Archive for the ‘International Taxation’ Category

When I write about the benefits of trade, I periodically point out that America has a trade deficit because it has a foreign investment surplus.

And since investment is a key driver of economic growth and rising wages, that’s a good outcome.

It basically means that foreigners who earn dollars by exporting to America are helping to finance America’s future prosperity by then plowing that money back into our financial markets (see this video for more details).

That’s the good news.

The bad news is that politicians are making cross-border investment more difficult.

They are using tax and regulatory policies to hinder the flow of money, just like they use protectionist policies to hinder the flow of goods and services.

A new report from the Center for Freedom and Prosperity, authored by Bruce Zagaris, explains this unfortunate development. He starts by explaining some of the bad policies imposed by Washington.

The ever-growing complexity and reach of the U.S. tax system impinges on the ability of U.S. taxpayers to live abroad, work abroad, open bank accounts abroad, or conduct business abroad. …These developments create a challenging environment, with taxpayers being subject to onerous – and sometimes conflicting – requirements. The complex array of obligations put taxpayers in legal jeopardy as governments threaten to impose sanctions on investors and businesses… The U.S. has even proactively prosecuted individuals and companies for cross-border tax activities that do not violate American laws. …The paperwork and reporting requirements for cross-border economic activity are extensive. …The icing on the cake of intrusiveness and costly compliance is the Foreign Account Tax Compliance Act.

FATCA is horrid legislation, perhaps the single worst part of the internal revenue code.

And bad policy from the U.S. has given other nations an excuse to adopt similar bad rules – aided and abetted by statist international bureaucracies such as the European Commission and Organization for Economic Cooperation and Development.

The difficulties caused by extraterritorial taxation are exacerbated by similar moves by other nations, often implemented as a response to aggressive policies by the United States. … the OECD has developed compliance and enforcement initiatives. …extraterritorial tax rules also are impinging on corporations. …The EU has taken a series of aggressive steps to impose tax on cross-border transactions. …Overly aggressive tax compliance and enforcement initiatives erode globalization, impede the ability of normal commerce and the movement of people, capital, and goods, and threaten privacy.

I especially like Bruce’s conclusion. All of the rules that stifle and hinder cross-border investment only exist because politicians have adopted bad tax laws.

Most of the policies reviewed above are only necessary because governments not only tax income, but also impose extra layers of tax on income that is saved an invested, exacerbated by decisions to impose such tax laws on income earned outside national borders. In a neutral, territorial tax system that taxes economic activity only one time, such as the Hall-Rabushka flat tax, almost all international tax conflicts disappear.

Amen. If we had a flat tax, there would be no case to be made for these bad policies.

Writing for the Washington Times, Richard Rahn of the Institute for Global Economic Growth cites this new study as he warns that an ever-expanding web of global tax rules is throwing sand in the gears of the global economy.

Global economic growth, particularly foreign investment, is slowing. One reason is likely the growing complexity of engaging in cross-border financial transactions. Major companies, banks and other financial institutions have been required to pay, in some cases, multi-billion-dollar fines to various governments for some alleged tax or other violation. The question is: Why is this occurring when virtually all of these institutions have compliance officers, tax lawyers, accountants, auditors, etc.? Much of the problem seems to stem from the ever-changing regulations and laws among countries, which are increasingly impossible to understand and comply with, even by the most sophisticated businesses. …The Center for Freedom and Prosperity Foundation has just published an important paper by the highly regarded international tax lawyer Bruce Zagaris, titled “Why the U.S. and the Worldwide Tax Systems Have Run Amok.” …Overly complex and even incomprehensible rules govern many international wealth and business transfers, as well as very onerous reporting requirements for people that have foreign interests. …In his paper, Mr. Zagaris details the problems caused by FATCA and a number of other international tax-related rules and regulations. Many of the rules and regulations would never meet basic cost-benefit analysis. They create much pain for little or no gain.

I would modify that last sentence.

The only “gain” from all these tax rules is a comparatively small amount of additional tax revenue for politicians (Obama originally promised $100 billion annually from FATCA and the actual law is projected to collect than $1 billion per year).

Yet there is great pain imposed on the private sector.

Moreover, laws to hinder cross-border capital flows are especially disadvantageous for the United States, as illustrated by this chart from Bruce’s report.

Sadly, damage to the productive sector of the economy is not something that politicians lose sleep over.

After all, they wouldn’t be imposing risky extraterritorial policies if they actually cared about what’s best for the nation.

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Since I consider myself the world’s biggest advocate for tax competition and tax havens (even when it’s risky), I’m always on the lookout for new material to share.

So I was delighted to see a new monograph from the London-based Institute of Economic Affairs on the benefits of “offshore” financial centers. Authored by Diego Zuluaga, it explains why low-tax jurisdictions are good news for those of us laboring in less-enlightened places.

Offshore finance serves several purposes, the most salient of which is the efficient allocation of capital. Some of this activity is tax-related, aimed at raising after-tax investment returns. If it were not for offshore jurisdictions, much foreign investment would be vulnerable to double or triple taxation. Because, under such punitive rates of tax, some of this investment would not take place, the existence of offshore centres has real positive effects on economic activity alongside the (plausibly) negative impact on the tax revenue of individual countries. These welfare gains have been amply documented… Beyond their impact on aggregate investment, research shows that the existence of an OFC is associated with better economic outcomes in neighbouring countries. Contrary to the popular narrative, these jurisdictions are well-governed and peaceful. Who, after all, would wish to use intermediaries in places where investors were regularly expropriated or harassed? …It is difficult to imagine the process of globalisation that has taken place over the last fifty years, bringing hundreds of millions of people out of poverty, happening without the robust financial and legal framework which offshore jurisdictions provide for investment. It would be counterproductive, for both the developing and the rich world, to undermine their essential functions. …Clamping down on offshore centres…would make societies less productive and prosperous, and this effect would compound over time.

