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Archive for the ‘Tax evasion’ Category

Why do I relentlessly defend tax competition and tax havens?

Sadly, it’s not because I have money to protect. Instead, I’m motivated by a desire to protect the world from “goldfish government.”

Simply stated, politicians have a “public choice” incentive for never-ending expansions of government, even if they actually understand such policies will lead to Greek-style collapse.

Speaking at a recent conference in Moldova, I explained why tax competition is the best hope for averting that grim outcome.

In my remarks, I basically delivered a results-based argument for tax competition.

Which is why I shared data on lower tax rates and showed these slides on what politicians want compared to what they’ve been pressured to deliver.

Likewise, I also talked about reductions in the tax bias against saving and investment and shared these slides on what politicians want compared to what they’ve been pressured to deliver.

There’s also a theoretical side to the debate about tax competition and tax havens.

In a 2013 article for Cayman Financial Review, I explained (fairly, I think) the other side’s theory.

…there also has been a strain of academic thought hostile to tax competition. It’s called “capital export neutrality” and advocates of the “CEN” approach assert that tax competition creates damaging economic distortions. They start with the theoretical assumption of a world with no taxes. They then hypothesize, quite plausibly, that people will allocate resources in that world in ways that maximise economic output. They then introduce “real world” considerations to the theory, such as the existence of different jurisdictions with different tax rates. In this more plausible world, advocates of CEN argue that the existence of different tax rates will lead some taxpayers to allocate at least some resources for tax considerations rather than based on the underlying economic merit of various options. In other words, people make less efficient choices in a world with multiple tax regimes when compared to the hypothetical world with no taxes. To maximise economic efficiency, CEN proponents believe taxpayers should face the same tax rates, regardless of where they work, save, shop or invest. …One of the remarkable implications of capital export neutrality is that tax avoidance and tax evasion are equally undesirable. Indeed, the theory is based on the notion that all forms of tax planning are harmful and presumably should be eliminated.

And I then explained why I think the CEN theory is highly unrealistic.

…the CEN is flawed for reasons completely independent from preferences about the size of government. Critics point out that capital export neutrality is based on several highly implausible assumptions. The CEN model, for instance, assumes that taxes are exogenous – meaning that they are independently determined. Yet the real-world experience of tax competition shows that tax rates are very dependent on what is happening in other jurisdictions. Another glaring mistake is the assumption that the global stock of capital is fixed – and, more specifically, the assumption that the capital stock is independent of the tax treatment of saving and investment. Needless to say, these are remarkably unrealistic conditions.

Since economists like numbers, I even created an equation to illustrate whether tax competition is a net plus or a net minus.

Basically, the CEN argument is only defensible if the economic inefficiency associated with tax minimization is greater than the economic damage caused by higher tax rates, plus the damage caused by more double taxation, plus the damage caused by a bigger public sector.

Needless to say, honest empirical analysis will never support the CEN approach (as even the OECD admits).

That being said, politicians and special interests are not overly sympathetic to my arguments.

Which is why I very much identify with the guy in this cartoon strip.

P.S. If you want more information, about 10 years ago, I narrated a video on tax competition, a three-part video series on tax havens, and even a video debunking some of Obama’s demagoguery on the topic.

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She’s not quite as bad as Matt Yglesias, who wants a top tax rate of 90 percent (a rate that Crazy Bernie also likes), but Congresswoman Alexandria Ocasio-Cortez is not bashful about wanting to use the coercive power of government to take much larger shares of what others have earned.

And she doesn’t want to take “just” half, which would be bad enough. She wants to go ever further, endorsing a top tax rate on household income of 70 percent.

Those of you with a lot of gray hair may recall that’s the type of punitive tax regime we had in the 1970s (does anybody want a return to the economic misery we suffered during the Nixon and Carter years?).

So it’s very disturbing to think we may get an encore performance.

Here are some excerpts from a Politico report.

