The Panama Papers and Incentives

After what's being hailed by some as the largest data leak in history, the journalism world is now awash in documents from a law firm based in Panama, Mossack Fonseca. This doesn't sound terribly interesting, except that this particular law firm's specialty was setting up and administering offshore shell companies for some of the world's wealthiest people. The leak apparently included several client lists, and some big names have shown up there. Naturally, most of the Western press is focusing on Russian President Vladimir Putin's connections in all this (in spite of the fact Putin wasn't actually in the list, just one of his friends). But there were some more interesting names. Pakistan's prime minister, Iceland's prime minister, Ukraine's president, and the father of British prime minister David Cameron all received honorable mentions in the leak. And since many people use offshore companies for the purpose of evading taxes, the idea that many leading politicians and their colleagues are implicated in such endeavors is delightfully ironic, if unsurprising.

The implicit spin on this story in most outlets is that it shows how the rich dodge taxes. And indeed, in the wake of this revelation, several governments have made it known that they are undertaking investigations to uncover any wrongdoing. There's a chance they might even find some legitimate violations. However, it's important to note, as Glenn Greenwald did at The Intercept, that there's nothing illegal about setting up a shell company to avoid taxes. Greenwald suggests the real scandal here is how much of this is in fact legal.

This write-up by Matt Yglesias at Vox offers a nice primer on the uses of shell companies and what we've learned so far from the Panama Papers. Among the interesting facts is an internal memo at the firm in question which notes that 95% of their business was related to tax avoidance. Unfortunately, the proposed solution from Yglesias is entirely implausible--a minimum global standard of taxation and disclosure. Right. I assume that will happen about the same time as the entire world agrees on climate change legislation--more commonly known as "never".

Greenwald and Yglesias both approach this as a problem, essentially, of political corruption and inaction. The underlying narrative is that the wealthy elite have de facto control over the political systems in the US and elsewhere such that they can avoid paying taxes. That's probably true. And we can complain about it and denounce it all we like, but it's not likely to change. Indeed, under Democratic President Barack Obama--which would theoretically care about the rich and their tax-dodging schemes--reports are that the US has actually become one of the most popular tax havens in the world based on the amount of secrecy it affords. Surely, some will blame this on the Republicans or Obama's relative centrism compared to someone like Bernie Sanders. But even if we grant the unlikely scenario of a Bernie Sanders Presidency and even assume his revolution retakes the House and the Senate for the Democrats as well, we should still be skeptical that he would be able to, in fact, do anything to improve the status quo.

In order to fully prevent tax avoidance, the US government would need to craft a comprehensive reform. But obviously, the most extreme loopholes in the system today probably weren't built into the codes intentionally. On the contrary, rich people with a 40% tax rate incentive, employed a small army of tax accountants and attorneys to come up with creative (and legal) and complicated systems to help them reduce their tax burden. For a great many people, creating favorable tax structures is a career. And there's nothing nefarious or illegal about it. High tax rates created a demand for this service; the market met the need.  The cost of these services certainly runs in the tens or even hundreds of thousands of dollars in some cases, but that sort of service would completely pay for itself if you're rich enough.

Thus, the question then becomes, is it likely that even a Bernie-inspired Congress is going to be able to design a tax reform that legions of well-heeled tax attorneys and accountants won't be able to get around? The answer is absolutely not. At best, Congress would be left to play a useless and ceaseless game of whack-a-loophole every time a new one was exploited.

And even if it did miraculously succeed, it would be a hollow victory. Companies that have been unable to sufficiently avoid US corporate tax laws have simply fled the country by reestablishing their headquarters in a more favorable jurisdiction. If high wealth individuals were faced with a similarly severe threat of massive taxation, chances are some of them would do the same.

A much better solution, from virtually any angle, is to try to reduce tax rates and simplify the tax codes. Reducing tax rates reduces the incentive for people to find elaborate tax avoidance methods. If someone has a choice between paying $1M in taxes or $800k to hire a slew of tax attorneys to create a potentially suspect tax strategy that gets around them, there's a chance they will just pay the taxes. But the higher the tax rate is, the greater that differential becomes. Similarly, simplifying the tax code, would reduce the cost of compliance and further decrease the incentive to avoid taxes. If people really care about reducing tax avoidance, we should start by decreasing the incentives.

Summing Up
Without question, the Panama Papers will continue to reveal some more major names among the offshore clientele, and hopefully even lead to some political scandals in the US. But as we learn about the clients and hear the inevitable accusations of criminality or insufficient patriotism on account of avoiding taxes, we need to remember two things: most if not all of what they did is probably legal, efforts to make it illegal in the future will fail. The solution to this problem won't come from increased threats or regulation; it will come from first understanding that which we all intuitively know to be true: incentives matter.