He provides some fiscal history, including the fact that government used to be very small in the industrialized world (indeed, that’s one of the big reasons why today’s rich nations got that way).

And he notes that low-tax jurisdictions became more important to global commerce as governments adopted dirigiste policies.

Before World War I, governments played only a small role in economic activity, rarely taking up shares of national income in excess of 15 per cent during peacetime. After the Great War, they took upon themselves ever larger fiscal and administrative functions, notably trade restrictions and capital controls. …In a context of punitive marginal tax rates, constrained capital movements…, OFCs were vital to the revival of cross-border trade and investment after World War II. Without stable intermediary jurisdictions with robust rule of law and low taxation, much international investment would have been too costly, whether because of the associated tax burden or the risks of expropriation and inflation.

Zuluaga notes that tax competition ties the hands of politicians.

Theory and evidence suggest that countries may have any two of free capital mobility, an independent tax policy and no tax competition (Figure 2). But they cannot have all three.

And here is the aforementioned Figure 2 from the report.

I wrote about a version of the tax trilemma two years ago and noted that there’s only a problem if a country has high taxes.

So I made the following correction.

Returning to the article, Zuluaga points out that low-tax jurisdictions have a much better track record in the fight against bad behavior than high-tax nations.

OFCs are neither the original source nor the ultimate destination of illegal financial flows. So long as there remain corrupt politicians, drug users and people willing to engage in terrorist acts, history suggests that some illegal financial activity will take place to make it possible. Furthermore, as we saw above, OFCs are as a rule far more compliant and transparent in their prevention of unlawful activities than onshore jurisdictions, including the United States and the United Kingdom.

Zuluaga concludes with a warning about how the attack on tax havens is really an attack on globalization. And the global economy will suffer if the statists prevail.

…an ominous alliance of revenue-greedy politicians, ideological campaigners and rent-seekers has emerged in recent years. Gradually, but relentlessly, they aim to dismantle the liberal financial order of which free capital movement is a fundamental component. …the alliance’s real goal: to eliminate tax competition and constrain the movement of capital in order to bring it under their control. The consequences of this effort would be long-standing and go far beyond a few tiny offshore financial centres.

Excellent points. I strongly recommend reading the entire publication.

Though I’m not sure Zuluaga and I agree on everything. His article notes, seemingly with approval, that offshore jurisdictions largely have agreed to help enforce the bad tax laws of onshore nations. Yet that’s a recipe for the application of more double taxation on income that is saved and invested, which he acknowledges is a bad thing.

In other words, I think financial privacy is a good thing since predatory governments are less likely to misbehave if they know taxpayers have safe (and confidential) places to put their money. Now that privacy has been weakened, however, anti-tax competition folks at the OECD are openly chortling that there can be higher taxes on capital.

The bottom line is that tax competition without privacy is not very effective. I wonder if Zuluaga understands and agrees.

Another IEA author, Richard Teather, got that key point.

In a 2005 monograph, he explained the vital role of financial privacy.

Although the country of residence may theoretically impose taxes on foreign income, it can only do so practically if its tax authorities have knowledge of that income. It is therefore common for tax havens to have strong privacy laws that protect investors’ personal information from enquirers (including foreign tax authorities). The best-known of these was Switzerland, which introduced banking secrecy to protect Jewish customers from Nazi confiscation, and there remains a genuine strong feeling in many of these countries that privacy is about more than just tax avoidance.

But I’m digressing. Since we’ve looked at one U.K.-based defense of low-tax jurisdictions, let’s also look at some excerpts from a column by Matthew Lynn in the London-based Spectator.

He makes a very interesting point about how so-called tax havens are basically the financial equivalent of free zones for goods.

…in a globalised economy, offshore finance plays an important role, enabling money to move across borders relatively easily. Rather oddly, a lot of the media seem to have decided that while it is fine for people and goods to move around the world, having a bank account or an investment in a different country makes you virtually a criminal. …The world already has an extensive network of free ports, tax-free zones where goods in transit can be processed or temporarily stored without having to pay local tariffs. There are an estimated 3,500 of them across 135 countries, facilitating the movement of goods around the world. They have helped trade grow hugely over the past couple of decades. Offshore centres…are now mainly financial ‘free ports’ — places where cash can easily be parked and transferred as it moves around the world.

He also makes a very important observation about how the theft of data leading to the Panama Papers and Paradise Papers revealed very little illegal behavior.

…one of the interesting things about the leaks is not how much wrongdoing they expose, but how little. Take last year’s Panama Papers scandal, for example. …For all the drama, it was pretty small beer. The reason? All the data revealed might have been interesting, and made for some lurid headlines, but very few people turned out to be breaking any laws. In only a handful of cases were taxes being evaded or money-laundered.

Which is a point I’ve made as well.

And here’s his conclusion.

…it turns out that offshore centres are used by just about everyone. Most pension funds use them, including those looking after the savings of the politicians queuing up to condemn them. They are part of the infrastructure of globalisation, as much as the container ships, airports and fibre optic cables. It is ironic that many of the same people who proudly describe themselves as citizens of the world think that applies to everything except money.

Amen. Once again, this is really a fight about globalization. Or, to be more accurate, a fight between good globalism and bad globalism.

To wrap up, here’s the video I narrated for the Center for Freedom and Prosperity on the economic benefits of tax havens.

