Weaknesses in the tax system are a threat to peace

By Natalie St-Pierre

June 14, 2016

The tax system may appear complex, opaque and understandable only by experts. And yet, it forms the basis of the social pact that is the foundation of all democratic societies. Taxes allow citizens to ensure that funding is available for the public services that they need. The tax system creates a relationship of interdependence that is predicated on people’s trust in the elected government. In this respect, citizens’ trust is fundamental to our democracy and guarantees social peace.

This trust has now been shaken. The Panama Papers affair has revealed the scope of planet-wide tax evasion problems and created an unprecedented interest in this matter. And for good reason: the leak of more than 11.5 million documents from the database of Panama-based law firm Mossack Fonseca shines a light on the extent to which foreign corporations are being used in tax optimization strategies. The Panama Leaks represent the largest data leak in history (approximately 2.6 terabytes, or 2,600 gigabytes) and involved many well-known people, including current and former heads of state as well as the people close to them.

When information of such a nature is leaked, the media and the public generally focus on the people involved: the Panama Papers are no exception. The some 400 investigative journalists who had access to the documents sought primarily to reveal the names of the people involved, i.e. account holders, go-betweens, businesses and financial institutions named in the leaked information. However, this focus on people left the real systemic scandal in the shadows.

A systemic problem

Beyond people’s actions, the real problem that has come to light points to a system that was able to emerge—and to continue to flourish—as the result of weak legislative and institutional frameworks. People were able to abuse laws because these laws allowed them to do so. This stems from a lack of oversight and commitment on the part of national administrations and international bodies, which have been unable to put a stop to this problem resulting essentially from the globalization of trade. Elected officials, tax authority personnel and specialists employed by publicly funded organizations, such as the OECD, the IMF or the World Bank, sat back and watched without taking the timely action that was needed. These civil servants, who are often experts in their respective field, have few performance incentives and the current framework does not provide for any real consequences when they fail to fulfill their duties to serve the citizens who are funding their organizations.

These specialists and experts have forgotten that they are citizens who need schools for their children, hospitals for their loved ones and safe roads and bridges for their daily commute.

One only need think of bank secrecy rules or tax treaties between countries to realize that tax avoidance or tax evasion schemes have been actively tolerated by national governments for decades and continue to be tolerated today.

As recently as last April, the OECD urged the international community to “call time on all remaining holdouts who have yet to implement internationally agreed tax transparency standards”. These rules adopted in 2009 provide for the exchange of tax information on request as a first step. Thereafter, the mechanisms should evolve so that information is exchanged automatically. In May 2016, Panama also agreed to make a similar commitment. The standards agreed upon by the 132 members of the Global Forum on Transparency and Exchange of Information for Tax Purposes must be implemented in 2018.

Massive implications

Although the recent initiatives made to ensure tax transparency should be praised, it is important to recognize that they do not substantively deal with the challenges. Opacity is a serious problem in any area of activity in a democracy. Where the tax system is concerned, it is a major scourge with serious consequences, particularly in terms of the trust that citizens and businesses have in governments as well as social prosperity.

While voter turnout rates are on the decline throughout the Western world, the Edelman Trust Barometer indicated, in its 2016 annual report, that only 48% of the general population, as compared to 60% of the “informed public,” had trust in institutions (governments, NGOs, the media and businesses). This 12% variance is the largest ever seen. Although the authors did not determine a causal relationship between the decrease in trust and the large-scale tax evasion schemes that have come to light, the two factors do appear to be closely related. How can a citizen or a business owner at the head of a locally-based SME who pays income tax on time view the fact that multinational corporations and the world’s most wealthy individuals are able to minimize their tax liability, with the consent of the various governments? Unfair tax treatment represents a breach in the social and economic pact that can only break the bond of trust between citizens and their public institutions.

The consequences of tax evasion and a lack of transparency for social prosperity are now quite clear. By depriving the public purse of substantial revenues, these phenomena limit governments’ ability to invest in the infrastructures required for economic development and the basic services to be provided to citizens, such as education and health care. Stella Agara, a tax justice activist from Kenya, recently told Euractiv.com that tax evasion costs African countries up to 60% of the revenue they lose. In her view, Uganda lost $350 million as the result of Heritage Oil’s decision to move their registration to Mauritius–a figure that is higher than Uganda’s health budget. This one example provides an indication of the scope of damage caused by worldwide tax planning strategies.

A threat to peace

The current tax system’s difficulty to adapt not only undermines the public’s confidence and limits prosperity, but also represents a threat to world peace.

Government shortfalls and difficulties in meeting people’s needs and fostering prosperity create poverty and instability. This, in turn, leads to conflict and mass movements of people which can upset the balance in a region. Moreover, in the midst of civil wars one regularly finds leaders who are clinging to power out of financial interests and who amass huge fortunes that are being sheltered in tax havens.

