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AT THE HEART of the case for the rule of law in tax is the need of both the tax authority and taxpayers for a degree of certainty, and for a balance between the two.
Every year, in advanced market economies like our own, between 30% and 50% of gross domestic product is taken in tax for various public purposes. At either end of that range (reflecting a huge variation in political, social and economic preferences), this would be a large undertaking, imposing significant challenges on tax authorities and taxpayers alike.
Yet we remain visibly market economies. Businesses, families, individuals and Government departments all need to plan their revenues and expenditures, if they are to function effectively at all.
Governments do not like uncertainties surrounding tax receipts: hence the talk of the 'tax gap'. Granted, despite some heated discussion, there is comparatively little explanation about how the original expectations of future tax receipts are formed, or indeed about what supposed elements of the gap, such as tax avoidance, actually mean. But leaving all that to one side, governments have a legitimate need for a degree of certainty over their receipts and, if they perceive them to be vulnerable, are likely to respond. Proof of this are the offensives against avoidance of the last couple of years.
It should be equally clear that individuals, families and businesses have similar needs, so that when they make decisions, they have a reasonable idea of what the tax consequences will be.
Giving one side certainty is simple. Expropriation would do it for the tax authority, but it would not do much for the vigour of the market economy. A voluntary 'whip round' would suit the citizen, but is not a very solid basis for planning public expenditure. The balanced answer is the rule of law.
Law does not bring mathematical certainty in advance. How could it when such basic matters as income levels, costs of significant purchases, and personal and economic circumstances, are all subject to some uncertainty? However, the framework of rules allows each side to predict, to some degree, how much will be paid or collected, what are the factors that will make that amount larger or smaller, and what the tax consequences of different outcomes and courses of action will be.
Implications of a rule of law
This analysis does not seem novel, but it has two interesting implications.
First, neither side can insist on absolute certainty if the whole thing is to work. External circumstances may change from those predicted. The tax authority may face unexpected tax planning by taxpayers. They face changes in tax law and practice. So, the actual tax will differ from what has been predicted.
For either party, an attempt to achieve total insulation against uncertainty and impose the full burden of it on the other, risks a slide back to expropriation or the whip-round.
Secondly, it seems to follow that the rule of law is not quite as absolute a concept as one might naturally assume. It can be defined in terms of minimum standards and then you can ask a 'yes or no' question as to whether each standard is met or not. This kind of approach does have a place and is reflected in the debate on taxpayer rights and responsibilities. However, looking to the broader purposes of the rule of law, the extent of certainty enjoyed by each side, and the balance between the two, are matters of degree.
If anyone doubts this, I suggest he asks himself how much certainty there would be, in what sense; indeed, would there be a rule of law at all, if as a formal matter tax was assessed only by law, but:
- the law was so voluminous, so detailed in its exceptions, and exceptions to the exceptions, that no individual could retain more than a fraction of it in his head?
- the law was incomprehensible in its expression?
- the law changed so frequently that it was impossible to retain a picture of it, even in the form of rough-and-ready 'guides to action'?
- the law was regularly changed retrospectively? and
- the letter of the law was draconian, and the effective burden of taxation was only mitigated by concession?
In other words, when you strip away the certainty which it is intended to provide, do you really have a rule of law?
Note, that although these questions are phrased from the standpoint of the taxpayer, it would be very difficult for the tax authority, in the first three of the five conditions highlighted, to predict its tax receipts with any degree of accuracy even in the short term, that is, before factoring in the effects of undermining the functioning of the market economy as entailed in imposing such uncertainties on the taxpayer.
In the extreme cases described, we would say there was no real rule of law at all. Yet the reader will be struck by the fact that each of the five conditions exists to some significant degree in the UK. It would be unfair to say we have no rule of law at all. We can say, however, that we do not have as much of it as we might ideally like. This leads on to the questions, how much rule of law do we have and could we, in practice, be doing better?
Do we have rule of law?
