The Fiscal Affairs Department (FAD) is the world’s leading source of fiscal expertise. It researches and analyses fiscal developments around the world, providing policy advice to IMF member countries and tailored technical assistance to countries modernising their fiscal policies and institutions. Former Portuguese Minister of State and Finance, Vitor Gaspar, is the Director of the FAD.
IFC: What are the main objectives of the IMF Fiscal Affairs Department? At what point does the IMF step in to ‘counsel’ a tax authority on its fiscal policy?
Vitor Gaspar: The mission statement of the Fiscal Affairs Department is simple: “Helping countries shape public finances that support sustainable and inclusive growth.”
Since 1964, the Fiscal Affairs Department (FAD) has been a leading source of fiscal policy and fiscal management expertise worldwide. FAD’s analytical pieces anticipate and examine policy issues, providing important contributions to the global policy debate. FAD advises countries on fiscal policies and fiscal structural reforms to promote stable, sustainable, and equitable growth. Each year, FAD staff and experts provide advisory services to about 130 IMF member countries across advanced, emerging, and low-income developing countries. This works feeds into the IMF’s country surveillance work. It also contributes to the design and implementation of IMF-supported programs.
IFC: What should be the main driving force behind a country’s fiscal policy?
VG: Fiscal policy plays an important role in supporting strong, lasting and equitable growth. Fiscal policy should therefore aim to ensure value for money from public spending, a fair and efficient tax system, and transparent and accountable management of public sector resources.
IFC: Can you outline what the April 2016 Fiscal Monitor says on fiscal reform to encourage innovation and growth?
VG: Many of our members are seeking ways to counter the productivity slowdown observed in recent years. And innovation is the key to long-term productivity growth.
The latest Fiscal Monitor explores three innovation channels: research and development (R&D), technology transfers, and entrepreneurship. One important finding is that governments in advanced economies can, with a fairly modest fiscal support, generate a significant growth dividend through stimulating R&D. In particular, fiscal incentives like R&D tax credits or R&D subsidies can encourage firms to undertake more R&D, which is not only beneficial for them but also for the wider economy. At a fiscal cost of 0.4 per cent of GDP, for example, advanced economies could raise R&D by 40 percent, which could ultimately lift GDP by five per cent. Globally, GDP could even rise by as much as eight per cent in the long term due to cross-border spillovers. These are big effects.
Also, the cross-border spillovers imply that developing countries can benefit by adopting technologies that come to them through trade relations or through foreign direct investment. For these countries, however, technology transfers can only be effective if there is a sufficiently educated workforce capable of absorbing new knowledge. Indeed, only knowledge begets knowledge. Fiscal policies in these countries should thus be geared towards investment in education to reap the fruits from innovation.
IFC: What kind of tax incentives and subsidies work most effectively?
VG: Subsidies and tax incentives that reduce the private cost of R&D can be powerful instruments to spur innovation. But their design and implementation are critical. Best practices are, for example, refundable R&D tax credits, payroll tax relief for researchers, and R&D subsidies that support research collaboration between universities and firms. Also, support for new innovative start-ups can be effective to foster innovation.
However, many countries employ tax incentives that are not well designed and which do not yield value for money. Let me give three examples. First, several countries have introduced patent box regimes, which provide for a reduced tax rate on income from patents. However, the Fiscal Monitor finds that these regimes either do not promote innovation at all or, when they do, are much more costly than fiscal incentives that directly reduce the costs of R&D. A second example is the preferential tax treatment of small companies, such as a reduced corporate income tax rate for small firms. This can even be counterproductive for innovation and growth, as it creates a ‘small business trap’, ie, an incentive for firms not to grow larger. And third, many countries employ special tax incentives for foreign direct investment in an attempt to promote productivity and growth. However, these tax incentives are often found to be ineffective and costly.
So overall, I believe that even countries with tight fiscal constraints can still promote innovation by reforming their fiscal incentives.
