Whether it’s the Pandora Papers or Lux Leaks – tax evasion and avoidance cost EU states billions annually and cause a stir even though many of the activities that are uncovered or remain hidden are not illegal. This is the reason why, last summer, EU states introduced mandatory disclosure rules for certain cross-border tax arrangements – much to the annoyance of the tax consulting industry. However, a study by Kai A. Konrad analysed the market for tax planning and showed that not only states but also the top players among the tax experts stand to benefit from the new rule.
Auditing and consultancy companies, tax consultants and lawyers have a key role to play in tax avoidance as they are the architects of tax savings models for well-heeled individuals or big companies. Complex tax laws intertwine with international tax treaties to produce a mesh of regulations and framework conditions – more densely woven in some areas and more loosely in others. As a result, multinational companies in particular are able to entirely legally and systemically reduce their tax burden. For this they take advantage of legal loopholes and freedoms granted to them under civil law in order to arrange their affairs beneficially in terms of their tax burden.
External tax experts frequently assist in an “optimisation of the tax situation”. Some of them are particularly inventive and develop innovative tax avoidance products with colourful names such as “Goldfinger” or “Double Irish with a Dutch Sandwich” which they can generally adapt with very little effort for a range of different companies. These experts compete with other service providers who may imitate the tax saving models the experts have developed and sell these on themselves. At some point, the innovators among the tax tricksters end up with so many copycats that the business is no longer really worthwhile.
EU-wide directive on mandatory disclosure
The role of the legislator in the market for tax avoidance models is to close unwanted legal loopholes so that existing models can no longer be implemented. In order to accelerate this process, a new EU-wide directive on the mandatory disclosure of cross-border tax arrangements was introduced on 1 July 2020. The tax consultancy industry heavily criticised the legislative proposals in the lead up to this. Kai Konrad’s game theoretical analysis shows that closing legislative loopholes more quickly is not just in the interests of the tax state, but also benefits the more innovative tax consultancies. This is because closing up old tax loopholes means new demand for more imaginative tax planning models. Due to a lack of alternatives, these can initially be sold at higher prices. For the highly innovative consultants this exclusive business is more lucrative than selling old tax saving models in a highly competitive market. And it seems that the Treasury also benefits from the new situation. Since the new models are more expensive than the old ones, they are purchased by fewer businesses. As long as no affordable copycat products are available, it is more beneficial for some businesses to pay their taxes than to hire innovative but expensive tax experts to provide consultancy. For those leading the sector, this removes an apparent conflict of interest between the tax state and tax consultancies, who earn money with tax optimisation. This is in line with anecdotal evidence and studies reporting that some of the major companies generously provide their advice and specialist knowledge on tax issues to representatives of political parties or to the fiscal authority.
Which Strategies Do the Market Participants Apply?
Kai A. Konrad examined the optimal behaviour strategies for the individual players in the market for tax avoidance and identified the following: a key factor in the market equilibrium is the relationship between the time it takes the tax authorities to close the tax loopholes and the time needed to develop new innovative tax planning models.
An optimal situation from the perspective of welfare economics – even though unrealistic – would be one where the tax authorities respond immediately to new tax avoidance products and can prevent these even before they are used.
A monopolistic situation with individual innovative businesses developing and selling new tax saving models, but where the legislator is able to intervene before copycats come in to imitate the products, is better for the tax state than a competitive situation in which lots of service providers crowd into the market with established tax avoidance products. The top consultancies will also benefit from the monopolistic situation because they are then able to earn significantly more. However, calculations show that if a competitive situation emerges, then periods where there are innovative tax planning products in a monopolistic market alternate with periods in which many businesses supply tax avoidance products in a competitive market. This would benefit those less innovative businesses; however, it is not in the interest of the tax authorities and is not beneficial for the top consultancies.
Konrad, K. A., 2021. Dynamics of the market for corporate tax avoidance advice. Scandinavian Journal of Economics, 123(1), S. 267-294.
October 2021