Rep. Alexandria Ocasio-Cortez (D-N.Y.) is floating an income tax rate as high as 60 to 70 percent on the highest-earning Americans… Ocasio-Cortez said a dramatic increase in taxes could support her “Green New Deal” goal of eliminating the use of fossil fuels within 12 years… “There’s an element where yeah, people are going to have to start paying their fair share in taxes.” …When Cooper pointed out such a tax plan would be a “radical” move, Ocasio-Cortez embraced the label… “I think that it only has ever been radicals that have changed this country,” Ocasio-Cortez said. “Yeah, if that’s what radical means, call me a radical.”

There are many arguments to make against this type of class-warfare policy, but I’ll focus on two main points.

First, this approach isn’t practical, even from a left-wing perspective. Simply stated, upper-income taxpayers have considerable control over the timing, level, and composition of their income, and they can take very simple (and completely legal) steps to protect their money as tax rates increase.

This is one of the reasons why higher tax rates don’t translate into higher tax revenue.

If you don’t believe me, check out the IRS data on what happened in the 1980s when Reagan dropped the top tax rate from 70 percent to 28 percent. Revenues from those making more than $200,000 quintupled.

Ms. Ocasio-Cortez wants to run that experiment in reverse. That won’t end well (assuming, of course, that her goal is collecting more revenue, which may not be the case).

Second, higher tax rates on the rich will have negative consequences for the rest of us. This is because there is a lot of very rigorous research that tell us:

And this is just a partial list.

And I didn’t even include the potential costs of out-migration, which doubtlessly would be significant since Ms. Ocasio-Cortez would impose the developed world’s most punitive tax regime on the United States.

I’ll close by recycling this video on the harmful impact of punitive tax rates.

P.S. Today’s column focused on the adverse economic impact of a confiscatory tax rate, but let’s not forget the other side of the fiscal equation. Ms. Ocasio-Cortez wants to finance a “green new deal,” which presumably means a return to Solyndra-style scandals.

P.P.S. There is some encouraging polling data on class-warfare taxation.

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My long-running feud with the Paris-based Organization for Economic Cooperation and Development could be categorized as a fight over tax compliance.

The bureaucrats at the OECD say that financial privacy must be eviscerated and the fiscal sovereignty must be wiped out so that high-tax governments can track and tax money around the world.

My view is that pro-growth reforms like the flat tax would be a much better approach. With a simple and fair tax code that doesn’t impose extra layers of tax on saving and investment, the IRS no longer would need to know about our bank accounts or investment funds – regardless of whether they are based in Geneva, Illinois, or Geneva, Switzerland.

Though I view better compliance as a secondary benefit. My main goal is to have a tax system that doesn’t impose needlessly high levels of economic damage.

But let’s stick with the compliance issue. Writing for E21, Daniel Di Martino explains that the Italian government makes evasion and avoidance a preferable option because tax rates are too onerous.

Italy’s problem, similar to many of its southern-European neighbors, is an oppressively high tax burden, irresponsible welfare programs that encourage high measured unemployment and increase the debt, and high levels of regulation. …the share of average wages collected by the Italian government via income and social security taxes is among the highest in the OECD at 48 percent. In addition, Italy imposes a value-added tax of 22 percent on most goods and services, one of the highest in Europe. Plus, Italy’s corporate, capital gains, gift, and myriad other taxes are passed on to individuals and borne directly by workers. These high taxes lead to a growing shadow economy, where people underreport work to avoid paying taxes. …many estimates point to more than  $175 billion (€150 billion) in lost tax revenue.

So what’s the best way of addressing that nation’s huge shadow economy?

Simple, less government.

Instead of cracking down on tax evasion and the shadow economy, Italy’s new government needs to rethink long-standing policies to bring a real economic recovery. Taxes need to be lowered so more businesses open and already-existing businesses and individuals come out of the shadows, broadening the tax base and raising revenue. This would allow those in the shadow economy to expand their businesses. Additionally, the welfare state should be trimmed so that people do not have an incentive to stay unemployed and young Italians are less burdened by government debt. Moreover, Italy needs to become more competitive by slashing the number of regulations.

The Institut Economique Molinari in Belgium took a look at the same issue, but included data for all European Union nations.

