There is something new brewing on the international tax landscape. Historically, countries competed with one another by offering lower corporate tax rates and other incentives in the hope of attracting companies to locate investment, reported profits, and jobs within their borders. Now, an attempt is being made to restrain this tax competition via regulations that would allow countries to extract a growing share of companies’ worldwide profits. With this shift, a central question of international taxation appears to be how big each jurisdiction’s slice of the pie of profits should be. And relatedly, how do we set up rules to ensure that there is international consensus on how this pie is divided? These are tough questions, and ones that I suspect countries will be debating for the next decade.
This shift in focus is necessitated for several reasons. Firstly, the location of profits and the location of physical capital are increasingly disconnected. While physical factories may be located in one country, the profits may be generated or located in another. This means the location of profits has become far more mobile. This is particularly true for digital companies. Secondly, complex rules govern how profits can be allocated to certain jurisdictions and what deductions can be claimed in inter-company transactions; this may further eat away at the ability of a country or jurisdiction to claim its share of profits. Finally, there is a global push to ensure that companies pay taxes not only in the area of physical location, but also in every other jurisdiction where they are shown to have an “economic” presence. All of these considerations imply that going forward, the total pie of profits is now likely to be divided up among many more countries than before.
In this article, I review where we are in this process, how we got here, and what this all means for the global economy.
I. From Tax Competition To OECD BEPS
International tax competition has a long history. Starting in the 1980s (and in some cases earlier), several countries around the world started cutting headline corporate tax rates in an attempt to attract investors within their borders. In a 2013 paper, Devereux and Loretz[i] review the empirical evidence on tax competition and the attempt to combat “harmful tax competition”, as well as the OECD’s attempt to target tax havens to inhibit profit shifting. The notable feature of this type of tax competition was that the process was largely uncoordinated. Rohac (2006) defines this type of tax competition as “the process of uncooperative setting of tax rates in order to attract mobile tax bases—leading to inefficiently low amounts of public goods”.[ii]
The first empirical assessment of corporate tax competition came from the Ruding Committee report in 1992, which found a long-term decline in statutory tax rates among countries in the European Union, with an accompanying increase in average corporate tax revenues (due to a widening of the tax base).[iii] Interpreting this as evidence of tax competition, the Committee recommended a minimum statutory tax rate within the EU to prevent a “race to the bottom”. Several other papers noted that there was strategic competition between countries in setting tax rates.[iv] Along these lines, Altshuler and Goodspeed (2002) found that during the period from 1968 to 1999, countries in the European Union behaved as if the US was a Stackelberg leader in setting corporate rates after the Tax Reform Act of 1986.[v]
While tax competition has continued to exist in some form, more recently the OECD has attempted to move countries away from tax competition to tax coordination. It has done so through its ongoing Base Erosion and Profit Shifting (BEPS) project.[vi] The OECD’s BEPS project aims to tackle the issue of domestic tax base erosion and profit shifting by multinational enterprises by coordinating the actions of 135 countries. Phase 1 included 15 action plans with the aim of improving tax transparency, reducing double non-taxation of company profits, and requiring detailed country-by-country tax and financial reporting by firms. More importantly, this first phase of the project as a whole aimed to address the tax challenges arising from digitalisation of the economy where there is an increasing disconnect between the location of profits, sales, and the physical location of production activities. While the project has the support of several countries, others have questioned the legitimacy of the BEPS process.[vii] Some view the BEPS project as a “tax grab” by European economies focused on US digital companies like Apple, Amazon, Facebook and Google.[viii] Are countries required to adhere to the actions laid out by the OECD and the G20? Are they losing fiscal sovereignty in doing so? Are developing countries being hurt or helped by the process?
Many countries have raised objections to the project, including the US. In 2015, Senator Hatch, then Republican Senator from Utah, criticised the BEPS project as moving forward unilaterally without involving members of the US Congress in the decision making process.[ix] India has criticised the OECD for addressing the issues “superficially”, and many major economies like France, the UK and Australia are moving forward with their own unilateral proposals.[x] In 2015, I commented that a significant concern with the original BEPS project for the US was its focus on economic substance requirements.[xi] Before the 2017 tax reform in the US, statutory corporate tax rates were the highest in the OECD, and there was a risk that the country would lose real economic activity—jobs, research activity and actual production—as these activities shifted to low tax jurisdictions with the imposition of substance requirements. However, the subsequent tax reform has alleviated some of these concerns.
II. The Tax Cuts And Jobs Act Response to BEPS
The US Tax Cuts and Jobs Act (TCJA) was passed in December 2017. As I have written earlier, many aspects of the TCJA were a counterpunch to the BEPS project, in that it represented unilateral steps to address base erosion and profit shifting.[xii] The centrepiece of the tax reform was the cut in the headline corporate rate from 35 per cent to 21 per cent, which brought US competitiveness in line with other OECD countries, thus making it an attractive location for investment. At the same time, it offered incentives to companies to locate intangible investments in the US through the Foreign-Derived Intangible Income (FDII). Broadly speaking, the FDII rule provides a 37.5 per cent deduction to intangible income of domestic companies from their overseas operations. In turn, this lowers a domestic corporation’s effective tax rate to 13.125 per cent. If FDII works effectively, digital companies should find it in their interest to shift not only their profits to the US, but their intellectual property as well.
