© Springer International Publishing Switzerland 2015Helmut P. Gaisbauer, Gottfried Schweiger and Clemens Sedmak (eds.)Philosophical Explorations of Justice and TaxationIus Gentium: Comparative Perspectives on Law and Justice4010.1007/978-3-319-13458-1_6
6. The Challenge of Tax Avoidance for Social Justice in Taxation
Facutly of Law, University of Toronto, 84 Queen’s Park, M5S 2C5 Toronto, ON, Canada
The Occupy Wall Street (OWS) movement has been criticized for not having a tax policy agenda. Critics contend that it has “no message,” “no goals,” and “no leaders.” This contribution accounts for this policy agenda deficit. Various tax policy prescriptions that address social resource inequality, including a wealth tax proposed by Pikkety and Goldhammer (Capital in the twenty-first century, 2014), suffer from serious weaknesses. More specifically, I explain why the most salient of the income tax policy ideas (increasing rates) is not, on its own, a solution. To see why, consider the US. The US has high corporate income tax rates; nevertheless, large American corporations such as Apple, GE, Starbucks and Google have been able to reduce their effective corporate income tax rate liability below statutory rates, often close to zero. The crux of the problem is that increasing income tax rates leaves those confronting such rates with greater incentive to engage in various activities in order to avoid those taxes. It also increases the return from lobbying for tax changes that make avoiding that burden more possible. Therefore, increasing income tax rates is not the clear-cut effective policy prescription one might think it should be. The example of the Bush tax cuts for individuals, and certain kinds of capital income, illustrates that cutting income tax rates is also not the right approach. In many countries, claims that cutting taxes will increase tax revenues (i.e., that we “are on the wrong side of the Laffer curve”) are incorrect. Thus, if income tax rates are increased, it is not necessarily the wealthiest that will bear the greatest burden, and if tax rates are cut, it is not certain—or even particularly likely—that it will be the least well off who will benefit. OWS ought therefore not to be criticized for not articulating a message with respect to income tax policy. Recent developments show that popular political pressure on leaders has led the G20 to the right—albeit difficult—track. The best income tax reform is one of base broadening and increasing international tax cooperation, perhaps coupled with making a transition from reliance on income tax to a greater reliance on coordinated wealth taxes. Responding intelligently to demands for a more progressive tax system that promotes the realization of social justice will require us to confront difficult practical and political challenges. These tax policies are available only if the political will can be found to sustain their introduction and implementation.
The Occupy Wall Street (OWS) movement seized headlines in September 2011 with the occupation of Liberty Square in Manhattan by hundreds of protestors. At the time, mainstream media featured interviews with OWS participants, many of whom aired different sets of grievances. External commentators were critical of the protest, not least because it was unclear what was being protested about and because there was no clarity as to what, moreover, would constitute success. One could plausibly put all this down to the difficulty of finding a sound bite that neatly captured the protest’s origins and its goals. However, there may be an underlying reason why the impetus for the OWS movement could not adequately be expressed in sound bite form. In this contribution, I focus on the social justice dimension of tax policy in positive terms and provide an account of the challenges faced by the OWS movement in articulating tax policy goals. More specifically, I identify and describe a form of screening or second-degree price discrimination that is at the core of domestic and international income tax systems, and argue that this mechanism complicates measures that would seemingly address the economic inequalities that motivate the OWS movement. A similar mechanism would also impair the effectiveness of a wealth tax along the lines now suggested by Piketty and Goldhammer (2014), though less seriously.
What is it that provides fuel for the OWS movement in the tax policy context? One view is that it is a sense that the wealthiest are not paying their fair share of taxes. The feeling is linked to the perception that wealthy individuals and large corporations often have the motive and opportunity to influence the design of tax rules so as to minimize their tax burdens and, where the rules are ambiguous, engage in tax planning that ranges from run-of-the-mill compliance to aggressive tax avoidance (not to mention evasion). The irritation exhibited by the OWS movement with this perceived rigging of the tax law is understandable given that many of the most effective anti-avoidance tools, such as retroactive specific anti-avoidance rules, lie unused much of the time. Even when governments use such tools, they are usually deployed with a significant time lag after new tax avoidance strategies have come to light. Moreover, most of the time, tax law changes are effective only prospectively. This allows tax avoiders to retain their transitory tax savings. Thus, the popular discontent with tax avoidance evidenced by the OWS movement is in tension with governments choosing to countenance ongoing and significant forgone tax revenues. Some in the OWS movement resolve this tension by assuming that there are imbalances in the social, political and economic structure. Indeed, one gets the sense that some OWS protestors believe in something that amounts to an elite conspiracy. In my view, these suspicions are too extreme to be credible. I argue in this contribution that, although there is no elite conspiracy, there is an identifiable socio-political-economic dynamic that accounts for the perceived unfairness motivating the OWS movement. Unfortunately, responsibility for this dynamic is diffuse. No one party in particular is to blame, and the appropriate policy responses will be difficult to coordinate and sustain. The contribution here is to argue that once we correctly diagnose the underlying conditions, it will be possible to have a clearer view of how best to address the resulting consequences in a socially just and desirable way.
