Monday, 8 July 2013

The Best Way To Get More Tax From Corporations Is To Stop Taxing Them

Hot on the agenda in recent times surrounding the World Leaders’ convention has been whether there is a tenable solution Governments can put in place to have global tax regulations that stop companies avoiding tax.  People are asking whether there can be such a thing on a world scale, as such an achievement would be unprecedented in terms of global economics.  As anyone who knows the history of attempted international coalescences would know, this is a very tricky situation to administer - particularly given the vast differences in the countries that would be involved in this kind of globalised tax system.  How on earth could we ever get so many different nations (with frequently changing Governments) to agree on, and proficiently oversee, such a complex system?  And even if we could, is it right to revert to potentially despotic measures to get places like Switzerland, Cyprus, Luxembourg and Ireland to conform, when such tax havens have self-governing national autonomy, and the good economies and high employment as a result of low income tax? Given the relationship between taxpaying and the positive impact on developing countries that need to be lifted out of the mire, I'm happy to assume that these measures are to be supported - so how, then, can such a complex and intractable system be achieved?

A bit of general advice, whenever you want to find the best solution, the first thing to do is identify the problem that needs solving, and make sure that that is the problem you are actually solving. The problem is twofold; firstly, that the whereabouts of a company's profits in a global economy is hard to keep a track of; and secondly, that it is often hard for outside authorities to identify what a company's profits amount to. From what I can gather from every time an MP speaks on this issue, their central focus is on refining the system to scour the market for companies' unpaid taxes and surreptitious distortions of the balance books.  I think this is a misjudged method of tackling the problem - not because it is the wrong thing to do, but because in the first place such an endeavour is probably going to end up being as costly as the tax they'd hope to recover; and in the second place I doubt whether a body of world authorities would have the competence (and synergy of thought) to achieve their aims.  And to add weight to the problem, tax avoiding companies hire economists that can show them how to find loopholes in Governments' tax policies, so these companies are adept at staying one step ahead of the authorities (these economists are often ex-treasury consultants who helped advise on the original policies, and are ideally equipped to understand profits and business practices a lot better than politicians).

So what's the best solution?  My view is, if the problem is to do with how hard it is to keep track of the whereabouts of a company's profits, and how difficult it is to identify what a company's profits amount to, the best thing to do is to ditch corporation tax altogether.  Here's why.  It's a great myth that corporations pay tax. Corporations don't pay tax - only individuals pay tax.  The cost of corporation tax is borne by customers (with increased prices of goods or services), employees (with decreased wages) or shareholders (with lower dividends).  Corporations pay tax only in the sense that the cheque or debit is written in the name of the company. If the cost of taxes ultimately falls on individuals, then it makes sense to have tax policies that are only focused on individuals, and scrap all the payments in the name of corporations.

This to me is an obvious solution to the aforementioned problems, because unlike profits in a global economy, the locations of personal incomes and expenditure are relatively transparent, so the Government might as well focus predominantly on taxing dividend income (shareholders profits), earnings (through income tax) and sales (through consumption tax).  The Government already does this anyway, but to a much less judicious level due to the corporate tax, so it wouldn’t be too hard or too costly to administer.  In actual fact, as far as Government income is concerned, taxing earnings and taxing consumption are more or less interchangeable; you can tax the money as it is being earned or you can tax it as it is being spent.

The obvious question is; if this idea is as good as I’ve made it sound, why don’t the Government follow the model and recover billions of pounds of tax that’s currently being avoided?  I’ll wager that the answer is twofold.  In the first place, such a policy is risky – not because it is a bad policy, but because a lot of the electorate have got the wrong idea about its demerits, which means the Government considers it a potential vote loser.  When you hear the rhetoric of those sceptical about ditching corporation tax, they usually say something along the lines of this;

Wouldn't the danger of scrapping corporation tax be that the companies (shareholders) would simply guard against their losses by increasing prices and lowering wages, meaning that the workers and consumers are getting penalised while the wealthier shareholders are hardly affected because they passed all the tax on to workers and consumers?

