Taxation of Revenues and Opportunities for Avoidance

social purposes and redistribution. For others, efficiency can only be assured by the private transactions of economic actors through the market, hence the state is always an obstacle. Whether from the perspective of fairness or efficiency, the major difficulty in ensuring the equal incidence of income taxation is the treatment of income from different sources. Should the same rates apply to the wage­earner and the rentier? Should business or corporate profits be treated as income and taxed on the same principles as individual income, so that the sole trader, the partnership and the company are taxed in the same way? Is there a clear and valid distinction between income and capital gain? Underlying all these questions is the definition of income itself, the tax base, which is at the heart of the operation of direct taxes. It is also at the heart of the problem of avoidance. Taxation is not an abstract exercise in political or economic philosophy, but a practical matter of raising state finance for the public good. The overriding aim is therefore effectiveness, which must be predicted, based on estimations of the patterns of compliance, non­compliance and avoidance. It is in this sense that the question of legitimacy is central to the evaluation of taxation, as well as other types of legal regulation of economic activity. Legitimacy in this sense combines the interrelated issues of equity and effectiveness. To the extent that a regulatory system lacks fairness it fails in political acceptability, and will also tend to fail in effectiveness as enforcement becomes difficult and noncompliance grows. Equally, a system which has problems of enforceability and therefore of effectiveness will tend to lose political acceptability.

2. Taxation of Revenues and Opportunities for Avoidance

Studies of enforcement and regulation as a social process have normally focussed on compliance and non­compliance, leading to debates about the legitimacy of regulatory agencies seeking negotiated solutions rather than strict enforcement of the law. This assumes that the content of the law is unproblematic, a positivist fixed quantity, whereas on closer examination neither compliance nor non­compliance are as straightforward as they may superficially seem to be. 1 More can be learned about the dynamic of regulatory processes by analysing the often large grey area in the middle: avoidance. In relation to taxation, the accepted terminology in English distinguishes between the reduction of tax liability by illegal means, referred to as 1 For a study of taxpayer compliance, focussing on individual taxpayers, see Smith and Kinsey 1987: the study emphasises the problematic aspects of compliance for example, according to US IRS data, RIWD[UHWXUQILOHUVRYHUSD\DQGWKHCFRPSOH[LW\¶RIWKHUHJXlations means that much non­ compliance may be unintentional, or due to inertia or indifference. However, as with other socio­legal VWXGLHVRIUHJXODWRU\HQIRUFHPHQWDOWKRXJKWKHODZLVDFNQRZOHGJHGWREHRIWHQCFRPSOH[¶DQGIXOORI CORRSKROHV¶LWVDFWXDl content is deemed to be ascertainable. This contrasts sharply with the rule­ scepticism of radical realism, critical legal studies and postmodern approaches to law. evasion, and the attempt to do so by lawful means, avoidance. In French, direct unlawfulness is straightforwardly described as tax fraud, the rest is `evasion fiscale ¶ However, international usage has now accepted the distinction between evasion, which is clearly illegal, and avoidance, which uses legal means, but might in some circumstances be invalid or unlawful. The category of unlawful avoidance has grown in importance, as regulators have been unwilling or unable to pursue evasion. This has been due to a combination of the social factors involved in pursuing the stigmatization as criminals of respectable people, and the legal problems especially in proving intent in relation to economic transactions. Revenue authorities therefore normally prefer to settle cases on the basis of the recovery of the unpaid taxes, plus a penalty if possible. Very few cases are dealt with by criminal prosecution, although some may be selected, to produce an `in terrorem ¶effect. Individuals in the public eye seem prone to such targeting, as shown by the prosecutions in the UK of Lester Piggott the jockey successful and Ken Dodd the comedian unsuccessful, and in the US of the Hemsleys, prominent hotel proprietors partly successful. Both the line between valid and unlawful avoidance, and that between avoidance and evasion may be difficult to establish. For example, a taxpayer may have grounds, based on professional advice, for arguing that a particular transaction has produced no taxable revenue, and therefore need not be reported. Such failure to report would be evasion if the transaction were shown to be taxable and the taxpayer to have deliberately withheld information; it would be valid avoidance if the transaction were indeed held not taxable; and it would be invalid avoidance if taxable but the taxpayer were accepted as having honestly believed there was no obligation to reveal it. This typical situation also reveals the difficulty in such a context of proving the intent necessary to establish evasion, and the importance of the role of the professional adviser. The form taken by avoidance reflects and responds to the forms of the regulation being avoided. In general, avoidance of legal regulation of economic activities is rooted in the divergence between the legal form and the economic substance of transactions ­ the possibility for an economic actor of achieving substantially the same economic result by formally different legal means. This possibility enables an economic actor or legal person to avoid a legal transaction to which penalties are attached, yet achieve substantially the same result, by means of another legal path to which these penalties have not formally been given. The possibility of avoidance therefore poses an inherent problem, since the effectiveness of the regulatory system depends on a degree of reliability in the predictions of behaviour on which it is based. Both the opportunity and the motive for avoidance are minimised to the extent that regulation can rely on the same legal rule applied universally. So, if the same rate of tax were applied to all revenues of all persons in a tax universe the system would be the most robust or impervious to avoidance. If the same rate of tax applied to earned income, investment income and capital gains, no tax reduction could be achieved by legal devices attempting to divert a revenue flow from one to another of these channels. As we have seen, however, economic inequalities and the effects of competition make it impossible to achieve equality of regulation by treating all legal subjects alike. Regulatory systems are therefore subject to contradictory pressures. On the one hand, the extension of formal equal treatment to the widest possible universe of legal persons creates the most robust system, from the point of view of technical enforcement. On the other hand, substantive or economic equality, and political notions of fairness, frequently require distinctions to be made between different categories of legal person. Attempts to achieve such substantive equal treatment can be undermined, however, if differences in treatment can be avoided by exploiting the separation between formal legal categories and their economic substance. Avoidance is therefore not simply an opportunistic activity, and the opportunities for it do not arise equally; rather, it develops symbiotically with the mode of regulation. This also explains why both the toleration of a certain degree of avoidance, as well as the development of anti­avoidance measures, are political questions. In relation to revenue taxation, therefore, the problems of avoidance centre on two main points. First, the existence of different tax rates for different types of revenue income from different sources, such as employment, investment or business; capital gains; gifts; inheritance; and second, differences in treatment of different categories of legal persons. Avoidance revolves around either the transfer of revenue to a lower­ taxed person or of expenses to one who is more highly taxed; or the manipulation of transactions so that a benefit is received in a form or at a time that attracts less tax. Generally, such manipulation centres crucially on the dividing line between income and capital Kay 1979; Bracewell­Milnes 1980, p.24. Avoidance opportunities are therefore much less in relation to individual employment income than for either business income or income from capital Kay 1979. For the employed taxpayer, there is a close correlation between receipts and income: opportunities for avoidance are limited to fringe benefits, payments in kind and deferred benefits such as pensions. In contrast, in relation to business or investment the relationship between receipts and income is much more tenuous: there may be income but no clear receipt, or it may be unclear whether a receipt is of income or capital. Allowable expenses are a broader category and again harder to define precisely for business than for employment. The distinction between investment and consumption is harder to establish and easier to manipulate. Finally, it is easier to manipulate the direction or timing of business or investment revenues by use of fictitious legal persons trusts or companies.

3. The Economics, Politics, and Morality of Avoidance