Let us start with a 'balanced scorecard' of where we are in the effective rule of law, or degree of certainty, stakes. I will look at the five conditions just mentioned in crudely quantitative terms:
The volume of law is staggering by any standard: 5,000 pages of closely typed pages of the Yellow and Orange tax handbooks, just for primary legislation on income tax, corporation tax and capital gains tax.
The rewrite project is working its way ponderously through the tax code arguably clarifying its expression, but at the expense of loss of familiarity, unannounced or maybe hidden changes, and considerably greater length.
There is now a chronically rapid rate of change embedded in the system. This year's Finance Bill might represent about a 10% turnover in volume terms, and it is probably below the average of recent years. It is also not unusual for a large proportion of new law to repeal or substantially amend legislation from the recent, as much as the ancient, past.
There is an open commitment to retrospective legislation where it is necessary to produce the (undefined) 'right amount of tax' (and National Insurance) on remuneration, including anything that might be considered to be remuneration at the time of legislating. It is argued, quite plausibly, that this does give you certainty insofar as you 'really know what they are after', e.g. the large bonus of someone who is undoubtedly an employee. But if we know, why can they not define it in legislation? Do we really know? The borderline between relatively heavily taxable and NICable remuneration and lightly taxed entrepreneurial capital gains is hideously complex, was totally rewritten without prior warning as recently as 2003, and is extremely tax-sensitive as a result of the introduction of business and taper relief.
Although there is some sort of effort to codify and legislate for tax concessions, especially given the Wilkinson case, much new, especially anti-avoidance, legislation, such as the pre owned assets charge of a couple of years ago, might on its literal terms catch millions of people who are probably blissfully unaware of this, and may remain so if they are not part of 'what they're after'.
More qualitatively, over the last decade there has been much more consultation about tax legislation than was the case in the heyday of the 'rabbit from the hat' tradition of Budget secrecy. This does give some clues as to the direction of Government policy, the intended interpretation of existing rules and the likely burden of future ones, or would do so, if the policy of consultation were consistently followed. Sadly, however, it is apparently randomly set aside, and in many more cases than can be justified by anti-avoidance considerations. Just as one example, the recent consultation on the modernisation of income and capital gains taxation of trusts, followed by the surprise Budget announcement of radical change to their inheritance tax treatment, partially undermined the validity of the consultation that was undertaken. Partial concealment can be more offensive than total silence.
Also, statutory interpretation has changed in the last 20 or so years. It used to be literalistic, with the remedy for any resulting perceived unfairness or ineffectiveness 'lying with Parliament'. Now transactions must be 'realistically' interpreted, and legislation 'purposively' applied, sometimes even taking ministerial statements into account. Arguably this gives greater qualitative certainty but at the cost of introducing further masses of additional material that might be relevant to statutory interpretation.
Could we do better?
We could do with less legislation. It is often suggested that length and complexity are the price of fairness, the inevitable consequence of avoidance, and a reflection of the complexity of modern life. But failure to think things through, and grasp nettles, can be just as important. The Government abandoned the central thrust of its corporation tax reform programme, e.g. the replacement of outmoded distinctions like capital/revenue and the schedular system, in deference, it says, to corporates' lukewarm support. Many corporates do indeed have large capital losses. But in the same breath, and without prior consultation, complex anti-avoidance legislation was announced to restrict severely use of such losses. The net result is a worst of all worlds: preserving archaic distinctions, complex new rules, and not giving business what it wanted, except in the most formal sense.
We need more consistent consultation. There is ample evidence that the process of consultation has improved new legislation where it has been allowed to. Even with anti avoidance it is possible to announce the thrust of anti-avoidance changes, to avoid forestalling, while consulting as thoroughly as ever on the form they will take. Consultation improves the effectiveness of legislation and reduces the collateral damage.
Legislation should be more principle-based, and purposive, taking advantage of the change in how the courts will interpret it. At the moment we have the courts looking for purpose and Parliament approving over-engineered drafting designed for a literalistic age.
