By Ewen McCann*
There have been no new taxes since GST so patterns of tax enforcement, tax evasion and tax avoidance are fairly settled. A new tax is now required to jolt the economy out of its deeply worn tax groove.
The settled tax system and ingrained tax practices contribute to the maldistribution of income and wealth. Among those tax practices are tax planning arrangements promoted by tax consultants to avoid or evade business income tax. These schemes erode the tax base, promote tax litigation, which is hard for the IRD and the tax payer alike to win, and further skew the distribution of income and wealth.
The IRD attempts to deal with tax planning schemes by closing tax loopholes once they are discovered. Who knows how many loopholes the IRD fails to discover or decides are too hard to close. Some tax planning schemes will be on the IRD’s borderline so they are not attacked and they are left to erode the tax base in perpetuity.
The extant approach to tax loopholes generates additional expensive litigation and additional, more devious, tax avoidance schemes. When a loophole is closed, the tax labyrinth extends, to the satisfaction of tax professionals in the private and public sectors.
This approach of the IRD involves a philosophical mismatch between legal thinking and commercial practice. It applies a legal remedy to a commercial problem. The problem and its remedy do not dovetail. The philosophical misalignment is the reason why tax planners can continue devising their tax schemes and why the IRD is unable to repress their activities.
A different philosophy of taxation is required.
Allow the shady, but tax the gains
The suggestion to be made allows the shady tax avoidance practices to continue but it taxes the pecuniary gains that they generate.
The approach adopts a commercial fix for the commercial problem of tax avoidance/evasion schemes.
The incentive structure of the proposal is such as to encourage the parties to pay the new tax.
Without those incentives tax confederations of companies would continue the avoidance/evasion that exists at present. These incentives ensure that there is no mismatch in the approaches of the parties, the taxpayers and the IRD, to the great tax game. The philosophies of the tax payer and the tax collector are aligned by the proposal.
Tax planning schemes often involve a number of interlinked corporations whose linkages are complex in the extreme. The shares of the members of a tax confederation are hard for outsiders to value. However, the contribution a confederate member makes to the tax savings of the group is the minimum value of its shares.
Pay tax on the value of shares
The proposal is that the shareholders of a confederation member would declare a value of the shares that they own and pay an annual tax on the declared value.
Take the easy case where a member company of the tax confederation is sold. The proposal then is that the buyer takes the selling price of the shares and for each year past subtracts the declared value for that year. The buyer is to pay a tax on each of the positive differences. That is to say any under-declaration, which would be the tax evasion, is taxed.
The effect of this buyer’s tax will be that the buyer reduces the offer price for the shares by the total amount of the buyer’s tax. That way the seller effectively pays the due amount of the tax.
The reduction in the future selling price of the shares is the incentive the owner has to annually declare their market value. Tax auditors would scrutinise owners’ valuations. Companies with low valuations serve little social purpose and would be compulsorily liquidated at little or no social cost. This would strike tax confederations.
Compound interest would be levied upon the buyer, on each year’s tax underpayment.
Capturing commercial benefits
Actually, this interest charge would also fall on the seller by way of a further reduction in the buyer’s offer price. The interest makes good the delay in the government’s receipt of tax revenue. It also captures commercial benefits otherwise accruing to the tax evader who was undervaluing the shares.
The seller has been evading tax by undervaluing the shares in the company member of the tax avoidance scheme. The tax dodging has caught up with the sellers.
The new tax suggested here is applied to businesses though the method applies more generally to wealth and capital gains taxes. An advantage of it is that it applies to hard to value assets.
The new tax philosophy has allowed a dodgy tax planning scheme to continue. A loophole, that perhaps the IRD could not close or perhaps did not know of remains. Instead, the commercial benefits from the exploited loophole or scheme flow into share valuations and so are taxed. A commercial fix has been applied to a commercial problem. The philosophies of tax payer and tax collector match.
Tax planning and litigation are expensive and make no contribution to the common weal. Tax planning schemes are truly unproductive in the social sense. All they do is reallocate profits from the government, as the tax collector, to shareholders and to tax consultants by way of the fees charged for the socially unproductive activity that is called tax planning. Tax planning schemes do not raise the output of a business one iota. They are pure rent seeking.
Tax Notes International has a discussion of the new philosophy of tax, and an application of it, in the April 16, 2018 issue.
Ewen McCann was formerly Head of the Department of Economics, University of Canterbury and latterly Principal Economist at the Inland Revenue Department.