by T. R. Reid
The case of Compañía General de Tabacos de Filipinas v. Collector of Internal Revenue3 was decided in 1927, but the international maneuvers the tobacco company employed would be familiar today to the corporate finance executives who dream up complex cross-border deals to avoid paying taxes. The Compañía General de Tabacos owned a warehouse in Manila; it needed fire insurance on the building and the cigars stored inside. The Philippine government imposed a tax of 1% on insurance premiums. The company did not want to pay. So the tobacco company in the Philippines arranged for its sister company in Barcelona to buy the insurance policy; the Barcelona office hired a broker in Paris, who bought insurance from one company in France and another in Britain. The Compañía General then argued it didn’t have to pay the tax, because the policy wasn’t purchased in the Philippines. This dispute wound its way up to the Philippine Supreme Court, which ruled unanimously that the tax had to be paid.
Because it lost its lawsuit in the nation’s highest court, you might think the cigar company would just shell out the 1% tax. But in those days, the losing party in a case before the Supreme Court of the Philippines had one more avenue of appeal.
In 1927, the United States was a colonial power; its scattered empire included the Philippine Islands. A legal case decided in the colonies could be appealed to the U.S. Supreme Court. The U.S. chief justice then was William Howard Taft, a former president and a man who never met a tax he didn’t hate. So Compañía General de Tabacos took its case to Washington—and won.
Chief Justice Taft’s opinion for the court majority is about as convoluted as the mechanism the tobacco company used to buy insurance. After several pages of impenetrable prose—“The collection of this tax involves an exaction upon a company of Spain lawfully doing business in the Philippine Islands effected by reason of a contract made by that company with a company in Paris on merchandise shipped from the Philippine Islands for delivery”—Taft concluded that the company didn’t have to pay the 1% tax. Six other justices concurred, so the Compañía won by a vote of 7–2.
The two who sided with the Philippine tax authority were Oliver Wendell Holmes Jr. and Louis Brandeis, a pair of justices who became known as the Great Dissenters because so many of their dissenting opinions turned into majority holdings in succeeding decades. In the Philippine Cigar Case, Holmes quickly brushes aside the tax-avoidance scheme, concluding that an insurance policy on a warehouse in the Philippines should be liable for the Philippine insurance tax. He goes on to explain that nobody likes paying taxes but it’s important to look beyond one company’s tax bill and see “its organic connection with the whole.” Seeing the whole picture, according to Holmes, reminds us that individuals and corporations get a lot of benefit out of the taxes they pay. “Taxes are what we pay for civilized society,” he explains, “including the chance to insure.”
Taxes, though, are not the only way to pay for civilized society. Governments have other ways to get by. At the simplest, most brutal level, a government that has a police force and an army can simply commandeer goods and services; countries like China, Venezuela, and Russia have occasionally decided to “nationalize” oil wells or gold mines or factories and then sell the output to earn government revenues. The previous owner of the well or factory might bring a lawsuit, but these actions tend to get snarled in the courts for years or decades. Even modern democracies like the United States sometimes use this approach; our government commandeered services from me and millions of others through the military draft during the Vietnam War. The problem with just seizing stuff, though, is that the citizenry hates it, so the commandeer approach tends to produce revolutions.
Governments have a convenient monopoly on the printing of currency (or legal currency, at least). In theory, a government that didn’t want to tax its citizens could just print the money it needs to provide common services. The problem here is inflation, which increases sharply as more and more money floods into the marketplace, with severe repercussions. A less damaging way to make money from printing money is the concept of “seigniorage,” which is the difference between the face value of a bill and the cost of printing it. The U.S. government spends about six cents for the paper and ink used to make a $10 bill, which means a seigniorage gain of $9.94 when a new $10 bill is put into circulation. The U.S. Mint says it earns something over $100 million each year this way. As long as a government doesn’t print so much money that it triggers inflation, seigniorage can be a small but steady contributor to revenues.
