Tax avoidance

Tax avoidance is the legal use of a tax regime to reduce the amount of tax a person or company must pay. It involves using the specific laws of a territory to one's own advantage. This is fundamentally different from tax evasion, which is the illegal attempt to avoid paying taxes. While tax avoidance is legal, it is often criticized when people use laws in ways that governments did not intend. Such actions are frequently called "aggressive tax avoidance" or "tax mitigation." These methods often fall into a gray area between standard tax planning and illegal evasion.

To understand how this works, we can look at three main principles. Economist Joseph Stiglitz identified these in 1986. The first is the postponement of taxes. This means delaying tax payments so the present value of the tax is lower than if it were paid immediately. The second is tax arbitrage across individuals. This happens when people move income between different tax brackets to lower their total liability. The third is tax arbitrage across income streams. This involves moving money between different types of income that are taxed at different rates. Many tax avoidance devices combine these three methods.

There are several specific tools used in these processes. A tax shelter is a way to protect assets from being taxed. A tax haven is a specific jurisdiction that makes it easy to reduce taxes. Companies may also use offshore companies or trusts to move money. Some individuals choose to change their country of residence to a tax haven like Monaco. This helps them avoid taxes in their home countries. However, some nations like the United States and Eritrea tax their citizens on all worldwide income. This means even if a person moves abroad, they must still pay taxes to their home country.

Governments use different types of anti-avoidance measures to stop these practices. The first type is the General Anti-Avoidance Rule, or GAAR. These are broad rules that apply to many different situations. The second type is the Specific Anti-Avoidance Rule, or SAAR. These rules target one exact technique or practice. Courts also use two guiding principles to judge these cases. The first is the "business purpose rule." This states that a transaction must have a real business reason beyond just saving money. The second is the "substance over form" principle. This means the actual economic reality of a deal matters more than the literal words used in the legal documents.

Many countries have passed specific laws to implement these rules. Canada passed Section 245 of its federal income tax act in 1988. This law invalidates tax benefits if the main goal was only to avoid tax. Australia has used a GAAR since 1981 and also uses the Multinational Anti-Avoidance Law (MAAL). The United Kingdom and several other nations like Norway and South Africa also use GAAR statutes. In the European Union, the Anti-Tax Avoidance Package was implemented in 2016. This package includes an Anti-Tax Avoidance Directive (ATAD) which contains five legally binding measures. These include rules on interest deductibility and exit taxation to prevent companies from moving assets to avoid taxes.

Tax history shows how laws can change the way money moves. In the United States, there have been six major tax reforms since the 1980s. The 1981 reform introduced various tax loopholes, which caused the tax shelter industry to boom. The 1986 reform tried to reduce avoidance by closing the gap between different tax rates. However, the 1993 and 1997 reforms created new opportunities for avoidance by changing how capital gains and ordinary income were taxed. By 2013, the U.S. increased taxes on capital gains and ordinary income to 20% and 39.6% respectively. These shifts show a constant struggle between new laws and new ways to find loopholes.

The scale of tax avoidance is quite large. Since 1995, trillions of dollars have been transferred into tax havens from developing countries and OECD nations. This movement of money has significant global consequences. The World Bank’s 2019 report suggests that governments should increase efforts to curb avoidance. They argue this is part of a new social contract. This contract focuses on investing in human capital and expanding social protection. By managing how taxes are collected, governments can better fund the systems that support their citizens.