Where there has to be a degree of arbitrariness about tax rules, the Government should accept that people will strive to be just one side of the line rather than another, and cost them on that basis. It should not change the rules every time it discovers that something is just inside that line. Something always will be. Frequent change reduces its own ability to cost, and introduces confusion, both for Government and the taxpayer, about what the tax policy is actually trying to achieve.
Gloomy outlook likely?
If the climate of certainty for compliant taxpayers is not improved, legitimate business will be undermined either to the benefit of the black economy or to our foreign competitors.
On the black economy, two years ago a report in the Economic Journal estimated cash-in-hand work as over 10% of GDP. Few would argue that this was an over-estimate. Despite a television advertising campaign, and recent initiatives on carousel fraud, honest taxpayers still perceive that more effort goes into tripping up the basically compliant than tackling this issue.
As far as driving business offshore is concerned, a colleague recently reviewed a draft tax disclosure in a prospectus for a Russian venture along the following lines:
Russian taxation
'Russian tax law and practice is not as clearly established as that of the UK and the practice of the Russian tax authorities may not always be in accordance with the law. The Russian tax authorities do not always apply the law evenly to all taxpayers, sometimes motivated by political reasons. It is possible that the current interpretation of the law or understanding of practice may change or, indeed, that the law may be changed with retrospective effect, although legislation with retrospective effects that cause deterioration in taxpayers' positions is generally prohibited.
'Russian tax laws, such as the Tax Code, have been in force for a short period relative to tax laws in more developed market economies; therefore the Government's implementation of these tax laws is often unclear or inconsistent. Often, differing legal interpretations exist between companies that are taxed and government organisations, such as the Ministry of Finance, the Federal Tax Service and its various inspectorates, creating uncertainties and areas of conflict. In addition, Russian companies often implement tax planning structures that are significantly more aggressive than would be seen in more developed environments. Generally, tax declarations remain open and subject to inspection by tax and/or customs authorities for a period of three years following the tax year in question. There is some discussion over a change to the limitation period, but how this will be resolved is currently unclear. Further, the tax authorities have in the past sought, and may again in the future, seek, ways to look back beyond the three year period. The fact that a year has been reviewed by tax authorities does not close that year or any tax declaration applicable to that year, from further review during the three-year period. These facts create tax risks in Russia substantially more significant than typically found in countries with more developed tax systems.
'The taxation system in Russia is subject to frequent change and inconsistent enforcement at the federal, regional and local levels. Until the recent adoption of the new Tax Code, the system of tax collection was relatively ineffective, resulting in the continual imposition of new taxes in an attempt to raise government revenues. There can be no guarantee that the Tax Code will not be changed in the future in a way that reverses recent positive changes. Among other things, the potential for Government deficits raises the risk of a sudden imposition of additional taxes on the company or entities in which it invests.
'Accordingly, it is possible that the company or any entity in which it invests could become subject to taxation in Russia that is not anticipated either at the date of this document or when its investments into Russia are made, valued or disposed of, which could have a materially adverse effect on the company.'
In most of these sentences there is at least one proposition concerning the Russian tax system which acts as a warning to the potential investor. Despite the assertion that the situation is worse in Russia than in more developed economies, there would seem to be a number of aspects in which, on the face of it, uncertainty in the UK is greater than in Russia or not self-evidently less. Hardly any of the sentences in the tax disclosure find no echo in the UK.
Business will continue to be done in Russia, and in the UK, even if the tax system does get worse. But we will be a needless drain on our economy, and ultimately tax resources. Those who deliberately move into the black economy are to be condemned. But their number will be swelled by very many people, such as many tax credit overclaimants, who are affected by the complexity of the tax system, and cannot afford the advice to ensure strict compliance with it. These are the sorts of consequences we face if we do not act now to move back in the direction of the rule of law.
John Cullinane is the new president of The Chartered Institute of Taxation and tax partner with Deloitte.