IFC: What is the IMF’s policy regarding international tax competition?
VG: Countries face a dilemma as they and their neighbours alter their tax rules, including through the granting of specific exemptions and special provisions, in the hope of attracting real investment and/or bigger parts of the profits tax base. Such beggar-thy-neighbour tax strategies can set off a global or regional race to the bottom. Over the past three and a half decades, corporate income tax rates have been cut almost in half. And the recent spread of patent boxes in advanced economies and the proliferation of tax incentives for foreign direct investment in developing countries are also highly suggestive of strong strategic spillovers from tax competition.
Some have argued that international tax competition is indeed a good thing, constraining governments from raising and wasting too much revenue. But we hear rather less of that argument these days. This is no doubt in part because of the fiscal pressures that many countries are under. It is also because of a greater awareness that fiscal rules can do the same job without arbitrarily distorting tax structures. Many of the concerns we hear are that tax competition causes mutual damage by resulting in shortsighted and ultimately self-defeating policy outcomes.
The question then is: how can countries work together to resist a race to the bottom? Let me lay out some key ingredients. First, we need to be realistic and acknowledge national interests and political economy constraints. Accountable to their electorates, governments have to pursue tax policies that put their national interests first. Second, we need to institutionalise collaboration at the multilateral level. Ideally, effective international cooperation in taxation requires political will and a carefully structured framework for cooperation with a global mandate. Sometimes, regional coordination can go a long way in mitigating tax competition. IMF technical assistance supports such efforts, for instance in the East African Community, the West African Economic and Monetary Union and the Eastern Caribbean Currency Union. But we should not underestimate the difficulty of the process.
IFC: Can such tax competition encourage growth and innovation on a global scale?
VG: There is a potential tension in that strengthening the corporate income tax by clamping down on avoidance might actually be bad for economic growth. But what might be more critical for growth is the actual design of the corporate income tax. For example, how much does it distort investment at the margin, ie, what is the marginal effective tax rate? So the issue is partly designing corporate tax systems to avoid these distortions, which is often a key element in the technical advice we give our members. And we should not forget that the revenues at stake in the future of the corporate tax can be large, sometimes very large – especially for developing countries. At the broadest level, developing countries actually have more to lose from tax competition in that they are more reliant on corporate tax as a share of revenue than are more advanced economies. This worries me, as revenue mobilisation is key for developing countries to finance productive public investment in education and infrastructure, which is so necessary for their growth and development.
IFC: There has been much criticism of the global corporate tax system – should the system be reformed?
VG: The current international tax architecture was developed nearly a century ago for a world in which cross-border trade was far less important and took place almost entirely in physical goods. It does not cope with today’s big challenges, which are set to grow: a vast expansion of trade within multinationals, a shift toward traded services and the huge importance of intangibles (including intellectual property), easily moved from one jurisdiction to another.
We all know that the system has many problems. First, it allows multinationals to engage in tax avoidance and tax planning schemes, substantially reducing tax revenue for governments that may greatly need it. This also creates a profound mismatch between where multinationals pay taxes and where they do business, feeding perceptions of unfair taxation. Second, it encourages destructive tax competition among countries and induces beggar-thy-neighbour strategies. Striving for a ‘competitive’ and ‘growth-friendly’ tax system, countries frequently pursue tax policies to reduce corporates’ tax burdens that leads to a race to the bottom. Unilateral measures to encourage FDI and expand tax bases thus ultimately hurt everybody.
The numbers speak loudly. Fund estimates suggest, for instance, that revenue losses from profit shifting could be as large as one per cent of GDP in OECD countries (around US$450 billion) and 1.3 per cent in non-OECD countries (around US$200 billion).
The G20-OECD BEPS project, of course, aims to fix many of the gaps that have emerged in the system. Moving to implementation—with special attention to the particular needs and circumstances of developing countries—is critical. We need to recognise too that many of the underlying pressures will remain, and I have no doubt that many observers who have pressed for more radical reform will continue to do so.
