International Tax Avoidance: Clever or Immoral?
Updated: Feb 9, 2019
Multi-national corporations and the super rich avoid taxes. But are they really doing anything wrong?
During one of the presidential campaign debates of 2016, Donald Trump laughed off claims that he avoided paying taxes, "that makes me smart," he quipped. The US president is certainly not alone in using current law to reduce or eliminate his tax bill. Leaks of confidential information, such as the Panama Papers and LuxLeaks, have highlighted the international networks in place that offer the super rich, politicians, and multi-national corporations opportunities to avoid paying tax at home. Are all these people and corporations evil or is the system fundamentally flawed? Let's take a look at the laws in place.
The International Tax Regime
The fact is that the most commonly used methods for skipping out on tax bills are perfectly legal, enshrined in domestic law and the international order.
To best understand the way that international tax avoidance works, let's look at a theoretical example. I don't want to get in trouble, so let's call this imaginary company "Glamazon," which is an international drag supply corporation, providing wigs, makeup and oversized heels to all your favorite drag superstars. But I digress. Glamazon sells products in the European Union and the United States and as a result has subsidiaries in each of the countries where it operates, as is required. Glamazon global headquarters are in the Cayman Islands where the corporate income tax rate is 0%. Let's say that a transaction of a US$100 in Lichtenstein yields US$40 in profit for Glamazon corporate, where it could be taxed at a rate of 12.5%. This means they should owe US$5 in income tax to the government. But this will not happen. Glamazon Liechtenstein will claim to local tax authorities that it has to pay Glamazon Ireland for use of technology (shopping carts, search algorithms, etc.) that facilitated the online wig sale. That amount will "magically" be equal to their taxable income, and thus the sale and costs of doing business cancel each other out bringing their tax liability to zero. The trend continues with Glamazon Ireland (or any other subsidiary), until the final corporate profits land in the Cayman Islands where corporate income and profits won't be taxed anyway. In other words, a series of internal payments can be reported to each local tax authority as an expense to be written off their taxable income, reducing it to zero.
This method for tax avoidance uses "transfer pricing," and is just one of many strategies. But all of them are based on the same rules that apply everywhere. A tax bill can be reduced by claiming that taxes are actually being paid somewhere else, even if they're not.
That is because at the heart of international tax law is the conviction that income should only be taxed once. This noble goal has been a cornerstone of tax policy since Adam Smith laid out his golden rules for tax in The Wealth of Nations (1776). For the most part bi-lateral treaties govern the rules for how and where a person's or corporation’s income can be taxable. Cross-border taxation hinges upon the choice between taxing income at the location where it is produced (“source” taxation) or taxing income where dividends are distributed (“residence” taxation). In both of these approaches is a consideration for questions of territory, and personage (legal and physical).
This body of law is based on the standard double taxation treaties or double taxation agreements promoted by the Organization for Economic Cooperation and Development (OECD), a club of mostly rich counties. The OECD and the UN have provided standards for how cross-border taxation should be treated.
Of course there are different types of taxation, some of which forces international companies to pay at least some tax to local authorities; say, sales tax or payroll tax. But at the level of corporate income tax (CIT) superpowers shaping the international order have leaned towards "residence" taxation that allows (or even promotes) tax avoidance.
Tax treaties consistently compel multinational corporations to pay tax to only one authority, generally where dividends are paid out, not where the company is actually doing business.
The Deep Consequences of Avoidance
A United Nations University working paper estimated that tax avoidance costs governments around US$500 billion annually. These losses have wide-ranging consequences for all countries. In rich countries, such as the United States or Great Britain, the losses in tax revenue are often presented in services not rendered. For example, the Tax Justice Network and other organizations point out how many new schools, teachers or health services could be provided with the income from tax avoiders. However, it's at the low-end of the development spectrum where tax avoidance really hurts.
Developing countries where multinational corporations operate become the victims of the aforementioned international tax regime that is stacked against them. So perhaps in my example I should have explained how Glamazon shifts profits from Zimbabwe and Bangladesh, rather than Liechtenstein and Ireland. But the methods are essentially the same. Businesses can use the existing laws and treaties to move profits to be paid out to their shareholders in rich countries, or hide the money for future capital investment in tax havens.
In poorer countries this loss of tax revenue is not about propping up their welfare state, or improving existing schools, policing, etc. The erosion of their tax base through profit shifting can mean the difference between a functioning state and a dysfunctional one. Low tax incomes mean that the administration, police and military all remain inadequate and therefore the state cannot provide the necessary conditions for widespread economic development. In essence, tax avoidance spurs on a nauseating cycle of domestic insecurity, corruption and poverty.
If we would like to see fewer Afghanistans, Libyas and Somalias perhaps we need to rethink how international tax obligations are distributed.
No Criminals Here
No matter how irrational it may be, people will always do what they can to reduce the amount of taxes they pay.
Companies that take full advantage of the countries where they operate then minimize their tax obligations through completely legal methods. They use the roads, water and electric infrastructure, take advantage of a local labor force educated through the public school system, and private property is secured by the local police force. When multinationals avoid tax they are skipping on paying for all those things.
While there will always be cheaters in any system, in this case perhaps the more urgent issue is that there are a number of perfectly legal ways to rip off governments. From the perspective of the collective, it is certainly wrong for corporations and wealthy individuals to act in this way. However, we should not be so naive as to believe that everyone will act in such a way that is most virtuous for the greater good. People and the organizations they direct act on interest. They ask and answer the question, what can I gain from this transaction? And in the tax game it is all about paying as little as possible. At some point we must conclude, sadly, that there are a lot of Donald Trumps in the world, and the only solution is to change the rules.