Two recent developments addressing tax avoidance are on the right track. The first is a report from the OECD (2013a) entitled “Addressing Base Erosion and Profit Shifting” (BEPS). The report advocates collective action by all OECD member governments to create similar, if not uniform tax rules to prevent corporations from shifting profits from higher tax to lower tax jurisdictions. The second recent development is the coordinated announcement on July 19, 2013 by the finance ministers of the G20 of an “action plan on BEPS” that essentially adopts the OECD’s recommendation of a fundamental rethink of international tax rules. While the report focuses primarily on profit shifting, a number of the corrective measures proposed could be extended to other forms of tax avoidance. The action plan (OECD 2013b) includes 15 different areas where tax rules need to be improved in order to mitigate tax avoidance and contemplates concerted action in these areas within 24 months. How likely is serious reform?
It is predictable that governments will tolerate tax avoidance until it becomes sufficiently visible to motivate political opposition or sufficiently widespread so as to significantly reduce tax revenues. If the BEPS action plan does yield tangible change—as seems possible—it will be a sign that the pendulum has swung too far in favour of tax avoidance. However, if the action plan does not yield aggressive anti-tax avoidance in an internationally coordinated way, it is likely that two accounts will be offered to justify its failure: justice and political economy. The first of these accounts, justice, invokes the rule of law to make the case that many of the most effective anti-avoidance strategies, such as retroactive legislation, are inherently antithetical to the principles and aspirations of modern legal systems and are, for that reason, off the table (except perhaps in the most exigent circumstances). The second account takes seriously the political economy hurdles militating against vigilance in enforcing tax laws. It may, for example, be extremely difficult to tackle aggressive tax avoidance because of the political clout of the economic interests favoured by inaction, or the practical difficultly of mobilizing tax authorities to revisit earlier tax assessments.
In what follows, the prospect for effective responses to concerns surrounding inequality is assessed against the backdrop of the political and economic realities of taxation. The result is an outline of the challenges for social justice in taxation. Part II provides a review of the literature on anti-avoidance. Part III elaborates on the rule of law and political economy accounts that provide an explanatory basis for anti-avoidance activity on the part of governments. Part IV describes the mechanism by which domestic and international income tax systems at their core depend (perhaps unintentionally) on screening and second-degree price discrimination, and explores the implications of this insight for the BEPS action plan, tax policy and administration more generally and, ultimately, for social justice in taxation. Part V concludes.
6.2 Literature Review
The legal and economic literatures discuss how tax avoidance strategies are identified by taxpayers, why they are tolerated, and how governments ought to respond to them. In a recent contribution, Leo Katz (2010) argues that the tax system embodies the result of multi-dimensional decision-making where the government decides what to tax based on a number of different underlying legal and economic criteria, each of which is susceptible to some degree of manipulation by taxpayers. The key idea is that some of the criteria made legally relevant for assessing tax liability by the government are substantially irrelevant from the point of view of the potential taxpayer. As a result, the taxpayer can structure her affairs by adjusting the criteria that are most relied on by the government in assessing tax liability, but least harmful to her economic or personal objectives in the light of the reduction in tax liability that these adjustments will occasion. Katz’s argument can be shown in a simple example. Suppose the government decides that dividend income from equity should be taxed, but interest payments on debt should not be. Assume that the criterion that this decision is based on is some non-tax benefit associated with the equity. An avoidance strategy forms as soon as there is a person who is indifferent to the benefit of the equity, as that person will simply choose the tax-free debt. This can be seen as a form of agenda manipulation because the inclusion of the irrelevant criteria leads the person to choose the non-tax route, i.e. the avoidance strategy.
In discussing the economic impact of government responses to various kinds of tax avoidance strategies, David Weisbach (2002, p. 90) explains that anti-avoidance is simply a form of expanding the tax base. The consequences of tax avoidance can be viewed as false negatives—those who should be paying tax are not. In his view (99), the goal of anti-avoidance doctrines is to reduce the ability of taxpayers to substitute into non-taxed activities, thereby forcing them into compliance—making their actions true positives rather than false negatives. However, in many cases, anti-avoidance rules may shift taxpayers into less efficient tax avoidance schemes rather than into compliance; that is, instead of becoming true positives, taxpayers may simply go to even greater lengths to remain false negatives. This results in a loss of utility for the taxpayer with no offsetting benefit for the government. The logical response to this would be to increase the scope of the anti-avoidance doctrine to preclude the new form of avoidance. However, Weisbach (116) warns that this could then make the anti-avoidance rule too inclusive, and accidentally penalize people who are engaging in legitimate business transactions through the generation of an inefficient rate of false positives. Furthermore, the cost of creating and enforcing anti-avoidance doctrines is often high. In essence, Weisbach’s argument is that due to uncertain taxpayer responses, it is often unclear whether the benefits of an anti-avoidance measure will outweigh its costs of enforcement.