P.S. I’ve previously cited other tax haven-related research and analysis from the United Kingdom, most notably from Allister Heath, Dan Hannan, Philip Booth, Godfrey Bloom, and Mark Field.

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Back in 2013, I wrote about a gay guy adopting his long-time lover in order to escape the evil and pernicious death tax. I speculated that this would cause confusion and angst in some circles.

  • Traditional leftists would want to applaud the adoption because of their support for gay rights, but they would be conflicted because of their support for the death tax.
  • Traditional conservatives, by contrast, would dislike the way adoption laws were being used, but presumably like the fact that the reach of the death tax was being curtailed.

Now we have a somewhat similar example of the death tax leading people to take an unusual step.

Here are some excerpts from a report in the Belfast Telegraph.

Two best friends in the Republic of Ireland who have decided to get married to avoid paying inheritance tax… Michael O’Sullivan, a father of three, is set to marry his friend Matt Murphy in January. …Friends for almost 30 years they have made the decision so that Michael will inherit Matt’s home in Stoneybatter, Dublin when he dies. …Neither man is gay and say they are like brothers.

Not only will this save them money, it will be beneficial for other taxpayers as well.

Both men say they are currently on a small pension and say their idea is “saving the State money”. Michael said: “We found out from a friend of mine that she is paying €1,760 a week to stay in a nursing home, okay I could put Matt in a nursing home and then people would be paying their tax to look after him in the nursing home. “I don’t have much money and Matt can’t pay me to look after him but we tried to find out how much it would cost for a 24-hour care, you’re talking about a couple of thousand a week. “We are saving the State money.”

By the way, this story also may be an indirect example of excessive regulation.

It seems the guys could have received a subsidy from the government so that Michael could take care of Matt, but that would have triggered so much hassle and red tape that it wasn’t worth it.

“We didn’t go for the Carer’s Allowance because Matt would have to be examined, the house would have to be looked at.

Amen. Nobody welcomes a bunch of nosy bureaucrats poking through their life.

Now let’s zoom out and consider some broader policy implications.

I like and defend Ireland’s policy of aggressively using low corporate taxes to attract jobs and investment, but that doesn’t mean other policies in the country are favorable for taxpayers.

Indeed, there’s plenty of evidence that other taxes in that country are too high and it’s quite clear that the burden of government spending also is excessive.

The story doesn’t give details about the extent of the death tax, but it obviously must be punitive if two straight guys are marrying each other to dodge the levy.

In any event, it belongs in my collection of odd moments in international taxation.

It doesn’t really belong in this collection, but I think the oddest tax story I’ve ever read is that a bureaucrat from the tax-loving European Commission criticized France for excessive taxation.

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I realize that we’re in the midst of an important tax battle in Washington and that I should probably be writing about likely amendments to the Senate tax bill.

But long-time readers know that I’m bizarrely preoccupied by international tax issues (I would argue for very good reasons since global tax competition is a way to discipline greedy politicians and because I want the power of governments to be constrained by national borders).

So I can’t resist commenting on a Washington Post story about the tax implications of the upcoming wedding of Prince Harry and Meghan Markle.

It may seem like a modern fairy tale, but the upcoming wedding of Britain’s Prince Harry to American actress Meghan Markle will come with some mundane hurdles. Perhaps most inconveniently for the British royals, this transatlantic partnership could end up involving the United States’ Internal Revenue Service.

Most readers probably wonder how and why the IRS will be involved. After all, Ms. Markle no longer will be living in the United States or earning income in the United States after she marries the Prince.

But here’s the bad news (for the millions of Americans who live overseas, not just Ms. Markle): The United States imposes “worldwide taxation,” which means the IRS claims the right to tax all income earned by citizens, even if those citizens live overseas and earn all their income outside of America.

…there already has been widespread speculation that the union of Prince Harry and Markle eventually could result in some British royal children wielding American passports. But there’s a big obstacle in the way: American tax laws. …The United States’ citizenship-based taxation system is unusual: Only Eritrea has a similar system. It’s a relic of the Civil War and the Revenue Act of 1862, which called for the taxing of U.S. citizens abroad.

Here’s what this means for the royal family.

Markle’s American citizenship could open up the secretive finances of the royal family to outside scrutiny. If she remains a U.S. citizen, Markle will have to file her taxes to the IRS every year. And if she has more than $300,000 in assets at any point during the tax year — a likely scenario, given her successful acting career and her future husband — she will be expected to annually file a document called Form 8938 that will reveal the detail of these assets, which could include foreign trusts. …Although Markle’s tax information would not become public once sent to the United States, it would leave the royal family open not only to IRS review but also the risk that the information could leak, said Dianne Mehany, a tax lawyer at Caplin & Drysdale.

So what’s the solution if the royal family wants to avoid the greedy and intrusive IRS?

Ms. Markle will need to copy thousands of other overseas Americans and renounce her citizenship.

…the royal family employs some of the country’s best tax consultants. …”My guess is that she’ll be pressured by the Royal family to renounce [her U.S. citizenship], even if she’d rather not,” Spiro added. In many ways, that solution may be the simplest. And if Markle does give up her citizenship, she won’t be alone. Treasury Department data show that 5,411 people chose to expatriate in 2016 — a 26 percent year-over-year increase and potentially a historic high — and experts expect that number to keep rising because of the increasing tax burdens placed on U.S. citizens living abroad.

And it’s embarrassing to acknowledge that the United States has a very barbaric practice (used by evil regimes such as Nazi Germany and Soviet Russia) of extorting funds from Americas who are forced to give up citizenship.

She…would be subject to a potentially considerable exit tax.

