Tax systems fingerprints are all over the crime scene of the 2008-2009 Financial Crisis

John Whitehead, former chairman Goldman Sachs, said, the current financial crisis could be worse than the one in 1930s.1 Though the start of current financial crisis was with crash in US housing market; It was not a sudden crash, it took over a decade to saturate market that finally created a bubble to burst. Henry Paulson, ex US Treasury Secretary, acknowledged subprime was due to bad lending standards and deficiencies in regulating investment banks.2 Despite having guidelines available for sale of derivative products3 the regulators failed4 to control sale of risky products.5 While financial industries regulators are being blamed for the crisis yet they are not alone who turned a blind eye; tax authorities should also be held responsible as they should have alarmed bell for exuberant profits reported by financial industry. While banks kept posting high profits through risky trades, the revenue collectors scored marks for increased tax collection without realizing the income was mark to market gain that did not realized with economic crash and banks had to close their shops. In March 2008, Bear Stearns was absorbed by JP Morgan Chase.6 Lehman Brothers filed for bankruptcy on September 15, 2008 and Merrill Lynch agreed for sale to Bank of America.7 This was all due to speculative trading business and closure of these banks impacted global financial markets. Until now tax authorities are using same stick for all types of income earned by financial institutions. Shaviro has rightly mentioned that despite highlighting various 8 deficiencies in income tax rules by experts, the authorities remained silent or did not change policy. US Tax history reveals tax has always been used as a tool to adjust financial needs of Government. Tax rate adjustments can be traced to specific events like wars. British Government passed Stamp Act in 1765 to cover expenses of their war with France (1754-1763).9 To cover expenses of the Revolutionary war, American Government levied certain excise taxes in 1789. To support war with France in 1790s, American Government again imposed certain direct taxes. US abolished direct taxes from 1802-1812, however American and Great Britain war in June 1812 prompted American government to impose additional excise duties and increase existing. In 1817, these taxes were repealed and US Federal Government collected no internal taxes for next 44 years. In 1861 eruption of civil war once again compelled US Government to introduce the Revenue Act restoring earlier excise duties and imposing tax on personal income. Sighting increased cost of war; taxes were hiked in 1862 and again repealed with end of war by abolishing income tax in 1872. Even during this period the US Government increased and levied some new excise duties to fund expenses for Spanish American war through passing War Revenue Act in 1899. The World War I also impacted revenue stream of US Government compelling her to increase tax rates through 1916 Revenue Act. This increase in tax rates helped US government in generating additional revenue and stabilizing national economy. The tax rates were again adjusted before and after the famous stock market crash of 1929. However the US involvement in the World War II impacted the tax payers as they had to suffer increased taxes in 1940 and 1941. In US tax policy was
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http://www.reuters.com/news/video?videoChannel=3104&videoId=93713 http://www.sec.gov/news/testimony/2008/ts092308cc.htm http://www.isda.org/press/pdf/GlobalPrinciples-sp.pdf p.5 http://www.parliament.uk/commons/lib/research/rp2009/rp09-058.pdf p.38

http://www.mhhe.com/economics/cecchetti/Cecchetti2_Ch07_StructuredProducts.pdf ; http://www.reuters.com/article/idUSTRE49E3BY20081015 6 http://nymag.com/daily/intel/2008/03/a_quickie_guide_to_the_fall_of.html

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http://www.nytimes.com/2008/09/15/business/15lehman.html
The 2008-09 Financial Crisis: Implications for Income Tax Reform by Shaviro p.2

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http://www.ushistory.org/march/phila/background.htm 1 of 7

Paper by Mubarak Aziz Jahangiri for International Taxation Law, submitted to University of Liverpool/Laureate

Tax systems fingerprints are all over the crime scene of the 2008-2009 Financial Crisis
increasingly seen as Government tool to control and stabilize macroeconomic activity. The policy makers adopted tax rates as a tool to adjust demand and supply to smoothen the business cycle. The US budget once again went in deficit during 1986 1990 due to high level of spending of which a major portion was first Gulf war and taxes were again increased in 1990. 10 The following graph reflects a comprehensive story of US budget deficits and impact of tax policies to reduce gap in income/expenses.

