June 1st, 2016

The Panama Papers’ sobering lessons

by Enrico Colombatto In early April 2016, the so-called Panama […]

Team AEC

In early April 2016, the so-called Panama Papers scandal broke. A consortium of journalists published a list of celebrities, artists, businesspeople and politicians who were connected to offshore companies managed by a law firm in Panama. Not all of these companies had been set up to reduce or evade taxes and not all had accounts in Panama, but the exposure caused considerable embarrassment.

The Central American country of Panama has the reputation of a tax haven that steadfastly declines to provide information to tax authorities around the world. Such havens go a long way toward frustrating government efforts to tax wealth and financial incomes effectively and they encourage tax dodging. The Panama Papers story invites one general observation and raises two important issues.

Political hypocrisy

The observation is simple: a significant number of the individuals implicated in the affair are not successful entrepreneurs or wealthy heirs to fortunes accumulated in the past; they are professional politicians. Some on the list occupy the most senior posts in their respective countries. This proves that seeking tax shelters is not a proclivity unique to multinational corporations, which are often pictured as agents of pure evil, greedy exploiters of naive consumers and hapless taxpayers.

The Panama Papers affair highlights that among the users of tax shelters can be found members of those very political elites that have been preaching equality and fairness for the little guy, and possibly the supreme interest of the fatherland. These are some of the same people who glibly pontificated about the allegedly disastrous consequences of globalization.

The healthy side of the Panama Papers episode is that it sets the record straight: tax evasion and tax avoidance reflect an attitude held by several layers of the global population. It cannot be dismissed as deviant behavior by select groups – say, criminals, successful entrepreneurs or multinationals.

Populism and money

Of the key issues raised by the scandal, one concerns future developments in tax structure, while the other has to do with intergovernmental cooperation on taxation.

Governments worldwide are aware that taxpayers have become less tolerant. States can still maintain significant budget deficits thanks to cheap debt financing, but raising taxes is out of the question – unless the tax hikes can be presented to the electorate as exceptional and mostly targeting the rich. In this respect, the Panama story sends out mixed signals:

It seems to confirm the widespread suspicion that the rich can quietly avoid high taxation. As a result, the Panama Papers scandal stokes envy and resentment; the logic of populism prompts politicians to demonize the rich in order to tax the middle class.
It illustrates why tax-the-rich campaigns have diminishing traction: they produce disappointing financial results, and for a good reason – in most countries, there are simply not enough of the rich to tax. The tax authorities are definitely aware of this reality.
Moreover, tax avoidance inevitably intensifies when tax rates surge – which only makes some new sort of government expropriation more likely down the line.
Public opinion also perceives tax shelters as an option available only to the ultrarich, not to the upper middle class and the lower layers of the taxpaying population. As a consequence, higher tax pressure leads to more inequality (the rich get off lightly in relative terms) and works as a powerful disincentive to investing in human capital and entrepreneurial ventures.

No consequences

Three preliminary conclusions are in order. Firstly, the Panama Papers scandal is not the first documented case of large-scale tax evasion. However, just as in previous episodes, it is nearly certain to have no practical consequences. Illegal tax avoidance will not disappear from the face of the earth, while the extra revenue that some governments may squeeze out of companies or individuals caught in such scandals will be a drop in the ocean of public indebtedness.

The problem might actually become more acute. The thriving activity of tax havens shows that a large market awaits countries that decide to make the switch from being tax hells. This could prove lucrative to a number of small and medium-sized states that overcome their populist reflexes and shrug off the inevitable attacks from Western media.

Shady intermediaries

Secondly, one can predict that those looking for reliable tax shelters after the Panama Papers will be paying more attention to the quality of intermediaries. Contrary to what is commonly believed, the key actors in a tax haven are not government bureaucrats but operators of asset management and law firms; they appear to have made the massive leakage in Panama possible.

And thirdly, tax structures are going to change in the future. The increasingly sophisticated tracking technologies used by the tax authorities to catch tax fugitives have proved to be largely useless. For incriminating information on taxpayers, national tax authorities continue to rely almost entirely on leaks and reports from citizens – which invites blackmail, revenge and corrupt behavior, and not just by disgruntled employees of the intermediary firms.

From a broader perspective, the ability of the tax havens to stay in business shows that the only sensible government strategy to limit tax avoidance (and the associated distortions) is to focus on taxing consumption, rather than income or wealth.

Tax quandary

This will lead to tension. As revenue-seeking states begin to reshape tax structures by increasing the burden on consumption, they will produce a political side effect. Progressivity, so dear to populists, is easily implemented when taxing income or wealth. It vanishes when consumption is taxed. The advocates of redistribution will complain, and politicians will be tempted to dull the egalitarian anger of voters by coming up with special wealth-taxing schemes that pretend to soak the rich.

Still, future taxation is likely to increasingly depend on consumption taxes, supplemented by a variety of levies on wealth that will leave the superrich unaffected. Such individuals will continue to enjoy nearly complete freedom to move their assets around the globe and avoid taxes. However, wealth taxes will take a toll on the upper middle classes and those who aspire to improve their standing in the hierarchy of income and wealth. In any case, there will be a drop in tax progressivity.

Futility of spying

What about the much talked-about international cooperation and monitoring of financial transfers? As mentioned earlier, the irony of the Panama Papers and of similar, earlier disclosures is that they did not surface thanks to government surveillance. In fact, the disclosures resulted from a combination of stubborn investigative journalism and the unprincipled attitude of individuals with access to the data. This suggests that cooperation between governments to hound the industry has merely succeeded in creating a noxious administrative hassle for millions of companies and individuals, without raising much additional revenue.

More generally, international cooperation in the realm of taxation is two-pronged. The exchange of information is supposed to help governments catch and prosecute tax dodgers, while tax harmonization’s goal is to reduce incentives for such behavior. Episodes like the Panama Papers highlight the fact that these two strategies actually address different problems and generate very different outcomes.

Banks in crosshairs

Intergovernmental cooperation on tax matters works only if the international authorities have enough clout to force the intermediaries in the havens to give in. From this perspective, one can expect that banks will soon be in the governments’ crosshairs. The banks may be offered, for example, more generous bailout options and less stringent stress tests in exchange for stricter regulation, transparent disclosure and systematic investigation. In particular, banks could be admitted to some kind of international guarantee and bailout system if they agree to assist governments investigating the activities of their clients.

By contrast, it appears that any progress toward harmonization will provide little real help in limiting tax evasion. That will not prevent governments from using episodes like the Panama Papers to promote harmonization for the sake of equality and social justice, despite evidence that the real objective is to enhance the role of government in the economy. The result would be to stifle competition and bring the developed world another step closer to some form of central planning.

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