Economic reasoning and international experience point invariably to common causes that consistently create obstacles to dealings in the official economy: prohibitions, compulsory levies and specific tax measures, as well as fastidious and complex regulations. …As noted by two specialists, “In almost all studies, one of the most important causes (…) is the rise of the tax and social security burdens.” The higher these burdens on labour relations and dealings in the official economy, the less profitable these dealings become and the greater the incentive to trade on the black market. …As long as taxes account for a high share of the final price, opportunities for profit are provided in the underground economy, which moves in on a long‐term basis and comes to account for a significant share of countrywide sales. …Increasing this tax burden can only increase the disconnection between the real production cost of goods and their price on the official market, to such a degree that consumers begin abandoning the official market on a larger scale.

So what’s the answer?

Definitely not more government.

Given the scope of the underground economy, public authorities generally suggest toughening the means of repression so as to collect more tax revenues. The justification for this repression remains the same: it would promote the transfer of all under ground activity to the legal market, thereby creating new tax revenues. Beyond the cost of this repression in terms of resources and bureaucratisation of the economy, this reasoning and the resulting forecasts are erroneous. Though certain activities may no longer be undertaken in the underground economy, they will not be undertaken in the official economy either — in part or even in whole, depending on the specific case — because of the burden of compulsory levies and regulations. …Increased repression by the public authorities, without any change in regulatory and tax frameworks, risks simply destroying economic activities and the associated revenues. The only long‐lasting solution for ending the underground economy consists of dealing with the causes that give rise to it and thus to free the official market from its fiscal and regulatory burdens. …there is no other choice but to lighten tax and regulatory burdens.

Let’s now cross to this side of the Atlantic Ocean.

In an editorial about the current and former Treasury Secretary and their Cayman investments, the Wall Street Journal highlighted hypocrisy. But the best part was the conclusion about bad government policy driving money away from America.

Mr. Mnuchin served as director of Dune Capital, an investment firm he said he registered in the Caymans primarily to “accommodate nonprofits and pensions that want to invest through these off-shore entities.” By contrast, Mr. Lew was personallyinvested in the Citigroup Venture Capital International Growth Partnership II. You know, like that evil profiteer Mitt Romney, the subject of a now infamous Barack Obama campaign ad scoring Mr. Romney for profiting from money in offshore havens such as the Caymans. Mr. Lew’s Cayman company even used the same Ugland House building in the Caymans that President Obama so famously trashed as an “outrage” and “tax scam.” …The Democratic goal…seemed to be to get Mr. Mnuchin to admit that investors go to the Caymans to avoid American taxes. Mr. Mnuchin denied it but needn’t have been so shy. The Caymans have no corporate tax rate. The way to deal with the Caymans is not to punish investors who go there but to get rid of the regulations and high tax rates that send capital offshore.

But it’s not just market-friendly organizations that realize high tax burdens bolster the underground economy.

The International Monetary Fund released a study earlier this year on the shadow economy, which is defined as legal activities that are hidden from government.

The shadow economy includes all economic activities which are hidden from official authorities for monetary, regulatory, and institutional reasons. Monetary reasons include avoiding paying taxes and all social security contributions, regulatory reasons include avoiding governmental bureaucracy or the burden of regulatory framework, while institutional reasons include corruption law, the quality of political institutions and weak rule of law. For our study, the shadow economy reflects mostly legal economic and productive activities that, if recorded, would contribute to national GDP.

And what causes people to hide legal activity from government?

Here are some of the factors that drive the shadow economy according to the IMF.

In other words, people are less likely to comply when they have to endure bad government policy.

…in most cases trade openness, unemployment rate, GDP per capita, size of government, fiscal freedom and control of corruption are highly statistically significant.

And the number one bad government policy is high tax rates.

Let’s close by looking at the other side’s arguments.

Earlier this month, I revealed that the OECD finally admitted that it’s anti-tax competition project was motivated by a desire for class warfare and bigger government.

That’s terrible policy, but I give the bureaucrats in Paris credit for finally being honest.

By contrast, I’m not sure what to say about the bureaucrats in Brussels. The European Commission’s idea of an argument is this vapid video, which attempts to convince viewers that 20 percent of what they like is missing because government isn’t collecting more tax revenue.

In reality, of course, the money isn’t “missing.” It’s still in the private sector, where it actually is providing things that people like, rather than financing the stuff politicians like.