Impact of tax increase after World War I

Impact of tax increase in 1940s

Korean War 1929 crash

Tax reforms during Regan era

1990 tax increase

Source:http://www.usgovernmentspending.com/downchart_gs.php?year=1900_2010&view=1&expand=&units=p&fy=fy11&chart=G0fed&bar=0&stack=1&size=l&title=US Federal Deficit As Percent Of GDP&state=US&color=c&local=s

The following templates show US tax rates were reduced during the period 2000 2007: Tax Year: Filing Status:
2000 Single

If your taxable income is between...

0 26,250 63,550 132,600 288,350

your tax bracket is:

15 28 31 36 39.6

and and and and and and

26,250 63,550 132,600 288,350 above

% % % % % %

Source: http://www.moneychimp.com/features/tax_brackets.htm

10

http://www.treasury.gov/education/fact-sheets/taxes/ustax.shtml

Paper by Mubarak Aziz Jahangiri for International Taxation Law, submitted to University of Liverpool/Laureate

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Tax systems fingerprints are all over the crime scene of the 2008-2009 Financial Crisis

Tax Year: Filing Status:

2007 Single

If your taxable income is between...

0 7,825 31,850 77,100 160,850 349,700

your tax bracket is:

10 15 25 28 33 35

and and and and and and

7,825 31,850 77,100 160,850 349,700 above

% % % % % %

Source: http://www.moneychimp.com/features/tax_brackets.htm

And corporate tax rates in US remained at same level between years 2000 2006 Corporate Tax Corporate Tax Rank in March Country Rank in 2000 Rate in 2000[1] Rate in 2006 2006 Japan 40.9 3 39.5 1 United States[2] 39.4 6 39.3 2 Germany 52 1 38.9 3 Canada 44.6 2 36.1 4 France 37.8 7 35 5
Source: http://www.taxfoundation.org/blog/show/1471.html

From the first chart we observe increase in tax revenue from year 2000 onwards; and the data for year 2000 2007 indicates US tax rates remained almost at same level. From the US tax history we noted taxes were always increased during war times and 2001 onwards US Government has heavily spend in the name of War on Terror but taxes were not increased; US Government introduced a tax cut in 200111 and this increased expense was funded by high tax payments by so called economic boom that primarily started with construction as financial institutions started lending mortgages to individuals with less or no credit history and no one cared about fictitious profits creating the bubble. Coincidently during this period sale of risky structured products increased. These products were introduced around mid 1990s and peaked in 2000s. CDOs (Collateralized Debt Obligation)12 and Subprime mortgages13 played a crucial role in the current financial meltdown. Both these products helped financial institutions in recording high profits that ultimately paid high income taxes. The
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http://www.treasury.gov/education/fact-sheets/taxes/ustax.shtml The Bush Tax Cut http://www.investopedia.com/terms/c/cdo.asp http://news.bbc.co.uk/2/hi/business/7073131.stm 3 of 7

Paper by Mubarak Aziz Jahangiri for International Taxation Law, submitted to University of Liverpool/Laureate

Tax systems fingerprints are all over the crime scene of the 2008-2009 Financial Crisis
corporate sector was paying high amounts in taxes and authorities were happy by keeping eyes closed as they need not to hike tax rates for funding their war; there tax revenue increased without any efforts but at a grave cost. Lehman Brothers posted a record profit and paid an amount of USD 8.7 billion as staff salaries and bonuses for year 200614, this figure was increased by 10% for 2007 15 and the bank filed for bankruptcy in September 2008. While Lehman was posting huge profits where the accountants and tax authorities were as no one raised any alarm for such increased revenue. The market would have never crashed if such market bulls were timely nailed. Lehman was not alone in this race; it was almost every big financial institution. High accounting profits of most of banks in US had income from property sector as a major contributor to net income of banks in 2005 when the US real estate market was at a boom and lending by banks fueled the construction market. This pace decreased in 2006 by slow down in home construction industry16 as the market was being saturated. US banking sector reported strong profitability from 1994 to 2006 on back of derivative products; lending of subprime mortgages also started during the same time by offering mortgages to borrowers who were not qualified for a standard mortgage due to their bad credit history and because of poor credit history of a borrower, lenders charged substantially high interest rate boasting their income; though market indicators revealed 6 time higher probability of default of a subprime loan when compared with a standard mortgage.17 Banks were being audited and filing returns with Revenue Office, however no questions were raised for such high income that significantly dropped from 2007 onwards with defaults in subprime mortgages. The following graph demonstrates changes in banking profits with current financial crisis:

