Oxford University Centre for Business Taxation
The design of taxes on the profit of multinational companies
Issues in the design of taxes on corporate profit
The Institute for Fiscal Studies recently organised a high-profile study of the fundamental design of the tax system, chaired by Nobel Laureate, James Mirrlees. This study presented a proposal for the reform of corporation tax that is essentially an updated version of the proposals of the IFS Meade Committee, thirty years earlier. The Meade Committee proposed a flow of funds tax, which would permit expensing for all expenditure, including capital expenditure. The Meade Committee proposed an allowance for corporate equity (ACE) which would give a notional deduction for the cost of equity finance, similar to that for debt finance. These are equivalent over the lifetime of an investment, with the tax applying only to economic rent, that is profit over and above the minimum required rate of return.
A Centre for Business Taxation research project addressed the merits of this proposal, which originated with an earlier IFS proposal. It is true that the proposed structure has distinct advantages over existing corporation tax. It solves the problem of discrimination in favour of debt finance, and by taxing only economic rent it avoids distorting marginal investment decisions. These would be significant gains if they were introduced in practice.
However, Mirrlees did not make any proposals designed to address one of the most difficult and intractable problems in international taxation, and one that has become increasingly important since the Meade Committee reported: where profit should be taxed. The problems encountered internationally are similar to some of those encountered domestically: how tax affects the choice between mutually exclusive options, and how income can be manipulated into forms that are taxed less heavily. But both of these issues become particularly important in an international context, with taxes affecting the location of real economic activity and the location of profits.
Modifying the structure of the tax within a country does not address these fundamental problems. They instead need a complete re-examination of how profit is allocated between countries for tax purposes. One option would be to tax profit on the basis of the destination of sales, as with a VAT, Admittedly there are strong institutional barriers to fundamental change. But it is disappointing that Mirrlees chose not to examine these questions.
The economic effects of EU-reforms in corporate income tax systems
This report was commissioned by European Commission as part of its Impact Assessment of the proposal for a Common Consolidated Corporate Tax Base (CCCTB) in the European Union. It uses an applied model developed for the purpose that analyses the economies of all 27 EU member states; it models corporate taxes in detail to assess the impact of reform on investment flows, employment, GDP and economic welfare. The research finds that there would be considerable variation in the economic effects of the new tax system on EU countries. The precise estimates depend on the definition of the proposed tax system, but in a typical case, UK GDP would fall slightly, by around 0.05 percent. For other countries, the effects on GDP would vary from a rise of 2 percent in Belgium to a fall of 3 percent in Ireland. Overall, GDP in the EU would also fall slightly, by around 0.15 percent. Overall, capital expenditure would fall a little, by 0.74 percent, but there would be virtually no net effect on employment or wages in the EU.
With which countries do tax havens share information?
In recent years, tax havens have been put under increasing political pressure to cooperate with high tax countries in efforts to reduce tax evasion and avoidance. One particular area of concern is the exchange of information for tax purposes. In order to encourage the exchange of tax information between countries, the OECD has created the Global Forum on Transparency and Exchange of Information for Tax Purposes. Its role is to provide a framework for international cooperation in the area of exchange of tax information.
Many tax havens have reacted to this political pressure by changing their policies with regard to bank secrecy and information exchange. As part of OECD standards, countries are expected to sign tax information exchange agreements (TIEAs) with other countries. TIEAs are particularly important in cases where no double taxation agreements exist because double taxation agreements often include arrangements for information exchange. Currently, tax havens are required to sign a minimum of 12 TIEAs in order to avoid being put on the list of uncooperative jurisdictions.
This research project considers how tax havens choose their partners for the signing of TIEAs and, as a consequence, whether the network of TIEAs is likely to be effective in fighting tax evasion. Two possibilities are: (a) that to avoid providing useful information, tax havens could systematically avoid TIEAs with countries with which they have a strong economic relationship; and (b) if another country knows that its residents favour a particular tax haven, it will try to achieve a TIEA precisely with this tax haven, rather than with others.
