Friday, September 11, 2009

On theorists and practitioners

Update Oct 1: Dev Kar writes again on the Financial Task Force blog about statistical issues; also see a summary on p13 of the last Tax Justice Focus.

Update, Oct 2: Videos of the Financial Task Force Conference, at which many of these things were discussed, here.

An old joke goes "economists are people who know 69 ways of making love without ever having had a partner." Ouch! Like all the best jokes, this gets rather close to the knuckle, especially at a time when the economics profession needs to do some serious navel gazing.

Over the course of this summer we have had a lively online correspondence with the Oxford Centre for Business Taxation. One thing that emerged loud and clear from these discussions was the massive gulf that exists between academic economists and accounting practitioners with real world experience. Our senior adviser Richard Murphy is both an economist and a chartered accountant. This combination gives him an extraordinary advantage over those (like this blogger) who know the economic theory but are weak on matters relating to the application of international financial reporting standards, interpreting what accounts say about deferred taxation, and such like. This is an area where practitioner expertise matters.

Richard has now penned this reply to the comment that Clemens Fuest and Nadine Riedel recently added to our earlier blog.

Dear Clemens

I have noted your reply to Raymond Baker et al dated 3 September 2009. I am leaving Raymond, Simon and others to comment on their own studies. Here I comment upon the work I have done for the Tax Justice Network and on your methodology.

In writing this mail I am suggesting two things. The first is that the methodology you use for your critique of TJN et al is flawed. Secondly, I want to open discussion on what you think transfer mispricing is.

Let me deal with your comments on the TJN paper 'The Price of Offshore' first. You say:

*What we consider to be a back of the envelope estimate is that these estimates are employed to derive estimates of the tax gap by multiplying the estimated offshore asset holdings by a rough estimate of an asset return and an assumed average tax rate. We believe that the discussion of the limitations of this approach in our report is moderate and entirely appropriate.*

That is an interesting suggestion but let me compare it with this comment of yours:

*Estimates of how mispricing affects tax revenue in a country have to take into account all mispriced transactions. A very simple example might help. Assume that there are three exporters of a good in country A. Firm 1 exports the good at a price of 4, firm 2 exports the good at a price of 8 and firm three exports the good at a price of 12. The mispricing approach would identify 8 as the undistorted price. Assume further that all firms have costs of 4 in country A which are deductible from the profit tax base in country A. The goods are exported to country B, where all three are sold at a price of 14 to consumers in country B. *

*In this example, the aggregate tax base in country A is equal to 12. Firm 1 shifts income out of country A and firm 3 shifts income into country A. In the absence of trade mispricing, the tax base in A would be the same. The tax revenue loss of country A due to mispricing is equal to zero. *

*A method which only takes into account firm 1 and neglects the implications of mispricing by firm 3 is clearly misleading.*

Let me compare these two scenarios. TJN used data you acknowledge has value. It then used verifiably appropriate assumptions on rates of return and tax rates which also accorded with reasonable market knowledge. And it allowed for the existence of compliant tax payers in the sample before suggesting a figure for tax lost. The resulting figure has been widely quoted precisely because whilst the resulting figure is, inevitably, an estimate it is easy for almost anyone to verify its credibility. The very 'back of the envelope' moniker you attach to it in pejorative form is in fact its essential strength: it feels right because everything about it is accountable, transparent, verified or plausible and therefore credible.

Now let me look at your scenario. You build an abstract model to dismiss our work. I do not, of course, dismiss the power of scenario building in economic theory: game theory proves its worth. The powerful model of the prisoner's dilemma shares with the TJN work some features in common. It, for example, models a scenario to which the reader can relate (one hopes in abstract alone) and this gives it an inherent plausibility because the user can relate it to real events.

I am not really not sure that your model shares these characteristics. For example, you present no evidence that the diversity of pricing that you model exists. Nor do you demonstrate that you have calculated a proper transfer price: you have just assumed it is the average of the prices you say have been charged by related entities. Now I may be wrong, but I don't think this is how the arm's length model works: that, as I understand it seeks to determine arm's length prices. In this case that might be anything from 4 to 14. I can't see the logic for assuming it is 8. Have I missed something?

