Otmar Hasler, Liechtenstein’s Prime Minister with Angela Merkel, the German Chancellor, in Berlin on Wednesday, Feb 20, 2008.

German Chancellor Angela Merkel on Wednesday threatened Liechtenstein that it would be isolated within Europe unless the Alpine tax haven, relaxed its bank secrecy rules, that have promoted tax evasion by wealthy German nationals.

Following a meeting in Berlin with Otmar Hasler, Liechtenstein’s Prime Minister, Merkel accused the principality’s banks of “encouraging lawbreaking” in Germany by offering services that promote tax evasion.

Merkel warned that the German parliament could block Liechtenstein’s entry in November into the European Union’s border-free Schengen zone. The issue is due to be discussed next Thursday by EU interior ministers, but the Chancellor said she “would not be surprised” if the German parliament “linked” its ratification of the territory’s membership to other issues.

On Wednesday, German legislators  called for an end to the status of Vaduz, the capital of Liechtenstein, as a tax haven in the heart of Europe.

Following the purchase by the German intelligence service of a DVD  from a former employee of the principality's biggest bank, which contains details of hundreds of Germans who secretly diverted income to the tax haven, Merkel said Liechtenstein must act fast: “The clock is ticking,” she said.

The Chancellor appeared to be particularly irritated by the Liechtenstein crown prince Alois von Liechtenstein who has accused Germany of mounting an “attack” on his country by allowing its intelligence to pay up to €5 million for "stolen" data.

Merkel said the prince’s outburst was “not the right way to proceed and frankly its not helpful for our relationship”.

Prime Minister Hasler promised Germany assistance with its investigation and praised Vaduz’s “good relations” with Berlin.

He said Liechtenstein’s standing as a financial centre was “going through a reform process”, but rejected German charges that the 35,000 population statelet, actively encouraged tax crime with its system of special foundations. “It is not legitimate to say that [investing in our] foundations means tax evasion”.

Chancellor Merkel said that the tax haven should move quickly to abide by global guidelines co-ordinated by the Organisation for Economic Co-operation and Development (OECD) to reduce tax haven secrecy.

In an article in the Financial Times on Wednesday, Angel Gurría, OECD Secretary-General wrote: Almost all the jurisdictions identified as potential tax havens by the OECD in 1998 have committed to the principles of transparency and effective exchange of information. Only three still remain on the OECD’s list of unco-operative tax havens: Liechtenstein, Monaco and Andorra.

Now the cat is out of the bag. The disclosure of tax evasion schemes running through Liechtenstein’s oldest bank has confirmed what tax authorities suspected. The affair has tarnished Liechtenstein’s attractiveness as a financial centre, not just for legitimate investors but also for tax evaders, who know their affairs will now come under increased scrutiny by all countries. Liechtenstein’s next moves are critical. It can continue to ignore the trend towards greater co-operation in combating tax evasion in the hope of recapturing the business of tax evaders. Or it can work to restore its reputation in the international community by establishing a network of bilateral tax agreements to improve co-operation.