Could two new proposals point the way to the creation of a more stable international tax system?
Caroline Scotter Mainprize
Tax avoidance by multinationals has come to be seen by the public in the US and Europe as a prime symptom of the unfairness of today’s global and technically sophisticated economy. It has become the subject of dinner-party conversations, a telling indicator of a global economy gone wrong.
Thanks to stagnating wages and long periods of under- and unemployment, middle-income Americans and Europeans have become fed up with headlines about how technology, pharmaceutical, and even retail companies can avoid tax by moving residence somewhere else, or paying themselves royalties, or shifting where they report income. Politicians have found it easier to create distractions – such as the UK’s Diverted Profits Tax – than genuine solutions to these problems.
At the same time, a wave of populism in Europe and the US, demonstrated by the Brexit vote and the rise of Donald Trump, is reflecting widespread insecurity, frustration, and anger. Worried that their jobs are going to be outsourced or disappear altogether, people are clamouring to put up barriers both to cheap labour from abroad and perhaps even global trade.
All this means that international taxation policy is now caught in a political whirlwind. No longer is it subject only to quiet negotiations among members of a ‘priesthood’ of experts, but to media and public comment, and potentially the knee-jerk reactions of embattled politicians.
These issues were at the heart of discussions at the Oxford University Centre for Business Taxation’s annual summer conference 2016. During the conference, members of an international group of economists and lawyers, convened in 2013 by Professor Michael Devereux, presented two options for fundamental reform.
What are the issues?
The basic international tax framework has not changed since it was developed nearly a century ago, though the world economy and financial technology have changed radically. Even the OECD’s BEPS (Base Erosion and Profit Shifting) project – an unprecedented effort endorsed by finance ministers in the G20 – changed no underlying principles, but just attempted to modernise them. ‘We have a 20th-century international tax system attempting to govern a 21st-century economy,’ commented Michael Graetz (Columbia University and Yale University).
As soon as we tax something it moves. The system that has grown up over the past century imperfectly allocates taxing rights to national governments and is full of contradictions as to where different forms of income are taxed. That gives companies opportunities to choose the form and location of both their activity and their profit, and they can change both with remarkable rapidity.
BEPS will not usher in new era of international cooperation in the area of international taxation. Nations will continue to compete with each other, especially for jobs, and will continue to offer low rates and tax breaks. Each country is likely to try to shift their taxes on to some other country’s multinational corporations. Tax policy in the future will reflect the tension between nations seeking new sources of revenue, often from non-resident corporations, and those they are trying to tax. Multinationals, however, ‘will engage in ongoing, complex tax planning and will tend to stay at least a step ahead of governments’, said Graetz.
Greater efforts will be made to tax wealthy individuals in the future. Political and popular concerns about inequality will lead to more attempts to tax individuals’ wealth, capital, or capital income.
Nevertheless, corporate income tax is here to stay. Economists uniformly regard corporation tax as a terrible concept from an economic point of view. It is also notably inefficient: research by Michael Devereux (Oxford Saïd) revealed that for every £1 collected in corporation tax in the UK there was a cost to the economy of up to £0.29. However, it remains popular politically because, as Devereux said, ‘Everyone thinks that someone else is paying for it’.
What principles should guide reform?
Any new system of corporation tax, whether designed from scratch or developed incrementally, should be robust to avoidance and evasion, economically efficient, and (relatively) easy to administer. Naturally it should also be fair – although, as Michael Devereux argued, ‘fairness’ is a difficult concept to define, especially when thinking internationally.
Currently, we tend to look at taxing business as a proxy for taxing individuals. From the public’s point of view, this is ‘fair’ because they imagine that the tax is mostly borne by the company’s owners, who are perceived as rich, and by the CEOs and board members – also typically thought to be part of the elite ‘1 per cent’. However, existing corporate taxes broadly tax profit where economic activity takes place, which is not necessarily where the owners live. Wolfgang Shön (Max Planck Institute for Tax Law and Public Finance) argued, too, that fairness would have to be measured according to at least three different criteria: fairness between different taxpayers, between domestic companies and multinationals, and between jurisdictions.
Alternatively, we could look at taxation as a ‘fee’ for using publically-provided goods and services. Buildings, staff, and vehicles, for example, are easy to spot: a tax on them would be relatively straightforward to implement and hard to avoid, although the value of these services does not necessarily correlate to profit.
Whichever view we take, an ‘efficient’ tax base must be relatively immobile. As Devereux asked, ‘What can we tax that isn’t going to move?’ He suggested that individuals are less mobile than profits or even economic activity, which opened the possibility of taxing corporations where their shareholders or their consumers were based.
You could argue, he said, that a place of sale is a source of profit. A tax based on where a company sells its goods and services would not be interpreted as a tax on the personal income of shareholders, nor could it be viewed as rent for the publically-provided goods and services used in production. But it could raise revenue while improving efficiency, being robust to avoidance and relatively inexpensive to collect.
What are the options?
