Tuesday, October 17, 2006

The mystery of the vanishing tax payer

IT WAS not a pretty sight. In 1839, the roads of Wales were crowded with men wearing women’s clothes, in an obscure reference to a story from the Bible. By the time they were back in their usual attire, several turnpikes (tax collection points) had been demolished. During the following five years, these “Rebecca rioters”, as they became known, donned their frocks and smashed turnpikes many times, doing what most taxpayers before and since could only dream about. But now some governments are starting to worry that globalisation, spurred by the Internet, will do to their tax systems what those transvestite Taffies did to the turnpikes.

Like the boy who cried “wolf”, governments have raised the alarm about globalisation so often that their credibility is in doubt. For all the talk of footloose capital heading for low-tax countries, starting a “race to the bottom” in which governments slash taxes and services to lure global business, the taxman’s cut of world income is larger today than it has ever been. Yet in the story the wolf eventually did attack the sheep, and the boy’s shouts for help went unheeded. Is the same thing about to happen to the world’s governments?

It does not help that globalisation can mean many things to many people, but a minimum definition would probably include a diminishing role for national borders and the gradual fusing of separate national markets into a single global marketplace. The term “globalisation” was probably first coined in the 1980s, but the idea has been around for a long time. Indeed, by some measures the world was more globalised a century ago than it is now: certainly people were far likelier to emigrate to find work. After an anti-trade backlash in the 1920s and 30s, globalisation has been accelerating during the past three decades. And thanks to innovations in communications and transport that let people and capital travel at great speed, it is now moving into a different gear altogether.

As globalisation ebbed and flowed, the taxman’s share of economic output went relentlessly up, despite warnings from politicians that globalisation would make it harder for governments to collect taxes and thus to provide public services. But now a new factor has entered the equation: the Internet. It epitomises borderlessness, and the irrelevance of being in a particular physical location. By being everywhere and nowhere at once, it seems certain to speed up globalisation. And in doing so, according to the Organisation for Economic Co-operation and Development, it might damage tax systems so badly that it could “lead to governments being unable to meet the legitimate demands of their citizens for public services”.

Shopping around

The Internet age has dawned just as tax collectors are getting worried about another aspect of globalisation: tax competition. Both the European Union and the OECD have declared war on “harmful” low-tax policies used by some countries to attract international businesses and capital. The OECD says that tax competition is often a “beggar-thy-neighbour policy” which is already reducing government tax revenues, and will start to be reflected in the data during the next couple of years. The Internet has the potential to increase tax competition, not least by making it much easier for multinationals to shift their activities to low-tax regimes, such as Caribbean tax havens, that are physically a long way from their customers, but virtually are only a mouse-click away. Many more companies may be able to emulate Rupert Murdoch’s News Corporation, which has earned profits of £1.4 billion ($2.3 billion) in Britain since 1987 but paid no corporation tax there.

Taxpayers, too, may dematerialise. In a famous New Yorker magazine cartoon showing two dogs sitting in front of a computer screen, one tells the other: “On the Internet, nobody knows that you are a dog.” The ability to collect tax is contingent on knowing who is liable to pay it, but taxpayers may become increasingly hard to identify as anonymous electronic money and uncrackable encryption technology are developed.

As almost everybody knows, there are two ways of cutting your tax bill. Tax avoidance is doing what you can within the law. As a great American judge, Learned Hand, put it, “There is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich and poor; and all do right, for nobody owes any public duty to pay more than the law demands.” Tax evasion is what happens outside the law. There may be a thin line between the two, but in one sense it is a solid one: as Denis Healey, a former British chancellor, once put it, “The difference between tax avoidance and tax evasion is the thickness of a prison wall.” The Internet is likely to make it easier to break the law.

The second challenge the Internet raises for the taxman is its potential for intensifying tax competition between governments. Tax collection around the world is built on the belief that every nation-state has the right to decide for itself how much tax to collect from the people and businesses within its borders. Governments may be willing to pool their sovereignty by joining international bodies such as the UN, the IMF or the EU, but they cling to their right to set their own taxes. Even in what some see as the nascent EU superstate, member countries refuse to give up their control of direct taxation.