This is adding injury to injury.

But Ms. Markle can be comforted by the fact that she’s not an outlier. Because of America’s bad worldwide tax regime (and especially because of FATCA, which makes enforcement of that bad system especially painful), an ever-growing number of overseas Americans have been forced to give up their citizenship.

Maybe as a wedding present to Prince Harry, American politicians can junk America’s terrible worldwide tax regime. That doesn’t require dramatic change, but why not fix a bunch of problems at once? I’ll simply point out that the flat tax is based on the common-sense approach of territorial taxation (governments only tax economic activity inside national borders).

P.S. This issue also impacts America’s Olympic athletes.

P.P.S. And Santa Claus as well!

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The Republican tax plan is based on some very attractive principles.

Unfortunately, the GOP isn’t planning to completely fix these policies, largely because there’s no commitment to control government spending. But any shift toward better tax policy will be good for the nation.

Another goal to add to the above list is that Republicans want to create a level playing field for American-based firms by replacing “worldwide taxation” of business income with “territorial taxation” of business income.

For those who have wisely avoided the topic of international business taxation, here’s all you need to know: Worldwide taxation means a company that earns income in another country is taxed both by the government where the income is earned and by the government back home. Territorial taxation, by contrast, is simply the common-sense notion that income is taxed only by the government where the income is earned.

In a column for the Wall Street Journal, two authors explain how America’s anti-competitive system of worldwide taxation undermines U.S.-domiciled companies.

…earlier this month Iconix , the U.S.-based company that owns the rights to Charles Schulz’s comic characters, announced it will sell them to Canada’s DHX Media. That makes Charlie Brown America’s latest expatriate. It’s a clear signal that U.S. corporate taxes are nudging business elsewhere. …why? In part because the U.S. corporate tax system hampers U.S.-based businesses by subjecting them to world-wide taxation. Canada’s aggregate corporate taxes are about 10 percentage points lower. …America’s high corporate tax rate and its practice of taxing international income is out of step with the rest of the world. The solution is so clear even a cartoon character should grasp it: Cut tax rates and adopt a system for taxing international income that more closely resembles those used by the country’s international competitors.

Indeed, it’s worth noting that the entire “inversion” controversy only exists because of America’s worldwide tax regime.

Simply stated, American-domiciled multinationals have a big competitive disadvantage compared to their foreign rivals. So it’s understandable that many of them try to protect shareholders, workers, and consumers by arranging (usually through a merger) to become foreign companies.

That’s the bad news.

The good news is that the Republican tax reform plan ostensibly will shift America to a territorial tax system. As explained above, this is the sensible notion of letting other nations tax income earned inside their borders while the IRS would tax the income earned by companies in the United States.

This would be good for competitiveness, particularly since the United States is one of only a handful of nations that impose a worldwide tax burden on domestic firms.

But not everybody likes the idea of territorial taxation.

One reason for opposition is that some people see corporations primarily as sources of tax revenue. So when there are discussions of international tax, their mindset is nations should compete on grabbing the most money. I’m not joking.

European Union regulators’ tax crackdown on Amazon.com Inc. — like the EU’s case against Apple Inc. — should spur U.S. policy makers to address companies’ aggressive offshore tax-avoidance strategies before it’s too late, experts said. …“Really, what we are seeing is a race by the different taxing jurisdictions to claim a share of the tax prize represented by the largely untaxed streams of income that U.S. multinationals have engineered for themselves,’’ said Ed Kleinbard, a professor at the University of Southern California and the former chief of staff for Congress’s Joint Committee on Taxation. “If the United States doesn’t join the race, it will just lose tax revenue to more aggressive host countries around the world.’’ The EU rulings “do make it clear that if we are not interested in protecting our corporate tax base, other countries will be more than happy to tax the income,’’ said Kimberly Clausing, a professor of economics at Reed College in Portland, Oregon.

Call me crazy, but I think American policymakers should be in a race to create jobs, boost investment, and increase wages. And that means doing the opposite of what these supposed experts want.

Unsurprisingly, left-wing groups also are opposed to territorial taxation. Here are some passages from a report published by the Hill.

One hundred organizations, including a number of progressive groups and labor unions, are urging Congress to reject a major international tax change proposed in Republicans’ framework for a tax overhaul. In a letter dated Monday, the groups speak out against the framework’s move toward a “territorial” tax system that would largely exempt American companies’ foreign profits from U.S. tax. …”Ending taxation of offshore profits would give multinational corporations an incentive to send jobs offshore, thereby lowering U.S. wages,” they wrote.

Both assertions in that excerpt are wrong and/or misleading.

First, territorial taxation doesn’t mean that profits are exempt from tax. It simply means that the IRS doesn’t impose an additional layer of tax on income that already has been subject to the tax system of another country.

And other countries impose plenty of tax on American firms operating overseas.

Second, the incentive to shift job overseas is caused by America’s high corporate tax rate. That’s what makes it attractive for firms to operate in other nations.

Worldwide taxation is not the way to fix that bias since foreign-domiciled companies wouldn’t be impacted and they easily can sell into the American market.

By the way, the Republican tax plan doesn’t even create a real territorial tax system. Returning to the Bloomberg story cited above, the GOP proposal basically copies a very bad idea that was being pushed a few years ago by the Obama Administration.

…the GOP tax framework contemplates a so-called “minimum foreign tax’’ on multinationals’ future earnings that would apply in cases where a company’s effective tax rate fell below a pre-determined threshold.

To be fair, the Republican approach is less punitive that what Obama wanted.

