you’ll have a rule that flows with the principle. But if you have a principle, say, of transparency and a court can judge were you transparent or were you not, you can maybe get outside the rule but you’re not going to get outside the principle.

I can think of two examples of that. Lehman Brothers, for example, took something like $50 billion off its balance sheet under arrangement for it to come back on afterwards? They couldn’t get an opinion initially, but later got one out of a London firm, that apparently, was legal.

Now, the management knew that that was not right, that that was done to deceive. How could they know otherwise? It’s not transparent. It was obviously done to basically dress up the balance sheet.

ED: Banks around the world keep doing that today. If you ask the CEO what his repo position is, he wouldn’t know because it’s a daily, hourly thing.

DJ: This is where principles should apply and there should be a way of enforcing the principle. If we start putting up rules, my point is, are we ever going to be able to get back to principles? We know it’s wrong. It may be legal, but it’s wrong. It is the same with the Greece’s national accounts where apparently Goldman Sachs helped dress up their national accounts.

If that’s true, then again, that may have been legal but it’s wrong. If we had an avalanche of rules coming in on every single area of market activity, I think we will seriously set back the market system.

ED: What sort of platform do you think will help to close the US-Europe divide a little bit? There was an attempt by the accounting bodies to come closer.

DJ: International accounting rules, which we adopted at OECD, is an issue which, technically, I can’t address. I’m aware of it and so on. But there has to be a great deal more work done and that should be done at OECD because the Americans are very much at OECD. The Europeans are also very much at OECD, so what better place to start?

ED: And that’s why on the tax issue, the final treatment became a rule-based mechanism; that again becomes another opportunity for one to break all the rules as one sees fit.

DJ: Yes, but this is where I think we’re not quite on the same wavelength. I’m saying governments should adopt a principle. For example, in Canada, we have the same problem with transfer pricing within provinces because the provinces have their own tax systems. So we’ve been addressing transfer pricing issues for some time. A formula has been developed to determine which parts of that chain go where.

That, though, should be based on a principle. The principle should be clearly stated as to that each jurisdiction should be entitled to receive – it’s basically a shared system, given a certain number of criteria.

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