econscius

Prisoners’ Dilemma: CFOs Want Simple Tax Code But Get Complicated Mess

In Corporate Taxes, Flat Tax, Income Tax Rates, Lobbying, Prisoner's Dilemma, Tax Breaks on November 6, 2011 at 1:01 am

A new Duke University/CFO Magazine survey found the vast majority of CFOs would be willing to give up all tax breaks in exchange for a flatter, simpler tax code at a lower rate.  

“Showing their frustration with the complexity of the tax code and the time and money they spend to comply, 71% of CFOs say they’d be willing to give up all existing exemptions and credits in return for a reduction in the overall corporate rate — even though they might not come out ahead on their tax bill. Another 17% say they’d forgo exemptions for a lower rate because they believe their companies would end up paying less in taxes than they do today.”  Forty-eight percent agreed the corporate tax system in the U.S. is “seriously flawed and needs a complete overhaul.” [1]

If the majority of CFOs want a flat tax, why do we have the world’s most convoluted tax code?  Why does the tax code increase in complexity each year? 

(1) One reason is politicians offering up new tax breaks for every conceivable problem.  Many of today’s tax breaks reflect societal goals such as increasing energy efficiency, encouraging R&D spending, helping American farmers, assisting exporters, operating businesses in economically depressed areas and employing more Americans.  Some of the goals are noble, but each attempt at changing corporate behavior through the tax code adds to the complexity and means some clever companies (e.g. GE) will use so many of these tax loopholes they pay little, if any, tax.

(2) The Prisoners’ Dilemma (“PD”) may help us understand why companies lobby for tax code loopholes even when they know a flat system would be better. 

In the classic PD game [2], two accomplices are arrested, but the police do not possess enough information for a conviction. The police separate the two men and the police offer each prisoner a similar deal:  if one testifies against his partner while his partner remains silent, the betrayer goes free.  The betrayed prisoner then serves a one-year sentence.

If both prisoners remain silent, the police simply have insufficient evidence and each prisoner will only serve one month in jail on a minor charge.   But, if both prisoners independently betray the other, the police then have evidence to convict both, earning each a three-month term. 

  Prisoner B Stays Silent Prisoner B Confesses
Prisoner A Stays Silent Each serves 1 month A goes free, B serves 1 year
Prisoner A Confesses B goes free, A serves 1 year Each serves 3 months

Obviously, the prisoners should each remain silent and receive a one month sentence.  But they end up each serving three months instead.  The reason is the essence of the PD: because the two prisoners cannot communicate, they have to rely on trust.  Confessing is the superior strategy as it leads to either going free (if the other prisoner is quiet) or serving a three-month term.  A prisoner would like to remain silent but that exposes him to the maximum prison sentence.  Remaining silent is the riskiest strategy as it means either going free (if the other prisoner is also quiet) or serving one year.  Unless the prisoners have a high degree of trust in each other, they will both confess. [3]

There is a very similar dynamic in play in corporate taxation.  Let us look at corporate tax breaks in terms of a simple prisoner’s dilemma model.

For simplicity, assume there are just two corporations, Amalgamated & Big Corp.  Each may pursue their own tax break, if they like, which would reduce their tax by $1, with that $1 paid through higher taxes on the other company

But it is not all tax break gravy, there is a cost for tax breaks.  Either company has to pay 25 cents for lobbying if they choose to influence tax policy; I assume lobbying is always successful.  Both companies pay 25 cents each for tax compliance costs (to accountants and tax lawyers) if there are any tax breaks.

What are the possible outcomes?

  Big Corp. Forgoes Tax Break Big Corp. Lobbies For Tax Break
Amalgamated Corp. Forgoes Tax Break Both Win (A $0, B $0) B Wins Tax Break (A -$1.25, B +$0.50)
Amalgamated Corp. Lobbies For Tax Break A Wins Tax Break (A +$0.50, B -$1.25) Both Lose       (A -$0.50,         B -$0.50)

Clearly, the optimal solution for the economy is no tax breaks because it means neither company has to pay lobbyists or tax accountants.  Yet, the equilibrium is always that both companies lose: they will each lobby for their own tax break and end up being out the $0.50 cost of lobbying and tax compliance.  Why?

For each corporation, the optimal strategy is to always lobby.  Amalgamated has no reason to trust Big Corporation will not lobby for Big’s own tax break.  The payoffs are such that lobbying is always successful and the cost of the tax break you win is borne by the other side.  The rational decision in this framework is always to lobby for the tax break, even if you know you will end up with a zero sum game where you are down $0.50 (for lobbying and tax compliance). 

The driver is you will always bear the cost of the other company’s $1 tax break if the other corporation chooses to lobby for its tax break.  The only way to protect Amalgamated from being stuck with Big Corporation’s $1 tax break cost is to exactly offset it with Amalgamated’s own $1 tax break.   The two breaks net to zero (because -$1 +$1 = 0), but unfortunately, each corporation is out the lobbying/tax compliance costs.

This takes us back to the CFO survey at the start of this post: most CFOs would be happy to give up their tax breaks (the “both lose” corner of my PD diagram) in exchange for no tax breaks at all (the “both win” corner of my PD diagram).  As long as we have a complex tax code filled with loopholes (see https://econscius.wordpress.com/2011/10/18/yes-there-are-lots-of-tax-loopholes/), corporate and individual taxpayers keep ending up in the “both lose” corner.

How do we break the mechanics of the Prisoners’ Dilemma where we always end up in the “both lose” corner of high costs of lobbying and tax compliance? 

I think the only plausible answer is to break the game by disallowing tax breaks in the first place.  That replaces the need for “trust” between the players of the tax game.  The way to disallow tax breaks is to have a simple, flat tax at a slightly lower rate.  Ask everyone to give up their favorite tax break in exchange for everyone else giving up their favorite tax break.   The total tax collected in the economy could be kept exactly the same through a lower rate, but we would remove the inefficiencies and noise that go with lobbying and complying with our labyrinth tax code.  Surely, that is better than the current dilemma of myriad tax breaks that cost a lot in lobbying and tax compliance.

[1] http://www.cfo.com/article.cfm/14599917?f=search.

[2] Discussion of Prisoner’s Dilemma can be found at: http://plato.stanford.edu/entries/prisoner-dilemma/.

[3] The PD helps demonstrate a facet of organized crime groups, which enforce “trust” through lethal force.  If the prisoners are members of the mob, the mob may threaten their lives if they confess.  That changes the outcomes (confess means go free or 1 month, now followed by probable death) and helps explain why mobsters almost always remain silent unless they can be completely shielded from harm from their fellow mobsters by participating in a witness protection program.

Dragnet & Basic Instinct pictures from Wikipedia Commons.  Comments are welcome below:

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