Competing visions

Many countries have bilateral tax treaties with other countries, mainly to avoid double taxation. But again the rules of such treaties assume that the nation-state is what counts: they merely determine which nation-state has priority where more than one country has a claim. Multinational companies complain that nationally based taxation inhibits them from operating as truly global businesses. But for governments, it makes sense to design tax systems that attract footloose wealth.
Tax competition raises three big questions which this survey will try to answer. First, is there really such a thing? Some pundits doubt that tax-cutting governments are indeed motivated by hopes of poaching economic activity from other countries. Yet, as we shall see, there is enough evidence to suggest that tax competition should be taken seriously, and that without intervention it will only get fiercer.
Second, can it be stopped? It will not be easy. Not many people will defend tax havens. But although they make fine whipping boys, tax havens simply do in a more extreme form what many “respectable” governments themselves increasingly indulge in.

Ireland opposes harmonising corporate tax rates in the EU because its low rates give it a competitive edge. Britain blocks an EU savings-tax directive because it might hurt the City of London. Luxembourg and Switzerland will not agree to share information with foreign tax authorities because people who want to cut their tax bills come to them looking for discretion. And America may well ask for a worldwide ban on new Internet taxes because as a net exporter of e-commerce it would be the biggest beneficiary.

Some policymakers think that a World Tax Organisation should take its place alongside institutions such as the UN, NATO, IMF, World Bank and World Trade Organisation (WTO). But tax nationalism is likely to ensure that this will not happen. The OECD lacks sufficient clout, especially over non-members. The EU has a better chance of curbing tax competition among its own members, both through its directives and through the European Court of Justice, which is steadily, if slowly, enforcing tax harmony in the name of the single European market. But any success the EU achieves internally may simply make it more vulnerable to tax competition from non-EU countries.

Third, is tax competition really so bad? The OECD thinks it could undermine democracy by stopping countries from pursuing the tax policies their voters want. Footloose capital is free-riding on less mobile taxpayers, getting the benefit of services provided by governments in higher-taxing countries while paying taxes in low-tax jurisdictions, if at all. The EU objects mainly to special tax treatment offered to some taxpayers but not others, on the ground that it interferes with the single market. Some EU governments also argue that tax competition makes it ever harder to tax mobile factors of production such as capital. Instead, they complain, they have to increase taxes on less mobile factors, notably labour, which may drive jobs away.

Charles Tiebout, an American economist, argued back in the 1950s that competition between governments can be as good for everybody concerned as competition in any other marketplace. Like companies, governments can compete by offering different combinations of public services and taxes; if people want bigger government and are happy to pay for it, they are free to choose it, just as some people choose a snazzier car, or fly business class. Tax competition will put pressure on governments to provide their services efficiently, but that need not mean they have to be minimal. There are limitations to this theory, notably Tiebout’s assumption that every taxpayer is mobile, and can vote with his feet. In reality, richer taxpayers tend to be more mobile than poorer ones. If tax competition becomes stronger, using the tax system to redistribute money from rich, mobile taxpayers to poor, less mobile ones may become worryingly hard. The Internet will make more people mobile, rendering the rest even more wretched.

- It may interest you to know that the article above was written in 2000, six years ago. Since then we are seeing a growing number of mobile entrepreneurs moving to jurisdictions in where tax is low. Business jets are becoming more affordable for the ‘low level rich’ and as a consequence we are seeing more and more rich tax payers using this freedom of movement to live overseas and work in the UK. Don’t believe me? Read the story of the ‘Monaco Boys’ that has been all over the British press recently.

They are exploiting the fact that the day you fly and the day you leave the UK do not count towards the 90 days you can spend in the UK without becoming resident for tax, so if you fly on your jet (owned or hired) on Monday morning from Nice to City airport and fly back to your residence in the principality on Friday you have only spent three days in the UK. This would give you thirty weeks of the year to work in London and not have to pay a penny in tax (Monaco is tax free).

Some may say that this is an affront to the decent tax payers in the UK, others would say it is shrewd tax planning. All I know, is that governments, especially somewhere like the UK which is hugely taxed, most indirectly through duty and VAT, should be very careful because as the technicalities of working overseas are made easier by technology, specifically the Internet and as the cost of travel decrease, it won’t just be the super rich who look to escape the clutches of the tax man.

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