Nonetheless, I worry that if Republicans adopt some sort of global minimum tax, it will just be a matter of time before that rate increases. In which case a shift toward territoriality actually plants a seed for a more onerous worldwide system!

Without knowing what will happen in the future, there’s no right or wrong answer, but I’m wondering whether the smart approach is to simply leave the current system in place. Yet, it’s based on worldwide taxation, but at least companies have deferral, which creates de facto territoriality for firms that manage their affairs astutely.

Such a shame that the GOP isn’t capable of simply doing the right thing.

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Why do many people engage in civil disobedience and decide not to comply with tax laws?

Our leftist friends (the ones who think that they’re compassionate because they want to spend other people’s money) assert that those who don’t obey the revenue demands of government are greedy tax evaders who don’t care about society.

And these leftists support more power and more money for the Internal Revenue Service in hopes of forcing higher levels of compliance.

Will this approach work? Are they right that governments should be more aggressive to obtain more obedience?

To answer questions of how to best deal with tax evasion, we should keep in mind three broad issues about the enforcement of any type of law:

1. Presumably there should be some sort of cost-benefit analysis. We don’t assign every person a cop, after all, even though that presumably would reduce crime. Simply stated, it wouldn’t be worth the cost.

2. We also understand that crime reduction isn’t the only thing that matters. We grant people basic constitutional rights, for instance, even though that frequently makes is more difficult to get convictions.

3. And what if laws are unjust, even to the point of leading citizens to engage in jury nullification? Does our legal system lose moral legitimacy when it is more lenient to those convicted of child pornography than it is to folks guilty of forgetting to file paperwork?

Now let’s consider specific tax-related issues.

I’ve written before that “tough on crime” is the right approach, but only if laws are legitimate. And that leads to a very interesting set of questions.

4. Is it appropriate to track down every penny, even if it results in absurdities such as the German government spending 800,000 euros to track down 25,000 euros of unpaid taxes on coffee beans ordered online?

5. Or what about the draconian FATCA law imposed by the United States government, which is only projected to raise $870 million per year, but will impose several times as much cost on taxpayers, drive investment out of American, and also causing significant anti-US resentment around the world?

6. And is there perhaps a good way of encouraging compliance?

The purpose of today’s (lengthy) column is to answer the final question.

More specifically, the right way to reduce tax evasion is to have a reasonable and non-punitive tax code that finances a modest-sized, non-corrupt government. This make tax compliance more likely and more just.

Here’s some of what I wrote back in 2012.

I don’t blame people from France for evading confiscatory taxation. I don’t blame people in corrupt nations such as Mexico for evading taxation. I don’t blame people in dictatorial nations such as Venezuela for evading taxation. But I would criticize people in Singapore,Switzerland, Hong Kong, or Estonia for dodging their tax liabilities. They are fortunate to live in nations with reasonable tax rates, low levels of corruption, and good rule of law.

Let’s elaborate on this issue.

And we’ll start by citing the world’s leading expert, Friedrich Schneider, who made these important points about low tax rates in an article for the International Monetary Fund.

…the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments… Several studies have found strong evidence that the tax regime influences the shadow economy. …In the United States, analysis shows that as the marginal federal personal income tax rate increases by one percentage point, other things being equal, the shadow economy grows by 1.4 percentage points.

With this bit of background, let’s look at the magnitude of non-compliance.

The Wall Street Journal reports on the history of dodging greedy governments.

Tax evasion has been around since ancient Mesopotamia, when the Sumerians were cheerfully working the black market. …The Romans were the most efficient tax collectors of all. Unfortunately Emperor Nero (ruling from A.D. 54 to 68) abandoned the high growth, low-tax policies of his predecessors. In their place he created a downward spiral of inflationary measures coupled with excessive taxation. By the third century, widespread tax evasion forced economically stressed Rome to practice expropriation. …Six hundred years later, during the Heian period (794-1185), Japan’s aristocracy acted in a similar manner and with similar consequences. …China’s Qing Dynasty (1644-1912) waged a harsh war against the tax-dodging gentry.

These same fights between governments and taxpayers exist today.

In a column published by the New York Times, we got some first-hand knowledge of the extraordinary steps people take to protect themselves from taxation in China.

In China, businesses have to give out invoices called fapiao to ensure that taxes are being paid. But the fapiao — the very mechanism intended to keep businesses honest — is sometimes the key to cheating on taxes. …My company would disguise my salary as a series of expenses, which would also save me from paying personal income tax. But to show proof of expenses, the accountant needed fapiao. It was my responsibility to collect the invoices. …But evading taxes in China was harder than I expected because everyone else was trying to evade taxes, too. …Though businesses are obligated to give out fapiao, many do not unless customers pester them. They are trying to minimize the paper trail so they too can avoid paying taxes on their true income. …some people are driven to buy fake invoices. It’s not hard; scalpers will sell them on the street, and companies that specialize in printing fake fapiao proliferate.

The author had mixed feelings about the experience.

I couldn’t figure out whether what I was doing was right or wrong. By demanding a fapiao, I was forcing some businesses to pay taxes they would otherwise evade. But all of this was in the service of helping my own company evade taxes. In this strange tale, I was both hero and villain. To me, tax evasion seemed intractable. Like a blown-up balloon, if you push in one part, another swells.

Meanwhile, Leonid Bershidsky, writing for Bloomberg, reviews what people do to escape the grasping hand of government in Greece.

In gross domestic product terms, Greece has the second biggest shadow economy among European Union countries without a Communist past…unreported revenue accounts for 23.3 percent of GDP, or $55.3 billion. …Had it been subject to taxes — at the prevailing 40 percent rate — the shadow economy would have contributed $22 billion to the government’s coffers.

