On Tea and Taxes
July 23rd, 2009
One evening in November 1773, colonists disguised as Mohawk Indians threw 342 chests of tea into the Boston Harbor. Later dubbed the Boston Tea Party, the protest was in dissent of what colonists believed to be unfair taxation by the interfering British Empire. This sentiment reverberated throughout the colonies, escalating until the colonists were freed from their oppressors many years later. Little did they know, but there are easier ways to use tea to avoid taxes.
A few weeks ago I wrote a blog about illicit financial flows, which are bundles of money that are sneaked out of developing countries illegally (see 10 times ODA, but what is that in Apple Pies?). IFFs can be sent out for various purposes—to launder money, evade taxes, or skirt capital controls.
In response to this blog, one reader asked “who wins (specifically) and who ‘loses’ (specifically) through these shadowy flows?” To illustrate the answer, I will use the example of Tai-Fu Chen, a wealthy Taiwanese immigrant in California who, like the Boston colonials, used tea to evade taxes. Tai-Fu didn’t throw any of his tea into a harbor, though. He used trade mispricing.
Trade mispricing occurs when a company or an individual shifts wealth between countries, using either export under-invoicing or import over-invoicing. Individuals like Tai-Fu Chen, whose U.S. based company sold herbs and spices from the Far East. So how does it work? Suppose Tai-Fu is importing $100 worth of tea leaves from Taiwan. Instead of paying $100, Tai-Fu reports and pays $200. Tai-Fu’s trading partner takes $100 for the tea and shifts the extra $100 to a secret Taiwanese bank account (and maybe keeps an extra few dollars as a transaction fee). Now Tai-Fu doesn’t have to pay taxes on the $100.
Tai-Fu repeated this practice many times over on a much larger scale, eventually shifting millions in profits to Asia. In additional real world examples, other U.S. companies imported tweezers from Japan for $4,896 apiece and razor blades from Great Britain for $113 each. The winners are the companies and individuals, like Tai-Fu Chen.
So who loses? The IRS loses and the American taxpayers lose. Well, actually, in this story the interfering, but resourceful, IRS eventually caught up with Tai-Fu and his tax-avoiding tea. Tai-Fu had to pay $93 million in back taxes to the IRS, $4 million to U.S. customs, and then went to jail for two years. Although tedious and a bit dramatic, looks like throwing tea into harbors was a better way to avoid taxes after all.
It doesn’t always work out so well. Most developing countries don’t have well-funded government branches like the IRS to root out men like Tai-Fu. So these countries hemorrhage hundreds of billions of dollars a year to the practice.
In an effort to root out his problem, the Task Force advocates requiring parties conducting an international transaction to sign a statement in the commercial invoice certifying that no trade mispricing had taken place. Maybe it’s a distant goal, but we dream of day that tea leaves are no longer used to avoid taxes, but just for hot water and drinking. Like God and the British intended.