Posted by on May 27, 2013

The hypocrisy of politicians never ceases to amaze me.

Of course, there are outstanding individual examples, such as the former French tax “czar” and “Mr Clean”, Jerome Cahuzac, who finally admitted that he had been engaging in tax evasion for over 20 years with offshore bank accounts, precisely the type of activity that he was publicly denouncing. But the best part was Cahuzac’s attempts to justify his behavior: “I fought a terrible internal struggle to try and resolve the conflict between the duty to tell the truth, which I failed to uphold, and the desire to honor the missions entrusted to me…I was stuck in a spiral of lies and misled myself. I am devastated by remorse.” In other words, he had wanted to tell the truth all along, but his sense of duty to his “missions” and la Belle France prevented him. Shame on us for putting him in this horrible position.

But these individual examples are nothing compared to the collective hypocrisy that is currently on display in the transatlantic witch hunt over corporate taxation. The politicians have created a taxation system that in its complexity and arbitrariness begs to be abused, and now they are complaining when companies such as Apple and Google do precisely that. This reminds me of the great Philip Marlowe line from the Big Sleep, where Marlowe complains that the thug Canino will “beat my teeth out, then kick me in the stomach for mumbling”. The politicians play the role of Canino.

In fact, the only politician to rise above the hypocrisy appears to be Senator Rand Paul, who commented during the Apple hearing that, if anyone should be on trial, “it’s Congress”. Too right.

It is not as if the politicians don’t know better. Economists and the general public have been begging for a simpler and more rational tax system for years, but the ruling class has no incentive to provide this. The tax code is the number one mechanism through which politicians and bureaucrats hand out favors or penalties, and garner benefits for themselves. Sometimes this is direct, in countries such as Italy and Russia, where the tax codes are kept deliberately ambiguous so that they can provide ample opportunity for graft. Although the famous mani pulite (“dirty hands”) investigations in Italy in the 1990s were mostly portrayed as a bribery scandal, anyone who has ever worked with the Italy tax code, as I have had the misfortune to do, knows the real crime here was extortion: politicians and bureaucrats using this byzantine system to extract payments from businessmen. Ditto the situation in Russia, where Medvedev’s (alleged) attempts to establish “the rule of law” ran straight into a wall of political and bureaucratic parasitism.

Of course, in America, our ruling class would never be so crude or obvious. We prefer the indirect route, through campaign donations from favored clienteles. Sure, this is not directly money in the pockets of politicians or bureaucrats – at least not while still in office, although they have numerous ways to monetize their former positions when they “retire from public service” – but it grants them the enormous psychic benefits of remaining in power. We must never forget that our politicians are “self selected” precisely to enjoy the exercise of power, which they like to dress up as a commitment to the general good. As the economist Frank Knight once put it: “the probability of the people in power being individuals who dislike the possession and exercise of power is on a level with the probability that an extremely tender-hearted person would get the job of whipping-master on a slave plantation”.

What would a rational tax system look like? I could obviously spend the rest of my life writing on this one subject, as many already have. The general parameters of rational tax system are well known: it should be simple and transparent, it should be “fair” (whatever that means), and, very importantly, it should not distort economic activity and not impose dead weight costs on society. Although I cannot claim to have studied this matter exhaustively, here are some thoughts:

The first thing we have to do is eliminate corporate taxation, which is the poisoned tree from which so much distortionary fruit comes. The simple fact is that the corporate form is a fiction, a convenient legal construct to facilitate collective action. But a corporation has no real independent existence and it should not be taxed as if it did. Every penny that flows through a corporation belongs to someone – an employee, a debtholder, a shareholder, etc. – and it should be taxed in the hands of that someone, and not in the fictional hands of the conduit.

But then this introduces another problem: Without corporate taxation, investors could indefinitely defer taxation by retaining earnings in companies. In addition to failing the test of “fairness”, this would introduce an enormous distortion since it would incentivize companies never to make distributions, even when they had no use for the cash. Given the already substantial motives for corporate managements to horde resources and perpetuate themselves, the last thing in the word we need to do is to give them another excuse.

Fortunately, the solution is at hand: All corporations should be tax transparent and their annual income should be taxable in the hands of their shareholders. This may seem like a radical and perhaps unworkable suggestion, until it is remembered how much of the US economy is already taxed on this basis. Partnerships, limited liability companies, sole proprietorships, etc., are all “pass through” entities that transfer their tax results to their owners. There are even publicly quoted vehicles, such as master limited partnerships, that are taxed on this basis. In fact, although we all automatically think of large, taxable corporations as constituting nearly all of the economy, a very large percentage of economic activity actually takes place in tax transparent forms. I want to make this 100%.

The benefits of this would be enormous. First, it would eliminate the economic distortions caused by the corporate tax system, which have been neatly chronicled in a recent Bloomberg article by Evan Soltas, entitled “Apple Shows It’s Time to Abolish Corporate Taxes”; the dead weight costs imposed by these distortions are huge. The tax advantage of debt financing would disappear, which through its promotion of leverage is one of the most pernicious biases in the US tax code. There would be no more argument for the favorable tax treatment of capital gain, on the basis that the income has already been taxed at the corporate level, thereby eliminating the types of distortions that cost Mitt Romney the 2012 elections. It would eliminate the motivation for Apple, among others, to move activities, real or fictional, to places like the Emerald Isle for tax reasons, or to park over $100 billion offshore to avoid US tax, while borrowing $17 billion in America to pay a dividend. (Whenever you see companies engaging in this kind of seeming madness, you know that tax is behind it.)

