In the 1980s, corporate tax rates for OECD countries averaged about 45 per cent.[i] Since then, in response to competitive pressures, corporate tax rates have declined to an average of 20 per cent in 2021 in the developed world, with only 18 out of 111 jurisdictions with statutory corporate tax rates above 30 per cent.[ii] The US reduced its headline corporate tax rate by 14 percentage points in 2017 as part of the Tax Cuts and Jobs Act from 35 per cent to 21 per cent, a late arrival relative to other OECD countries that had been lowering rates significantly over time. However, while statutory rates have been declining, there is momentum building towards base broadening measures to expand the pie of corporate income that comes into the tax net. There is a growing sense that the pendulum has swung too far to the right, and a course correction is necessary for the corporate income tax to more fairly capture the economic activities of the modern corporation. What does this new world of corporate taxation look like? One obvious change in thinking is the shift towards a corporate minimum tax, as opposed to the statutory maximum tax rate, that has traditionally been the focus of intense debate. In this article, this change in thinking is detailed through the actions taken by the OECD as well as tax changes in the US.
The taxation of multinational corporations has become increasingly complicated as firm activities have expanded both geographically as well as in the digital space. In the 1970s and earlier, taxation of companies was determined by the location of the company and the location of income and profits, both of which were determined relatively easily by the physical location of corporations. As economist Alan Auerbach notes in his recent NBER lecture, if you compare the list of top five companies in the US in the 1970s with the top five companies today, there has been a shift in the types of activities that the top companies engage in and where.[iii] In the 1970s, companies largely produced in the US and had markets within the US as well. Therefore, taxing company profits was relatively straightforward. In the 1980s and 1990s, however, tax competition amongst OECD countries resulted in a delinking of profits and economic activity from the physical headquarters of companies.[iv] The share of profits coming from overseas has grown multiple fold over the last several decades, according to data from the Bureau of Economic Analysis.[v] Another interesting development has been that today’s companies rely significantly more on intellectual property and the provision of digital products and services. As per the Bureau of Economic Analysis, intellectual property products accounted for 1 per cent of the corporate capital stock in 1925. Today that number is 16 per cent.[vi] More importantly, companies are not only producing products and services in the US but also overseas, and foreign ownership of these products and services has increased as well.
This has led to a concern about profits escaping taxation in a world where the location of economic activity and profits is less clear. News stories regularly point out that many otherwise profitable companies have been paying zero taxes, particularly when it comes to US multinationals.[vii] A study from ITEP states that 55 of America’s largest companies paid zero dollars in taxes in 2020, and half of those had paid no taxes in the prior three years as well.[viii] Aside from certain domestic provisions such as net operating loss provisions, a primary concern appears to be a firm’s ability to offshore profits to low tax jurisdictions or to completely avoid taxation because of double non-taxation, i.e. profits going unreported and untaxed across multiple jurisdictions. In response, we have seen multiple efforts targeted at imposing minimum taxes on multinational corporations.
While the 2017 Tax Cuts and Jobs Act lowered headline corporate tax rates to 21 per cent, it also for the first time created a minimum 10.5 per cent income tax rate, GILTI, on the domestic and foreign income of US multinationals after allowing for a basic deduction (QBAI). In the pre-TCJA regime, which allowed for deferral, profits earned overseas could avoid taxation until the cash was repatriated to the US parent company. This is no longer the case, even though some incentives for profit shifting may still persist since there is a gap between the domestic corporate tax rate of 21 per cent and the GILTI rate of 10.5 per cent. Further, the BEAT provision under TCJA imposed a new minimum tax of 10 per cent on related foreign party transactions that were considered to be “base-eroding”, such as royalties and interest payments.
The OECD Base Erosion and Profit Shifting (BEPS) project is a response to concerns around non-taxation for nearly a decade and recently, in October 2021, reached an agreement on a global minimum tax. The OECD BEPS Project began in 2013 as an attempt to address profit shifting by multinational corporations from high tax to low tax jurisdictions which results in companies paying lower taxes and countries losing out on these tax revenues. Estimates of profit shifting and revenues lost from profit shifting vary a lot across studies. A recent Congressional Research Service report estimates the cost at between US$77 billion to US$100 billion.[ix] The OECD published a report in 2015 outlining 15 action items. Most prominent of these action items was Action 1 that focused on the taxation of digital activities of companies.[x] In response, several countries outlined proposals for digital services taxes, such as the UK, US, Germany and France.[xi] These then paved the way for the OECD Pillar 1 and Pillar 2 approaches which are discussed below.[xii]
Pillar 1 aims to tax profits of companies based not just on the source of income or residence of the company but also where its products and services are consumed or used. For instance, if Facebook has several million users in France or India, under Pillar 1 Facebook would have a liability to pay taxes not just in the US, where it is headquartered, but also in France and India, since advertisers on the Facebook platform are benefitting from these users in non-US countries. In other words, taxation is a function of not just where the company is headquartered or where it has “production” activities but also where its end customers and users are located. Draft rules on Pillar 1 are still in development but seek to allocate a share of in-scope companies’ profits to “market” countries. Furthermore, they attempt to do this as an overlay on existing rules that will continue to respect source and residence as relevant concepts for the allocation of taxing rights. As one can imagine, there are several complications around the use of these approaches which may make them difficult to enforce.[xiii] The OECD has recently released draft rules on Amount A under Pillar 1 for public comment which provide a framework for allocating profits based on location of consumers and marketing and distribution activities. Pillar 1 will reallocate taxing rights relative to the status quo and will create winners and losers – that is, countries that stand to gain tax revenues and others that stand to lose. However, it is not clear who the winners and losers will be and aspects of those rules that will finally determine the winners and losers are still being decided.[xiv]
Pillar 2 more directly aims to get at the question of base erosion and profit shifting, by imposing a minimum global tax on companies with overseas operations. The TCJA imposed a minimum tax on US corporations under the new GILTI provision. However, the OECD approach is different in terms of disallowing certain tax credits and deductions in calculating the minimum effective tax rate. Model rules for Pillar 2 were released in December 2021, and these include three rules and a tax treaty.[xv] The “domestic income tax” rule allows countries the first right to tax any income that is currently taxed at below the 15 per cent rate. The “income inclusion rule” allows countries to tax the foreign income of domestic companies after certain deductions and also imposes a minimum effective tax rate of 15 per cent, otherwise additional taxes would be owed. The third rule is the “under-taxed profit rule” which would allow countries to impose a higher effective tax rate, again of 15 per cent, if a related party in a different jurisdiction is taxed at a lower rate. Figuring out how an OECD minimum tax or base erosion tax would interact and apply to countries with very different tax systems is likely to be challenging. This suggests that it may be a few years before these proposals are put into practice or adopted by different countries.
