If you own the business, you can expense almost anything
A new study shows how owners tend to charge more of their personal consumption to the firm
Arbitrage is one of the most fundamental principles of economics, and that holds for the tax system as well. People will go to great lengths — buying a home they can barely afford, say, or running up itemised expenses — to minimise their tax liabilities. And as knowledge of the system evolves, they devise new methods for tax arbitrage.
A peculiar problem arises when personal income tax rates are much higher than tax rates on corporate perks and benefits. Assume, for instance, that workers face marginal income tax rates of 50% to 60%. Such tax rates are not unusual in Western Europe, and can also apply to upper-class workers in New York and California. Now imagine that a company paid its workers somewhat lower wages than it would otherwise, instead offering extravagant in-kind benefits.
If the company served fresh high-quality sushi for lunch every day in its stylish cafeteria, for example, the workers wouldn't be taxed on the sushi at all, whereas if they were paid cash to buy their own sushi, they would have to fork over at least half of that income to the government. In this example, workers who would be buying lunch anyway are better off. The system helps transfer money to them indirectly, by eliminating the need for lunch expenses and avoiding the personal tax liability.
But other parties are worse off. The government gets less revenue, and some workers are stuck with a consumption bundle — too much sushi — that is not ideal. The company may be able to reduce its overall compensation costs, but it is not clear that translates into a better deal for the customers, since (tax effects aside) sushi-based compensation may be a less effective motivator than cash-based compensation. In short, to some degree, everyone is engaging in distorting behavior.
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This phenomenon is one reason that many office jobs in Nordic countries seem so pleasant. The workers have nice lunches and the use of comfortable and stylish furniture, which they are not taxed on, though of course their take-home pay may be less.
If you think that such workplace comforts make people happier than cash, then you may approve of such arrangements. And it is one vision for how to make society marginally less competitive.
An alternative model is that, with a proliferation of workplace perks and a diminution of earning power, workers become somewhat less ambitious on the earnings front. Peer norms may change, and the dynamism and innovation of the economy can decline accordingly. There are, in fact, signs of these problems in current-day Europe.
A recent study looked at some comparable effects in Portugal where the in-kind benefits accrue to a firm's owners rather than its workers. When people own enough of a firm to control its behavior, they charge some of their personal consumption to the firm. Or, to put it another way: They draw more in-kind income from the firm, and take less cash. That lowers their total tax burden.
For the top quintile of the Portuguese income distribution, once those people are able to control a business, about 20% to 30% of their consumption expenditures are switched to benefits reaped within the firm. For the top 1% of earners, attaining a position of business manager is associated with an almost 18% drop in monthly expenditures. And lest there be any doubt about what's happening here, the paper notes that "business expenditures on hotels and restaurants significantly increase by 9.8% in the birthday month of the owner-manager and by 6.1% in the birthday month of the owner-manager's spouse."
The paper estimates that the revenue loss from these arrangements is about 1% of Portuguese GDP. Income inequality rises as well, since it is the wealthy who have greater latitude to create and exploit such arrangements.
Still, all this arbitrage raises several questions: Are tax rates on personal income too high, or are they too low on business perks? Or both? Does it really make sense to evaluate for tax purposes all the nice things businesses do for their workers? Who's to say how much that sushi is really worth, after all? Is the smile of the boss to be taxed as well? Making much progress on this front won't be easy, if it's even worth trying.
The core lesson is that tax arbitrage is powerful — and difficult to stop. It has negative consequences, but it is also a check on the rapaciousness of tax authorities. No one should feel too good about what is going on here.
Tyler Cowen is a Bloomberg Opinion columnist, a professor of economics at George Mason University and host of the Marginal Revolution blog.
Disclaimer: This article first appeared on Bloomberg, and is published under a special syndication arrangement