IFC: Do you believe the OECD’s BEPS project and other international regulation such as the Common Reporting Standard go far enough to protect national tax revenues and growing economies or have they the potential to stymie growth?
VG: It is important to recognise that beyond the current initiatives, important though they are, lie deeper unresolved issues that have hardly begun to be addressed. Some of these are technical – for instance, understanding whether and when offering special regimes for the most mobile businesses may serve to beneficially ease other distortions. Some are political – for instance, how to develop effective institutions for tax cooperation, not least to protect the interests of developing countries. The demand for more and better-informed analysis and debate can only increase.
Reflecting both this and concerns with the ‘fairness’ of the allocation of the tax base across countries, there is indeed a lively and fascinating debate on more fundamental reform of the architecture itself. For instance, some have suggested that instead of trying, as now, to use internal transfer prices to allocate a multinational’s profits across all the countries in which it operates, we should simply allocate their consolidated profits by some formula, based for instance on shares of assets, payroll, and/or sales in each. However, as spelt out in our 2014 paper , such formula apportionment involves significant risks of creating new distortions. It leaves plenty of scope for game-playing in manipulating the weights. It also might not benefit developing countries, unless sheer labour input is given a large weight.
In some respects more attractive, not least in being closer to where the world may be in effect heading, is the idea of moving toward a combination of arm’s-length pricing on transactions where this is relatively easy (such as for most tangibles) and a formulaic profit split where it is not (such as for most intangibles). And there are other suggestions for fundamentally different international tax policies, such as that for destination-based corporate tax, which mimics a VAT but with a deduction for the cost of labour. At the moment though, there is neither consensus amongst academics nor policymakers on the ideal way forward. This reflects the need for more and better informed analysis and dialogue.
As a final remark on this, it is important to recognise that international tax issues are not all that matter for revenue and growth. This is especially so for developing countries, where fixing the VAT or developing a proper tax compliance strategy is often far more important to protect national tax revenue.
IFC: In April the Panama Papers were published, which has raised issues over the ‘morality’ of tax avoidance and asset protection. How do you feel about this and the wider issue of international tax planning and the impact it has on national fiscal policy?
VG: The Panama Papers reveal that the problems of taxation in a globalised world concern both the complex (but legal) tax avoidance by major corporations and the evasion of taxes by elite individuals using offshore accounts. The revenue effect of both can be very large—and very damaging to the fiscal situation of many countries, including developing countries. Tax evasion by the richest citizens, facilitated by the misuse of shell companies, contributes to the widespread and growing problem of inequality and damages wider trust in tax systems.
But we should recognise that progress is being made. The world is beginning to come to grips with these issues through multilateral actions, such as the Global Forum on Transparency and the Financial Action Task Force, and countries’ own actions to crack down on tax evasion, such as the US Foreign Account Tax Compliance Act (FATCA) rules. The Fund is supporting these initiatives, working with its members and with other international organisations to ensure that countries get the fundamentals of taxation right, and this includes fighting against evasion and ensuring that countries effectively implement the FATF standard to enhance transparency of corporate structures. I very much hope and expect that the ‘Panama Papers’ will lead us in the direction of increasing tax transparency and fairness.
IFC: Do you believe international finance centres or ‘offshore jurisdictions’ have a place in the global financial system?
VG: In a world of globally integrated capital markets, financial centres that facilitate transactions in the global financial system can play an important and constructive role; and sovereign countries are free to create comparative advantages and become financial centres. After all, low tax rates per se are not generally regarded as unacceptable. But of course, it is vital that these jurisdictions be part of the solution to address global spillovers associated with tax evasion and tax. There is an ever-increasing political will to strengthen global standards with respect to transparency and automatic exchange of information, to which all countries—again, recognising the special circumstances of many developing countries that are not financial centres-should subscribe to make it effective.
Vitor Gaspar Director of Fiscal Affair Department