Setting tax policy: unintended consequences

January 24, 2013

By Dr. Paul Kielstra

Measuring economic activity to decide on tax policy

In science, the “observer effect” describes how the very act of measuring something has an impact on what is being measured. A similar phenomenon has long been visible with tax policy.

The act of measuring economic activity or assets, and then using that information to decide tax policy, has an inevitable impact on the things being taxed.  This often leads to unintended consequences.

For example, Denmark recently announced that it would repeal its much heralded “fat tax” – a duty on foods high in saturated fats. Many Danish consumers had started visiting Germany to buy their treats, thereby damaging the local economy and minimizing any desired health benefits.

As Chris Sanger, the Global Leader of Ernst & Young’s Tax Policy Development team, puts it:

The challenge of unintended consequences is inherent in how tax policy is made. Fundamentally, when designing it, you are doing so based on the economic system at a point in time. Given today’s competitive global environment, change and the need for innovation by businesses are constant. As such, tax systems will constantly be challenged by change.”

Four multiplier effects

As early as 1936, American sociologist Robert K. Merton identified a series of possible reasons for unanticipated results of actions in any social sphere. These included four that remain of relevance to tax policy-making today:

  1. Lack of relevant information
  2. Errors about existing conditions
  3. Short-term pressures that cause policy-makers to ignore possible future ramifications
  4. Basic values or beliefs that direct actions in a certain way, whatever the conditions.

Sometimes, all these factors can come together too. In the Netherlands, up until 1991, the conversion of debt to equity in a corporate restructuring had no tax consequences. That year, the authorities changed the regulations so that the creditor who obtained the shares in such an arrangement had to recapture previous write offs on the receivables it gained, but only if both parties were within the same corporate group.

A decade later, the Government passed legislation that taxed the transaction in the hands of the debtor, whether in the same corporate group or not, on the grounds that it was the real beneficiary.

Over the next few years, the problem with this approach became increasingly plain: companies engaged in debt-for-equity swaps are often seeking ways to avoid bankruptcy and are therefore in no condition to pay high tax bills.  As the dotcom bubble burst, one prominent case of the law punishing such restructuring involved VersaTel, a Dutch fiber-optic cable company.

Struggling under a significant debt load, it swapped all of its high yield and convertible debt for equity in 2002. Because that debt had been trading below par on the open market, the conversion triggered substantial tax.

At the end of the year, the company reported a deferred tax liability of €134m, while its gross operating profit was just €18m. Similar cases led to the law being repealed in 2005.

In looking at what led to the problem legislation in the first place, a lack of understanding certainly played a part. As Reinout Kok, a Partner with Ernst & Young Tax Advisors in the Netherlands, points out, debt restructuring is a highly complicated area.

You need to deal with debtors and creditors that may be in the same corporate group, with third-party situations, and the international context. There are quite complex cases that would all have to be covered by the legislation.”

Error had a role too. And there was also some reluctance to change the law. Potential embarrassment and political fallout from reversing an earlier decision were factors that seemingly outweighed, at least for a time, the damage that the law was doing.

Correcting unintended consequences

While unexpected outcomes can never be completely eliminated, there are underlying drivers that authorities can take in order to reduce their frequency and impact. The most obvious is to address the issues of lack of knowledge and error.

This begins with governments devoting the necessary time to considering what they are doing. Ton Daniels, a Partner with Ernst & Young Tax Advisors in the Netherlands, and a Professor of Tax Law at Nyenrode Business University, adds that, too often, not enough time is taken in the legislative process to consider complex issues that require clarification.

Also, governments can develop processes to get better information in the drafting of legislation or regulations. The Australian State of Victoria, for example, has a State Taxes Consultative Council – made up of senior members of the State Revenue Office, professional bodies and industry executives – which meets quarterly to provide input into policies and procedures.

Whatever their form, however, making such initiatives effective requires effort on both sides. Sanger finds that often businesses are willing to “engage on policy only once they see the legislation in place.” That may be too late to make meaningful revisions.

Tackling complexity

Other strategic considerations can also help. The newest approach focuses instead on the taxpayer. General anti-avoidance rules (GAARs) are a key example.

These are broad and general principles-based rules within a country’s tax code designed to counteract the perceived avoidance of tax. Instead of a specific set of rules, they provide authorities with a way to overrule the tax benefits of transactions or arrangements typically on the grounds that they are judged not to have any substance other than to generate a tax benefit.

But GAARs also bring their own dangers, and indeed their own unintended consequences. In particular, they create uncertainty around the tax consequences of transactions, as the provisions can be used to override a host of transactions.

A resulting drop in business confidence and investment, especially in the case of a badly planned GAAR, might damage the economy far more than the government would benefit from increased revenues. Overall, there is no easy or perfect way to eliminate unintended consequences.

The best approach is ensuring that legislation is clear, well informed, and well-thought out. Beyond that, governments need to ensure that mechanisms are put in place to allow for proposed plans or rules to change, once awareness grows of a planned law’s potential flaws or failures.

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