Governments can also bring in money by borrowing. When the U.S. government spends more than it takes in—in fiscal 2016, we ran a deficit of $590 billion—it borrows money from banks, investors, and foreign governments to make up the difference. For all the breast-beating in our political debates about “unsustainable deficits,” the U.S. government is a relatively conservative borrower compared with other rich countries. Among the thirty-four richest countries, government deficits averaged 111% of GDP in fiscal year 2014; the U.S. deficit was actually below average, at 106% of GDP.4 Countries like Italy (147%), Portugal (141%), and Ireland (133%) had significantly bigger debts, as a share of their total wealth, than the United States. Not surprisingly, Greece ranks near the top of debtor nations, with outstanding loans that total 188% of its GDP. The world champion at borrowing money, though, is the government of Japan, which has been running annual deficits for years greater than 225% of its GDP. This is less of a burden for Japan than it would be for most other countries because Japanese people have traditionally been prodigious savers, and their bank deposits provide most of the money the government needs to borrow. So Japan has huge debts, but it is indebted mainly to itself.
Borrowing money can be less painful than taxes, but here, too, there’s a limit. At some point, the interest charges become a significant part of the national budget, which means either reduced government services or higher taxes just to pay the interest. And if a government gets so deep in debt it can’t borrow any more—as happened to Greece after the Great Recession of 2008–9—the result can be severe austerity. Dozens of the planet’s two hundred or so countries are too poor to get a loan; for many of them, foreign aid from the United States, other rich nations, and UN agencies is an important source of revenue.
Finally, governments can sell goods and services to bring in cash. The U.S. government charges entry fees at national parks and sells timber from the national forests. It collects royalty payments when somebody mines coal or drills for oil on public land. It collects fees from banks to finance the Federal Deposit Insurance Corporation (FDIC) and from pharmaceutical companies to pay for testing new drugs. For a few lucky countries, government sales bring in all the revenue needed; some of the oil kingdoms in the Middle East collect no taxes from their citizens.
In ancient times, the king taxed what he could see. The Romans would measure the crop from a farmer’s field, or count the number of cows in the stable, and take 10% in tax; thus the tax collectors, or “publicans,” were derisively called tax farmers. In the 1790s, France imposed the “contribution des portes et fenêtres,” a tax on doors and windows, on the theory that only well-off people could afford such luxury; naturally, some homeowners bricked in their windows when they suspected the tax collector was coming around. Using the same tax-the-rich logic, European governments in the eighteenth century collected a duty on the elaborate wigs that the gentry wore and the powder they used to keep their wigs white.
As the nation-state concept developed and countries began to have discernible borders, the easiest way to collect taxes was export and import duties. There were only so many ports of entry, so this didn’t require a large number of tax offices. And this tax was not easy to evade; after all, it’s hard to conceal a clipper ship sailing into harbor with a cargo of tea from India. Custom duties brought in 90% of federal revenues for the newborn United States in its first decades; our government nearly went broke during the War of 1812, when the British navy blockaded all American port
s.5 In the young United States, the U.S. Customs House was the most imposing building in all port towns; these old structures can be seen today at the edge of Boston and Baltimore harbors. The handsome redbrick Customs House in Salem, Massachusetts, where Nathaniel Hawthorne worked while writing The Scarlet Letter, still stands as a reminder of the nation’s first revenue service.
Over time, though, as a nation’s domestic economy builds up, “internal revenue” becomes more important than taxes at the ports. State and local governments create their own tax systems; the property tax has always been an important source of revenue for local government, because you can’t pick up your house or farm and move it to the next state.
In the twenty-first century, the United States and other established countries have come to rely on income and consumption taxes as their main sources of revenue. But newer nations are replicating the history of taxation we saw in the United States. Achilles Amawhe, a senior director in Nigeria’s Federal Inland Revenue Service, told me that he has watched his country’s tax bureau grow throughout his career. “I was just a boy when Nigeria won her independence,” he said. “And as soon as I got out of school, I went to work for the nation, in the tax bureau. I have devoted my life to giving my country an honest, efficient, and respected tax service.” Achilles gave me a baseball cap bearing his agency’s logo, FIRS, and told me that the whole history of Nigerian tax was in that hat. “We started with custom duties; then we began taxing inland enterprises; then the provinces opened their own tax offices, and we became the ‘federal’ service. So FIRS—the Federal Inland Revenue Service—captures the development of taxes in our new nation.”