Source: http://www.federalreserve.gov/pubs/bulletin/2010/pdf/bankprofits10.pdf
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http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article754348.ece http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ajI8xAslBPLc http://www.federalreserve.gov/pubs/bulletin/2007/pdf/bankprofit07.pdf p.A37,A38 http://research.stlouisfed.org/publications/review/06/01/ChomPennCross.pdf p.31,32 4 of 7

Paper by Mubarak Aziz Jahangiri for International Taxation Law, submitted to University of Liverpool/Laureate

Tax systems fingerprints are all over the crime scene of the 2008-2009 Financial Crisis
From the history we noted that tax rates have always been used as a tool by government to stabilize economy, however this role was not effectively performed over the last two decades; tax authorities could have imposed higher tax rates on income from speculative trading activities including derivatives.18 Such high rate would have discouraged speculative trading. As mentioned by Shaviro, Even if one accepts that tax distortions did not play a dominant role in causing or exacerbating the crisis, the fact that they frequently pointed in the wrong direction is important.19 Lenders preferred debt financing over equity financing as debt financing is taxed once and equity financing twice that also encouraged banks to lend aggressively. Though US Treasury Department tax reform plan of 1992 proposed tax treatment of debt and equity at par, however this was never seriously considered for implementation.20 Tax rates are another reason that forced companies to invest in countries with lower tax rates where debt investment may have been tax preferred.21 A survey by International Monetary Fund22 to evaluate major reasons behind the financial crisis also highlighted following deficiencies in tax system: Excess use of debt financing; Use of complex financial derivatives and tax relief for losses from them; Preferred tax treatment of income from properties; Different tax rates in various countries providing tax arbitrage at high risk. Apart from housing bubble, tax arbitrage and use of derivative products, inconsistency between accounting profits (mark to market) and computation of tax revenue is also a major reason flaring the financial crisis.23 IAS 39 was introduced to standardize principles for recognition and measuring of financial assets and liabilities24 and related profit/loss; tax authorities should have also applied different tax rates in accordance to risks associated with a product. While IAS 39 changed concept of hedge accounting by not allowing taking a gain from a hedged asset/liability if the hedging derivative was showing opposite results. The taxation rules did not follow the same; while income was considered for tax and losses deferred. Tax incentives are another main reason that led to wrong economic decisions by financial institutions for excessive lending. Tax policies in US and many more countries allowed deduction of mortgage interest payments from tax liability that encouraged excessive lending/borrowing in property sector.25 Lower tax rates in US for capital gain especially exemption of up to USD 500k capital gain on sale of principal residence also encouraged many to speculate.26

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The 2008-09 Financial Crisis: Implications for Income Tax Reform by Shaviro p.16 The 2008-09 Financial Crisis: Implications for Income Tax Reform by Shaviro p.3

ibid p8 ibid p10 http://www.imf.org/external/np/pp/eng/2009/061209.pdf http://www.bus.umich.edu/otpr/NTA%20crisis%20talk%20050809.pdf http://www.iasb.org/NR/rdonlyres/1D9CBD62-F0A8-4401-A90D-483C63800CAA/0/IAS39.pdf http://ec.europa.eu/taxation_customs/resources/documents/taxation/gen_info/economic_analysis/tax_papers/taxation_paper_20_en.pdf http://www.bus.umich.edu/otpr/NTA%20crisis%20talk%20050809.pdf p6 5 of 7

Paper by Mubarak Aziz Jahangiri for International Taxation Law, submitted to University of Liverpool/Laureate

