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TAXOPHOBIA: LOOKING INTO THE EYE OF THE COBRA


TWO COUNTRIES, TWO TAX SYSTEMS

In December, the boards of directors of the Israel Diamond Exchange and Israel Diamond Manufacturers Association reached agreement with the local authorities about a new company tax framework. It was the second of two tax deals signed in the international diamond industry within just several weeks of each other, coming after a much heralded agreement reached between the Belgian sector and its country’s tax authorities.


What was surprising was that, while the Belgians adopted a system in which tax is paid on a percentage of gross sales, with a minimum level of net taxable income, the Israelis swapped such a system for one in which they will only pay taxes on profit.


According to the Israeli agreement, diamantaires will be able to deduct all their expenses and will only be required to pay tax when showing positive net income. They will also have to maintain accurate accounting records and issue a detailed tax return, like other sectors of the Israeli economy, which is something they have always not done in the past.


Their Belgian counterparts will pay tax on total income, on which a gross profit margin of 2.1 percent is assumed. They will be able to subtract expenses and deductions from that margin, as long as taxable income does not fall below 0.55 percent of gross revenue, and below 0.65 percent during the first year of the arrangement.


But despite the diamtarically different systems, both the Israelis and Belgians declared that the new-found transparency and apparently lower risk resulting from both of their respective agreements would hopefully encourage the banks to raise the level of the financing being made available to each of their industries.


The need to create customized tax agreements for the diamond sector results from the idiosyncrasies of a business in which the value of inventory is a work in progress; the same diamond may be bought and sold multiples times, and actually never really change hands; and real profit margins are a question for debate. But in both countries the authorities would like to gain reasonable tax benefit from their diamond industries, and the diamantaires would like to be able operate without the Sword of Damocles hanging over their heads.


In Israel and Belgium, both the authorities and industries appear convinced that what they have is better than what existed before. What are the chances that all the players will be satisfied several years down the line?


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THE COBRA EFFECT

Allow me to digress for a moment to consider an incident in India during the time that British ruled the subcontinent. The Colonial Office was concerned about the number of deaths by venomous cobra snakes in Delhi. To tackle the problem, it decided to offer a bounty for every dead cobra.


The initiative was successful in the beginning. People killed snakes and brought their lifeless bodies to the authorities, where they received a cash payment per dead cobra. The number of bite victims fell, but only for a while.

Not long after the new initiative was launched, some clever entrepreneurs realized that it would be possible to breed cobras, and then simply kill them and collect the reward. To counter this problem, the authorities decided to lower the value of the bounty. That destroyed the entrepreneur business model, but it led to many of the newly bred cobras being set free. What this meant was, that there were now more cobras in the wild than ever before, and the number of bite victims climbed dramatically.


So was coined the term The Cobra Effect, which describes situations where actions ultimately achieve the opposite, or at the very least grossly different effect from the ones that originally were aimed at. In other words, the solution becomes worse than the problem. It is the result of the creation of unintended incentives.


We all learn to react to incentives from a young age, and the Cobra Effect is often evident. School children are supposed to be incentivized by good grades, but these are frequently more effective in encouraging cheating on exams, rather than studying beforehand.

Examples of perverse incentives are aplenty. Prohibition on alcohol in the United States in the 1920s did not stop people from drinking, but rather created a thriving black market, smuggling of alcohol from out of the country and funding organized crime. China’s one-child policy, which was introduced to get control of the country’s rising population, led to an increase in the deliberate mortality of female infants and a society with no numerical parity between men and women. Today China is struggling with the effects of a prematurely aging population.


READ THE FINE PRINT

This brings us back to the issue of taxing the diamond industry. First let’s accept reality – working the system by searching out it flaws and loopholes is generally considered good business. Remember when, during one of the recent presidential debates in the United States, Donald Trump was accused of having used a massive business loss 20 years earlier to avoid paying income tax for the next two decades. Characteristically, he was unapologetic. “I did it because I was smart,” said the billionaire.

That’s the way the world works. Even law-abiding citizens pay the least amount of tax that the tax code will allow them to.

So how do you mitigate the Cobra Effect? You need to convince your public that the intended consequence “trumps” any other possible outcomes.

  1. Shout out Don’t make deals behind closed doors. The people leading the change often think the process of negotiations is best handled in private. But if the negotiations are successful, you are then going to spring massive change upon an unexpecting public. The knee-jerk reaction will be one of pushback. To get your public to buy into what you are doing, they need to feel included. For that to happen, they must feel informed, and in real time. Shout out what you are doing and what are your intentions.

  2. Be environmentally aware Diamantaires are not going to buy into the system that does not take into consideration the business environment in which they operate. If the situation is already one in which large companies are migrating to other bourses, factories are being shipped to low-cost production centers, bankruptcies are rife and companies close down with frequency, a tax system will not be effective if does not offer hope for a better future.

  3. Compare If the tax rate is zero elsewhere, any agreement where a tax rate the higher provides only a temporary solution, unless there is a clear understanding as to why moving to the zero-tax is a non-option. Always be aware of what is happening elsewhere. We operate in an international industry.

  4. Look out for the small guy The diamond industry must nurture the small manufacturers. If the system does not work for them, then ultimately it will not work for anyone. There is no trickle down into diamond business, only trickle up.

  5. Read the fine print Do you know the difference between being educated and being experienced? Being educated is when you read the fine print. Being experienced is when you don’t. An educated person is almost always likely to survive better than who learns purely through experience.