Bershidsky cites some new academic research.

…researchers used loan application data from a big Greek bank. …The bank…regards the reported income figure as a fiction, as do many other banks in eastern and southern Europe. As a result, it uses estimates of “soft” — untaxed — income for its risk-scoring model. Artavanis, Tsoutsoura and Morse recreated these estimates and concluded that the true income of self-employed workers in Greece is 75 percent to 84 percent higher than the reported one.

Greek politician have tried to get more money from the shadow economy but haven’t been very successful.

Even the leftist government of former Prime Minister Alexis Tsipras, which came up with unworkable schemes to crack down on tax evasion — from using housewives and tourists to inform on small businesses to a levy on cash withdrawals — failed.

Bershidsky notes that some have called for indirect forms of taxation that are harder to evade.

The researchers suggest the government should sell occupation licenses through the powerful professional associations: a harsh but effective way to collect more money.

Though his conclusion rubs me the wrong way.

The shadow economy — and particularly the contributions of professionals — is an enormous potential resource for governments.

At the risk of editorializing, I would say that the untaxed money is “money politicians would like to use to buy votes” rather than calling it “an enormous potential resource.” Which is a point Bershidsky should understand since he wrote back in 2014 that European governments have spent themselves into a fiscal ditch.

Now let’s shift to the academic world. What do scholars have to say about tax compliance?

Two economists from the University of Rome have authored a study examining the role of fiscal policy on the underground economy and economic performance. They start by observing that ever-higher taxes are crippling economic performance in Europe.

…most European economies have been experiencing feeble growth and increasing levels of public debt. Compliance with the Stability and Growth Pact, and in particular with the primary deficit clause, has required many governments to raise taxes to exceptional high levels, thus hindering business venture and economic recovery.

And those high tax burdens don’t collect nearly as much money as politicians want because taxpayers have greater incentives to dodge the tax collectors.

…between a country’s tax system and the size of its shadow economy is a two-way relationship. …there exists a positive relationship between the dimension of the tax burden on economic activity and the size of the informal economy. …various tax reform scenarios, recently advocated in economic and policy circles as a means to promote growth, such as…ex-ante budget-neutral tax shifts involving reductions of distortionary taxes on labor and business compensated by an increase in the consumption tax or counterbalanced by decreases of government spending. We will see that all these fiscal reforms give rise to a resource reallocation effect from underground to official production or vice versa and have rather different implications in terms of output, fiscal solvency and welfare.

The authors look at the Italian evidence and find that lower tax rates would create a win-win situation.

Our main results can be summarized as follows. …the dimension of the underground sector is substantially decreased by fiscal interventions envisaging sizeable labor tax wedge reductions. Finally, all the considered tax reforms have positive effects on the fiscal consolidation process due to a combination of larger tax revenues and positive output growth. …consider the case in which the decrease of the business tax is met by a public spending cut…an expansionary effect on output, consumption and investments, and, despite the overall reduction of tax revenues, the public-debt-to-output ratio falls. However, we notice that the expansionary effects are…magnified on consumption and investments. In this model, in fact, public spending is a pure waste that crowds out the private component of aggregate demand, therefore it comes as no surprise that a tax cut on business, counterbalanced by a public spending reduction, is highly beneficial for both consumption and investments. …the underground sector shrinks.

The benefits of lower tax rates are especially significant if paired with reductions in the burden of government spending.

When the reduction of the business tax, personal income tax, and employers’ SSC tax rates are financed through a cut in public spending…we observe positive welfare effects… The main difference…is that consumption is significantly higher…due to the fact that this reform leaves the consumption tax unchanged, while public spending is a pure waste that crowds out private consumption. …all the policy changes that lower the labor tax wedge permanently reduce the dimension of the underground sector. Finally, all the considered tax reforms positively contribute to the fiscal consolidation process.

Let’s now look at some fascinating research produced by some other Italian economists.

They look at factors that lead to higher or lower levels of compliance.

…a high quality of the services provided by the State, and a fair treatment of taxpayers increase tax morale. More generally, a high level of trust in legal and political institutions has a positive effect on tax morale. …two further institutional characteristics that are likely to negatively affect an individual’s tax morale: corruption and complexity of the tax system.

By the way, “tax morale” is a rough measure of whether taxpayers willingly obey based on their perceptions of factors such as tax fairness and waste and corruption in government.

And that measure of morale naturally varies across countries.

…we examine how people from different countries react to varying tax rates and levels of efficiency. …We focus our analysis on three countries: Italy, Sweden and UK. …these three countries show differences concerning the two institutional characteristics we are focused on. Italy and Sweden show a high tax burden while UK shows a low one. Whereas, Sweden and UK can be considered efficient states, Italy is not.

By the way, I don’t particularly consider the United Kingdom to be a low-tax jurisdiction. And I don’t think it’s very efficient, especially if you examine the government-run healthcare system.

But everything is relative, I guess, and the U.K. is probably efficient compared to Italy.

Anyhow, here are the results of the study.

Experimental subjects react to institution incentives, no matter the country. More specifically, tax compliance increases as efficiency increases and decreases as the tax rate increases. However, although people’s reaction to changes in efficiency is homogeneous across countries, subjects from different countries react with a different degree to an increase in the tax rate. In particular, participants who live in Italy or Sweden – countries where the tax burden is usually high – react more strongly to an increase in the tax rate than our British subjects. At the same time, subjects in Sweden – where the efficiency of the public service is high – react less to tax rate increases than Italian subjects.

So low tax rates matter, but competent and frugal government also is part of the story.