In addition I admit I am confused by your model. Again, this might just be me, but you seem to suggest that in the face of identical facts one exporting firm shifts income into a territory to secure a tax advantage and another shifts income out of it for the same purpose. I admit I do not subscribe to the view that all human behaviour is rational, but to put forward such a model seems decidedly odd. It seems to suggest you expect irrational behaviour, indeed even inexplicable behaviour in the face of consistent tax incentives. As far as I can see you have provided evidence as to why this perverse behaviour would arise, and I have to admit that
without that explanation I am having real problems working out what the use of your model might be. Might you explain it to me? Might you also explain how this proves the work I and my colleagues have done is wrong? Is it that you wish us to build irrationality into our models in a way that we have so far failed to do? No doubt you will let me know.

Let me move now to areas I can speak on with more assuredness since they relate to my particular expertise, and not to economic modelling. Firstly, I note you propose that future work on transfer mispricing be based on micro-economic data based on the accounts of limited liability entities, and especially those in secrecy jurisdictions. I note you suggest that this has been done in the past. I have read some such work. Unfortunately I do not think this terribly relevant. First, as I presume you admit, the data of this sort that is available is very unreliable: only 6 of the secrecy jurisdictions currently being researched by the Tax Justice Network require that accounts be placed on public record. The UK is one of them. This is hardly the basis for a valid sample, I think. If you disagree, might you say why?

Second, the whole nature of accounting has changed since the widespread adoption of International Financial Reporting Standards in 2005. It is no longer true to say as a result of that adoption that reported profit in a
set of accounts need bear any relationship at all to taxable profit, even if they ever did. This is because profit can now include fair value movements. This means that accounts are an increasingly poor source of data for this research.

Thirdly, the very issue which this work seeks to highlight, being transfer mispricing, usually results in tax deferral for tax reporting purposes, not absolute tax avoidance. However, academic economists who research this issue seem to persistently use the profit and loss account charge for taxation as a proxy measure for corporation tax paid even though it incorporates that deferred tax charge which might in itself disguise that transfer mispricing. As such unless the methodology you propose to use identifies the current tax charge, or better still, tax paid in cash (allowing for time delay factors) then it is very unlikely that meaningful data on tax paid will be surveyed by any such study.

Finally academic research in this area persists in using database data on accounts. That rarely has the information required to identify deferred tax charges and almost never includes data on tax haven / secrecy jurisdiction companies where, if our hypothesis is correct, much of transfer mispricing is hidden. For all these reasons the basis of analysis you propose seems inherently flawed. If you think I am wrong might you explain why?

This does not, though address another issue. At its core there remains a further methodological issue that needs to be resolved. You are seeking to approach this matter as if it is one of micro-economics. It is not. It is a macro-economic issue. The methodologies we at Tax Justice Network and those our colleagues have used recognises this fact. It is not at all clear you do. We challenge your assumption that any findings based on micro-economic analysis can be extrapolated to indicate the scale of the issue we are addressing. Why do you think that is possible?

Let me turn then to the final remaining flaw that I think is inherent in your logic, which I think of considerable importance. You state that all flows into and out of a state should be considered in any analysis of tax loss to developing countries as a result of transfer mispricing. I, in principle, agree. That would be desirable. But I wholeheartedly disagree with your contention that to measure flows in only one direction will lead to overstatement of the tax losses arising from any analysis. That is not possible. Let me explain why I think the only risk that arises is that a one direction analysis will understate the value of tax lost to developing countries.

Firstly, there is little or no evidence of inward flows to developing countries resulting in the reporting of significant taxable profits. If there were inward profit flows then there is very clear evidence that this
would only arise because there was no chance of a corporate profits tax arising upon them as a result e.g. due to tax holidays or excess allowances. In that case there would be no tax gain in the developing country, albeit
there might be tax loss elsewhere. As such your first assumption, that inward flows would create revenues that will negate outward flow losses would seem to be wrong: the incentives for each differ because the tax
treatment for each differ and therefore it is completely incorrect to assume each might or would give rise to equal and opposite tax impacts.

