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The Benefit Principle of Taxation and the Economics of Fiscal Membership
The benefit principle of taxation, which dates back to the earliest times of public finance, suggests that taxpayers contribute to the state based on the amount of public goods and services they consume, such as roads, courts, national defense, regulatory institutions, and judicial enforcement—and, therefore, the taxes they pay in order for these public goods/services to exist.
This principle fits the definition of territoriality: if you're a resident of a particular country, then you are consuming its public goods/services and should be responsible for paying for them.
Unfortunately, the U.S. uses a citizenship-based system for taxing its citizens (i.e., the U.S. taxes American citizens on their global income regardless of where they live), which disrupts this definition of fiscal membership for purposing of taxation by creating conflict between the fiscal membership (for purposes of taxation) created by being a U.S. citizen, and the fact that American citizens living overseas consume foreign public goods/services, and thus owe neither the U.S. or any other country a tax for such consumption.
Public Goods and Territorial Consumption
Public goods are generally characterized by being both non-rivalrous and non-excludable across different jurisdictions of the world. All residents of a nation enjoy benefits that arise from national defence, the operation of judicial systems, the enforcement of regulations, and macroeconomic stability. However, the ability to utilize a given public good will often depend upon one’s geographic location. For example, a citizen of the United States permanently residing in London will use the policing services, transportation infrastructures, and health services provided by the United Kingdom; he or she will not make use of those that are provided by the United States.
According to the benefit principle, taxes are justified when there is a link between the tax paid and the benefit received. When this link weakens, it raises issues with regards to fiscal equity and fiscal efficiency. As a result, expatriates typically pay large amounts of tax to their country of residence, even though the U.S. provides foreign tax credits and exclusions to help alleviate double taxation. However, the compliance obligations that expatriates face are still complicated and onerous.
Compliance Costs and Economic Frictions
The economic impact goes far beyond the tax liability faced by the taxpayer. Compliance with reporting requirements under laws such as FATCA, for example, produces compliance costs in addition to taxes owed. Surveys of expatriates indicate that annual accounting fees often range from hundreds to thousands of dollars, depending on the complexity of the taxpayer’s assets. Even when no net U.S. taxes are owed due to foreign tax credits, filing requirements with the IRS still remain.
From an economic perspective, these compliance costs represent a form of deadweight loss. The focus is on wasted resources: the money spent on legal advice and accounting services represents frictional costs associated with maintaining U.S. tax compliance.
The magnitude of the response can be observed in renunciation statistics. U.S. Treasury data show that thousands of individuals expatriate from the United States each year. In some years over the past decade, more than 5,000 people renounce US citizenship while living in the UK. For some individuals living in the United Kingdom and other countries, the decision to renounce is less about avoiding taxes entirely and more about reducing long-term tax and compliance burdens. When individuals conduct a cost-benefit analysis, they must consider the administrative burden, financial uncertainty, and future planning difficulties associated with maintaining U.S. tax obligations while living abroad.
Economic Forces Driving the Tension
Several factors contribute to this fiscal mismatch.
- Growth in global labour mobility and remote work
- Growth in cross-border financial assets
- The generation of digital income streams regardless of physical location
- Increasing levels of international financial transparency
As highly skilled labour becomes more geographically mobile, the elasticity of fiscal membership increases. If an individual can relocate without losing their ability to generate income, taxation tied to citizenship rather than residence becomes more visible and more burdensome to those individuals.
Additionally, as countries attempt to prevent the erosion and shifting of tax bases, citizenship-based taxation may be viewed as a way to preserve the state’s ability to tax its citizens at some point in time. However, if geographic mobility becomes sufficiently high, separating taxation from the location where consumption occurs may increase the likelihood that individuals formally exit the tax system by renouncing their citizenship.
Broader Ramifications
The latest divergence of fiscal membership and territorial benefits has implications for public finance theory by challenging the coherence of the benefit principle in a world where there is a difference between citizenship and residency. The divergence also has implications for political economy, where one potential response to an ongoing perceived imbalance will be to exit. In a globally integrated economy, as an increasing number of individuals are able to move from one country to another and as digital work reduces ties to geographic locations, the economic rationale for fiscal membership is evolving alongside the institutions sustaining fiscal membership.