Our findings suggest that on average the existence of stronger economic links between two countries does increase the likelihood of signing agreements. But this effect is not very large. Focusing on the 5 partner countries which are most important in terms of economic links for each haven, we find that on average tax havens have agreements on information exchange - either as TIEAs or in double taxation agreements (DTAs) - with just under half of them. This suggests that tax havens do not systematically avoid signing TIEAs with countries to which they have strong economic links. But it also suggests that many relevant relationships are not covered. There is also evidence that the activity of signing TIEAs slows down after countries have reached the threshold of 12 agreements.
How should foreign profits be taxed?
This research reviews the recent debate on the taxation of foreign source income of multinational firms. For a long time, the optimality of the tax credit system referred to as the ‘old view’, was widely accepted, and served as an important benchmark in the policy debate. Recently, however, a ‘new view’ has emerged, which argues that rules for taxing foreign profits might be in need of reform. However, the direction of reform is controversial. Some authors view exemption as the best option on the grounds that domestic and outbound investment are not substitutes. Others argue for exemption on the grounds that, if corporation tax is a tax on domestic economic activity, justified as firms benefit from public services, then corporate income earned abroad should not be taxed domestically. A third, more pragmatic view, places less emphasis on the impact of taxation on the international capital allocation and focuses on the implications of taxes on foreign profits for administration and compliance costs.
Where should profit be taxed?
The international corporation tax system has developed in a way which has resulted in the primary place of taxation being where capital, or economic activity, is located. Although this is the international norm, its theoretical rationale is weak. As a proxy for personal income tax, corporation tax should be levied where the shareholder resides. But existing taxes do not follow this pattern, with the result that economic activity and profits are diverted between countries for tax reasons. This research project makes a theoretical contribution to analysing the most efficient location for taxing profit. It considers taxation at residence, source and destination (like VAT). It shows that a destination-based corporation tax can be neutral with respect to investment and location decisions. It also shows that an individual country could benefit from switching to a destination-based tax even if no other countries did so.
Alan Auerbach and Michael Devereux, CBT working paper 12/14
Do tax burdens depend on whether companies are resident in worldwide or territorial countries?
Since Japan and the UK adopted a territorial system in 2009, the US is the only remaining major country with a worldwide system that aims to tax fully foreign source income. This issue is the subject of lively debate in the US, with some arguing for a territorial system while others demand the abolition of deferral to strengthen the US system. One important piece of evidence needed in this debate is the extent to which companies headquartered in countries with worldwide systems systematically face higher tax burdens than those in countries with exemption systems.
This research project addresses this question using consolidated firm-level accounting data for about 3,400 companies in 15 OECD countries between 2003 and 2007 (when the UK and Japan had worldwide systems). The research estimates a marginal effective tax rate (METR) which measures the average rise in the tax liability as a result of an extra £1 of profit in the financial report. The results present clear evidence that this METR was significantly higher for companies headquartered in countries that had a worldwide system.
However, there were other differences in taxes between the countries considered, notably in statutory tax rates. To take account of differences in tax rates, we also estimate a marginal effective tax base (METB) that measures the increase in taxable profit resulting from an extra £1 of profit declared in the financial report. In effect, this measure controls for differences in tax rates and therefore permits an assessment of the underlying system independently of the rate. The results are again striking; there is no significant difference in the METB across countries. This indicates strongly that differences in the METR between countries are due primarily to differences in statutory tax rates, rather than in the treatment of foreign income.
This project also investigates the use of tax havens in affecting aggregate tax liabilities. It questions whether having a presence in a tax haven tends to reduce the aggregate tax liability of a company; and more specifically, whether this effect differs according to whether the company is headquartered in a country with a worldwide or territorial system. Consistent with greater opportunities for tax planning, the results suggest that presence in a tax haven reduces the METR and the METB more for companies headquartered in countries with territorial systems.