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Taxing profit in a global economy: How to reform a broken tax system

The system for taxing the profit of multinational companies is not fit for purpose and needs fundamental reform.

Although the international community is currently debating the most far-reaching reform proposals in a century, those proposals are founded on the existing rules; they do not go far enough. 

There are many elements to the problems currently faced. The most significant political problem is that it is too easy for multinationals to reduce their tax by artificially shifting profit from high tax countries to low tax countries. Estimates of the size of the problem vary widely; at the top end the IMF has estimated this form of tax avoidance to be as high as 1% of GDP for developed countries and 1.3% of GDP for developing countries. For comparison, the UK raises about 3% of GDP in taxes on profit.  

But this is far from the only problem. A wealth of academic research also demonstrates that differences in tax rates and regimes among countries affects the choices of business as to where to locate their operations. This creates real costs to society, for example when businesses choose locations which are favourable for tax purposes, but which result in a higher underlying cost of production. 

These two problems stem from the mobility of the tax base. And that also creates a third problem: tax competition. Countries compete with each other both for tax revenue and for inward investment. One way they do so is by reducing tax rates on profit. Over the last two decades, corporation tax rates around the world have fallen by approximately one percentage point a year. There is no sign of this competitive process easing and so they are likely to keep on falling. 

That is not all. Businesses are not keen on the system either. That is because it is mind-numbingly complex and creates significant uncertainty – and both problems are getting worse. Complexity and uncertainty both stem from the system’s underlying structure, in which each entity within the multinational is supposed to be allocated its share of the overall profit. The problem of mobility also ultimately arises due to this “separate entity” approach. 

What is needed is a radical rethink and fundamental reform. For the last seven years I have chaired a group of economists and lawyers from Europe and the USA which has set out to identify what is wrong with the existing system and to come up with practical proposals for reform. That work culminates in a book published by OUP.

The key to our proposed solutions is to allocate taxing rights to countries where the activities undertaken by a multinational are less mobile. And there is an activity that largely fits the bill: sales to third parties. Only in extreme circumstances would an individual customer be willing to move to another country in order to reduce the tax on the profit of a multinational that supplies her with a good or service. That gives an opportunity for countries where those consumers live to tax the profit of that multinational.

We develop two proposals that are developed from this key insight, both of which move the system towards taxing profit in the location of the sale to a customer. These two proposals differ in how radical they are. 

The first (Residual Profit Allocation by Income, RPAI) is designed to build on the existing system, and thereby to minimise the transition costs of reform. It would keep the key elements of the existing system but apply them only to “routine” profit. Any “residual” profit, over and above the “routine”, would be taxed in the country of sale. The ideas here is that, under the existing system, the most significant problems arise in taxing “residual” profit. Reallocating the taxation of residual profit would therefore significantly address the existing problems, while enabling many of its features to remain in place. That could make it more acceptable to those who are nervous about radical reform.

The second (Destination-Based Cash Flow Tax, DBCFT) is more radical. It would allocate all taxing rights to the country where sales take place: the tax base in any country would be domestic sales less any costs incurred domestically. This would be achieved by borrowing the “border adjustment” mechanism from VAT, under which exports are not taxed, but imports are taxed. In principle the DBCFT would address all of the problems above.

Traditional methods of profit shifting would become redundant, since the tax liability would depend on a relatively easily observed sale to a third party. And distortions to the location of a multinational’s activity would also disappear since the tax depends only on where it makes sales. This approach should also be considerably easier to implement than the existing system. 

So the DBCFT offers a more complete long term solution than the RPAI, but it requires more fundamental change. And that raises the question of what kind reform is feasible. 

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I first developed the idea of the DBCFT in a paper in 2002. In the succeeding 15 years or so, it is probably fair to say that the idea did not catch on in policy circles. However, recognition of the problems of the system have been growing, and as a result, opinion has begun to change. For the last couple of  years, the international community has been meeting under the auspices of the OECD to debate possible reforms, and there are currently two proposals being considered. One of these would introduce some modest taxing rights for the country of sales. But it would do so only partially, adding an additional layer to  the existing system, with the result being even greater complexity. 

There are many reasons why countries are nervous about fundamental reform. There is a real path dependence in an international tax system built up over a century, buttressed by over 3,000 bilateral double tax treaties. The RPAI would require some modification of those treaties, but they would become largely redundant for taxing profit under the DBCFT. There are also legal questions about whether the DBCFT would be consistent with WTO rules. Beyond those possible legal impediments to reform, countries perceive their self-interest differently, and so favour different directions of reform. And at heart there is a resistance to what would undoubtedly be a radical change from professionals that are expert on the existing system. 

However, the OECD has let the genie out of the bottle. There is discussion of radical reform now that would have been unimaginable even 5 years ago. But the proposals currently being debated have not yet addressed the fundamental problems of the existing system. 

In the longer run, there are two ways forward. One is that the international system for taxing profit will collapse under the weight of its own complexity and competition in tax rates. The other is that there will be reform which really does address the fundamentals of the system. Each of our proposals is a blueprint for the fundamental reform required.