Loss of confidence in government institutions also has a destabilizing effect that is felt as far as in Western democracies. By further contributing to the lack of confidence, the failures of the tax system result in greater polarization of public opinion. This is manifested in the emergence and growing popularity of political parties and candidates at the extremes of the political spectrum. These parties and individuals often build their positions by rejecting existing institutions and calling for radical solutions that can cause considerable upheaval.

A productive society is a peaceful one. On the other hand, a society that cannot flourish due to a lack of shared purpose and appropriate tools is destined for trouble. In order for a tax system to be sustainable, the interdependence of all players (i.e., businesses, governments, civil society, and entrepreneurs) must be taken into consideration and efforts must be made to achieve a balance between their particular interests in working towards a common purpose.

A new Approach to find new solutions

Given the scope of problems that are attributable to the current tax system, a steadfast response is needed. This response must be provided by all parties concerned, including, governments, NGOs, international public institutions, public corporations, banks, universities, philanthropic organizations, the media, citizens and business owners. To preserve the integrity of the democratic pact, the public sector must listen to civil society, particularly to players who cannot make themselves heard in the current framework.

As Albert Einstein said: “We cannot solve our problems with the same thinking we used when we created them”. This means that a new system must be developed using a different approach which fosters innovation and collaboration. It must be built upon principles of co-creation. This approach, which is also referred to as co-design, makes it possible to carry out a development process by involving the user or the final beneficiary. It is based on the exchange and sharing of expertise and outlooks in an evolving framework in order to identify innovative solutions.

In particular, this approach has the merit of dealing directly with the “iceberg of ignorance” phenomenon. This theory was developed by Sydney Yoshida, a researcher and consultant who noted that management is aware of approximately 4% of the problems in an organization, which prevents it from taking the necessary steps to deal with issues. The same reality exists in government administrations responsible for developing tax policies, which all too often are far removed from the citizens, businesses and entrepreneurs they are supposed to be serving. Having a collaborative approach therefore ensures unprecedented visibility for tax problems affecting all players in society.

For a simple, fair and intelligent tax system

It is clearly time to make a crucial paradigm shift to develop a new tax system that will foster global peace and prosperity. This new system must be simple, fair and intelligent.

The new tax system must be simple. This means that it must primarily be consumption tax based. Unlike income taxes and the obsolete residence rules that form the cornerstone of this system, consumption tax mechanisms are clear, easy to administer and may have an impact on people’s behaviour. For example, a recent study showed that a 20% tax on certain agri-food products would be enough to bring about lasting changes in consumption habits. This, in turn, would generate a substantial reduction in greenhouse gas emissions and health problems related to obesity. This principle, which is already being applied to alcohol and tobacco products, could easily be implemented across the board for a wide array of products to encourage citizens to adopt more responsible behaviour.

The new system should be fair. Having access to justice is a major challenge for citizens and business owners in many countries, due to the complexity of the current tax systems and procedures as well as the related costs. The simplicity of the new tax system will reduce the amount of litigation. However, the system must also encourage alternative ways of settling disputes, such as tax mediation, to restore citizens’ confidence in the public institutions that must serve them. Ultimately, governments must strike a balance between fighting tax evasion and relentlessly going after local business owners, which penalizes a society’s economic growth.

The new system must be intelligent. It must leverage new technology to be more effective, more secure and more transparent. Using systems to gather real-time data can drive a paradigm shift that will reduce tax evasion and the related corruption.

A tax system for the 21st century

The current tax systems are from another age and have lost their relevance today. Generalized globalization, new technologies and ecological and public health challenges that are being faced today have rendered the traditional approach obsolete. Income taxes should no longer be the cornerstone of the tax system. New types of taxes more in line with the economy of the 21st century must be devised.

The new tax system that we are hoping for must be co-managed by citizens’ representatives, elected officials and civil servants, with media participation, in a compassionate manner. It is only by channelling the strengths of all parties involved in an open, transparent and innovative approach that we will be able to devise a simple, fair and intelligent solution that can address the problems being experienced today. World peace depends on this.

About Richter: Founded in Montreal in 1926, Richter is a licensed public accounting firm  that provides assurance, tax and wealth management services, as well as financial advisory services in the areas of organizational restructuring and insolvency, business valuation, corporate finance, litigation support, and forensic accounting. Our commitment to excellence, our in-depth understanding of financial issues and our practical problem-solving methods have positioned us as one of the most important independent accounting, organizational advisory and consulting firms in the country. Richter has offices in both Toronto and Montreal. Follow us on LinkedInFacebook and Twitter.