What is tax avoidance?

There seems to be a fair amount of confusion in the public discourse between the idea of tax avoidance and that of tax evasion. These phenomena are different, and they require distinct responses from the writers and the administrators of the tax law system. We can observe the efforts to address them in the ongoing coordination efforts unfolding at the international level under the guidance of the OECD.

taxesIf a taxpayer engages in tax planning, or fails to do something (such as declaring an amount as income), and as a result pays little or no tax, is this clearly a problem that the tax system ought to fix? It depends on the reasons for the outcome. The common law principle is well known: Taxpayers are free to arrange their affairs to reduce taxation, and there is no duty to pay more than the law requires. Because of this foundational principle, the relevant inquiry is: What does the law require? This question cannot be answered simply by consulting the relevant legal texts. Instead it requires an examination of the architecture of rulemaking, implementation and enforcement.

There are any number of perspectives to consider in such a reflective exercise, including the spirit of the law as a whole and the intent of the lawmakers. Central to these inquiries are the roles played by two functions that are critical to every legal regime, namely: the detection of and response to relevant behaviours by administrators.

Detection and response are necessary factors for determining what constitutes sanctioned behavior. A taxpayer often pays a lower tax in one scenario than she would in another. In order to know whether and how the tax system should respond to the differential between the taxpayer’s outcome and any number of counterfactual outcomes requires as a threshold the ability to both detect the factual and construct the counterfactuals. Failing to detect that such a differential has occurred necessarily means failing to respond to the differential, and therefore raises the potential that taxpayers systemically violate the law.

Fixing information asymmetries to solve the detection threshold is what drives the OECD’s work on information gathering and exchange among countries. The goal of these efforts, most forcefully playing out in the context of the “common reporting standard” and appearing throughout the base erosion and profit shifting (BEPS) initiative, is to resolve informational asymmetries faced by tax administrators. Armed with the relevant facts about their taxpayers, tax administrators will be better able to detect deviations from the rules.

However, having information, even perfect information, does not reveal the definition of tax avoidance, since we have not identified the counterfactuals. Consider, for example, the taxpayer that engages in a series of transactions using various legal structures and mechanisms, and claims to owe a given amount of tax as a result. Even a tax administration equipped with perfect information about the taxpayer’s behaviour does not immediately reassess the taxpayer for a different amount of tax. Instead, the administrator faces a choice: Should it investigate and reassess the taxpayer, or not? It seems clear that the tax administration certainly should not pursue the taxpayer if it is clear that the taxpayer would prevail in the challenge.

To take an extremely oversimplified example, the tax administration should not (and most likely would not) investigate and reassess a taxpayer who successfully reduced or eliminated her tax burden by placing approved investments in tax-favored instruments, such as a government-sponsored registered retirement savings plan. To pursue such a taxpayer where the taxpayer’s behavior was clearly contemplated and indeed encouraged by the relevant legal text would be to waste resources.

One could therefore protest that investing in such tax-favored savings plans should not be seen as tax avoidance at all, since the tax system explicitly provides that the given behavior is not subject to tax. The action was by definition tax compliant, not tax-avoiding. But even if we can accept this idea, it is subjectively unsatisfying to apply the same logic to the taxpayer engaged in complex cross-border legal gymnastics to exploit highly technical rules with the assistance of an army of tax advisers.

There seems to be a world of difference between “straightforward” tax planning that is explicitly offered to “regular” taxpayers by their governments, and the ongoing public narrative about the convoluted undertakings of sophisticated taxpayers, involving offshore structures and transactions. The OECD work on country-by-country reporting seems clearly intended to address the public perception surrounding this gulf.

We can interrogate this space by considering the reasons why certain actions that are clearly known to tax administrations are nevertheless allowed to stand, other than for the reason that pursuit would certainly result in the taxpayer prevailing. This is a broad range of cases, and a voluminous one: A tax administration might choose not to pursue a given taxpayer or transaction for any number of reasons. Some of these are more palatable to the public than others.

For instance, lack of administrative capacity and resources likely top the list of reasons why a tax administration might not pursue actions that appear inconsistent with the law. This is a problem prominent in, but not limited to, lower income countries. But even in richer countries, administrative resources are scarce and decision-makers must triage their efforts strategically to meet economic, social and political goals. Waxing and waning of public reaction is one reason why administrators might direct resources to problems that are disproportionate to the revenues at stake.

Similarly, tax administrations may decline to pursue a given taxpayer or issue based on litigation risk – the chance of losing a contested assessment even where the government’s position seems stronger or more plausible than that of the taxpayer. This cost-benefit analysis can understandably be an unsatisfactory response to a public angered by the apparent unfairness of well-resourced and well-advised taxpayers. But it is a systemic problem that has little or nothing to do with the tax administrators’ access to information about the taxpayers’ behavior.

Finally, and significantly for the characterization of a taxpayer’s behavior as tax compliant or the opposite, a tax administration may decide not to pursue a given taxpayer or transaction following a calculation about how the actions of this type of taxpayer affect the economy as a whole, or (more sinisterly) the political fortunes of lawmakers. No amount of information disclosure or exchange resolves these issues. For this reason, much of the OECD’s work on BEPS involving information gathering and exchange is not a solution to a problem but a way to generate another round of bargaining on changes to the rules going forward.

Information asymmetry between taxpayers and tax administrations has played a role in confusing the public discourse about the distinction between tax avoidance and evasion. It is thus understandable that increased information gathering and exchange on a global basis have become key to many governments’ efforts to bolster the integrity of their tax systems. It seems likely that resolving this problem will not resolve all confusion and finally help the public understand how to identify and what to do about tax avoidance. However, it may help refocus public debate on what sort of tax policy is acceptable in a world of globally mobile capital.