Everyone’s A Tax Evader

People respond to incentives. Often governments attempt to change the inputs of an existing situation to get a certain output without anticipating that people will respond differently to the new inputs. I find this most consistently and amusingly illustrated with tax policy.

For example, pending a “fiscal cliff” agreement, capital gains taxes are set to rise significantly in 2013. But even if rates go up, the government still won’t have a revenue increase that’s equivalent to the rate increase. Why not? Because lots of corporations are responding to the impending tax hike by paying out next year’s dividends a little early so they fall under this year’s tax rates.

This cleverness is not restricted to big businesses and their shareholders. People all over the world try to avoid onerous taxes if they can help it – and I’m not just talking about those infamous “offshore accounts” for wealthy Americans. No, the generally higher-taxed Europeans are even cleverer than us.

By now we all know about those Greeks who somehow had 50 times more swimming pools in satellite photos than on their tax forms. But there are smarter ways to avoid taxes, and it seems like every week I read about a new country whose citizens are responding to changing tax incentives in remarkable ways.

Country #1: Britain. When their government raised the top tax rate to 50% in 2009-10, two-thirds of Britain’s millionaires disappeared from the official statistics. When they lowered the rate a couple years later, almost half of the millionaires suddenly appeared again. Did thousands of Britons temporarily flee the country, or did they just come up with creative accounting to lower their declared incomes? We may never know, but it certainly took its toll on the government’s coffers.

Country #2: France. France is trying to solve its budget woes with a whopping 75% tax rate on its wealthy citizens. Many of them are fleeing to Belgium.

Country #3: Spain. It’s not just millionaires who are avoiding taxes in Europe. The Cleverest Evasion of the Year Award goes to this Spanish theater director who is avoiding a new 21% tax on theater tickets by selling carrots (taxed at 4%) that come with free tickets!

Many of these countries have racked up serious debts by spending more money than they’ve been taking in. It’s never popular to cut spending, but deficits are not solved on taxes alone. This is not due to any philosophical theories about the right to keep your own earnings but simply due to the reality that people respond to higher tax rates by figuring out ways to avoid them.

To bring things back to the United States, despite thousands of changes in tax laws over the last century, the percentage of income taken by the government has remained remarkably consistent.

It’s almost like there’s a sort of “natural law” that limits the amount of money governments can reasonably extract from their populations. They can increase the rates or the kinds of things that get taxed at those rates, but there’s a point of diminishing returns where people just don’t respond the way governments expect them to, whether it’s a millionaire deciding to work less or a local theater director giving away highly-taxed items with purchase of lower-taxed items.

This has consequences for those attempting to reduce our deficit. I’m not opposed to higher taxes as part of a deal; our spending levels may be much higher than our revenue limit, but that doesn’t mean revenues are close to that limit, either. The “Bush tax cuts” of the last decade clearly led to tax revenue that is lower than average, despite claims by Mercatus that “it is spending, not revenue, that has deviated from its historical path.” They both have deviated, and spending has deviated more, but revenue has deviated as well.

Still, it is clear that revenue alone cannot resolve all of the deficit, or even most of it. You might be able to pick tax rates that do so in theory, but if you tried to do that in reality, you would find people responding to those new incentives in brilliant ways you never imagined. You might squawk about how greedy and selfish and unfair all of those people are. You might double-down on your proposals to extract all that revenue from them. But it would all be wishful thinking, and that’s just a reality that many opinionated policy proposers seem unwilling to accept.