Leigh Osofsky (2013, p. 1058) raises a similar argument to Weisbach regarding the structure of avoidance rules. She notes that, ideally, avoidance rules should create frictions that make it more costly for tax avoiders to avoid taxes, which forces them to comply. However, poorly constructed avoidance regimes might also lead to a deadweight loss for non-planners, or result in the planners finding a more costly method of avoidance. Thus, the existing literature suggests that there are some circumstances in which full enforcement of tax laws is not desirable.
The account that I develop here shows that the problems of full enforcement are linked to a form of screening mechanism that is similar to second-degree price discrimination. A number of contributions by Alex Raskolnikov implicitly recognize aspects of this kind of screening function. Raskolnikov (2009, p. 695) suggests that there are two kinds of taxpayers: gamers, and non-gamers. Gamers are the neo-classically “rational” taxpayers, who avoid taxes as long as the cost of avoidance is less than the cost of compliance. Non-gamers generally comply with taxation, even if it can be avoided at a cost less than paying tax. Raskolnikov (691) argues that the American tax system adopts a one size fits all approach to tax law enforcement, resulting in the inefficient treatment of both gamers and non-gamers. In its place, Raskolnikov suggests a system that causes taxpayers to self-select in an incentive-compatible way into a particular enforcement regime, with the result that gamers and non-gamers self-identify. The government would then offer two parallel systems, one that is best for gamers, and one that is best for compliers. Take for example a simplified version of Raskolnikov’s regime. The government would offer a system similar to the current deterrence approach, as well as an alternative filing option with lower penalties. The low-penalty option would presume that the government is correct in the event of a tax dispute. Those who comply do not mind this presumption since they do not expect a dispute, and therefore elect to take advantage of the lower penalties. Gamers, on the other hand, expect a dispute to be more likely, and do not choose the alternative option. Thus, as a consequence of this self-selection, the government would be able to introduce tailored and efficient enforcement policies for each taxpayer type.
Raskolnikov (2006, p. 590) also argues that current deterrence regimes are ineffective because the available penalties do not vary with probability of detection. As such, the expected penalty of avoidance methods that are difficult to detect is quite low, since the magnitude of the penalty is no larger than most other avoidance methods. These flaws make enforcement strategies less effective at catching or deterring tax avoiders. Extending Raskolnikov’s work perhaps explains some of the tolerance towards tax avoidance, as the ineffectiveness of anti-avoidance rules could be a reason why they are not used more often. Raskolnikov’s assumption that taxpayers exhibit differing levels of responsiveness to tax liability has empirical support. Empirical work has found that effective tax liability does track the morale of taxpayers with respect to taxation. For example, Doerrenberg et al. (2012, p. 1) found that governments are likely to tax citizens based on levels of “tax morale” (a taxpayer’s “intrinsic motivation to honestly pay taxes”). They also suggest that tax morale is a suitable proxy for proclivity for tax avoidance. The result of these two ideas is that governments are likely to tax those who are least likely to take measures to avoid taxation at the highest rates—an implicit recognition of the screening function at the core of domestic and international income tax systems.
This finding is also consistent with theoretical work done by Hettich and Winer (1999, p. 46) who present a model of a democratic government with a governing party that wishes only to be re-elected. Voters have different valuations of government services, which lead them to support the government, and different reactions to taxes, which make them likely to oppose the government. The optimal solution makes the “marginal political cost”—which is understood as the reduction in expected votes of raising an additional dollar in revenue—the same for all taxpayers. As a result, under this system, the financing of beneficial government services will largely be borne by those taxpayers whose political preferences are the least likely to be affected by increases in their tax burden. This maximizes the probability of the government being re-elected. While this model does not explicitly discuss tax avoidance, it can easily be extended to do so. The model assumes that the government has perfect information and can tax individuals at their exact marginal political cost. However, information asymmetries exist in the real world. Tolerating tax avoidance is therefore one way that a government could encourage taxation at a level close to the marginal political cost for each taxpayer, as the more tax averse will end up with lower taxes. Under the extension of this model, the government can be seen to tolerate tax avoidance in the government’s own self-interest.