P.S. Speaking of vapid arguments from the European Commission, the bureaucrats actually created an online game designed to brainwash kids into supporting higher tax burdens.

P.P.S. The Wall Street Journal’s editorial mentioned Ugland House in the Cayman Islands. That’s the building that featured in some of Barack Obama’s dishonest demagoguery.

P.P.P.S. I’m still mystified that Republicans continue to send our tax dollars to Paris to subsidize the OECD. Actually, I’m not mystified. This is actually a good example of why they’re called the Stupid Party.

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I wanted California to decriminalize marijuana because I believe in freedom. Smoking pot may not be a wise choice in many cases, but it’s not the role of government to dictate private behavior so long as people aren’t violating the rights of others.

Politicians, by contrast, are interested in legalization because they see dollar signs. They want to tax marijuana consumption to they can have more money to spend (I half-joked that this was a reason to keep it illegal, but that’s a separate issue).

Lawmakers need to realize, though, that the Laffer Curve is very real. They may not like it, but there’s very strong evidence that imposing lots of taxes does not necessarily mean collecting lots of revenue. Especially when tax rates are onerous.

Here’s some of what the AP recently reported about California’s experiment with taxing pot.

So far, the sale of legal marijuana in California isn’t bringing in the green stuff. Broad legal sales kicked off on Jan. 1. State officials had estimated California would bank $175 million from excise and cultivation taxes by the end of June. But estimates released Tuesday by the state Legislative Analyst’s Office show just $34 million came in between January and March. …it’s unlikely California will reap $175 million by midyear.

And here are some excerpts from a KHTS story.

Governor Jerry Brown’s January budget proposal predicted that $175 million would pour into the state’s coffers from excise and cultivation taxes…analysts believe revenue will be significantly lower… Some politicians argue high taxes are to blame for the revenue shortfalls preventing that prediction from becoming reality, saying the black market is “undercutting” the legal one. …The current taxes on legal marijuana businesses include a 15 percent excise tax on purchases of all cannabis and cannabis products, including medicinal marijuana. The law also added a $9.25 tax for every ounce of bud grown and a $2.75-an-ounce tax on dried cannabis leaves for cultivators.

These results should not have been a surprise.

I’ve been warning – over and over again – that politicians need to pay attention to the Laffer Curve. Simply stated, high tax rates don’t necessarily produce high revenues if taxpayers have the ability to alter their behavior.

That happens with income taxes. It happens with consumption taxes.

And it happens with taxes on marijuana.

Moreover, it’s not just cranky libertarians who make this point. Vox isn’t a site know for rabid support of supply-side economics, so it’s worth noting some of the findings from a recent article on pt taxes.

After accounting for substitution between products by consumers, we find that the tax-inclusive price faced by consumers for identical products increased by 2.3%. We find that the quantity purchased decreased by 0.95%…, implying a short-term price elasticity of -0.43. However, over time, the magnitude of the quantity response significantly increases, and our estimates suggest that the price elasticity of demand is about negative one within two weeks of the reform. We conclude that Washington, the state with the highest marijuana taxes in the country, is near the peak of the Laffer curve – further increases in tax rates may not increase revenue. …tax revenue has historically been one of the many arguments in favour of legalising marijuana…the optimal taxation of marijuana should be designed to take into account responses…excessive taxation might prop up the very black markets that legal marijuana is intended to supplant. As additional jurisdictions consider legalising marijuana and debate over optimal policy design, these trade-offs should be explored and taken into account.

Let’s close by reviewing some interesting passages from a McClatchey report, starting with some observations about the harmful impact of excessive taxes.

Owners of legalized cannabis operations face a range of challenges… But taxes – local, state, federal – present a particular headache. They are a big reason why, in California and other states, only a small percentage of cannabis growers and retailers have chosen to get licensed and come out of the shadows. …In a March report, Fitch Ratings suggested that California may not realize the tax revenue – $1 billion a year – the state projected when Proposition 64, a legalization initiative, was put before voters in 2016. “While it is still too early to assess California’s revenue performance, comparatively high taxes on legal cannabis will likely continue to divert sales to illegal markets, reducing potential tax collections,” Fitch said in its report. …Add it all up, and state-legal cannabis in some parts of California could be taxed at an effective rate of 45 percent, Fitch said in a report last year.

