There are two clear and present dangers looming on the Bermuda horizon. One will hurt us a fair bit, the other a lot. And if they both happen, they will end the affluent lifestyle Bermudians now enjoy.
Two Types of International Businesses
Before we can have a meaningful discussion about which of our international companies are likely to leave, we need to first avoid the trap of clumping all companies into one big group called “International Business.” There are in fact two distinct groups: high-profit-margin companies and low-profit-margin companies.
The high-margin companies (insurance and reinsurance companies, hedge funds and large mutual funds) have hundreds of millions (and in some cases billions) of dollars in capital (think big pile of stocks and bonds) and they generate profits by taking underwriting and investment risk (i.e., they write insurance policies and invest money in stocks and bonds). Sometimes they make a lot of money by taking these risks and sometimes they lose a lot of money, but their ultimate profitability has little to do with the amount they spend on wages. So when the Finance Minister announces a huge increase in payroll taxes, these companies are upset that it cuts into their profits, but that added cost does not threaten their ability to carry on business in Bermuda. It simply encourages them to accelerate what some of them are already doing–moving some high-paying jobs in Bermuda to an affiliate company in another country. The problem, of course, is that the transfer of a senior job out of Bermuda usually means the transfer of many more junior jobs, which is a big negative for local employment and our economy.
The low-margin companies (captive management companies, fund administration companies, and small investment management firms) are service companies that charge customers a fee for the work they do. Unfortunately for both them and Bermuda, there is a lot of competition in their industries and so if they try to pass on their increased costs to their customers by increasing their fees, the customer simply goes somewhere else for a cheaper price. Consequently, the only way they can remain profitable is to keep their expenses at a minimum, and since wages are by far their largest expense, they are very upset when the Finance Minister announces a large increase in payroll tax. It is a direct attack on their profit margins, which makes it harder for them to compete for business against competitors operating from lower-cost jurisdictions. In other words, if they want to survive, they will have to move (or outsource jobs) somewhere with cheaper labour and lower taxes.
The great benefit of having these two types of international companies is that they add diversification to our economy: if one group were to leave because of this huge increase in payroll taxes, we would still have the other, right? Yes, except if that other group has its own reasons for leaving.
Insurance Companies—Will They Win the US Tax War?
The good news is that none of the high-margin companies are likely to leave the island solely because of the increase in the payroll tax. The bad news is that, with the stroke of a pen that is every day getting closer to paper, the US can make a change in its tax laws that would cause the big insurance and reinsurance companies to move all or a very large part of their business from Bermuda, resulting in the loss of thousands of direct and indirect jobs for Bermudians, from secretaries to vice presidents through to the secondary industries that support these companies (think law firms, accounting firms, computer companies, janitorial companies), third tier businesses that rely on these patrons (think landlords, retailers, restaurants, hotels, hair salons) and charities that depend on their donations.
There are two tax threats presently being discussed by Washington lawmakers. The first deals with related-party transactions. At present, many of these huge Bermuda reinsurance companies generate a large part of their business through their US affiliates (companies that are owned by the same people). The US company writes a large insurance policy for many millions of dollars. It then reinsures a major chunk of that policy with its Bermuda affiliate (sometimes as much as 90%). Under present US tax laws, the US affiliate can take a tax deduction for the insurance premiums paid to the Bermuda parent under the reinsurance contract, making their US taxes lower. The Obama administration has proposed a new law that would disallow any part of the reinsurance deduction that exceeds 50% of the direct premiums paid, making their US taxes higher.
This is not good news for the Bermuda companies, but it is probably not enough to make them leave the island. Unfortunately, if that amount is ever lowered to say 20%, some of these companies would leave Bermuda and set up in a jurisdiction that has a tax treaty with the US (like Switzerland) to minimize the taxes they would have to pay. And the reality is that the 50% threshold could be set much lower over the next few months as the tax amendment goes through the legislative process. Further, even if it stays at 50% this year, it is an easy target to be lowered next year as the US, with its massive national debt (sound familiar?) scrambles to raise tax revenues wherever it can.
The second threat, while less likely to occur but more catastrophic if it does, is an increase in the federal excise tax. At present, the US charges a one percent tax on reinsurance premiums that US companies pay to Bermuda reinsurance companies and a four percent tax on insurance premiums similarly paid. If that excise tax were increased to say 8%, but exempted for companies from treaty countries (Bermuda’s US tax treaty doesn’t help here), all of these big insurance and reinsurance companies would be gone within months.
Bermuda’s principal argument against these US tax increases is that they will cause US insurance rates to rise. Proponents of the tax increases say that even if we are correct, our argument is hollow. If you tax farmers, food prices go up; if you tax doctors and pharmaceutical companies, healthcare costs go up; if you tax contractors and cement companies, housing costs go up. It is simply the economic reality of a system that taxes the income of some for the benefit of all. So we are left arguing that it is more important for the US to keep their insurance costs low than it is for them to keep their food, healthcare and housing costs low. When you consider that Bermuda’s economic future may depend on our ability to win that argument, you realize how precarious our economic situation is.
And remember, every single one of these companies has its exit plan in place ready to be launched at a moment’s notice. Why? Because it would be negligent of them not to. Unfortunately, both the government and the Bermuda public are not even discussing this problem, let alone taking the urgent steps needed to prepare for the potential devastation that lurks just around the corner.
Luckily, we will still have the low-margin companies to soften our fall, won’t we?
Low-Margin Companies—Does their Business Model Work in Bermuda Anymore?