Second, what evidence there is for the underpricing of inward flows suggests that these arise to avoid or evade duties, tariffs and other charges arising on import and not to secure corporate tax advantages, for reasons noted above. These import tax abuses are not taken into account in any estimate Baker, Christian Aid, Pak et al have made. In that sense those authors underestimate the lost taxes. It is important to note though that such evasion of import tariffs would not rationally arise if it gave rise to overall increase in tax liability i.e. the tariff saving must always be more than any additional tax due on additional corporate profits, if any.
Therefore, again, the existence of inward flows does not suggest that losses might be lower than estimated; it would suggest that they are more than estimated.

Thirdly, you seem to assume that transfer mispricing inward takes place on the same trade as the transfer mispricing outward. You therefore imply there is a net offset available between the two. Firstly I suggest that the existence of inward and outward mispricing in developing counties on the same trade is very unlikely because there is no evidence of developing counties being used, unlike tax havens, for repricing of goods and services in vertical supply chains. In other words, there would appear to be little or no chance that any inward transfer mispricing can be netted off against outward transfer mispricing for tax purposes. Second, even if in economic terms you believe that this offset might be reasonable- assuming if, and only if, they arose on the same trade, the reality is that this is not how the two errors would be treated by tax authorities. Those authorities can treat the two transactions as entirely independent variables i.e. they are perfectly entitled to pursue an underpayment arising as a result of transfer mispricing outward even if the goods exported had mispriced inwards. In other words, the two errors are wholly independent of each other, net off is not possible, and correction can be made in both cases, to upward lift the sale price to collect additional taxes on profit and upward lift the inward price to correctly collect taxes on import but without allowing any
resulting adjustment for the purposes of taxing profits. Your contention appears to ignore this reality. The result is that that your claim that netting off takes place is, in my opinion, wrong: the errors are additive,
not subtractive and accordingly the point you make only serves to indicate the conservative nature of the calculated loss to developing counties inherent in my colleagues' work.

Given these facts I am finding it very hard to find merit in the arguments you have presented, but look forward to hearing your further opinion on the observations I make.




Tax Research LLP

The Old Orchard


Blogger Henry said...

Where does the crackdown stop? You only need one little island somewhere on the planet to do its own thing. What if North Korea decides to get in on the act? It is not out of the question, the old dictator is on his last legs and his son is some kind of Swiss-based playboy, and they have got nukes.

And all the time, any country that wants to stop the leakage needs only to mend its own broken pipes.

10:28 pm  
Anonymous TJN said...

When armies of people are constantly drilling into your pipes, then clearly a policy that focuses solely on "mending the broken pipes" is a foolish one.

8:56 am  
Blogger Dev said...

I am sorry for this rather belated response to Clemens Fuest and Nadine Riedel's criticism of our work.

The point I will make here is that the authors make a fundamental error in citing their example of firms making inward and outward transfer pricing decisions and take that example to mean that our estimates of illicit flows from developing countries are overstated insofar as we do not include inward illicit flows.
The fundamental error they make in presenting their arguments based on their model stems from a basic confusion regarding the micro-economic drivers behind firm-level decisions and the macro-economic factors that drive illicit flows. One of the fundamental economic postulates taught to undergraduate students in Econ 101 is that "what is true of the part is not necessarily true of the whole and what is true of the whole is not necessarily true of the whole". In other words, we can easily have a situation where there are macroeconomic reasons causing capital flight from a developing country even as A FIRM MAY BE BRINGING IN CAPITAL THROUGH TRANSFER PRICING. THE TWO ARE NOT MUTUALLY INCONSISTENT, IN THAT FIRM-LEVEL DECISIONS NEED NOT BE INCONSISTENT WITH THE MACROECONOMIC DRIVERS DRIVING ILLICIT FLOWS.

An example will suffice. We could easily have a situation where large fiscal deficits, negative interest rates, and high inflation can be driving illicit outflows which would not preclude a firm from exploiting a tax loophole at any point in time to its own advantage (based on its own accounting position regarding particular transactions).

9:02 am  

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