Interestingly, even politicians realize they need to adapt to the harsh reality of the Laffer Curve.

Some state lawmakers blame the taxation for creating a price gap between legal and illegal pot that could doom California’s regulated market. Last month, Assembly members Tom Lackey, R-Palmdale, and Rob Bonta, D-Oakland, introduced legislation, AB 3157, that would reduce the state marijuana sales tax rate from 15 percent to 11 percent, and suspend all cultivation taxes until June 2021.

And I can’t resist including one final passage that has nothing to do with taxes. Instead, it’s a reference to the lingering effect of Obama’s dreadful Operation Choke Point.

Davies owns Canna Care, a medical marijuana dispensary in Sacramento. Like other state-legal cannabis businesses nationwide, her pot shop operates largely with cash. Most banks won’t transact with enterprises deemed illegal by the U.S. government. That forces Davies to stuff $10,000 in bills into her purse each month… even lawyers who represent state-legal marijuana businesses face financial risks. Sacramento lawyer Khurshid Khoja recently lost his two bank accounts with Umpqua Bank, after Umpqua started asking him about his state-legal cannabis clients.

The good news is that Trump has partially eased this awful policy. The bad news is that he only took a small step in the right direction.

But let’s get back to our main topic. I’ve written several times on whether our friends on the left are capable of learning about the Laffer Curve. Especially in cases when they imposed a tax in hopes of changing behavior!

What’s happening in California with pot taxes is simply the latest example.

And I’m hoping leftists will apply the lesson to taxes on things that we don’t want to discourage – such as work, saving, investment, and entrepreneurship.

P.S. I’ve pointed out that some leftists want high tax rates on income even if no money is collected. That’s because their real goal is punishing success. I wonder if there are some conservatives who are pushing punitive marijuana taxes because they want to discourage “sin” rather than collect revenue.

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When I write an everything-you-need-to-know column, it’s not because I’m under any illusions that I’ve actually amassed all the information one could need on a topic. Instead, it’s just a meme.

Today’s column belongs in the latter category. Could there possibly be something that more perfectly captures the essence of California than a story about the over-taxation of legal marijuana?

Marijuana dispensaries across California experienced long lines on the first day of legal recreational pot sales. But advocates warned the legal industry won’t survive without big changes…said Steve DeAngelo, co-founder and CEO of Harborside in Oakland. “At the same time, I’m terrified about what’s going to happen with these taxes.” Harborside has been a medical marijuana dispensary for more than a decade, and is now selling recreational marijuana… “In our shop here, the tax rate has gone from 15 percent all the way up to almost 35 percent for adult consumers,” DeAngelo said. …There is the regular state sales tax of 6 percent, and the regular Alameda County sales tax of 3.25 percent. Then there is a 15 percent state tax on marijuana, and a 10 percent Oakland tax on recreational marijuana. Total taxes: 34.25 percent. …In addition to taxes, marijuana regulations drive up the cost.

Excessive government and lifestyle liberalism. A perfect summation of California.

By the way, even though I’m a social conservative-style teetotaler, I agree with the pot legalization. But I have mixed feelings because I don’t want politicians to get more money to waste.

Though I am happy that people have the option to still use the underground economy.

…”a significant number of people, less affluent consumers, are going to turn to the lower prices of the underground market,” DeAngelo said. …People who are disabled or on fixed incomes may turn to the black market. “They can barely afford cannabis now, much less with a 35 or 40 percent tax increase,” DeAngelo said. When people aren’t buying from a regulated business, the state is getting zero taxes.

Yet another example of the Laffer Curve, which is simply the common-sense notion that marginal tax rates impact incentives.

When taxes are too high, there’s either less taxable activity, or the activity moves where the government can’t tax it. In other words, higher tax rates don’t necessarily mean higher tax revenue.

And it definitely means revenues will never be as high as the pro-tax crowd would like.

Such a simple concept that even some leftists are catching on.

This may lead California to lower tax rates, as has happened in other states.