These low-margin companies were set up in Bermuda during the 1980s and 90s when wages were much lower and payroll tax minimal. Over the last ten years, these low-margin companies have had to pay their employees significantly higher wages partly because of the arrival of the high-margin companies competing for employees from the same local talent pool, and partly because the cost of housing in Bermuda rose so dramatically that these companies had to raise salaries so their employees could afford the higher rents. Since the payroll tax is calculated as a percentage of wages, and wages have dramatically increased, these companies would have paid higher taxes even if the rate of tax had not been increased. But over the last decade they have been hit with a triple whammy: the base for calculating the tax (wages) has increased, the tax rate has increased (from 9% to 16%) and the maximum salary cap has increased (from $60,000 to $750,000).
When you add up the wages, payroll tax, pension and health-care costs, over the last 12 years these companies have seen their average annual employee costs more than double, all of which is a direct attack on their profitability and their ability to compete.
That’s very bad news for these low-margin businesses, and that’s why this latest increase in payroll tax looks like the nail in their Bermuda coffin. These companies, hoping to delay their decision to move, asked the Finance Minister to at least say that the payroll tax increase was a temporary measure for just one year until we get the national debt under control, but she was not swayed.
Now these companies have to decide if it is time to leave. The biggest problem is that they know a lot about finance, and this knowledge tells them that the Finance Minister’s projection of increased government revenues this year is unrealistic. The government is already set to lose a significant amount in payroll tax receipts because of big layoffs in the construction industry. Further, with the new payroll tax increases, not only is it unlikely that any new companies will come to Bermuda, but it is very likely that many will leave, or at a minimum simply move jobs to less expensive jurisdictions (what you call the “Silent Exit”). That means that even though the tax rate and the salary cap per employee will be increased, the total revenue government generates from payroll taxes may actually fall because the number of employees left to tax will decrease dramatically as more companies leave or outsource jobs.
But it gets worse. Along with the dramatic fall in national revenues, these companies know that as more Bermudians lose their jobs, the costs of government social assistance will increase dramatically, and when they add these costs to government’s own projected increase in expenditures, they see the national debt skyrocketing even further next year, which likely means another payroll tax hike. So even if some of these companies were to take a big gulp and pay the dramatic increase in taxes this year, they know that they will only have to write a bigger cheque next year.
So at this very moment, these companies are asking themselves the question: Do we stay on the island or do we move (either the whole company or many of the jobs) to one of the numerous other countries that offer cheaper labour costs, lower taxes, no term limits, and a larger, better-skilled pool of workers from which we can draw the best and the brightest?
Unfortunately, early indications are not looking good for Bermuda. Many of the low-margin companies have already begun outsourcing jobs to their overseas affiliates because it is now cheaper to pay the applicable income tax and wages in Halifax, Montreal and India than to continue operating in Bermuda. The increase in Bermuda’s payroll tax is simply speeding up the outflow of those jobs. And as the companies dwindle down the amount of work they do in Bermuda, they soon will reach the threshold point where it no longer makes operational sense to have a presence here. They will simply move everything.
What We Can Do About These Companies Leaving
The first thing everybody must do it get a sense of urgency. Bermuda’s economy is heading for the cliff’s edge, and it is happening now.
Second, we must stop talking about “International Business” as if it were a homogeneous group. The next time someone starts talking about “International Business” stop them in their tracks and ask if they are talking about low-margin companies or high-margin companies. Only after making that distinction can you have an intelligent conversation.
Finally, the government must try to cut a deal with the business community. During my years as a corporate securities lawyer, I learned that as long as each party can give the other side something they need, all parties can benefit from a deal if each of them remains reasonable in their expectations. Remember, “Pigs get fat and hogs get slaughtered.”
We know what these companies need (lower payroll taxes), so let’s look at what the government needs. The government needs to keep jobs in Bermuda and decrease its national debt. To lower debt you need to either cut expenses or raise revenue. Any experienced businessman will tell you that while you can control expenses (you cut back staff, trim down departments etc.) you can’t control revenues. You may raise prices (or if
you are a government, raise taxes) but customers (and International Companies) have the ability to simply walk away. In fact, sometimes so many customers walk away that your total revenue may actually decrease when you raise prices, which unfortunately is what is happening with the recent increase in payroll taxes–it looks like so many companies may be leaving or outsourcing jobs that total government revenue is likely to fall, making the national debt even bigger. So rolling back the recent payroll tax increase (keep it at 14% and leave the salary cap at $350,000) may actually increase government revenue.
But government may be able to bargain for something even bigger to help lower its debt. Over the last ten years the number of government mployees has increased by more than a thousand workers. Government would love to reduce the millions of dollars in increased wage expense that go with these jobs, but politically it is very difficult to lay people off, and as Bermuda’s economy falls over a cliff, it will be almost impossible for these people to find work. The sad part is that if government doesn’t cut many of these jobs now, its debt will be even higher next year, which will mean even bigger job cuts or severe pay cuts then.
Here’s a suggested deal that I think might work. Government enters into a public-private partnership under which, in return for exempting participants in the partnership from the payroll tax increase (go back to the 14% tax on a $350,000 salary cap) the business community (both local and international companies) agree to provide jobs and training for government employees. Companies that enter the program, at predetermined levels based on their size, can avail themselves of the lower tax thresholds, and those who don’t will pay at the increased rates. The program can be designed through discussion between Government and the Business Community and should allow those who cannot directly employ and train additional people to contribute in other ways, probably through funding.
This deal will enable government to lower its expenses and the national debt, it will provide jobs for redundant government employees who would otherwise be jobless, and it lowers the payroll tax, thereby saving jobs in Bermuda that otherwise would be outsourced.
By acting reasonably, the affected parties can help the people of Bermuda weather what is soon to be a very big storm.