April 4, 2013

The Guardian’s BVI revelations may cause a damaging flight of the wealthy

Today’s revelations in the Guardian about people who hold accounts in the British Virgin Islands certainly heightens interest in this area. The really interesting story will be “What happens next?”

This has several facets:

1) How many of these accounts are tax compliant and how many represent tax evasion?

2) How vigorously will the authorities prosecute the tax evaders?

3) What resources and skill sets do the government tax authorities have to follow-up?

4) Can whistleblower legislation be used to arm a private sector army of tax evasion hunters to supplement government tax authority efforts?

5) What will be the response of the wealthy to this event and what will be the impact of that response on government resources?

Read more: The BVI revelations tar all HNWs with the same brush

Options for the wealthy

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Let me expand on this last question.

A wealthy individual who feels they pay too much tax has three basic strategies that they can follow:

Option 1) “Play the Game Better”: This means using all the LEGAL methods of avoiding tax under the laws of the relevant taxing jurisdiction(s). This option has the advantage that the individual does not need to overcome life inertia with major life or business disruptions.

The disadvantages are that there is only limited tax reduction which can be accomplished with this option AND the government constantly moves the goal posts. This results in decreased future tax savings as loopholes/ exemptions disappear and also on-going costs of adjusting your previous strategy and structure;

Option 2) “Leave the Game”: For most taxpayers, this involves becoming non-resident. For Americans this requires giving up their US citizenship or resident alien status. Generally it means bringing forward the payment of capital gains.

This is not necessarily a bad thing for the following reasons a) interest rates are low to borrow money to pay any tax immediately owing on a deemed disposition; b) no longer have any tax liability to your current tax home from this point forward; c) do not have to worry if government decides to increase income or capital gains OR bring in new taxes like mansion taxes, wealth or estate taxes.

The major disadvantage is that the individual has to go through a one-time effort to overcome their life inertia. As there are MANY places in the world that the wealthy could move their tax residence which allows them to minimize their future tax payments without compromising their personal or business lifestyle, the future benefits could easily outweigh the one time effort;

Option 3) “Cheat the Game”: In years past, it was cheap and easy to engage in tax evasion. This meant that the morally challenged who were considering this option, did not seriously consider that they would ever have the pay the penalty of discovery. However, for all the reasons I predicted in my blog (and which have been borne out by actual events), the penalties of executing Option 3, are suddenly real and unattractive.

Which one to choose?

The obvious impact of the wealthy no longer considering the last option is that they will be focusing on the first two options. This means that more wealthy taxpayers will be taking advantage of legally available tax avoidance strategies. Obviously the government will respond by closing various currently legal opportunities.

Since Option 3 is off the table and it is predictable that Option 1 will have decreasing value in the future, this will focus the attention of the wealthy on Option 2. As they discover that the cost and difficulty of leaving the game is not really that high (now that they have seriously examined it), you will see an ever increasing number of wealthy taxpayers leaving their current tax system.

Since in most G9 countries the top 1% account for just over 1/3rd of all personal taxes collected, even a slight increase in the number of 1%ers who leave the tax system will have a dramatic impact on future tax revenues. The real question will be how will the government legislatively respond to all of this.

How to keep the Golden Geese

There will be naive efforts to try and lobby the OECD to advocate a global tax “level playing field”. This effort is doomed from the outset, because of the prisoner’s dilemma. Hell, efforts to try to impose standards for government fiscal policies across the eurozone weren’t even possible. Try making a broader effort over a vastly increased number of independent countries, all of whole are trying to keep and attract Golden Geese to their shores, is hopeless.

Therefore the real action will take place domestically as government examine their options. If they decide to increase the cost of leaving (the American approach), they will see the same result the US experienced. Specifically RECORD numbers of Golden Geese leaving, before the cost gets even higher.

If the government were smart, they would rather bring in policies that would attract more Golden Geese to their tax system. This means making if more attractive than the system that they are currently considering leaving. Just as a small number of departing Golden Geese has an asymmetric negative impact on total tax revenues, the attraction of even a relatively small number of Golden Geese will have a disproportionate positive impact.

I don’t know if I am showing my geekiness by being so intellectually interested in the bigger implications of these various events, but I truly feel that there are a variety of things from Cyprus to outing of tax evaders which have caused a tipping point to be reached where we are experiencing a major disruption to the standard government revenue model which has been in place for the past century. Recognition of the paradigm shift is the first step. Properly reacting to the paradigm shift is ultimately the most important step.