Failure to Enforce the Tax Laws

David Cay Johnson’s Tax Cheats Called Out of Control notes:

So many superrich Americans evade taxes using offshore accounts that law enforcement cannot control the growing misconduct, according to a Senate report that provides the most detailed look ever at high-level tax schemes.

This article drew the attention of Mark Thoma, Max Sawicky, and Kevin Drum. Kevin recommends:

Better statutes and more auditors would help, as would appointment of judges who don’t turn themselves into pretzels to find reasons to approve of convoluted tax avoidance schemes. (“The money changed hands for two and a half minutes? Sounds like a genuinely risky investment to me, not a sham transaction. Case dismissed!”) There is, literally, no non-laughable argument for not cracking down on this stuff.

An earlier article by David Cay Johnson noted:

The federal government is moving to eliminate the jobs of nearly half of the lawyers at the Internal Revenue Service who audit tax returns of some of the wealthiest Americans, specifically those who are subject to gift and estate taxes when they transfer parts of their fortunes to their children and others.

Kevin calls this for what it is – a de facto repeal of the Estate Tax. Dean Baker notes:

these lawyers generate an average of more than $2,000 per hour of work in revenue for the government. This implies, that unless they are paid more than $4 million a year, the government will lose money by laying them off.

I have argued that effective enforcement of the Estate Tax would require that the government improves its ability to spot low-ball valuations.

One could note the good news that the IRS is increasing its staff to enforce the transfer pricing regulations against attempts by multinational enterprises to shift income from U.S. entities to their offshore affiliates. We at Angrybear have spent a fair number of posts over whether the IRS is appropriately addressing transfer pricing enforcement, including this example:

But you might ask don’t the tax authorities have economists working for them as do the representatives of national tax authorities. While they do, I would ask you to review some of the insightful (if not jaded) comments from AB reader OldVet as to how the attorneys for the IRS seem to get in the way of effective transfer pricing enforcement while those pretending to be economists for the representatives of the taxpayer play the economists at the tax authorities for fools with “analyzes” so disingenuous that I suspect the National Review would refuse to put their writings up as being credible. Note, however, that the point that Kash and Alfons J. Weichenrieder make is that tax authorities often ask their economists to also act like overpriced whores. At the end of the day, honest multinationals have to pay more to avoid double taxation, while those who engage in transfer pricing manipulation to evade U.S. taxation somehow escape effective scrutiny. I wish it were as simple as the line in Shakespeare’s Henry VI: “The first thing we do, let’s kill all the lawyers”. Yet, these lawyers are trained to be advocates. Economists are not trained to be paid whores, but alas we see so many behaving that way.

The point that Kash was making in his paper with Alfons J. Weichenrieder is that tax authorities unfortunately go after honest multinationals, which imposes either double taxation or compliance costs. The IRS often goes after the small fish in these endeavors, but alas they often leave the big fish alone even when the big fish are doing some brazenly suspect transfer pricing games.

Consider, for example, the transfer pricing game that got Tommy Hilfiger in hot water:

Tommy Hilfiger may not be the only company to find itself on the hot seat over the potential to use foreign buying offices to improperly shift income overseas and, thereby, avoid paying U.S. income taxes. As large American manufacturers have moved production abroad throughout the last decade, the practice of using foreign buying offices to help source, develop and produce merchandise has become widespread and so has the potential for fraud, analysts said.

While Tommy Hilfiger initially paid its related its related party foreign buying office a commission equal to 10% of goods purchased, the government ultimately allowed it to charge a commission rate equal to 7.5%. I’m not sure whether Wal Mart does the same transfer pricing game, but since everyone likes to pick on the world’s largest distributor, let’s do as well. Wal Mart purchases about $20 billion in goods from China so a 7.5% commission rate would translate into $1.5 billion in commission payments. Maybe the arm’s length commission rate is 2.5% so the amount of income shifting is only $1 billion. Only?

You might protest that it’s only 6% of Wal Mart’s worldwide income but its imports from China are about 8% of their total purchases. Companies that rely more extensively on purchasing goods from China have been known to cut their effective tax rates in half or more. And consider the fact that our imports from China are approaching $300 billion so if the typical income shift is 5% of these purchases, we are talking about losing $15 billion in the corporate income tax base.

So isn’t this worth a little IRS scrutiny? Our story on Tommy Hilfiger continues:

The Internal Revenue Service is currently conducting an audit of toy maker Mattel, which uses foreign buying offices, according to SEC documents and a report by Prudential Equity Group analyst Lizabeth Dunn. Mattel spokeswoman Lisa Marie Bongiovanni said that it would be unfair to draw comparisons between Mattel and Tommy Hilfiger. An IRS audit is “done in the normal course of business,” Bongiovanni continued, “and does not mean that a law has been broken.” Companies that own foreign buying offices outright, as Tommy Hilfiger does, are likely to come under more scrutiny than those that hire outside firms to perform the same services, experts said. To protect themselves in the event of an audit, companies that own their own buying offices typically obtain what is called a transfer pricing agreement. The analysis, usually conducted by an accounting firm, scrutinizes the transactions to ensure they are conducted at arm’s length.

While the IRS has its transfer pricing specialists, multinational enterprises can hire their own specialists. Any guesses as to who will prevail in this “battle of the experts”?

As an aside that might get Brad Setser thinking, consider the claim from Stephen Green that China’s Trade Surplus May Be an Illusion, which rests in part on this argument:

IN THE FAMILY. This “mis-invoicing” of trade was commonplace in the last decade, but back then it was a way of getting money out of China. Now we think it is being used to bring funds in, given the strong likelihood the yuan will appreciate in value relative to foreign currencies down the road. This again inflates the value of Chinese exports. The exaggeration in the value of Chinese exports is probably getting another boost from the phenomenon of transfer pricing. This involves the price at which transactions between units of multinationals take place. When a mainland company trades with a sister company or affiliate offshore, the value of goods depends a great deal on where the company wants to book the profit. Usually firms will ensure that profit on trade transactions within a company are booked in lower tax jurisdictions. And that has usually meant offshore in the past, given the relatively high tax rates on the mainland compared to Hong Kong and other regional economies.

Another possible example of how transfer pricing manipulation may be part of the observed Dark Matter!