19 Apr 2016 16:24 IST

Taming the tax havens

Smart policy alone can rid us of the cancer that is international tax havens

Government’s goal is to maximise tax collections so that it can spend the money on things it deems worthy. These worthy causes, in and of themselves, are not because government policy makers are altruistic saints. On the contrary, politicians have several self interests — such as winning elections and staying in power — which motivate them to forcibly take money from some and give to others.

On the other hand, every citizen’s incentive is to legally limit the taxes that he pays to the government (let’s not consider illegal tax evasion just yet). Even the most altruistic people do not voluntarily contribute their excess earnings to the public treasury. Had this been the case, the world’s governments would never have budget deficits because the rich would simply write up a cheque to address their countries’ debt.

The simple question

This inherent conflict between government and citizens was explained brilliantly on the back of a napkin by Arthur Laffer, an economist during the administration of US President Gerald Ford. The question that was posed to him at a White House meeting was simple and has vexed policy makers for centuries: What, professor, should be the tax rate at which the government maximises tax revenues?

In problems such as these, Laffer said, the endpoints are easy to discern. Clearly, if the tax rate is zero, the government realises no revenue. On the other extreme, if the tax rate is at 100 per cent, the government again realises no revenue because at such a punitive rate, there is no incentive for people to work.

Laffer went on to argue that while the exact shape of the curve joining these two points may be up for debate, it is clear that the line has to start from zero (when tax rates are zero), reach a maximum and then drop down to zero again (when tax rates are 100%).

Panama scandal

Anyone who can provide an answer to this optimum tax-rate problem will surely win the Nobel Prize in Economics, but a good gut answer is to say that the tax rate should never be “too high” — whatever high means.

Which brings us to the Panama tax haven scandal. The BBC reports that information about nearly 214,000 entities worldwide was leaked. These ‘entities’ were dummy companies set up to shield the income of famous people around the world, including actors, politicians and heads of state. Some famous Indians were named in it too.

Each shell company went to extraordinary lengths to hide its income from taxing authorities in home countries for one simple reason: the taxation rates in their countries were deemed “too high”. If the rates were “reasonable”, these individuals would not have bothered to set up these complex transactions in such secrecy, risking prosecution, fines and jail time if caught.

The Panama leaks date back to transactions in the 1970s and are just a small subset of deals made by one Panamanian law firm, Mossack Fonseca. There are scores of such law firms in Panama and thousands more, if you count a dozen other tax havens. It should therefore come as no surprise that millions of additional income and tax avoidance schemes will never see the light of day.

They will continue to be under wraps, their secrets known only to a few family members, lawyers and accountants who each have a vested interest in maintaining the status quo. And as long as they are under wraps, the governments from whom the income was hidden, will never realise a penny in tax revenue.

An experiment

Let us therefore engage in an interesting thought experiment. We know that the people who engage in these schemes are the super wealthy. In the Indian context, what income level would identify the super wealthy?

Let us arbitrarily define this as a family which earns ₹1 crore (about $147,000). This is about 95 times the average Indian’s income as defined by the World Bank ($1,581). The Indian government levies a special surcharge on income taxes for those earning in excess of ₹1 crore, leading to a tax rate of nearly 35 per cent.

Suppose the government were to drop tax rates for all incomes in excess of ₹1 crore, to just 5 per cent. Someone who earns ₹5 crore will now pay taxes of ₹34.75 lakh (for the first ₹1 crore) and only ₹20 lakh (for the next ₹4 crore), for an effective tax rate of just 11 per cent. That person will think long and hard before cooking up an elaborate scheme to go to Panama to hide income. To him, the 11 per cent rate somehow “appears fair”; so fair, in fact, that domestic “black money” hoarders may start reporting their ill-gotten monies so they can now spend and invest freely, without fear of persecution.

Basic human fact

Most would never agree with this approach because it is counter intuitive to the progressive ideals of fair tax policy, that the rich must pay ever higher tax rates. And naysayers will be alarmed by the loss of tax revenue if rates plunge “unfairly”.

True, but if the alternative is that the rich hide away incomes for eternity and never pay any taxes on hidden income, the 5 per cent tax rate immediately becomes an attractive option. At least it brings in some revenue to our cash strapped government.

This is the genius of Arthur Laffer. He introduced a basic fact of human behaviour to the dull subject of tax policy: that we respond positively to carrots and negatively to sticks. It is time our policy makers see Laffer’s wisdom and enact bold tax structures to ensnare the super rich — because smart policy alone can rid us of the cancer that is international tax havens.

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