Tax systems fingerprints are all over the crime scene of the 2008-2009 Financial Crisis
Tax policies regarding the compensation packages are also responsible to encourage executives to earn short term gains rather than focusing on long term stable income of an organization.27 Ireland is another country most hit by Financial Crisis. In a recent report published 31st May 2010 crisis, on Irish banking crisis, Patrick Honan, Governor of the Irelands Central Bank has held Irish taxation policies also responsible for flaring the financial crisis. He said, Much of the reason for the revenue collapse lies in the systematic shift over the previous two decades away from stable and reliable sources such as personal income tax, VAT and excises towards cyclically sensitive taxes. Revenue became increasingly dependent on corporation tax, stamp duties and capital gains tax. The Irish Tax authorities provided a lot of incentives to construction sector like ceiling of mortgage interest deductibility were increased and imputed rental income or capital gains for owner-occupiers were also tax exempted thus creating a construction boom to ultimately burst the inflated bubble. Mr. Honan, further states, Domestic policies did not act as a sufficient counterweight to the forces driving this unsustainable property bubble. Indeed, the increased reliance on taxes . made public finances highly vulnerable to a downturn. Specific tax incentives also boosted rather than restrained the overheated construction sector. 28 Learning lesson from loopholes in US Tax policy other countries started tightening their policies. In 2009, Ireland introduced NPPR (Non principal private residences) charge.29 Similarly UK increased capital gain tax by 10% for higher rate taxpayers.30 In addition to these moves the UK Government also introduced a super tax on bank bonuses. This move was to discourage banks from paying high bonuses 31 and instead utilize cash to increase capital base. I will also briefly discuss how incorrect tax policies of Pakistan have negatively impacted the countrys growth. Tax authorities have always focused revenue collection through the easiest possible route that may even increase social disparity. This is in contrast to developed countries where taxation laws are designed to create social equality. Pakistan tax policy requires businesses to pay taxes up to a rate of 35% compared to passive income that is taxed at a much lower rate of 10%. This disparity forces investors to buy properties or simply leave deposit with banks. Result of such policy is fewer businesses are established; creating very few jobs. Agriculture income, certain capital gains and any gain from sale of listed companies shares are also exempt from tax. 32 Import trading items are taxed at 2% compared to 3.5% tax on locally manufactured goods. In addition to this immunity is also available to a commercial importer from Sales and Income Tax audits.33 While such revenue policy discourages business environment, it also impacts state revenue and as a result Pakistan is always dependent on either IMF or World Bank assistance. Though Pakistan did not suffer any major losses from the recent financial crisis, however, the nation is suffering from bad tax policies. Estimated population of Pakistan is 170 million and tax policy is designed in such a way that
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ibid p19,20 http://www.businessandfinance.ie/files/Honohan%20report.pdf p20, p29-31 http://www.moneyguideireland.com/new-property-tax-on-second-homes.html http://www.independent.co.uk/money/tax/capital-gains-tax-secondhome-owners-are-spared-punitive-rise-2007785.html http://english.aljazeera.net/business/2009/12/200912915573813417.html http://www.dailytimes.com.pk/default.asp?page=2009%5C06%5C16%5Cstory_16-6-2009_pg5_13 http://www.accountancy.com.pk/articles.asp?id=185 6 of 7

Paper by Mubarak Aziz Jahangiri for International Taxation Law, submitted to University of Liverpool/Laureate

Tax systems fingerprints are all over the crime scene of the 2008-2009 Financial Crisis
most taxes are paid by salaried class while most businesses including agriculture (a main sector) enjoys complete immunity. A World Bank report of 2007-08 indicated that tax evasion in Pakistan stood at Rs. 796 billion.34 (Then USD 12 billion) (Rs 66 = USD 1). By having a right tax policy and proper tax collection mechanism Pakistan can get rid of all international loans. To conclude I strongly recommend countries need to have tax reforms besides enforcing financial regulations as if one fails other controls. Tax authorities need to check on speculative trading; a higher tax rate may be helpful in reducing speculative trading; tax policies also need a revisit to avoid tax arbitrage, tax distortion and preferred tax treatment for certain business types.

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http://www.geo.tv/9-6-2009/48808.htm

Paper by Mubarak Aziz Jahangiri for International Taxation Law, submitted to University of Liverpool/Laureate

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