Solving the problem of black money in real estate

By Ajay Shah, on May 5th, 2011

Manmohan Singh as finance minister killed off smuggling, by eliminating customs duties. Black money in the real estate sector recently attracted his attention. He suggested lowering of stamp duties to check the flow of black money in this sector. But will this solve the problem of black money? And how will the State compensate for the loss of revenue collected from stamp duty?

Stamp duty is a transaction tax; it is charged as a percentage of the transaction value of the property. Public economics teaches us
that all transaction taxes are bad taxes, that the right level for the stamp duty is zero (as it is for all taxation of transactions).

The stamp duty distorts the behaviour of parties to the transaction. Stamp duty on property is usually paid by the buyer. Hence, the buyer tries to coax the seller to agree to undervalue the property on paper (the transaction value declared to the government) and accept the rest in black money. On the other hand, sellers have an incentive in accepting black money from the buyer in order to evade the taxation of capital gains. As long as real estate capital gains are taxed, eliminating the stamp duty will influence the
behaviour of the buyer but not that of the seller.

Hence, modest changes in the stamp duty rate will not solve the problem of black money in real estate. When stamp duty is  eliminated, the buyer will be comfortable with zero evasion, but the seller will still urge him to take some black money.

Bad taxes should be eliminated because they are bad taxes. There should be no attempt at finding a direct replacement. As an example, India largely phased out customs duties, because the economists said these are bad taxes, without specifically trying to find a replacement. The elimination of customs duties enabled high GDP growth, and the main pillars of taxation (income tax and the VAT) generated bountiful revenues. A similar story will hold for stamp duty.

The economists teach us that all taxation of transactions is wrong. The property tax suffers from no such problems. Much work is needed in India in building a sound property tax system. In some countries, property tax revenues can be as large as 1% of GDP, which is a very big number compared with the financing of local government in India. The key issue is that the average value of property in each micro neighbourhood (e.g. a 200 metre stretch of road) needs to be assessed correctly and revised every year. This should then be used as a preumptive property tax rate, per square foot, for that micro neighbourhood. Once this is done, property tax collections will be a powerful source of revenue for local government.

There is a link between these two issues. As long as there is a stamp duty and high taxation of real estate capital gains, the reported data will understate property values. This will hamper the revenues obtained through the property tax. To the extent that we solve the twin problems of stamp duty and capital gains taxation, the data in the hands of government about real estate prices will improve, and this will bring property tax to life as a significant revenue source.



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Coming in 2010: New IRS Rules to Fight Tax Evasion

By G.L.C., on November 4th, 2008

Many wealthy Americans have been using offshore services provided by foreign banks to evade tax. Things may now get a little difficult.

Until now foreign banks could funnel hundreds of billions of dollars overseas on behalf of American clients without disclosing their names to the Internal Revenue Service (IRS) under a program known as qualified intermediary. The banks would withhold any taxes due on United States securities in their accounts and send that money to the I.R.S. The program was established 2001 in an attempt to attract foreign investors to U.S. securities. More than 7000 foreign banks participate in the program.

Concerned that it has delegated too much control and authority to the banks and that in recent years American investors have been evading taxes by hiding behind offshore shell companies and trusts set up by the banks, the IRS has issued new rules which will go into effect in 2010. The new rules require the banks participating in the program to actively determine whether U.S. investors are behind the foreign accounts they set up. The banks will have to alert the IRS to any potential fraud that they detect, whether through their own internal controls, complaints from employees or investigations by regulators.

The new rule could be an outcome of the federal investigation of the Swiss banking giant UBS. Federal prosecutors claim that UBS misused the program by selling American clients offshore banking services that went undeclared to the IRS, helping its American clients hide as much as $20 billion in assets offshore, thereby evading at least $300 million in taxes.

The changes to the program means the IRS will now audit small samples of individual bank accounts in the program, without knowing the clients’ names, to determine whether U.S. investors actually have control over foreign entities set up by the banks. Participating banks must now hire external auditors who will have to zero in on the bank employees responsible for identifying and preventing abuse of the program. The external auditor must report all red flags to the IRS. In addition, banks using foreign-based external auditors will have to work with an American auditor.

That’s not all. There is more bad news for those looking at foreign banks to evade taxes. The US has succeeded in getting the Swiss tax authorities to hand over confidential data on wealthy American clients of UBS. Under Swiss law, it is a crime to disclose client name or data unless the Swiss authorities think that the client has committed a serious offense like money laundering or tax fraud. Tax evasion is not considered a crime in Switzerland. This is a major shift in the Swiss banking secrecy laws. The US could now use this as a precedent in the future to get more Swiss banks to disclose the details of their American clients.

The message is loud and clear – Uncle Sam will take his rightful share of your money no matter where you hide it.



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