Colorado, Washington state and Oregon each legalized marijuana at one tax rate and then had to lower the rate to keep people in the legitimate market. DeAngelo believes California will have to do the same. “I don’t think that the current tax rate for cannabis in California is sustainable,” he said.

That last sentence puts me in a good mood. I very much like when greedy politicians are forced to lower tax rates.

For those that want a more detailed and serious look at the economics of taxation and drug prohibition, this column from last November is a good place to start.

And for those who want a closer look at the moral/practical issues of drug prohibition, I recommend this piece from last May.

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I’ve been at the United Nations this week for both the 14th Session of the Committee of Experts on International Cooperation in Tax Matters as well as the Special Meeting of ECOSOC on International Cooperation in Tax Matters.

As you might suspect, it would be an understatement to say this puts me in the belly of the beast (for the second time!). Sort of a modern-day version of Daniel in the Lion’s Den.

These meetings are comprised of tax collectors from various nations, along with U.N. officials who – like their tax-free counterparts at other international bureaucracies – don’t have to comply with the tax laws of those countries.

In other words, there’s nobody on the side of taxpayers and the private sector (I’m merely an observer representing “civil society”).

I could share with you the details of the discussion, but 99 percent of the discussion was boring and arcane. So instead I’ll touch on two big-picture observations.

What the United Nations gets wrong: The bureaucracy assumes that higher taxes are a recipe for economic growth and development.

I’m not joking. I wrote last year about how many of the international bureaucracies are blindly asserting that higher taxes are pro-growth because government supposedly will productively “invest” any additional revenue. And this reflexive agitation for higher fiscal burdens has been very prevalent this week in New York City. It’s unclear whether participants actually believe their own rhetoric. I’ve shared with some of the folks the empirical data showing the western world became rich in the 1800s when fiscal burdens were very modest. But I’m not expecting any miraculous breakthroughs in economic understanding.

What the United Nations fails to get right: The bureaucracy does not appreciate that low rates are the best way of boosting tax compliance.

Most of the discussions focused on how tax laws, tax treaties, and tax agreements can and should be altered to extract more money from the business community. Participants occasionally groused about tax evasion, but the real focus was on ways to curtail tax avoidance. This is noteworthy because it confirms my point that the anti-tax competition work of international bureaucracies is guided by a desire to collect more revenue rather than to improve enforcement of existing law. But I raise this issue because of a sin of omission. At no point did any of the participants acknowledge that there’s a wealth of empirical evidence showing that low tax rates are the most effective way of encouraging tax compliance.

I realize that these observations are probably not a big shock. So in hopes of saying something worthwhile, I’ll close with a few additional observations

  • I had no idea that people could spend so much time discussing the technicalities of taxes on international shipping. I resisted the temptation to puncture my eardrums with an ice pick.
  • From the moment it was announced, I warned that the OECD’s project on base erosion and profit shifting (BEPS) was designed to extract more money from the business community. The meeting convinced me that my original fears were – if possible – understated.
  • A not-so-subtle undercurrent in the meeting is that governments of rich nations, when there are squabbles over who gets to pillage taxpayers, are perfectly happy to stiff-arm governments from poor nations.
  • The representative from the U.S. government never expressed any pro-taxpayer or pro-growth sentiments, but he did express some opposition to the notion that profits of multinationals could be divvied up based on the level of GDP in various nations. I hope that meant opposition to “formula apportionment.”
  • Much of the discussion revolved around the taxation of multinational companies, but I was still nonetheless surprised that there was no discussion of the U.S. position as a very attractive tax haven.
  • The left’s goal (at least for statists from the developing world) is for the United Nations to have greater power over national tax policies, which does put the UN in conflict with the OECD, which wants to turn a multilateral convention into a pseudo-International Tax Organization.

P.S. The good news is that the folks at the United Nations have not threatened to toss me in jail. That means the bureaucrats in New York City are more tolerant of dissent than the folks at the OECD.

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The value-added tax is a very dangerous levy for the simple reason that giving a big new source of revenue to Washington almost certainly would result in a larger burden of government spending.