In all 3 countries, higher tax rates imply lower compliance. This is in line with experimental evidence: as Alm (2012, p. 66) affirms: “most (but not all) experimental studies have found that a higher tax rate leads to less compliance” and “The presence of a public good financed by voluntary tax payments has been found to increase subject tax compliance”. …The stronger negative reaction of Italian subjects to an increase in the tax rate may be due to the fact that in everyday life they suffer from high tax rates combined with inefficiency and corruption. …In fact, in the final questionnaire, 67.5% of Italian participants state that people would be more likely to pay taxes if the government were more efficient (vs 34.4% and 30.3% in UK and Sweden respectively) and 54.6% would comply with their fiscal obligations if they had some control over how tax money were spent (vs 30.8% and 25.8% in UK and Sweden respectively)… No way to impose a high tax burden on citizens if the tax revenue is wasted through inefficiency and corruption.

Here’s one additional academic study from Columbia University. The author recognizes the role of tax rates in discouraging compliance, but focuses on the impact of tax complexity.

Here’s what he wrote about the underlying theory of tax compliance.

The basic theoretical framework for tax evasion was derived…from the Becker model of crime. This approach views tax evasion as a gamble. …when tax evasion is successful, the taxpayer gains by not paying taxes. In other cases, tax evasion is uncovered by tax authorities, and the taxpayer has to pay taxes due and fines. The taxpayer compares the expected gain to the expected loss. …This approach highlights a number of factors that determine whether and to what extent taxes are evaded. These are: the magnitude of potential savings (which, on the margin, is simply equal to the tax rate)… This model therefore highlights…natural policy parameters that can affect evasion. …the marginal gains from tax evasion could be reduced by imposing lower marginal tax rates.

Interestingly, he doesn’t see much difference between (illegal) evasion and (legal) avoidance.

The ideal compliance policy should target both tax avoidance and tax evasion. While there is a legal distinction between the two, from the economic point of view the difference is less explicit. Both types of activity involve a loss of revenue and both involve a loss of economic welfare.

He then brings tax complexity into the equation.

…the appropriate extent of tax enforcement critically depends on the underlying tax structure. In particular, the role of complexity in the tax system as a factor influencing the size of the tax gap, as well as legal but undesirable tax avoidance, are highlighted. Two principal implications of tax complexity are stressed here. First, complexity permits additional ways to shield income from tax and, consequently, complexity increases the overall cost of taxation. … Reasonable simplification can more adequately combat tax evasion and avoidance than traditional enforcement measures.

Here are some of his findings.

Tax avoidance is a function of ambiguity in the tax system. …Administrative investment in enforcement becomes more important when the tax system is more distortionary. One way to reduce the need for costly tax enforcement is to reduce distortions. … Higher complexity induces tax avoidance and other types of substitution responses. A tax system that allows for many different types of avoidance responses is likely to cause stronger behavioral effects and therefore higher excess burden. …Shutting down extra margins of response can be loosely summarized as expanding the tax base by eliminating preferential treatment of some types of income, deductions, and exemptions. …One of the consequences of complexity is that it makes it difficult for honest taxpayers to fulfill their obligations. …The bottom line is that complexity makes relying on penalties a much less appealing approach to enforcement. …From the complexity point of view, itemized deductions add a multitude of tax avoidance and evasion opportunities. …They stimulate avoidance by introducing extra margins with differential tax treatment.

Sounds to me like an argument for a flat tax.

Incidentally (and importantly), he acknowledges that greater enforcement may not be a wise option if the underlying tax law (such as the code’s harsh bias against income that is saved and invested) is overly destructive.

…tax avoidance—letting well enough alone—may be a simple and practical way of addressing shortcomings of an inefficient tax structure. For example, suppose that, as much of the optimal taxation literature suggests, capital incomes should not be taxed, or should only be taxed lightly. In that case, the best policy response would be cutting tax rates imposed on capital income. If it is not politically feasible to pursue such policies explicitly, a similar outcome can be accomplished by reducing enforcement or increasing avoidance opportunities in this area. …The preferred way of dealing with compliance problems is fixing the tax code.

Amen. Many types of tax evasion only exist because the politicians in Washington have saddled us with bad tax policy.

And when tax policy moves in the right direction, compliance improves. Consider what happened in the 1980s when Reagan’s reforms lowered the top tax rate from 70 percent to 28 percent. Rich people paid five times as much to the IRS, in large part because they declared 10 times as much income.

But it’s very unlikely that they actually earned 10 times as much income. Some non-trivial portion of that gain was because of less evasion and less avoidance.

Simply stated, it makes sense to comply with the tax system when rates are low.

Let’s close by addressing one of the ways that leftists want to improve compliance. They want to destroy financial privacy and give governments near-unlimited ability to collect and share financial information about taxpayers, all for the purpose of supposedly bolstering tax compliance.

This agenda, if ultimately successful, will cripple tax competition as a liberalizing force in the global economy.

This would be very unfortunate. Tax rates have fallen in recent decades, for instance, largely because governments have felt pressure to compete for jobs and investment.

That has led to tax systems that are less punitive. And politicians really can’t complain about being pressured to lower tax rates since these reforms generally led to more growth, which generated significant revenue feedback. In other words, the Laffer Curve works.

There’s even some evidence that tax competition leads to less government spending.

But these are bad things from a statist perspective.

This helps to explain why politicians from high-tax governments want to eviscerate tax competition and create some sort of global tax cartel. An “OPEC for politicians” would give them more leeway to impose class-warfare tax policy and buy votes.

The rhetoric they’ll use will be about reducing tax evasion. The real goal will be bigger government.