But maintaining a civilized society is not the only reason for taxation. Governments use taxes for numerous other purposes beyond the basic task of raising revenue to pay for public programs. “Virtually everything governments attempt to do with direct expenditure programs they also attempt (for better or worse) to do with taxation policy,” notes the economist Sven Steinmo. “Indeed, no other public policy issue has been used so widely for so many purposes. . . . Raising revenue, redistributing income, encouraging savings, stimulating growth, penalizing consumption, directing investment, and rewarding certain values while penalizing others are just some of the hundreds of goals that any modern government tries to promote with its tax system.”6 Tax has become a multipurpose government tool that performs many missions.
Encourage Good Behavior
For example, taxes turn out to be a powerful instrument for getting people to do what government would like them to do. The U.S. government wants to encourage you to contribute to charity, to buy an electric car, to get a college degree, to support your dependent children, to buy health insurance, to insulate your attic, to invest in oil wells, to fund a retirement account, and to take out a mortgage to purchase a home; accordingly, all those desirable practices provide a deduction, an exemption, or a credit that will lower your federal income tax bill. Inducing desirable behavior can also help to build “civilized society,” although that aspect of taxation does not appear to be what Justice Holmes had in mind. But governments everywhere use the tax code to promote good citizenship.
When the government of South Korea wanted corporations to use more of their profit for wage increases and less of it for dividends, the corporate tax code was amended to reward companies that raised their workers’ pay. To encourage people to leave their cars at home, Germany gives a tax break for commuting expenses, but only for those who commute by bus or train. Canada and Australia think it’s beneficial for individuals to support political parties and candidates, so they offer a tax credit for political contributions. Unlike the United States, though, Canada has a strict limit on contributions—nobody can give more than $4,800, total, in one year—so the maximum tax credit is $650.
Discourage Bad Behavior
In the same way, taxes are often an effective tool to discourage people from doing things perceived to undermine the common good. This kind of levy is sometimes called a “sin tax.” A sin tax is the exception to the consensus view among economists that taxes should be “neutral”—that is, designed so that people base their decisions on business or personal grounds, not on tax considerations. But taxes imposed on what we don’t want people to do are specifically designed to influence our decisions and conduct. The father of modern economics, Adam Smith, strongly endorsed this kind of tax in his famous study The Wealth of Nations: “Sugar, rum, and tobacco, are commodities which are nowhere necessaries of life, which are become objects of almost universal consumption, and which are therefore extremely proper subjects of taxation.” For Smith, taxes on sugar, rum, and tobacco had a double benefit: they discourage consumption of unhealthy products, thus reducing the cost of health care over time; they also bring in a steady flow of revenues, because those who smoke, drink, and eat candy generally do so even when the national economy is in a slump.
The great success story in the realm of taxing bad behavior is the cigarette tax. In the mid-1960s—the period depicted in the smoke-filled TV serial Mad Men—more than 40% of Americans smoked daily; they paid less than thirty cents per pack, including sales tax. After the surgeon general first warned, in 1966, that “smoking may be hazardous to your health,” the federal and state governments started taxing tobacco products heavily, to discourage the habit and to help offset the health-care cost governments were facing because of illness due to smoking. The taxes have consistently gone up since then—Americans today pay twenty times the 1965 price for a pack of cigarettes—and the number of smokers has consistently gone down. Today less than 16% of Americans smoke regularly. The experts attribute this partly to improved education efforts but largely to that huge increase in the sin tax on smokers. When cigarette taxes go up, smoking goes down.