Residual Profit Allocation (RPA)
This proposal takes as its starting point the classic ‘entrepreneurial’ transfer pricing model in which a multinational sites an affiliate that ‘owns’ its intellectual property in a favourable tax jurisdiction. That affiliate is regarded as the ‘developer’ of the business supply chain and earns residual profits. All other affiliates, meanwhile, earn ‘routine’ profits, basically the cost plus mark-up of products and services such as contract manufacturing, R&D services, distribution, and marketing.
The key change is that the proposal recommends that residual profits should be taxed in the place of sale to a third party, as arguably the place of sale is the ‘source’ of the income rather than where intellectual property is ‘owned’ (this is the destination-based aspect of the proposal). Other affiliates would, as now, be taxed in the country in which the activity takes place, still calculated as a mark-up on costs incurred in each country, excluding inter-company purchases of intermediate goods and services.
In order to keep reforms to a minimum, the proposal deliberately leaves some factors unchanged. For example, it would still incorporate relief for debt, but not equity, finance. The proposal would also maintain a positive marginal tax rate on investment.
Benefits of the proposed system are:
1. It will reduce distortions to the location of real economic activity. Currently, active business income is taxed where activity takes place, which means that differences in effective tax rates affect location: companies understandably want to conduct the bulk of their activities in jurisdictions with a favourable (i.e. low) tax rate. Under the RPA proposal, only routine profits are taxed in the place of economic activity, which means that it may still have some impact on location decisions, but it will be less significant.
2. It will be more robust to tax avoidance, because internal transfers are generally not included in the base for either routine or residual profit
3. It is likely to lower incentives for governments to compete on rates, as tax in the place of economic activity will be levied only on routine profit.
Destination-based cash-flow tax (DBCFT)
The idea of a cash-flow tax is not new. The Meade Committee, for example, introduced the concept in 1978. What is new, however, is the proposal that a cash-flow tax should be combined with a destination-based tax along the lines of VAT.
The destination-based element of the proposed tax works on the principle that people are less mobile than many elements of multinational corporations. VAT zero-rates exports and taxes imports, so that it becomes a tax in the place of consumption. Where the DBCFT differs from VAT is that it would give tax relief for labour costs.
The cash-flow element is very simple: all expenses get relief and all income is taxed. Effectively this makes it a tax on economic rent, which means there should be no effect on prices, rates of return, of scale of investment.
A DBCFT would be relatively simple to administer. There would be no need to capitalise expenditures or keep track of asset values. And as long as it operated on a real cash-flow base (as opposed to real and financial flows) there would be no need to identify separately flows of debt and equity. But it would be necessary to distinguish between real and financial flows, and it is likely that taxable losses would be more common.
Benefits of this proposed system are:
1. It would reduce distortions to business decisions. Like VAT, the effect of a destination-based tax is likely to be raised prices in each location relative to the rest of the world. This would offset the potential ‘gain’ of receiving relief at a higher tax rate (for example, if R&D was conducted in one country but the product sold in another), implying no distortions due to location.
2. It would be robust to tax avoidance. Internal transfers within multinational groups would ‘net out’, as exports are not taxed, and imports are taxed but costs can be offset against them. Even royalty payments can be accounted for as they would be treated like imports. And if a real-flow base was used, interest payments also would be excluded, thereby closing off another avenue of potential avoidance.
3. There would be no incentives for government to compete on rates. The tax rate in the place of economic activity would be zero, and the tax paid in the place of consumption would be built into the price. This is what currently happens with VAT, and there is no evidence of competition between countries on VAT rates.
How do we define fair and how important is public perception?
· Although it is true that there are many different interpretations of what is fair, and it would be helpful if we could find a single definition that the public could agree with, multinational tax avoidance flunks every single test of fairness. This is why BEPS, whatever its weaknesses, is very important.
· The collection of VAT is more efficient than that of corporation tax. But corporation tax is favoured politically because it is seen as a tax on nameless corporates rather than on consumers. So should we be aiming for a corporation tax that is more like VAT, but not so like VAT that the public think that they’re paying for it?
· Perhaps the problem boils down to: we need taxes to appease people and we need to tax what we have.
Is corporation tax ‘broken’ enough to need radical reform?
· OECD research suggests that the overall share of corporate revenue collected in the 1980s is roughly similar to the overall share of corporate revenue collected now.
How do we plan for the future and more companies like Uber, Amazon, Google, and Alibaba?
· Most tax work starts from the basis of The Firm, and an assumption that it is fundamentally the same as it was in the nineteenth century, even though it may cross a border or two here or there. BEPS was intended to respond to the new global, digital economy, but it remains hard to define where economic activity takes place.
How do we go about building consensus?
· Whatever the proposals for reform look like, there is still a big challenge ahead in terms of explaining the proposals to politicians and other people who are not tax experts. Too often ideas for change are abandoned before they have been explored fully because the people developing them believe they will not be able to ‘sell them’ to policymakers.
‘Corporation Tax for the 21st Century’: the Oxford Centre for Business Taxation’s Summer Conference 2016 was held jointly with the Max Planck Institute for Tax Law and Public Finance, Munich.