How does political gridlock encourage tax avoidance?

Political gridlock in Congress, plus a weakened IRS, has led to more tax avoidance, writes Eric Toder. How is that true, and what can be done to stop it?

In July, Treasury Secretary Jack Lew asked Congress to stop the current wave of corporate expatriations. The legislation is going nowhere, and Treasury and the IRS are unwilling to act on their own, though some legal experts believe they already have the authority to curb the transactions.

This is just the most recent example of a disturbing trend: Political gridlock combined with a severely weakened IRS has opened the door to widespread tax avoidance. Congress could halt transactions such as these without becoming hopelessly entangled in broader arguments over tax and budget issues. The question is: Will it?

The repatriation issue is a classic case study. Senior Senate Finance Committee Republican Orrin Hatch (R-UT) shares Lew’s concerns about these transactions, but opposes the Administration’s proposal, stating that any solution should be neither retroactive nor “punitive” and must not raise revenue. And the Republican-controlled House won’t accept these proposals either, absent fundamental tax reform.

I agree that the Administration’s proposal on expatriations would supply only temporary relief and fails to address the broader problems of taxing multinational corporations. This is just the tip of the iceberg, however. Because the tax code is so flawed, the challenge goes far beyond one highly publicized tax avoidance technique. Numerous other anomalies are exploited currently or waiting to be discovered.

Tax avoidance strategies often start small and then reach a critical tipping point and explode. A historical example: the use of tax-exempt bonds for private purposes. The federal tax code has always excluded from tax the interest on securities issued by states and localities. For decades, these securities were used only to fund schools, highways, and other public projects. Beginning in the 1930s, a few states began issuing so-called industrial development bonds, using the proceeds to supply low-cost loans to firms looking to invest in their states. By the 1960s, these “private-purpose” bonds threatened to dominate the tax-exempt market, and in 1969 Congress placed the first limits on their use.

Every president in recent memory has advanced proposals to limit tax avoidance techniques, even President Reagan, who adamantly opposed increases in income taxes. In 1984, the year before releasing his sweeping proposals that led to the 1986 Tax Reform Act, Reagan proposed net tax increases that would grow to an estimated 0.4 percent of GDP in 1989. His budget described these as “measures to strengthen the revenue base and adjust certain unwarranted or no longer justifiable features of the Internal Revenue Code.”

Even a well-crafted tax reform would leave some gaps. No tax system can ever be perfect. And corporations and wealthy individuals, aided by well-paid advisors, will always figure out new ways to circumvent the intent of any law.

Therefore, we need constant review of new tax-avoidance strategies. The IRS must be vigilant and nimble. Where regulatory authority is insufficient, Congress must be willing to plug holes that appear in the system.

Today, many of the safeguards that once protected the tax code are weak or non-existent. Buffeted by political attacks and budget cuts, the IRS struggles to police the system. Congress is equally paralyzed. Republicans refuse to close loopholes if that would increase net revenues. Democrats won’t go along with tax cuts to offset any revenue gains.

The inability of the system to react emboldens the designers of new avoidance strategies. With less fear that a transaction will be disallowed by the IRS or nullified by an act of Congress, avoidance strategies will proliferate, eroding the income tax base and further reducing public confidence in the fairness of the tax code.

There is no easy solution to this mess. Waiting for the parties to agree on fundamental tax reform seems hopelessly naïve at present.

But there may be an answer. Each year— outside of its annual budget–the Administration should compile a list of proposals to halt unintended tax benefits. If necessary, the White House could package these measures with tax simplification or even modest tax reductions to offset any revenue gains. The political parties could continue to argue over broad fiscal issues. But a very narrow housecleaning bill could be a vehicle for them to stop abusive transactions that Congress never envisaged or intended.