Governments also try to prevent the excessive use of beer, wine, and liquor. As the United States proved between 1920 and 1933, outright prohibition doesn’t work in a free society. So different countries have tried different approaches; Germany, for example, has an “apple-juice law,” requiring that bars and restaurants include nonalcoholic drinks on the menu at a price lower than the cheapest beer or whiskey. Several provinces in Canada set a minimum price for alcoholic beverages so the bartender can’t lure people in with free or cheap drinks. But here, too, taxation has proven most effective. When the journal Addiction studied changes in alcohol taxes around the world, it concluded that a 10% increase in the tax on a drink reduces alcohol consumption by about 5%, which is enough to avoid tens of thousands of deaths and accidents each year.7 After British Columbia raised liquor taxes in 2002, deaths attributed to alcohol dropped by 32% over the next six years; the Canadian government attributes this to the higher price of booze.
As obesity has become a bulging health problem in many wealthy countries, the so-called sugar tax has begun to spread as a way to cut the consumption of high-calorie cola, candy, and junk food. Adam Smith would presumably approve. France, Denmark, and Belgium have all imposed various versions of the “fat tax.” Mexico, where the problem of obesity is even greater than in the United States, imposed new taxes in 2014 on sugared soda pop and junk foods like potato chips, cookies, and cheese curls. The sugar tax makes a regular Coke cost about 25% more than a Diet Coke; it makes a candy bar significantly more expensive than an apple. To complete the symmetry, the government promised to use some of the money from the sugar tax—initial revenue estimates were $1 billion annually—to improve the purity of the country’s water supply, because a lack of clean water is one of the reasons Mexicans consume so much soda pop in the first place.
Some countries, eager to enhance civic participation, charge a tax penalty for people who fail to vote. Mandatory voting is particularly popular in Latin America; among the nations that penalize nonvoters are Argentina, Brazil, Costa Rica, Ecuador, Peru, and Uruguay. The mechanism is pretty simple. You get a certificate at the polling place that says you voted; you attach that to the tax return. If the tax a
gency doesn’t receive proof that you voted, you pay more tax. President Barack Obama proposed a similar penalty for American nonvoters; so far, this idea has gone nowhere.
Taxes designed to curtail certain actions or purchases don’t always work. Following the oil shocks of the early 1970s, the U.S. Congress was eager to reduce Americans’ consumption of petroleum and thus reduce the nation’s dependence on foreign oil. One proposal called for a minimum level of fuel efficiency in all cars, so that it would be illegal to sell or buy a car that used too much gasoline per mile. But that was considered too draconian for the automobile-dependent United States, where the chance to buy a muscle car is considered a basic American birthright. So Congress instead passed the “gas-guzzler” tax in 1978, imposing a hefty tax on any car that gets less than 22.5 miles per gallon. The point was to discourage the purchase of these profligate vehicles. You can still exercise your God-given right to buy a gas-guzzler, but you have to pay extra for the privilege. (Nobody thought of minivans or SUVs back then as family cars, so they weren’t included on the taxable roster in 1978.)
There’s a two-page addendum to IRS Form 1040—it’s Form 6197—that collects the tax for wasteful autos; the top rate is $7,700 for a car that gets less than 12.5 miles per gallon. In 2014, according to the Environmental Protection Agency, no car sold in the United States was that extravagant, but seventy-eight different models from twelve different makers were officially labeled “gas-guzzlers.” The thirstiest passenger car sold in the United States was the Bentley Mulsanne, rated at 15.9 miles per gallon; the ten-cylinder Lamborghini Gallardo Spyder was second worst (16.2 miles per gallon), followed closely by the twelve-cylinder Ferrari FF (16.4 miles per gallon). Did the tax discourage anybody from buying one of these notorious fuel gulpers? Sales figures don’t show it, which is not surprising. The gas-guzzler tax on that inefficient Bentley Mulsanne is $3,700 (in addition to the normal sales and registration taxes); it doesn’t seem likely that somebody who wants to ride around town in a $279,000 Bentley would choose a Ford hybrid instead just to save $3,700 of tax.