Regulatory Arbitrage in Cross-Border Digital Services

In economics, government regulations are considered to increase the cost of production, reducing firms’ profitability.  As a result, most firms and business leaders typically oppose increased government regulations.  In extreme instances, firms may even relocate operations to jurisdictions with less regulation.  [In]famously, this occurred in the 1990s when free trade agreements made it easier for multinational corporations to produce goods abroad and import them home - the multinationals could move factories to low-income, low-regulation countries and pay few or no tariffs when “offshoring” operations.

While business relocations to enjoy reduced regulations in the 1990s were primarily focused on factory production, such strategic decisions are now occurring around digital services.  Tech companies and websites must follow the laws and regulations of the jurisdictions where they operate…but this is more complicated thanks to the remote capabilities of the Internet.  A website used by Germans and Britons may exist on a server in Sri Lanka, while a digital service provider creating documents and media presentations for companies in Canada may be headquartered in Brazil.

Regulatory Arbitrage Explained

Arbitrage occurs when an asset can be simultaneously purchased and sold in different markets for different prices, allowing a broker to make risk-free profit.  Basically, a “deal” exists in real time and, if there are no transportation or brokerage costs, profit is guaranteed.  Regulatory arbitrage implies that a firm can swiftly and seamlessly relocate from a high-regulation jurisdiction, such as the European Union, to a low-regulation jurisdiction, such as developing nations in the “Global South”, and make more profit by enjoying lower costs of production.  While there are often some physical costs associated with purchasing new capital goods like computer servers and office space, a tech company could save billions of dollars on tech regulation compliance (and taxes) by changing jurisdictions.

Jurisdiction Shopping

Thanks to the modern Internet, online companies can exist virtually anywhere.  As a result, they can “jurisdiction shop” for the most friendly laws and regulations for their digital services.  A fintech (financial technology) company may face less government oversight in some jurisdictions, meaning it can facilitate more lending and rake in more revenue through interest and fees.  Stock and cryptocurrency trading apps may face fewer restrictions in some jurisdictions, allowing them to increase the volume of trades and receive more trade commissions.  Fintech and trading companies may take advantage of fewer regulations in terms of customer identity verification to allow likely criminal organizations to invest or launder funds.

Economics of Regulatory Arbitrage

Cross-border digital services, often in finance, allow companies to provide services worldwide while keeping their headquarters in desirable jurisdictions.  The differing laws and regulations by jurisdiction create economic effects for both established online companies and aspiring start-ups.  When tax revenue is factored in, jurisdictions and their infrastructures can also benefit or suffer from the movement of online company headquarters.

Regulatory Competition to Attract Firms

Many firms seek to incorporate to enjoy the investment-raising benefits of being a stock-selling corporation, as well as the legal benefit of limited liability.  However, the ability to incorporate is affected by the laws and regulations of the jurisdiction where the firm will be headquartered…and pay taxes.  To attract corporations, some jurisdictions have intentionally created generous laws and regulations that make it easy to incorporate.  By also offering low taxes, they can get established businesses to relocate their legal headquarters to the jurisdiction, perhaps just an office or so, and reap the additional tax revenue.

“Race to the Bottom” Regulations

However, similar to a price war among oligopolists, reducing corporate regulations and tax rates among developed nations can result in economic harm as less and less tax revenue is raised.  While early tax-cutters may enjoy a period of increased tax revenue due to the relocation of online corporations, future rounds of cuts to keep corporations from relocating further can result in reduced revenue.  Eventually, all jurisdictions lose because tax rates have fallen so low that, even with more corporations headquartered there and making more income than ever before, little tax revenue is being received.  This hurts local infrastructure and the citizens who rely on that infrastructure.

High Barriers to Entry in Low-Cost Jurisdictions

Before easy online corporation relocations, start-ups in developing countries had a chance to grow without stiff competition from major firms.  Now, with major firms being headquartered in those same developing countries to enjoy low taxes and regulations, start-ups risk being quashed immediately, perhaps with the help of domestic authorities.  For example, a hot new app may be easily bought up by a major multinational, even against the wishes of the app’s creators, because that multinational is headquartered in the same jurisdiction and can purchase all the stock.  Domestic authorities and courts may favor the multinational out of a desire to keep that firm’s tax revenue, putting any local rivals at a disadvantage in legal disputes.

This legal disadvantage creates high barriers to entry into the tech market for start-ups in low-cost jurisdictions.  Although the cost of production is low, so are the legal protections against hostile takeovers from larger corporations.  As a hedge against competition, large corporations in low-cost jurisdictions may also intentionally hire or purchase a majority of available resources to deprive rivals of their use.

Long-Run Welfare Implications from Fragmented Regulation

Allowing corporations to relocate their headquarters easily to enjoy a more favorable set of regulations and taxes can cause significant social and economic harm in the long run.  Low-regulation governments may enjoy the brief tax revenue boon in the short run, but quickly come to find that they are more beholden to the newly-arrived corporations than they are comfortable.  Balance of power often shifts from the [less wealthy] government to the [wealthier] multinational corporation.

Regulatory Capture

When governments try to operate more favorably toward producers, especially when it involves relaxing protections of consumers, regulatory capture becomes more likely.  Regulatory capture occurs when a producer, such as a multinational corporation with a strong online presence, comes to dominate the regulators in its jurisdiction(s).  This can occur informally, such as through close relations between the regulators (legislators, regulatory agency officials, or law enforcement) and the firms (corporate executives).  The regulators, enjoying the benefits of friendship, which may or may not include financial incentives, may be lenient when it comes to enforcing rules.

More formal regulatory capture can occur over the long run, when former executives of the corporation are chosen as regulatory agency heads under the rationale that they “understand the industry.”  As a former employee of the corporation, the new regulator is unlikely to abandon past friendships and will retain some loyalty to his or her former employer.