Tax Avoidance And The 2011 GDP Dip

UK investment banks are preparing to pay many of their big earners at the beginning of 2010 to avoid an income tax on April 5. The Times points out that this may reinforce notions that investment bankers are now so greedy that they plan to shift taxable income from one year to the next.  Protests are useless and the tax strategy that has produced this practice will be a huge drain on government revenue in the US and UK. These losses will probably be significant enough to undermine tax receipts in 2011 and challenge GDP growth as well.

The same “adjustments” to the year in which UK financier compensation payments will be made are also likely to happen in the US.  Bonuses that total billions of dollars will be moved to late 2010, to avoid the payment of higher taxes which are likely to be part of the IRS revenue collection in 2011. This will be true of executive compensation across all industries, which means that the income transfer from one year to the other will be hundreds of billions of dollars. Intelligent CPAs will encourage their business customers to move taxable income and profits into the fourth quarter as well, to the extent that they can do so legally.

The dislocation will cause an unanticipated jump in the last quarter of 2010 and a tremendous drain to GDP in 2011. The financial press will run articles about how even average taxpayers can save money. The influx of IRS income to late 2010 will grow as nearly everyone and every business that pays taxes decides that avoiding larger payments to the federal government is the smart thing to do and that Washington can do nothing about it.

The Fed will see the gathering storm as well, and will have to be prepared to act to stimulate the economy to prevent a second recession in 2011 just as the US is climbing out of the one that will probably end in the fourth quarter of this year.

The government has several options, the least effective but most likely of which is to keep taxes the same in 2011. The Budget is based on increasing taxes and the forecast for 2011 and 2012 does not take into account that the increase may be regressive and could bring down total tax receipts even though income will be taxed at a higher rate.

Another option is to phase the increase in more gradually. This would smooth out the effects of a jarring change from December 31, 2010 to January 1, 2011. The tax rate could be slowly increased over several quarters. This approach would still undermine total 2011 revenue, at least according to the Administration. The impact of the tax program as it exists today may be regressive so a phased-in approach could mitigate that somewhat.

The final option is to tether the tax rate to GDP growth. Trouble in the economy is usually ameliorated by Fed policy and stimulus spending engineered in Congress and approved by the Administration, a deeply political process. A system that links GDP growth to taxes does not change the nature of the taxes or where they are levied. It simply keeps the tax rate somewhat lower if GDP is sluggish and raises the rate if economic growth is robust. If the system that acts as governor of the tax rate is the same across all taxes, the political haggle over whose ox has been gored stays largely is likely to be modest.

The taxation/GDP relationship, if indeed it begins at the start of 2010, will be the result of advice from the accounting profession that sees the current program’s weaknesses.
Any change in the tax system after this advice is acted upon will be much too little and much too late.

Douglas A. McIntyre