The tax dilemma

Stopping the erosion of the government tax base is a compelling proposition. Ending offshore profit shifting may be a solution, writes AICD chief economist Mark Thirlwell MAICD.

When US Treasury Secretary Janet Yellen addressed the Chicago Council on Global Affairs on 5 April this year, the effect was to revitalise the long-running campaign to reform the global framework for corporate income tax (CIT) and tackle base erosion and profit sharing (BEPS).

After declaring that one “consequence of an interconnected world has been a 30-year race to the bottom on corporate tax rates”, Yellen said that Washington would “work with other countries to end the pressures of tax competition and corporate tax base erosion… to agree to a global minimum corporate tax rate that can stop the race to the bottom”. While the G20 and the OECD have been working on BEPS since the aftermath of the global financial crisis (GFC), they have had only limited success, not least because of clashing national interests. One of the most important of those clashes involved US reluctance to see its major tech companies subjected to a tax grab by other nations. Now, Yellen was indicating, Washington has had a change of heart.

That reflects three other changes. The first and most obvious is last year’s presidential election result and the arrival of the Biden administration. Second is that administration’s desire to fund an ambitious multi-trillion-dollar domestic spending package, in part through a higher CIT. Washington wants to increase the US rate from 21 per cent to 28 per cent and also plans to impose a 21 per cent minimum tax on US companies’ foreign income. However, it is mindful that big unilateral tax changes could disadvantage US firms relative to their overseas competitors.

The third change is that COVID-19 has transformed public finances, both in the US and worldwide. According to the latest IMF Fiscal Monitor, the average budget deficit in advanced economies soared to almost 12 per cent of GDP in 2020 and is expected to exceed 10 per cent this year. That will see general government gross debt hit an eye-watering 122 per cent of GDP in 2021 and remain close to that level for at least another half-decade.

While a post-crisis desire to secure government funding may well be a necessary condition for progress on global tax reform, past experience suggests it is not a sufficient one. After the GFC, when rich country governments were similarly contemplating a future of swollen budget deficits and higher public debt burdens, attention also turned to the global tax regime as they came under pressure to respond to a perception that they were losing out on CIT revenues from multinational enterprises (MNEs). But progress was limited.

The underlying problem, then and now, was that the international tax regime relied heavily on concepts such as the “residence” of companies (usually deemed the country from where the company is effectively managed and headquartered) and the “source” of income (deemed to be determined by where investments are made and production takes place, but typically not by the location of sales). Dating back to the 1920s and the League of Nations, this framework generated inevitable tensions over the balance of taxing rights between residence and source countries. And as time passed, globalisation and technological change made it increasingly anachronistic.

Tax avoidance and tax competition

In an integrating world economy with an ever more online commercial world, businesses could be heavily involved in the economic life of a country without requiring a significant physical presence, for example. Likewise, the rise of multicountry supply chains and powerful MNEs had made it easier to shift profits to locations with more favourable tax treatments. This growing scope for tax avoidance via cross-border profit shifting, plus rising pressures for tax competition to attract or retain increasingly footloose MNEs, combined to erode national tax bases.

These issues were taken up by the OECD and a freshly empowered G20, culminating in 2015 in a set of policy proposals. Yet when the IMF reviewed the state of corporate taxation in the global economy in March 2019, it judged that the “international corporate tax system is under unprecedented stress”. True, there had been several technical fixes — some of the most egregious forms of tax avoidance had been limited, and improved standards around transfer pricing and treaty abuse had been introduced. But complexity and uncertainty had grown and the fundamentals of the crumbling global tax architecture were largely still in place— as were the twin dynamics of tax avoidance and tax competition.

Moreover, some problems seemed to be getting worse. The advance of digitalisation had continued to erode the link between physical geography and tax liability, while the US company tax cuts of 2017 confirmed that tax competition was alive and well. Frustrated by the lack of a cooperative solution, governments were turning to national initiatives including the Trump administration’s introduction of a new minimum tax (the global intangible low-taxed income rule, or GILTI) and the unilateral introduction of a range of digital services taxes by countries including the UK, France, Italy, Spain and Turkey. An annoyed Washington had responded to the latter move with plans to impose retaliatory tariffs.

In an effort to prevent further fragmentation and head off the potential outbreak of several tax wars, the OECD suggested additional reforms based around two pillars. Pillar one targeted tax avoidance, focused on the digitalisation challenge and proposed a new tax regime for the largest MNEs that would include taxing rights based on sales in-market. Pillar two targeted tax competition and proposed a minimum level of taxation for MNEs.

Until recently, Washington had been cold on the first pillar, which it saw as unfairly targeting the US big tech companies. But with the Biden administration’s own priorities making it keen to secure progress on pillar two, it has now proposed a compromise deal — global minimum CIT of 21 per cent plus a compromise deal on pillar one that would revise taxation rights for a small number of MNEs based on their size and profits.

Any deal would have to negotiate the formidable hurdles of a divided US Congress, conflicting self-interest of a range of national economies, and similarly divergent views on the appropriate level of any minimum rate, making agreement far from guaranteed. Nevertheless, Washington’s change of heart plus the post-pandemic landscape have delivered the real prospect of a radical shift in the global tax regime for MNEs.