Effectiveness and Economic Impact of Tax Incentives in the SADC ...

ECONOMICS OF TAX INCENTIVES 3-9
Exhibit 3-2
Small Companies, Giant Loopholes
In 1954 the United States Congress approved an
income tax exemption for small mutual insurance
companies collecting less than $350,000 in annual
premiums. The purpose was to encourage small
start-up companies to insure farmers, small
businesses, and others who had problems obtaining
coverage from major insurers. In 1986 the provision
was amended to cover privately owned companies
as well as mutual associations. That opened the
door for wealthy individuals to avoid huge tax bills.
According to a New York Times report in April, 2003,
one New York billionaire has used this provision to
escape more than $100 million in taxes.
The loophole arose because the legislation did
not set any limit for assets of “small” insurance
companies. As long as they collect just a small
amount of premium income, they qualify for tax-
free status—even if they earn an enormous income
by investing reserves that astronomically exceed
any plausible business requirement for covering
potential loss claims.
By creating and heavily capitalizing small
insurance companies, and making sure that they
don’t sell much insurance, wealthy investors have
sheltered huge amounts of income from tax. Better
yet, the Internal Revenue Service has not been
auditing or even keeping track of filing records for
these “small” tax-exempt insurance companies.
Needless to say, this has not escaped the attention
of accountants and lawyers who provide tax advice
to wealthy clients.
The moral of the story is that even in a system
with strong tax administration, well intentioned tax
incentives can open the door to abuses that cause
enormous revenue losses, from activities that have
nothing to do with the policy objective. Worse, is it
possible that special interest groups pushed
through the 1986 amendment to take advantage of
the loophole that was then created?
SOURCE: Based on David Cay Johnston, “Insurance Loophole Helps Rich,” New York Times, April 1, 2003.
Tax advisors everywhere steer clients toward tax-saving techniques like these, wherever the
tax code creates opportunities to do so. Large taxpayers, who have the best tax advice and the
most to gain from minimizing tax obligations, use these techniques the most. Abuse is
especially likely where companies with tax holidays are not audited, by virtue of having no
tax obligation.
The incentive to misuse tax incentives can be mitigated (at least marginally) by imposing low
basic tax rates in the first place, by minimizing tax differentials due to incentive programs, by
strengthening tax investigation and audit, by simplifying the tax code to make it easier to
administer, and by enforcing economically meaningful tax penalties. Technically, the revenue
loss from abusive techniques could be averted with thorough diligent audits and application
of provisions in the tax law regarding the use of sham transactions or non-arms-length
pricing. In reality, though, tax officers in developing countries rarely detect such practices.
Thus, the anticipation of aggressive tax planning should be a central consideration in the design of tax
incentives in the SADC region.
3. Impact on Tax Administration. Incentive programs encumber tax administration in several
ways. First, selective incentives require applying different rules to different taxpayers, which