Francesco Parisi (Minnesota; Google Scholar), Emanuela Carbonara (Bologna; Google Scholar), Claire A. Hill (Minnesota; Google Scholar) & Philip A. Curry (Waterloo; Google Scholar), Institutional Flexibility in Tax Law and Enforcement:
Taxation is one of the few things that we can take as a given in life. People will always look for ways to minimize the tax burdens that governments seek to impose on them. Indeed, there is a very well-developed industry devoted to that end. How should governments proceed? We develop an economic model to show that the government may be best off not attempting to prohibit all tax minimization efforts. We provide some illustrations drawn from tax practice. …
Conclusion
Tax avoidance can be socially detrimental. Significant resources are expended in developing and using tax avoidance methods; this yields a dissipation of resources on several margins. The development, purchase, and use of the methods is in itself costly. Structuring business activities to obtain desired tax treatment often may lead to distortions and suboptimal firm organization and yield social costs as well. Our findings suggest that notwithstanding these costs, often governments should only target and close some tax avoidance methods, but should tolerate and legitimize others.
The extent to which the government should legitimize tax avoidance methods hinges upon the question of how much of an effect these policies have had on tax avoidance dissipation—a question that is worthy of empirical exploration. For many reasons, including resource constraints, the government cannot stop the usage of all tax avoidance methods. While the government has had considerable success with closing domestic tax shelters (Dharmapala 2008), other tax avoidance methods involving foreign jurisdictions have come into greater use. How much the government is able to ‘close the tax gap’ is difficult to assess. As the government closes certain tax avoidance methods, firms invest more effort into finding other methods. Certainly, the considerable market for tax avoidance methods is likely to continue. Changes in tax law, required or deemed desirable or politic for some reasons, will always provide opportunities for an arms race in the development of new methods, as old ones are prohibited (Rostain and Regan 2014) or become less profitable. For example, the rate disparity between the top marginal individual rate and the 2017 tax law’s lowered corporate tax rate (Kamin et al. 2017) may lead to the creation of new tax avoidance methods. The incentive to attribute income to a corporation rather than an individual in the common case where the corporate tax rate is lower than the individual tax rate, will surely motivate organizational restructuring and investments to that end. Additionally, the ability of global entities to engage in extra-jurisdictional tax avoidance by shifting their operations to tax havens (Bruner 2013; Desai and Hines 2002) also assures that appreciable tax avoidance methods will continue to be developed. Global cooperation may improve matters; indeed, there are some recent initiatives in that regard, notably Treasury Secretary Janet Yellen’s attempt to achieve a global minimum tax, but significant opportunities for tax avoidance will likely remain and be exploited, at least in the near term (Kudrle 2019).
Additional theoretical questions not addressed in this paper could yield further research. An interesting extension should consider the possibility of credible commitments in audit strategies. If the government can credibly commit to an audit strategy, it can prevent high value methods from ever being developed in the first place. At the limit, if the government can credibly commit to audit any innovative tax-planning methods, in equilibrium none would be developed. Future research should investigate the design and viability of credible commitment auditing strategies by the government. Similarly, if the government can credibly commit to a selective auditing strategy, by targeting methods that impose larger development costs, it would disincentivize developers for engaging in the design of complex methods, and the higher level of dissipation created by those firms could be effectively prevented. In this context, an interesting extension would be that of determining how would the auditing budget be endogenously chosen and allocated on the basis of the government’s objective function developed in this paper.
Further, it may be fruitful to examine the effect of tax avoidance within the context of optimal taxation, such as the work of Mirrlees (1971). The extent to which the benefits of tax avoidance are correlated with one’s wealth would seem to play an important role in the design of optimal redistributive taxes. On the one hand, the greater the correlation of benefits and wealth, the more sensitive redistributive taxes would have to be to tax avoidance costs. On the other hand, the less correlated they are, the less effective tax policy would be in redistribution.
While there are certainly many other issues to be examined, we hope that this paper may encourage both researchers in tax policy and policymakers themselves to account for the social cost of tax avoidance and the arms race dissipation in the development and prohibition of new methods into their analysis.