That’s certainly what happened in Europe, and there’s even more reason to think it would happen in America because we have a looming, baked-in-the-cake entitlement crisis and many politicians don’t want to reform programs such as Medicare, Medicaid, and Obamacare. They would much rather find additional tax revenues to enable this expansion of the welfare state. And their target is the middle class, which is why they very much want a VAT.

The most frustrating part of this debate is that there are some normally rational people who are sympathetic to the VAT because they focus on theoretical issues and somehow convince themselves that this new levy would be good for the private sector.

Here are the four most common economic myths about the value-added tax.

Myth 1: The VAT is pro-growth

Reihan Salam implies in the Wall Street Journal that taxing consumption is good for growth.

Mr. Cruz has roughly the right idea. He has come out in favor of a growth-friendly tax on consumption… Rather sneakily, he’s calling his consumption tax a “business flat tax,” but everyone knows that it’s a VAT.

And a different Wall Street Journal report asserts there’s a difference between taxing income and taxing consumption.

…a VAT taxes what people consume rather than how much they earn.

Reality: The VAT penalizes all productive economic activity

I don’t care whether proponents change the name of the VAT, but they are wrong when they say that taxes on consumption are somehow better for growth than taxes on income. Consider two simple scenarios. In the first example, a taxpayer earns $100 but loses $20 to the income tax. In the second example, a taxpayers earns $100, but loses $20 to the VAT. In one case, the taxpayer’s income is taxed when it is earned and in the other case it is taxed when it is spent. But in both cases, there is an identical gap between pre-tax income and post-tax consumption. The economic damage is identical, with the harm rising as the marginal tax rate (either income tax rate or VAT rate) increases.

Advocates for the VAT generally will admit that this is true, but then switch the argument and say that there’s pervasive double taxation in the internal revenue code and that this tax bias against saving and investment does far more damage, per dollar collected, than either income taxes imposed on wages or VATs imposed on consumption.

They’re right, but that’s an argument against double taxation, not an argument for taxing consumption instead of taxing income. They then sometimes assert that a VAT is needed to make the numbers add up if double taxation is to be eliminated. But a flat tax does the same thing, and without the risk of giving politicians a new source of revenue.

Myth 2: The VAT is pro-savings and pro-investment

As noted in a recent Wall Street Journal story, advocates claim this tax is an economic elixir.

Supporters of a VAT…say it is better for economic growth than an income tax because it doesn’t tax savings or investment.

Reality: The VAT discourages saving and investment

The superficially compelling argument for this assertion is that the VAT is a tax on consumption, so the imposition of such a tax will make saving relatively more attractive. But this simple analysis overlooks the fact that another term for saving is deferred consumption. It is true, of course, that people who save usually earn some sort of return (such as interest, dividends, or capital gains). This means they will be able to enjoy more consumption in the future. But that does not change the calculation. Instead, it simply means there will be more consumption to tax. In other words, the imposition of a VAT does not alter incentives to consume today or consume in the future (i.e., save and invest).

But this is not the end of the story. A VAT, like an income tax or payroll tax, drives a wedge between pre-tax income and post-tax income. This means, as already noted above, that a VAT also drives a wedge between pre-tax income and post-tax consumption – and this is true for current consumption and future consumption. This tax wedge means less incentive to earn income, and if there is less total income, this reduces both total saving and total consumption.

Again, advocates of a VAT generally will admit this is correct, but then resort to making a (correct) argument against double taxation. But why take the risk of a VAT when there are very simple and safe ways to eliminate the tax bias against saving and investment.

Myth 3: The VAT is pro-trade.

My normally sensible friend Steve Moore recently put forth this argument in the American Spectator.

…a better way to do this…is through a “border adjustable”…tax, meaning that it taxes imports and relieves all taxes on exports. …The guy who gets this is Ted Cruz. His tax plan…would not tax our exports. Cruz is right when he says this automatically gives us a 16% advantage.

Reality: The protectionist border-adjustability argument for a VAT is bad in theory and bad in reality.

For mercantilists worried about trade deficits, “border adjustability” is seen as a positive feature. But not only are they wrong on trade, they do not understand how a VAT works. Protectionists seem to think a VAT is akin to a tariff. It is true that the VAT is imposed on imports, but this does not discriminate against foreign-produced goods because the VAT also is imposed on domestic-produced goods.