What they mean is, if corporation tax is ditched and individuals associated with the companies pay more tax through the extra taxing of income and sales, then that extra expenditure will come from the reduction in staff wages and in increased prices on goods as shareholders won't want the losses to come from their dividends. Here’s what they are missing.  Except where a company enjoys a monopoly (which is rare in this day and age), shareholders of any company cannot decide what prices to charge for their goods or services, nor can they decide their labour rate either. These prices are determined by supply and demand of the goods, services and labour concerned, not by shareholders.  Further, if corporation tax is abolished, salaries and dividends will be higher not lower, and prices will be lower (with consumption being higher).  The Government can automatically recoup what it has lost from corporation tax in extra income tax and sales tax without having to radically change the system. Whether they recoup less, more or the same depends on whether personal income, tax rates and VAT are higher or lower than corporation tax rates, and on the effect of ditching corporate tax on aggregate employment and consumption.

A second reason why the Government may be furtive about this policy is that many low earning consumers may think they are going to be hit hardest.  They have it in their heads that if corporation tax is abolished then individuals associated with the company (primarily customers) are going to pay more to make up for what the Government is now not getting, which means more on consumption tax. They are worried about average earning Joe who ends up paying more for his goods, because relatively speaking average Joe is getting hit harder than richer people on this consumption tax because a few pounds extra on goods prices for him has a greater effect than on the wealthiest who will hardly notice.

Not only do they fail to realise that if the lost tax is transferred to earning and consumption then the rich will get hit hardest (because they earn and consume more), they also fail to realise how switching tax within a corporation to individuals affects the situation.  Let’s use a simple illustration to show what happens.  Suppose the Government gets £1 million from a corporation in corporation tax. If the Government didn’t get it, either someone else would get that £1 million, or several other people would get a share of it. For simplicity, suppose the £1 million would all go to a single shareholder (let’s call him Bob) in dividends. If the Government taxes Bob’s dividend at 45%, then the Government has £450,000, even without changing tax rates. Now the Government can increase taxes on dividends to make up the £550,000 it has lost.  Bob is now no worse off than when there were corporation taxes and lower taxes on dividends, and the Government is no worse off because it still gets its £1 million.  But the world is altogether better off because corporate taxes being more avoidable have higher deadweight costs for the Government than individual income taxes. That is to say, they dampen economic activity and waste resources on unproductive avoidance efforts (usually in the form of accountants).  

The third and final reason why I think the Government won’t ditch corporation tax is a pretty ugly reason, but undoubtedly true, at least to a great degree.  The Government is primarily concerned with how it can buy votes – and many of the people that bear the cost of corporation tax are foreigners who have no power to vote, so they are ideal people on whom to impose a cost.  You can see from the reaction to non-UK citizens using our NHS how pervasive this national prejudice really is.  Once we jump these three Government hurdles, there is no logical reason why we can’t see the abolition of corporation tax. 

I said earlier that taxing income and taxing consumption is pretty interchangeable, so which is preferable as a primary source of Government income?  Well given that higher earners spend proportionally less of their income on consumption, the ratio of tax obligation diminishes as wealth grows, so it is important that higher earners still pay proportionally more tax on their earnings, and low earners are taxed at a much lower rate (in both cases the Government recoups these tax losses when people spend their money on consumption – but this kind of economy is much more mobile and faster growing than a tax system that discourages earning and spending). 

The general rule of thumb with taxation is that when the Government taxes something it results in less of it.  For example, higher tax on savings discourages saving; higher tax on earnings discourages work, and higher tax on consumption discourages spending.  That’s why I favour taxing consumption over earnings, because consumption tax yields higher employment and formation of capital, which increases a nation’s economic growth.  This has a positive corollary effect; if when the Government taxes something it results in less of it, then higher taxes on the things we want less of (or things that we like but know are bad for us) will bring about a reduction of those things.  So I’m all for much higher tax on cigarettes, alcohol, gambling, pollution and use of natural resources that degrade the environment (I draw a distinction here between taxes related to genuine degradation of the environment, which are mostly progressive, and green taxes, which are mostly regressive and unjustified – that’s another future Blog post)

The upshot, though, is it is possible to have a much better tax system that closes the loopholes being exploited in tax avoidance – and this will put an end to the deadweight losses associated with corporation tax, and it will help spread the money to developing countries in which many of these multinational companies make so much of their money. 


* Picture courtesy of tax.donut