Furthermore, under the TCJA, the US put forward unilateral proposals to widen the tax base for companies in order to minimise base erosion and profit shifting. The new Global Intangible Low Taxed-Income (GILTI) regime imposes a minimum tax on returns that exceed a 10 per cent rate, irrespective of where the income is located. Additionally, the base erosion and anti-abuse tax (BEAT) is a 10 per cent minimum tax on the amount of any base-erosion tax benefits that US companies derive from transactions with non-US affiliates. It relates to any deduction that results from a payment by a US company to a related party, such as interest or royalty payments. Plus, this structure allows the Treasury to obtain information on reporting companies such as the name, place of business, countries in which related parties reside, and any base erosion payments made.
Following the TCJA, several countries are now starting to impose unilateral digital taxes. In 2019, France signed legislation to pass a new 3 per cent digital tax on tech firms with sales within its borders. Italy, Turkey, Austria and Spain are all set to impose levies in the coming year. [xiii] A report from the Office of the United States Trade Representative (USTR) shows that US companies will face most of the burden imposed by these taxes.[xiv]
III. BEPS 2.0: A Response To The TCJA?
In an attempt at dissuading unilateral actions that could again result in a “harmful race to the bottom”, the OECD has now released “BEPS 2.0”, or the new Unified Proposal. This two pillar platform tries to confront any unresolved BEPS issues. Pillar 1 develops a programme aimed at allocating taxing rights across countries, and Pillar 2 is a global minimum tax.[xv] Under Pillar 1, a jurisdiction’s right to tax a multinational enterprise (MNE) will no longer rely on physical nexus, but on factors such as sales and advertising services that show “sustained and significant involvement in the economy of a market jurisdiction, such as through consumer interaction and engagement, irrespective of its level of physical presence in the jurisdiction”.[xvi] The new approach can be viewed as an extension of the OECD’s ongoing work on base erosion and profit shifting. However, it is also fair to point out that the momentum, in particular Pillar 2, may have been driven in part by the TCJA’s imposition of minimum worldwide taxes and anti-base erosion provisions, via Global Intangible Low Tax Income (GILTI) and BEAT. Both pillars may be viewed as a competitive measure to drive revenues towards European countries after the cut in the US corporate rate to 21 per cent. Clearly, multinational companies are going to face higher tax burdens under the new regime. A recent analysis by the OECD shows that under Pillar 1 and Pillar 2, average corporate tax revenues across the globe will rise by 4 per cent.[xvii] Much of this increase will come from the Pillar 2 minimum tax regime. The biggest beneficiaries are likely to be low income countries, even though the US Treasury will likely also gain revenues if the US complies with the new Pillar 1 and Pillar 2 regimes. [xviii]
Where does the US figure in all of this? On the one hand, the US is part of the OECD Inclusive Framework that is leading the latest project. But the US is not aligned with every aspect of the project which has stakeholders with competing interests. In December 2019, the US proposed a safe harbour approach, which would allow an MNE to choose to be subject to Pillar 1 on a global basis, rather than be mandatorily subject to those rules. Many OECD countries have expressed concern with this approach, suggesting that such a provision would lead to a failure of the policy to effect any meaningful change. The US statement has raised concerns that further work will be derailed, since in order for the process to work, every country must agree to the final package of reforms.[xix] The deadline for agreement is the end of this year.
While there is a tremendous amount of uncertainty regarding the new world order in taxation, it is clear that the new rules are a significant departure from the old. They will upend existing tax frameworks, impose much higher burdens on multinational companies and possibly lead to severe disputes among countries competing for a slice of the tax revenue pie. Many of these changes will require changes in countries’ domestic tax legislation and a much higher level of harmonisation in how countries interpret and apply tax rules.
And if that’s not enough, within the US, the clamour for higher corporate rates is growing on the Presidential campaign trail. Several Democratic candidates have proposed higher corporate tax rates of either 25 or 28 per cent, and, in some cases, reversion to a rate of 35 per cent. Senator Elizabeth Warren has proposed an additional 7 per cent tax on profits over US$100 million, and Joe Biden has proposed a 15 per cent minimum tax on book income, offset by foreign taxes paid.[xx]
The future of corporate and business taxation in this international and domestic tax ping pong game looks incredibly messy. While the popular support for higher rates seems to be a response to the large increase in the deficit caused by TCJA’s provisions, rising inequality, and the worry that profitable companies are not paying their fair share in taxes, the US should take cautious steps when treading in this direction. The TCJA took a few paces forward with the goal of helping the US move ahead of its competitors and encouraging investment and profit relocation here. Let’s assess where we are before going along with BEPS 2.0.[xxi] Significantly higher levels of taxation of businesses may be harmful for long-term investment and economic growth and may be a reversal from what the TCJA hoped to accomplish. There is no need to barrel forward down that path.
[v] In game theory, a Stackelberg game is one in which the leader moves first and then others follow sequentially. https://www.researchgate.net/publication/24126273_Follow_the_Leader_Evidence_on_European_and_US_Tax_Competition.
[xviii] Analysing the implications of Pillar 1 Amount A for US tax revenues, Martin Sullivan shows that for the US, tax revenues would likely go up while tax haven countries would lose out. This analysis is subject to revision as better company level data becomes available. https://www.taxnotes.com/tax-notes-today-federal/digital-economy/economic-analysis-oecd-pillar-1-amount-shakes-worldwide-profit/2020/02/24/2c6fl
Resident Scholar in Economic Policy Studies. Her research includes income inequality and mobility, tax policy, labor markets, and small businesses.