Triumphing on Tax – Adam Smith’s contribution

Adam Smith had several things to say about taxation.

Triumph on Tax: A framework to talk about Tax

   Adam Smith may well be bewildered by the complexity of modern economic life, but he had some valuable things to say about the current corporate tax issue.

When talking about tax, it’s important to understand that there are all sorts of trade-offs that are made when legislating the rules on tax. There are four (maybe five) principles that apply:

  1. Proportionality / Fairness
  2. Certainty
  3. Timeliness
  4. Simplicity / Efficiency

Adam Smith, in his Wealth of Nations, penned those principles in 1776 making them as old as the United States. All of those principles, like the ones in play when it comes to CSR reporting, are more or less at odds with each other.

For example, the Proportionality/Fairness principle requires that every entity (person or organisation) should be treated equally. But we quickly realise that taxing companies on the same basis as individual taxes (largely on the basis of total revenue) would mean that most companies wouldn’t be able to make profits. So we have different rules for companies and individuals which falls firmly under the principle of Efficiency. However, that same variation also offends the Simplicity principle, which would otherwise encourage keeping legislation to a minimum (writers since Smith have separated and further divided his 4th principle).

Modern Taxation

The Simplicity principle has largely been discarded in modern tax systems, partially in response to the changing nature of business transactions, but also in response to increasing global trade. Instead Certainty and Efficiency now dominate legislative policy. As national tax legislation has increased (globally since the 1950s, both for income tax and company tax), international tax legislation has barely occurred at all, other than in the form of bilateral taxation treaties and free trade agreements. Usually those two things have the effect of reducing the overall amount of tax paid.

Some countries in that time have specifically designed their tax systems to encourage multi-national companies to set up local operations paying low taxes. For some, that is a deliberate strategy to attract foreign investment and stimulate economic activity. For others, it is the symptom of a bit of strong-arming by companies with much greater negotiating power than some governments can summon.

Companies meanwhile, using things like subsidiary entities, intellectual property and transfer pricing, have been able to avoid paying tax in countries where profit is made and artificially recognising profit in another country. Which means that some companies are paying less tax on their profits than citizens of countries where they operate. Such arrangements are entirely legal.

All of that to say that international trade and globalisation has had a somewhat unintended consequence of creating havens that are very low on tax legislation, or at least with a low (or zero) tax rate. Those havens are fundamentally at odds with Smith’s principle of Proportionality and Fairness. Some may argue that Smith’s principles don’t apply when companies go Super-National, but many would struggle to see why companies should be above nations in a global geo-political hierarchy.

Triumph on Tax: Differences between Individuals and Businesses

Triumph on Tax - Income tax is difficult for most of us to avoid

Triumph on Tax – Income tax is difficult for most of us to avoid

As individuals, we often seek to pay the minimum amount of tax we can, but no-one seriously believes that paying the least amount of tax possible is good for us all. Smith’s Fairness principle assumes that all meaningful participants in any Nation would be happy to pay something toward the upkeep of that Nation and to do so proportionally with the extent to which they rely on the Nation’s stability. It’s not entirely clear, but it seems as though Smith would rely on level of economic activity and amount of value extracted from a Nation as a guide.

I think we all intuitively get that companies should pay tax only from profits they have made, which is why we are all relatively happy that companies pay 30-40% tax (on average and in many countries) on their profits, which, as it turns out is not so different to what average individuals pay on their earnings.

We also inherently understand that, if someone isn’t paying their fair share of tax, others have to pay more in order to pay for all the things that government does or there will be a reduced level of services from government.

Jurisdiction Shopping

It’s no surprise then when individuals find out about companies avoiding tax on revenue earned in certain countries in favour of recording profits in low tax countries, they choose to stop buying from such companies (I’m looking at you, Starbucks). It grates on many people’s inherent sense of fairness.

Individuals usually can’t decide where they will earn their income (unless you are relatively wealthy and can afford to set up companies in low tax places like Guernsey or the Jersey Islands). Largely we pay tax based on the location of employment and we aren’t free to decide where that is. I’m not intimately familiar with Jimmy Carr’s tax affairs, but presumably he used a corporate entity of some type based in a low tax jurisdiction to help reduce the amount of tax he was paying. No doubt that cost a pretty penny, but also saved much more in tax.

Businesses are usually much more able than individuals to decide where they will pay tax and their ability to do so is, of course, entirely legal. Which means anything else is a moral question that companies should ignore, right?

Wrong, and we’ll see why next week.

“Every tax, however, is to the person who pays it a badge, not of slavery but of liberty

It denotes that he is a subject to government, indeed, but that, as he has some property, he cannot himself be the property of a master.”

Adam Smith, The Theory of Moral Sentiments (companion to the Wealth of Nations)  

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This is part Two of a Four part series on Tax. Other parts are available below:

Part 1     Part 2     Part 3     Part 4

While you’re waiting for the next instalment, here’s a video about global wealth distribution, including a small reference to transfer pricing and how it disadvantages ‘developing’ countries.

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