I’m not joking. Left-wing international bureaucracies such as the Organization for Economic Cooperation and Development have justified their anti-tax competition efforts by asserting that jurisdictional rivalry “may hamper the application of progressive tax rates and the achievement of redistributive goals.”

I suppose we should give them credit for being honest about their ideological agenda. But for those who want good tax policy (and who also understand why that’s the right way to boost tax compliance), it’s particularly galling that the OECD is being financed with American tax dollars to push in the other direction.

P.S. I don’t know if you’ll want to laugh or cry, but here are some very odd examples of tax enforcement.

P.P.S. Here’s more evidence that high tax rates and tax complexity facilitate corruption.

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What’s the difference between Bernie Sanders and Hillary Clinton?

I suspect that most people would cite differences in personal ethics, but I’m a policy wonk so I actually think the leading candidates for the Democratic presidential nomination are two peas in a pod.

The only real difference is that Sanders is more open about his statist beliefs and is more anxious to adopt bad policies as quickly as possible.

But since I don’t want to become Greece, I have a hard time being impressed by politicians who bicker about the best route and best speed to get to the wrong destination.

Consider, for example, their views on corporate taxation. And let’s look specifically at the issue of how to deal with corporate inversions.

First, some background. The Wall Street Journal opines about the logical argument – and fiduciary obligation – for companies to escape America’s awful corporate tax system.

A major U.S. company merges with a foreign firm in part to avoid America’s punishing corporate tax code, and the politicians who refuse to reform the code denounce the company for trying to stay competitive. …Sigh. …Let’s try to explain one more time why it makes perfect business—and moral—sense… The U.S. federal corporate income tax rate is 35%. The Irish rate is 12.5%. …A CEO obliged to act in the best interests of shareholders cannot ignore this competitive reality.

All this makes great sense, and I’ve made similar arguments.

But what do Sanders and Clinton think? Well, the editorial skewers the two leading Democratic candidates for their vacuous demagoguery.

…none of this business logic impresses Hillary Clinton or Bernie Sanders, who helped to write the U.S. tax code as Senators but are now competing as presidential candidates to see who can demagogue more ferociously against American employers.Neither one wants to reform the tax code to make U.S. tax rates more competitive with the rest of the world. Instead they want to raise the costs of doing business even further. Mrs. Clinton’s solution is to raise taxes on investors with higher capital-gains taxes, block inversion deals, and apply an “exit tax” to businesses that manage to escape. Mr. Sanders would go further and perform an immediate $620 billion cashectomy on U.S. companies. The Vermonter would tax the money U.S. firms have earned overseas, even though that income has already been taxed in foreign jurisdictions.

Call me crazy, but I don’t think the ideas being peddled by Clinton and Sanders will lead to more and better jobs in the United States.

Which is why, when given the chance to  write about this topic for Fortune, I suggested that it would be best to actually fix the tax code rather than blaming the victim.

Some U.S. politicians respond to these mergers with demagoguery about “economic treason,” but that’s silly. These corporate unions are basically the business version of a couple in a long-distance relationship that decides to live where the economic outlook is brighter after getting married. So instead of blaming the victims, the folks in Washington should do what’s right for the country by trying to deal with the warts that make America’s tax system so unappealing for multinational firms.

And what are those warts?

The same ones any sensible person would identify. First, America’s corporate tax rate is absurdly anti-competitive.

With a 35% levy from Washington, augmented by smaller state corporate taxes, the combined burden is more than 39%. In Europe, by contrast, the average corporate tax rate has now dropped below 24%. And the average corporate rate for Asia’s major economies is even lower.

Second, we have a peculiarly self-destructive practice of wanting to tax income earned in other countries.

…the IRS also imposes tax on income earned in other nations. Very few nations impose a system of “worldwide taxation,” mostly for the simple reason that the income already is subject to tax in the nations where it is earned.

So here’s the bottom line.

The combination of a high rate and worldwide taxation is like a one-two punch against the competitiveness of U.S.-domiciled firms, so it’s easy to understand why inversions are so attractive. They’re a very simple step to protect the interests of workers, consumers and shareholders. …Let’s hope politicians put aside class warfare and anti-business demagoguery and fix the tax system before it’s too late.

By the way, even a columnist for the New York Times agrees with me. He has a piece on the inversion issue that is not very favorable to companies, and it certainly reads like he’s in favor of governments having more money, but he can’t help but come to the right conclusion.

Ultimately, the only way inversions will stop is when the corporate tax code changes so it becomes more attractive for American companies to be American companies.

And I can’t resist closing with a great blurb from George Will’s most recent column.

Having already paid taxes on it where it was earned, the corporations sensibly resist having it taxed again by the United States’ corporate tax, the highest in the industrial world.


Will succinctly brings together the two most important things to understand about this issue. First, the income earned by American companies in other nations already is subject to tax, and, second, companies understandably don’t want it taxed again by the world’s highest corporate tax rate.

P.S. I’ve made the serious point that Sanders isn’t really a socialist, at least based on his voting record and what he proposes today. Instead, he’s just a conventional statist with mainstream (among leftists) views about redistribution.

Yet because he calls himself a socialist, that leads to amusing moments when other Democrats are asked to identify how he’s different. I’ve already mocked Debbie Wasserman Schultz for her inability to answer that question.

Now let’s see Hillary Clinton dance and dodge. The parts worth watching are all in the first half of the video.

Too bad Chris Matthews didn’t actually press her to answer the question. Though I’m vaguely impressed that she actually knows there are such a thing as libertarians.

P.P.S. While Hillary is clueless, there’s another Clinton that actually has some semi-sensible views about corporate taxation.

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