As inspired from the compliments I’ve received
concerning my previous post and from the leaked so called Panama Papers, I want to talk about taxation.
Ah yes, the taxes. No-one likes them and no-one
wants to pay them. Corporations, businessmen, politicians, celebrities and even
a well-known Nordic financial services group try to avoid them by different
kinds of shady arrangements. They rather recycle their money through a holding
company in the British Virgin Islands or other tax havens which facilitate
reduced taxes. Why couldn’t everyone be the good tax-paying citizen that every
government needs?
The Panama Papers have gotten a decent slide of media
attention during the past week and organizations and people around the world
judge this kind of tax-avoidance completely. Tax-avoidance can be highly
advantageous to corporations and wealthy people, so the incentive to this kind
of behavior is also considerably high. Everyone likes money and want to have
that as much as they can. When the taxes are high or there exists a lower
alternative tax-rate, there’s always an incentive to try to avoid the higher
tax-rate. Makes sense.
The biggest problem with tax-avoidance is that
it isn’t completely illegal, but it is just widely condemned. The most common
way of tax-avoidance is by moving individuals’ or corporations’ tax residence
to a tax haven, such as Switzerland or Luxembourg. The definition of tax-haven
states that a country can be classified as a tax-haven if certain tax-rates are
very low or zero. With that token, any country could become a tax-haven if it
wanted to do so. The country just needs to stop taxing its residents or lower
the tax-rates close to zero. Could this work?
Surprisingly, the answer is no. There are a
couple of good reasons for high tax-rates if the taxation system is designed
proper and the government acts right.
First of all, taxation exists because the
government acts as an agent in distribution of income. We all know the story of
Robin Hood, who stoles from the wealthy and distributes that wealth to the
people who actually are in a desperate need for income. And because of that,
the story has the happy ending it deserves. In real life, the one major
function of taxation is to even the economic inequality in the economy. When
the tax-burden of the wealthy in the economy is high for example through
progressive taxation, that income is distributed to the poor through transfer
payments, for instance. This balances the economic inequality.
There’s a good reason for this kind of
distribution of income. If you are more interested in the economic inequality,
I suggest you to watch former U.S. Labor Secretary Robert Reich’s documentary Inequality for All (2013). In the
documentary, Reich emphasizes the significance of the distribution of income by
taking the case of the middle-class in the economy. According to him, the
middle-class is the most crucial focus group in the U.S. when it comes to
aggregate demand in an economy. The high-numbered middle-class is the class
which consumes the most in the economy, and therefore would need the income to
consume and to contribute economic growth. This income can be only attained by
taxing “the richest 1 %”.
But as you might guess, high-tax rates in a
hope for better distribution of income encourage more wealthy people and
corporations to the use of tax-havens. So, the question is, that is there an
inverse relationship between the tax-rate and the amount of government revenue?
There actually is, and the theory behind it is called the Laffer curve which is illustrated below.
With a higher tax-rate than t* people are more
willing to try to avoid paying their taxes with different kinds of actions,
which results in a decrease in government revenue. There exists some good
real-life examples of the phenomenon. For instance, lowering the tax-rate of vehicle
taxation of new cars in Finland resulted “against all odds” an increase in government revenue. So this theory of lowering the tax-rates seems to work for
the government and for the economy.
Should all of the taxes in that case be
lowered to result the increase in governments wealth? I would say no. Clearly
by lowering the tax-rate the government is entitled to more revenue, but more
revenue isn’t necessarily the same thing as increase in welfare. The reason to
my denying answer is the existence of so called demerit goods with their
negative externalities.
Demerit goods are goods that the government would
like to see consumed in a lesser degree, or not at all. These kinds of demerit
goods are for example alcohol, cigarettes and pornography. For example alcohol
consumption creates negative externalities when consumed: Intoxicated people
can hurt themselves or others, be encouraged to criminal activities such as
theft and vandalism, and cause anxiety among other people and in the worst case
cause a death. The government tries to reduce these externalities with
taxation, as the figure below illustrates.
The figure illustrates the marginal social cost
and the marginal social benefit of the good for the economy. The marginal
private benefit illustrates the maximization of consumer’s private benefit, so
they consume the good in a free-market where MPB = MSC. This means that they
overconsume by drinking amount Q1 alcohol at a price of P1 and the potential
welfare loss is indicated as the blue triangle. When the government imposes an
indirect tax on the good, it causes the MSC-curve to shift upwards, until the
point of MPB = MSC is in the socially efficient output level of Q*. And since
the demand of alcohol, cigarettes and pornography can be considered as
relatively inelastic, the amount of imposed tax needs to be very high to effect
the amount consumed.
As a conclusion we could argue on the solution
to tax-avoidance. The obvious solution would be to simply ban all kinds of
shady tax-avoidance activities. Because banning this kind of activity is much
harder than it seems, should the economies consider to loosen their tax
policies? Even though demerit goods with their negative externalities exist, I
believe that with lower tax-rates it is possible for the government to increase
their revenue as shown in the Laffer curve. In Finland where the price of
alcohol is considered as high, people decide to buy their alcohol from Estonia
and Sweden and pay zero tax to their country. In a country where the income
tax-rate and corporate tax-rate are high, individuals and corporations have an
incentive to use tax havens, and pay minimal or zero tax to their country.
Lowering the tax-rates to an optimum level
could be a seriously adequate solution. The countries need to seek their level
of t* as shown in the Laffer curve. With more revenue, the government could
provide the essential services and public goods for the economy, and most of
all, ensure the equity in the distribution of income. Lowering the tax-rate
isn’t a threat to economic development, just take a look at the current
situation of welfare in Switzerland and Luxembourg.
Text. SW
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