Tax competition between states presents an important obstacle to states in pursuing their policy agendas. It involves the strategic, non-cooperative setting of taxes by governments with the aim of attracting capital from other jurisdictions. Individual and corporate taxpayers shift their capital in response to the fiscal policies adopted by governments.
This capital can take various forms: portfolio capital of individuals (think of secret bank accounts in tax havens such as Switzerland or the Cayman Islands); the profits of multinational enterprises (Apple and other major corporations have used loopholes to channel taxable income through Ireland to the Caribbean, for example); and foreign direct investment (FDI). Ireland, with its low corporate tax rate of 12.5 percent, is an example of a country competing to lure FDI.
Downward pressure on tax rates on mobile capital both undermines states’ capacity to provide public goods and tends to make tax systems more regressive. Rich countries have been able to shift the tax burden onto less mobile factors such as labour and consumption, thus protecting their revenues and public spending, but at the price of a more regressive tax system. Poorer countries tend not to be able to accomplish this shift, and thus find themselves closer to a race to the bottom.
The issue of tax competition was one of the issues I tackled as part of the Think7 summit held in Quebec City, May 21-23, 2018. The summit was a gathering of G7 academic institutions and think tanks invited to reflect on the challenges of complexity and inclusion in global governance. (The Think7 Quebec Declaration on Global Governance and the Challenges of Complexity and Inclusiveness touched on tax competition as part of its proposals for action to G7 leaders.)
This particular issue has been on the international agenda for at least 20 years, starting with the Harmful Tax Competition initiative of the Organisation for Economic Co-operation and Development (OECD), launched in 1998. In the wake of the financial crisis, several tax scandals — LuxLeaks, the Panama Papers, the Paradise Papers — have prompted governments and international organizations to reinforce their actions to combat tax evasion and tax avoidance. Arguably, the current strategy suffers from an important blind spot.
Tax competition both undermines a level playing field in trade relations and distorts the free-market allocation of jobs between countries.
There are two kinds of tax competition for corporate capital. First, there is competition for corporate profits. Multinational enterprises (MNEs) are economically active in high-tax jurisdictions but, using a variety of techniques such as transfer mispricing or earnings stripping, they manage to shift their profits to low-tax jurisdictions. Transfer mispricing shifts profits between subsidiaries of the same MNE through over- or underinvoicing of goods and services. Earnings stripping allows subsidiaries in high-tax countries to deduct interest payments to subsidiaries in low-tax countries from their taxable income, thus again minimizing the tax burden.
Even though much of this kind of activity is legal under current rules, it is morally on par with individual tax evasion: after all, MNEs benefit from the public goods and infrastructure in a given location without shouldering their fair share of that jurisdiction’s costs.
The second type of tax competition for corporate capital is for real economic activity. Through low tax rates on corporate profits, some countries attract substantial foreign direct investment. Small countries have an advantage in this context, because the inflow of capital tends to compensate for the revenue losses related to lower rates.
Crucially, there is an inverse relationship between these two kinds of tax competition. The harder it is for MNEs to engage in profit shifting, the bigger the incentive to actually relocate the economic activity to a low-tax jurisdiction.
Where current initiatives fall short
Both the OECD, with the support of the G20, and the European Union (EU) have long been alert to the problems that tax competition generates. As far as fighting individual tax evasion is concerned, they have made substantial progress (see the OECD’s Common Reporting Standard, put in place in 2014, or the EU’s efforts to adopt a Common Consolidated Corporate Tax Base). However, when it comes to taxing MNEs, their policy initiatives are all limited to addressing the first kind of tax competition for corporate capital; the OECD’s base erosion and profit shifting (BEPS) actions are emblematic in this regard.
We have reason to be skeptical about the effectiveness of this approach. Will the governments of rich countries be truly committed to ending profit shifting if the price they have to pay is an outflow of productive capital (and jobs) to lower-tax or, more generally, lower-cost jurisdictions? The plausible answer to this question is no. Certain kinds of profit shifting might indeed be ruled out, but others will replace them. For example, we have seen the proliferation of “patent box regimes” in recent years, through which MNEs are able to minimize the taxes paid on their revenue from intellectual property rights. The basic dynamic of international tax competition is unlikely to change.
A potential solution
Corporate taxes are here to stay. One way to strike a compromise between fiscal autonomy on the one hand and minimizing the distortions from large discrepancies in corporate tax rates on the other hand is to complement efforts against profit shifting with a minimum corporate tax rate (somewhere between 10 and 15 percent). Even though this idea does not form part of the OECD’s current strategy against corporate tax avoidance, it represents a logical extension of its BEPS program.
Importantly, the introduction of a minimum corporate tax rate should not be limited to OECD countries; the fact that the OECD is increasingly reaching out to include developing countries in its initiatives is an encouraging sign in this regard. This makes the OECD a natural candidate to enforce a minimum corporate tax regime, even if other institutions (such as a UN agency) could also do the job, provided they are given an appropriate mandate.
By directly addressing the trade-off between the two kinds of tax competition, such a policy promises to be more effective than current initiatives. One reason for anticipating this boost in effectiveness lies in the fact that such a policy curtails not only the capacity of MNEs to shift their profits but also the capacity of states to “poach” the tax base of other jurisdictions.
If you think that a minimum tax is unrealistic, think again. The base erosion and anti-abuse tax (BEAT) introduced in the 2017 US tax reform effectively represents a minimum tax. It is currently at 5 percent but is set to rise to 10 percent in 2019 and 12.5 percent in 2020. In effect, this means that MNEs will no longer be able to reduce their effective tax rate below this minimum rate. Other countries should follow the example set by the US in this regard.
Three unjustified worries
Is a minimal corporate tax rate inefficient, either in the sense of reducing economic growth or in the more technical sense of Pareto inefficiency: that is, would a minimum corporate tax rate make anyone worse off without making someone else better off? There is no obvious reason to think so. On the contrary, one might believe that by reducing the discrepancies in corporate tax rates between countries, such a measure would contribute to levelling the economic playing field.
Does a minimal corporate tax rate violate national sovereignty? It does indeed limit the de jure fiscal sovereignty of states to some extent: they would no longer be allowed to levy a lower rate. However, it would boost the de facto fiscal sovereignty of states, which is what matters for their policy agenda.
Would a minimal corporate tax rate be unfair to developing countries? In other words, is it unfair to deprive a poor country of one of the available tools to attract capital? This is an important objection, and some exemptions for poor countries might be appropriate.
In sum, it is fair to say that introducing a minimum corporate tax rate represents a desirable measure, both because it would enhance the effective fiscal autonomy of states and because it would reduce economic distortions. While such a measure would have been swiftly dismissed as unfeasible a few years ago, the changing economic and political circumstances have turned it into a reform that G7 countries can realistically strive to implement in the coming years.
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