This struggle for adoption is evident in the US, where Treasury Secretary Yellen and the Biden Administration were influential in pushing for the OECD two-pillar approach and agreement in October 2021. However, they have as yet been unsuccessful in legislating these changes in the US Congress. The Biden Administration, as part of its Build Back Better Campaign, proposed to increase the corporate tax rate to 28 per cent from 21 per cent. It further proposed applying a 15 per cent minimum “under-taxed profits rule (UTPR)”, and a 15 per cent domestic minimum tax on corporate book income. However, concerns around how higher taxes would affect the US economy and US multinationals stalled progress on these proposals.[xvi]
After the Build Back Better Act failed to gain enough support in the Senate, the next legislation, the Inflation Reduction Act (IRA), included just the 15 per cent minimum book tax on large corporations with exemptions for items such as accelerated depreciation. This is different from the OECD global minimum tax since it allows for tax credits and accelerated depreciation, and also applies to worldwide profits rather than per country profits.[xvii] The OECD does not recognise this 15 per cent minimum tax as adhering to the Pillar 2 guidelines.
The path forward for international corporate taxation is unclear. The OECD proposals on Pillar 1 and 2 have provoked reactions in the EU and US, with some countries like Hungary backing out of the process, and the US unable to ratify the international tax proposals in Congress. Movement on these will require countries to agree to removing unilateral digital services taxes and similar policies as part of Pillar 1, and working together in a coordinated and multilateral framework. In addition, details of how the global minimum tax will work with national systems of taxation are complicated.
However, whether the two-pillar approach succeeds or not, we have entered a new framework for global taxation. The key features are (1) the concept of a minimum tax that forces companies to pay some level of tax irrespective of which jurisdiction they pay it in, is here to stay. This implies that large corporations, particularly those engaged in digital activities, are likely to pay higher taxes than they have before; (2) tax competition will no longer be about countries lowering their headline rates to attract businesses, but will instead be about which countries can reap the most benefit from profit reallocations and top-up taxes; and (3) it is patently unclear who the winners and losers in this new paradigm are likely to be.[xviii] While profit shifting to tax haven countries is likely to reduce, who gains more will depend upon how the rules are actually implemented, crafted and adopted across multiple jurisdictions. Economic analysis suggests no clear answer to this question.[xix]
This is the brave new world of international taxation. No wonder countries are hesitant to commit to making giant leaps forward.
[iv] Research shows that higher corporate tax rates are associated with lower economic activity, and also lower wages for workers (Hassett and Mathur, 2011).
[xiv] For instance, see Kartikeya Singh, “Relieving Double Taxation of Amount A: Different Ways to Spread the Pain,” Tax Notes Federal, Feb. 7, 2022, p. 797.
[xviii] What is clear, at least for Pillar 1, is that U.S. companies will bear the lion’s share of the incremental tax burden. See for example, Kartikeya Singh, “Amount A: The G-20 Is Calling the Tune and U.S. Multinationals Will Pay the Piper,” Tax Notes Federal, Aug. 2, 2021, p. 753.
Aparna Mathur is a former Senior Fellow at Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government where she is researching the US social safety net. She is a Visiting Fellow at FREOPP and a Senior Research Manager in Economics at Amazon. Aparna spent a year as a Senior Economist at the Council of Economic Advisers during the pandemic. She joined the Council as part of the COVID-19 response task force at the peak of the crisis in April 2020 and worked with epidemiologists on the health aspects of the crisis, while also tracking the economic downturn that came with the lockdowns. Prior to joining CEA, she was a resident scholar in economic policy studies at the American Enterprise Institute. At AEI, she directed the AEI-Brookings Project on Paid Family and Medical Leave, building bipartisan momentum on paid leave, for which she was recognized in the Politico 50 list for 2017. Her academic research has focused on income inequality and mobility, tax policy, labor markets and small businesses. She has published in several top scholarly journals including the Journal of Public Economics, the National Tax Journal and the Journal of Health Economics, testified several times before Congress and published numerous articles in the popular press on issues of policy relevance. Her work has been cited in leading news magazines such as the Economist, the New York Times, the Wall Street Journal and the Washington Post. She has regularly provided commentary on prominent radio and television shows such as NPR’s Marketplace and the Diane Rehm Show, as well as CNBC and C-SPAN. She has been an adjunct professor at Georgetown University’s McCourt School of Public Policy. She received her Ph.D. in economics from the University of Maryland, College Park in 2005, and is currently serving on the University of Maryland Economics Leadership Council. She is also on the Board of the National Academy of Social Insurance, Simply Green and the National Economists Club.