How to reduce inequalities through better taxation?

This week, Pfizer, a US pharmaceutical behemoth, proposed to buy US rival Allergan for $160bn. One of the attractions for Pfizer was the ability to save $21bn in tax through the process of tax inversion. A tax inversion is the relocation of your tax domicile in a lower tax country. Allergan is registered in Ireland, where the corporate tax rate is 12.5% versus the US’s 35%. This is another example of a multinationals shifting profits.

dilbert tax inversion

Tax inversion can lead you to unsavoury juridictions

It is obvious that tax savings are helpful to create value for Pfizer’s shareholders. This made me think of the fundamental difference between corporation and income taxes, their role in wealth creation and why, in order to reduce inequalities, we actually need to lower income tax rates and increase corporate tax rates. Yup, you read correctly.
The misunderstanding comes from the fact that the base for corporate and income tax are very different. Let’s imagine a country where income tax is 30% and corporate tax 20%. Imagine two consultants. They have the same skills, generate the same income of €100,000 per annum and have the same spending patterns as illustrated below:john and jane spendingThere is one major difference though: John is employed while Jane is an independent consultant, billing her work through her own corporation.While in appearance, John and Jane have the same decent revenue, they will not accumulate the wealth at the same pace. Let’s start with John.

john taxation

Note that this is a good result as many people fail to save.

What about Jane? She bills her clients €100,000 pa through her corporation. However, a corporation allows her to expense many items. She works from home often? Then half her mortgage and bills can be expensed as a “home office cost”. She travels to meet the clients? Then she can expense her travel and the lease costs on her car. Dining out and the Golf Club membership are marketing outlays to woo clients. Laptop and phones are deducted as office equipment. Finally, she conducts her annual board meeting in the Bahamas where she happens to take her vacation. Jane’s corporation’s tax return will look that way:
jane taxationSince her corporation was taxed, Jane can draw some dividends from this net result free of income tax, I spare you the details of the calculation and give a rough €30,000 estimate. Jane will now be taxed on her income from her corporation:Jane Taxation 2While (V) looks lower than John’s, remember that Jane already deducted most of her expenditures through her corporation. She just has to pay half her mortgage and utility bills by herself and the discretionary spending items or €25,000.  What is left to save is therefore €23,200, which is €8,200 more than John.Jane puts one third more than John in her pocket from the same revenue. This money can be reinvested to generate bigger profits down the line.  This is how inequality is created through the tax system. This is why either income tax rates must fall or corporate tax rates must rise or both in combination.

shoes dilbert

Jane may struggle to expense her shoes though

Of Symmetry
Therefore, when I hear calls to increase income tax rates, I cringe. It ignores the fundamentals: an employee earns money, gets taxed and then can spend. A corporation earns money, spends and then gets taxed. Demanding higher income tax rates can only increase this asymmetry.

Now, let’s check some national examples. In the UK, the current Conservative government is working to cut corporation tax rate from 25% to 18% by 2020 while keeping the 45% income tax rate. They thus confirmed their reputation as working for the wealthy.

In France or Switzerland, there are many allowances for individuals to reduce their taxable base. Dividends are taxed at high rates, further reducing the advantages of corporations. However for France, the “prélèvements sociaux”, another tax, suddenly wipe out the previous positive impacts.

Last but not least, the US. The 2001 Bush tax cuts helped reduce marginal income tax rates but they also slashed capital gain and dividend tax rates from the marginal income tax rate to 15%. In the end, the asymmetry was not eliminated and the lower rate on dividends explain easily why former presidential candidate and millionaire Mitt Romney can pay an effective tax rate of 15%.

To solve the inequality crisis, the US needs comprehensive tax code reform. The US presidential election is in less than a year – let me know if you saw an astute tax reform in the candidates’ platforms.

tax rate dilbert

Citizen Warren Buffett is also donating most of his shares to attract a sizeable tax break.

PS: this week and next I am travelling so you may not hear from me next Friday. Have a great week-end.

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