Eliminate Individual and Corporate Tax Deductions

Getting rid of deductions would allow taxes to be lower and fairer

George Osborne, Britain’s Chancellor of the Exchequer (think: Treasury Secretary with a posh accent and a permanent sneer), earlier this month announced his solution to the country’s fiscal problems: clamp down on “tax avoidance.” While tax avoidance is certainly not desirable, Osborne’s solution for the most part would be counterproductive.

In particular, his proposal to adopt a General Anti-Abuse Rule (GAAR) and to work with the G8 to force companies to pay higher tax rates would make us all worse off: tax rates everywhere would rise, economic growth would fall, and we would end up even more in debt. A far better solution would be to remove the deductions and other loopholes that enable such avoidance – and lower tax rates.

Tax avoidance is legal (and must not be confused with tax evasion, which is the failure to pay taxes that are legally due). Most tax avoidance entails the use of deductions expressly created by governments, and it includes everything from the homeowner’s mortgage-interest deduction to corporate deductions for research and development. But the largest source of avoidance in the U.S. is on deferred income from controlled foreign corporations (CFCs) – that is income earned overseas by a U.S. corporation that isn’t brought back to the country right away. Such deferred income reduces America’s federal receipts by about $40 billion per year.

Now, ironically, these American CFCs have become bogeymen in Britain as well because they are using offshore companies to reduce the taxes they pay in the UK. (For example, Starbucks pays a 6 percent royalty to a company domiciled in the Netherlands, where it has negotiated a favorable tax agreement with the government.) In a November report, the British Parliament’s Public Accounts Committee claimed that it is “immoral” for a foreign corporation to minimize its tax obligations – and that such action is also economically harmful because it disadvantages British businesses. The committee singled out Starbucks, Google and Amazon for such practices, leading to a flurry of media attention to these allegedly immoral companies.

Starbucks quickly caved in to what its executives presumably thought was a burgeoning PR problem and offered to pay an additional $32 million on top of the $14 million it has already paid to the British government in corporation taxes. Google refused to pay more taxes than it legally owes – and with good reason. As Google Chairman Eric Schmidt, noted: “To go back to shareholders and say, ‘We looked at 200 countries but felt sorry for those British people so we want to [pay them more]’, there is probably some law against doing that.”

Although Osborne hasn’t released many details about how he would go after “abusive tax avoiders,” the basic idea of a GAAR is to make certain kinds of avoidance illegal. In other words, it would arbitrarily declare some currently legal actions to be illegal. This is directly at odds with the rule of law. Adding insult to injury, in the same budget Osborne created new tax avoidance schemes, including tax breaks for fracking natural gas.

But while the GAAR would make it easier for Her Majesty’s Revenue and Customs (really, that’s what the Brits call their version of the IRS) to target companies established in Britain, foreign businesses would likely still be able to avoid some taxes using the kinds of structures established by Starbucks. That’s why Osborne pledged to work with the G8 to establish international rules to make it more difficult for companies that can’t be caught by the GAAR to domicile in low-tax jurisdictions. No specifics were given but one way to do so would be to coordinate tax rules so that companies tax-domiciled in lower tax jurisdictions would be forced to pay punitive taxes on their operations in G8 countries.

Very crudely, currently, any British citizen may legally establish a company in another country, remit payments there, and thereby avoid British corporate taxes. So, the public accounts committee’s assertion that the tax rules disadvantage “British” businesses is only partly true and is mostly irrelevant because the rules actually benefit the people who matter most to the British economy: entrepreneurs.

Under the current rules, many entrepreneurs living in Britain are able to legally avoid paying high corporate tax rates. As a result, they can build up capital to further invest in their business – to the benefit of customers, employees and the wider public. Thousands of entrepreneurs already do this, from small businesses all the way to Richard Branson’s Virgin Group. And the Internet has significantly reduced the cost and difficulty of establishing a company in a foreign jurisdiction.

By enabling British entrepreneurs to build businesses in Britain that are tax-domiciled in another jurisdiction, the current rules also check the government’s temptation to impose excessive taxation on businesses that are tax-domiciled in Britain. The government knows that entrepreneurs have a choice, so it is forced to keep British taxes somewhat competitive, with a top corporate rate of 28 per cent. It also imposes some restraint on individual taxation, since lower individual taxes encourage entrepreneurs with foreign tax-domiciled businesses to locate in Britain. That is why Britain offers resident non-domiciled individuals a flat tax of 30,000 pounds ($48,000) per year (rising to 50,000 pounds ($80,000) for individuals who have lived in the UK for 12 years or more).

The British government currently nets approximately nine per cent of its total revenue from business taxes. By comparison, the United States, where the top rate of corporation tax is 35 per cent, nets only 8 per cent of its income from business taxes. This is partly due to the larger number of deductions available in the U.S. But the higher tax rates also encourage American businesses to utilize those deductions and keep their assets off-shore. Ok, so why does the U.S. have higher rates in the first place? One possible reason is that tax rules that make it much more difficult and less advantageous for U.S. citizens to establish a company with a tax domicile in another jurisdiction minimizes the need for Uncle Sam to keep its tax rates competitive. Larger companies can always find ways to get around rules barring them from shifting their assets offshore, leaving smaller entrepreneurs at a disadvantage. So, by introducing the kinds of rules that Osborne favors, the U.S. has brought about precisely the outcome that the British Chancellor says he wants to avoid!

Osborne understands full well that high taxes are bad for businesses and bad for the economy. After all, in March, he announced a lower top individual rate of 45 percent, which will apply from April 2013 — replacing the current 50 percent top rate on individuals earning over 150,000 pounds. And in his December announcement he reasserted: “Punitive tax rates do nothing to raise money, and simply discourage enterprise and investment into Britain.” Yet he failed to apply the same logic to corporations.

His clampdown on “abusive tax avoidance” is perhaps a response to pressure from the Public Accounts Committee. If so, that is a pity as this is likely to undermine tax competition, resulting in higher tax rates. Those higher tax rates would in turn reduce investment and economic growth in Britain and around the world. Over time, lower rates of economic growth mean reduced tax revenue. Given that Britain, like the U.S, is currently facing a prolonged fiscal crisis, with government debt forecast to remain close to 100 percent of GDP for many years, that is a miserable prospect.

If Osborne really cared about tax avoidance, he would stop blaming foreign domiciled companies and instead eliminate individual and corporate tax deductions – which are by far the largest sources of tax avoidance – and use the additional revenue thereby generated to cut tax rates. That way people and companies would have both fewer options to avoid paying taxes and less reason to do so: taxes would be lower and fairer. Moreover, since tax deductions distort investment, their removal would mean more resources would flow into more productive endeavors, resulting in more rapid economic growth and potentially generating government revenue that can be used to pay down debt. That sounds like a rosier outcome!

Julian Morris is Vice President of Research at the Reason Foundation. This column first appeared at RealClearMarkets.