Under current law, American goods sold in America do not pay a VAT, but neither do German-produced goods that are sold in America. Likewise, any American-produced goods sold in Germany are hit be a VAT, but so are German-produced goods. In other words, there is a level playing field. The only difference is that German politicians seize a greater share of people’s income.

So what happens if America adopts a VAT? The German government continues to tax American-produced goods in Germany, just as it taxes German-produced goods sold in Germany. There is no reason to expect a VAT to cause any change in the level of imports or exports from a German perspective. In the United States, there is a similar story. There is now a tax on imports, including imports from Germany. But there is an identical tax on domestically-produced goods. And since the playing field remains level, protectionists will be disappointed. The only winners will be politicians since they have more money to spend.

I explain this issue in greater detail in this video, beginning about 5:15, though I hope the entire thing is worth watching.

Myth 4: the VAT is pro-compliance

There’s a common belief, reflected in this blurb from a Wall Street Journal report, that a VAT has very little evasion or avoidance because it is self enforcing.

…governments like it because it tends to bring in more revenue, thanks in part to the role that businesses play in its collection. Incentivizing their efforts, businesses receive credits for the VAT they pay.

Reality: Any burdensome tax will lead to avoidance and evasion and that applies to the VAT.

I’m always amused at the large number of merchants in Europe who ask for cash payments for the deliberate purpose of escaping onerous VAT impositions. But my personal anecdotes probably are not as compelling as data from the European Commission.

To give an idea of the magnitude, here are some excerpts from a recent Bloomberg report.

Over the next two years, the Brussels-based commission will seek to streamline cross-border transactions, improve tax collection on Internet sales… In 2017, the EU plans to propose a single European VAT area, a reform of rates and add specifics to its anti-fraud strategy. …“We face a staggering fiscal gap: the VAT revenues are 170 billion euros short of what they could be,” EU Economic Affairs and Tax Commissioner Pierre Moscovici said. “It’s time to have this money back.”

For what it’s worth, the Europeans need to learn that burdensome levels of taxation will always encourage noncompliance.

Though, to be fair, much of the “tax gap” for the VAT in Europe exists because governments have chosen to adopt “destination-based” VATs rather than “origin-based” VATs, largely for the (ineffective) protectionist reasons outlined in Myth 3. And this creates a big opportunity to escape the VAT by classifying sales as exports, even if the goods and services ultimately are consumed in the home market.

P.S. At the risk of being wonky, it should be noted that there are actually two main types of value-added tax. In both cases, businesses collect the tax, and the tax incidence is similar (households actually bear the cost), but there are different collection methods. The credit-invoice VAT is the most common version (ubiquitous in Europe, for instance), and it somewhat resembles a sales tax in its implementation, albeit with the tax imposed at each stage of the production process. The subtraction-method VAT, by contrast, relies on a tax return sort of like the corporate income tax. The Joint Committee on Taxation has a good description of these two systems.

Under the subtraction method, value added is measured as the difference between an enterprise’s taxable sales and its purchases of taxable goods and services from other enterprises. At the end of the reporting period, a rate of tax is applied to this difference in order to determine the tax liability. The subtraction method is similar to the credit-invoice method in that both methods measure value added by comparing outputs (sales) to inputs (purchases) that have borne the tax. The subtraction method differs from the credit-invoice method principally in that the tax rate is applied to a net amount of value added (sales less purchases) rather than to gross sales with credits for tax on gross purchases (as under the credit-invoice method). The determination of the tax liability of an enterprise under the credit-invoice method relies upon the enterprise’s sales records and purchase invoices, while the subtraction method may rely upon records that the taxpayer maintains for income tax or financial accounting purposes.

P.P.S. Another wonky point is that the effort by states to tax Internet sales is actually an attempt to implement and enforce the kind of “destination-based” tax regime mentioned above. I explain that issue in this presentation on Capitol Hill.

P.P.P.S. You can enjoy some amusing – but also painfully accurate – cartoons about the VAT by clicking here, here, and here.

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