New Venture Lab: Equipping Christian Entrepreneurs

Politicians love to talk about tax reform, but real reform almost never actually happens.  Instead of real reform, we usually just get more of the same: additional rules added to our already bloated tax code that is estimated to stand at around 74,994 pages as of the election in 2012 and costs the U.S. 30 cents of every tax dollar to collect.  Imagine the complexity of trying to interpret, file, collect, and adjudicate such a complicated tax code and now you can see why the IRS has a staff of 93,337 employees.

So how does a new tax law actually work and what are the unintended consequences?  Once a new piece of tax legislation gets enacted, the details of what the law means and how it will be enforced is left to a troop of relatively junior policy analysts who aren’t very business savvy, so it should be no surprise that there are all kinds of unintended consequences.  And, in a game similar to , once the market figures out how to get around the new tax law, and the law is changed to correct that work-around, yet another work-around is developed.  Indeed it is a bit of a game: the policy wonks come up with a new law and then the attorneys and CPAs working on behalf of the tax payer or company get to figure out a legal way to avoid the tax.  This is what I call “the law of unintended consequences.”  Like I blogged about in the past: “The collective wisdom of the free market is far smarter than the collective wisdom of our federal lawmakers and their staff.”

Here’s a few examples of unintended consequences in terms of corporate taxes and investor’s dividend taxes:

Some big corporations pay little or no taxes – Here’s just one example from this article about companies that pay little or no taxes: GE made a worldwide profit last year in 2010 of $14.2 billion, but made absolutely no U.S. taxes.  In fact they received a U.S. tax credit of $3.2 billion (more on how they manage their taxes here from the New York Times).

One example of how a company can avoid paying U.S. taxes is what’s known as tax arbitrage.  Just like my recent post on Accenture and the Irish corporate tax rate and it impact on jobs, U.S. companies with smart advisors will figure out how to game the system.  A very simple form of tax arbitrage works like this:

Let’s say the Chinese corporate tax rate is only 20%, while the U.S. tax rate is 35%.  A U.S. corporation that does business in China will then have the incentive to set up a Chinese corporation and run as much business through their Chinese corporation as possible.  Rather than move those earnings back to the U.S. corporation or parent company (known as repatriation), they simply keep the money in the Chinese subsidiary and then loan the money to the U.S. corporate parent.  The result of this transaction is that the U.S. corporate parent gets all the funds (which is what they really want), but pays no taxes on those funds.  In addition, the U.S. corporation is able to claim a tax deduction on the interest paid on the loan to their Chinese subsidiary, thereby actually reducing the amount of taxes paid to the U.S. on any U.S.-based earnings.  Sometimes those funds are never repatriated back to the U.S. and according to one economist, the amount of funds waiting to be repatriated is over $1 trillion.  Pretty slick, right?  And you would expect the CFO and his advisors of that company to do just that in order to boost shareholder returns.  That is the law of unintended consequences.  How could the policy wonks that wrote that part of the corporate tax code possibly have anticipated that move?

Foreign investors do not pay the anticipated capital gains tax on U.S. company dividends – U.S.-based investors are currently taxed at a capital gains rate of 15%, while foreign investors are supposed to be taxed at a rate of 30%.  Not only does this disparity in tax rates discourage foreign investment, which is one of the few ways to truly grow our economy, I’m just positive that policy analysts counted on gobs of extra tax revenue based upon that higher rate because foreign investors like buying dividend-paying U.S. stocks. 

But what happens in reality is a dividend tax arbitrage that works like this:

Instead of buying the U.S. company stocks directly, all the foreign investor has to do is pay a U.S. based investment bank to buy the stock for them, collect the dividends for them, and then pay them the dividends.  The U.S. investment bank only pays 15% in taxes and charges a fee to the foreign investor for their services.  The foreign investor is happy to pay the investment banking fee because the net result is an overall tax burden in the range of only 20%, a full one-third less than anyone thought they would pay.  And the U.S.-based investment bank is happy to provide the service and make a fee on the transaction.  Again, pretty slick move.  All legit and all an unintended consequence of a misguided tax law.

So how do we squash unintended consequences for good in terms of tax reform?  We have to simplify the tax code with a complete overhaul – real reform – that makes it so simple to understand and so simple to enforce that even a child can figure it out.

Look no further than the example of Estonia, one of the Baltic Tigers, and the simplicity of their flat tax system where nearly all businesses and residents file taxes themselves with a simple online tax form.  No CPA, no tax preparation, no receipts, no deductions, no hassle, and almost no unintended consequences.