There are more subtle benefits too. It would encourage companies to pay dividends since there would no longer be a tax cost to doing so; in fact, they would be virtually compelled to pay a divided at least equal to the taxes payable by their shareholders, who would otherwise suffer from “phantom income”. There are numerous studies showing that retained earnings are inefficiently invested by corporations, frequently in projects that yield more benefits to management than the shareholders, and therefore dividends should be encouraged. Finally, since any tax benefits “negotiated” with a government would be dispersed among a wide shareholding, rather than concentrated in a corporation, we could expect that this change would reduce the incentives to lobby for these types of loopholes.

Now, of course, this is only the first step. There will still have to be rules for the determination of the income to be attributed to the shareholders, although the reported earnings per share (EPS) are probably a good first cut. These rules already exist for tax transparent vehicles, but they are needlessly complicated. Moreover, corporate loopholes will still have to be dealt with, but at least we will be starting from a rational base.

We must also deal with personal taxation, which is equally a disaster. This post is already too long for my limited attention span, and probably those of my readers, so I won’t treat this at length. What is required here is simplication, a widening of the tax base through the elimination of deductions, a unified treatment of all forms of income, and a reduction of marginal tax rates.

The pity is that the issue of tax simplification has become conflated with the completely separate issue of the “flat tax”. The flat tax is a political impossibility and the Republicans, in particular, have made an enormous mistake in tying the two together. Personally, I think that there is little justification for a flat tax, either in “normative” economics or on the basis of my personal sense of fairness: anyone who has been in business for any period of time knows that there is a substantial element of luck in the distribution of incomes and a graduated tax helps to “smooth out” this randomness. I also know that a graduated tax that tops out at a reasonable level will not have a significant impact on incentives or behavior, particularly if the tax code is modified to simultaneously curtail many of the loopholes that currently exist. My suggestions on corporate taxation will automatically eliminate many of these, which often turn on the creative use of corporate forms.

Tax reform is one of the most pressing issues facing America. Done in a tax-neutral way, it is an “easy win”, a change that can sharply enhance America’s economic performance without imposing fiscal burdens. It can also dramatically increase the sense of “fairness” in society, which is one of the keys to social cohesion and a self-imposed adherence to the rules. In fact, the only downside I can see to this reform would be the mass unemployment it would cause among tax lawyers, accountants and former IRS employees. Society will have to be on guard to be sure that these desperate people do not turn to other forms of anti-social behavior, perhaps violent.

Roger Barris, Switzerland

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Posted in: Economics, Policy

Comments

  1. Jim Miller
    May 27, 2013

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    Hello Roger. I am a fried of Jay Dreifus. He forwards your articles to me and I enjoy them very much . You are a refreshingly “honest” person.

    I majored in Economics at University of Michigan. The “rational man” philosophical underpinnings of classical economics are useful in describing human behavior and motivation, but only to a limited degree. And so I like your social/psychological/political perspective on todays issues, and tax policy in particular.

    When today’e tax code is three telephone books thick, and nobody knows what it says or what it means, you know something is wrong. Simplification is the key, and that is where I think you should re-visit your views on flat tax and the progressive tax system. Progressive rates are nice in theory because they smooth out the randomness of luck, as you said, but why bother trying to smooth out good fortune? Luck is luck. Misfortune is unfortunate. Flat taxes are simpler and easier and fairer. When you legislate progressive rates, you venture into the world of complexity, (people who are luckier should pay more taxes), which is not where I want our tax system to be.

    • Roger
      May 28, 2013

      Leave a Reply

      Thank you for your comment, Jim. And any friend of Jay’s certainly more than welcome….

      In general, I agree with your desire for simplicity. I am a huge believer in Occam’s Razor, the philosophical belief that simplicity is more likely to be the truth. Or as my friend Marvin always used to say, KISS: “Keep in simple, stupid”.

      The reality is, though, that the vast majority of the 3 telephone books consists of the rules for determining income, not the rules for determining tax. As you know from doing your own taxes, you spend infuriating hours determining and documenting your income, and then you spend 2 minutes with a graduated tax table calculating your tax — maybe 5 minutes if you are shocked by the end result and want to make sure its correct. So, the problem isn’t the graduated tax; the problem is the arcane rules for determining income. We won’t gain much simplicity by going to a flat tax.

      My major problem with the flat tax, as I say in the post, is that it is politically impossible. By insisting on a flat tax as part of an overall simplification, we merely insure that neither will happen, which is a tragedy. For me, this is more of a practical matter than it is one of principle. Politics is the art of the possible.

      Secondarily, I also think that a graduated tax is fair, for the reason I state. But I have to admit that there is no scientific justification for my feelings of fairness, although I think that the “normative economics” argument for progressive taxation and some redistribution is pretty compelling. Or, put another way, I find the counter-argument that one cannot make comparisons of inter-personal utility, although formally correct, to be pretty weak.

      Let’s agree to disagree on the flat tax and work on getting the rest of it simplified.

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