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A Few Words on Tax Evasion, Tax Avoidance, and Tax Competition

4 min readBy: Mark Robyn

An organization called the TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Justice Network (TJN) will soon release a study that ranks the United States, specifically the state of Delaware, as number one in the world on their Financial Secrecy Index. The study looks at 12 indicators of bank and corporate transparency to determine which countries (or states) are most secretive.

I am not a financial secrecy expert and I am not going to dispute their findings. However, on TJN’s blog they cite an article by another source that they say comes to the same conclusion, the Spear’s Wealth Management Survey. But the TJN and the Spear’s studies don’t seem very comparable. The Spear’s article that they cite focuses on Delaware tax rates and apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. issues, something the TJN bank secrecy study doesn’t touch on. And I think the comparison highlights some important issues regarding taxes that are worth exploring.

First of all, on the factual side, the Spear’s article claims that Delaware has “a zero per cent rate of tax.” This is simply incorrect. Delaware has an 8.7% corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate, plus a gross receipts taxA gross receipts tax, also known as a turnover tax, is applied to a company’s gross sales, without deductions for a firm’s business expenses, like costs of goods sold and compensation. Unlike a sales tax, a gross receipts tax is assessed on businesses and apply to business-to-business transactions in addition to final consumer purchases, leading to tax pyramiding. . Delaware also has a personal income tax with rates ranging from 2.2% to 5.95% of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . Whether a business is a flow through entity (LLC, LLP) or a corporation, their Delaware income will be taxed one way or another in Delaware, either under the personal or corporate income tax.

I emphasize Delaware income because it is possible for a company to be based in Delaware and earn income outside of that state (say in another state or another country). In such a case that income earned elsewhere may only be taxable in that second jurisdiction and not in Delaware. But this does not make Delaware a tax haven, as Spear’s seems to indicate. Determining the income that is taxable by a given jurisdiction, a process known as apportionment, is essential to ensuring that income is not taxed twice in two different jurisdictions. Just because a corporation is based in one jurisdiction does not mean that all its income necessarily is or should be taxable in that jurisdiction.

Secondly, and most importantly, Spear’s seems to be confusing low-tax jurisdictions with tax evasion havens. In the United States a state’s legislature can choose to fund its state-level government in a variety of ways. Some states have no sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. , some states have no personal income tax, and some states have no corporate income tax. States choose levy a combination of some or all these taxes, plus others. These differences between states promote healthy competition for businesses looking to get the best product for the taxes they remit. We would expect a business to want to locate in a state with a comparatively low tax rate, all else equal, and there is nothing wrong with that.

Finally, it should be noted that even in states that have no corporate or personal income taxes (like Wyoming or Nevada), companies based there will still pay the U.S. federal corporate income tax at a rate ranging from 15% to 35% (or the federal personal income tax, for flow-through entities like LLCs or LLPs) on their U.S. income. Again, the apportionment issue (determining what income is taxable in the U.S. and what income is not taxable) is important, justifiable, and unavoidable.

TJN can plausibly argue that Delaware’s minimum requirements for forming a corporation are too lenient, that it makes the state a good location for foreigners looking to evade their country’s taxes. Tax evasion, that is, not paying taxes that are legally owed, is a problem and should be addressed. For more information on properly defining tax havens see Tax Foundation Senior Fellow Robert Carroll’s Special Report: Bank Secrecy, Tax Havens and International Tax Competition.

However, tax avoidance, defined as organizing one’s affairs in such a way as to legally minimize one’s tax liability, is more of a gray area. We oppose arrangements like Sale-In Lease-Out deals, which are (or were) technically legal in the U.S. but have no real economic substance. But as the well-respected Judge Learned Hand commented in 1935, “Anyone may arrange his affairs so that his taxes shall be as low as possible… Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.” Most people would not consider the use of 401(k)s to be tax avoidance, even though such accounts receive preferential tax treatment and allow taxpayers to minimize their current tax liability.

Finally, tax competition, epitomized in certain jurisdictions offering broad, low taxation (which is not the same as targeted tax breaks), encourages efficiency in government and provides a way for taxpayers to decide if they are getting their money’s worth from the government services they pay for.

These are all worthwhile ideas to explore, but in these discussions we need to be to careful not to confuse issues like tax evasion, tax avoidance, and tax competition.