UNCTAD’s big number: A critique

Update 2: 8 May 2015, a slightly tweaked version of the blog is now back up, and the UNCTAD study authors will provide a comment which I’ll add at the start of next week.

A critique of the UNCTAD analysis of corporate tax avoidance suggests things may be (even) less rosy for developing countries.

It is a mark of the importance of UNCTAD’s study on corporate tax avoidance in developing countries that it is provides the first numbers mentioned by the World Bank’s MD and COO Sri Mulyani in a major speech last month:

A recent UNCTAD study indicates that about $100 billion in annual tax revenue is lost to developing countries in transactions directly linked to offshore hubs. The total “development finance” loss – counting both revenue and reinvested earnings – is estimated in the range of $250 to $300 billion. This prevents developing countries from stopping the outflow of money – which thus bleeds them of essential resources.

For the schoolchild in Haiti, the new mother in Malawi, or the farmer in Bangladesh, these losses have a real impact: They result in classrooms that are overcrowded, health clinics that are never built, and water that is never delivered. People’s opportunities are being stolen from them – because tax revenues are not collected.

But there is a critique of the UNCTAD report, which also found that multinational enterprises (MNEs) may be paying developing countries around $700bn in revenues.
The import of the critique is that, rather than multinationals in developing countries avoiding a dollar of tax for every seven they contribute, they may by one form of avoidance alone be avoiding a dollar of tax for every three or four they contribute. Total revenue losses to avoidance might even stack up against the total contribution made… but I’m getting ahead of myself.
There are two main elements to the critique being advanced, one conceptual, the other practical. I should repeat my disclosure from the earlier blog that I’m part of the expert group that has fed in views about drafts of the study, so I’m probably not neutral.

The role of investment

The conceptual critique concerns whether the UNCTAD study appropriately captures the role of investment in development.

One risk is that a policy of avoidance might somehow be seen as an acceptable tool to encourage investment, that a tradeoff might exist (p.5):

The dilemma is clear: how can policymakers take action against tax avoidance to ensure that MNEs pay “the right amount of tax, at the right time, and in the right place” while avoiding excessive tightening of the fiscal regime for MNEs which might have a negative impact on investment.

Three main criticisms are made.

First, the study concentrates on FDI rather than the total of investment. But it’s conceivable that reducing multinational tax avoidance could (i) increase revenues for public investment, (ii) reduce the unfair competitive disadvantage faced by domestic firms (and more compliant multinationals), and through the combination of (i) and (ii) actually increase overall investment.

Second, any possible tradeoff hinges on assumptions of the importance of tax for investment (that is, for FDI). Namely (p.5, emphasis in original):

Tax is a key investment determinant influencing the attractiveness of a location or an economy for international investors.

Taxation, tax reliefs and other fiscal incentives are a key policy tool to attract investors.

The criticism is that these statements are undercut by the evidence – for example, TJN research (PDF) drawing on the IMF and McKinsey’s inter alia has long highlighted the non-importance of tax in locational decisions. [Such overall findings do not necessarily rule out any potential role of well-administered tax incentives as a possible lever of industrial policy, however.]

The third element of the conceptual critique is that while FDI inflows might fall in the event of targeted reduction in MNE tax avoidance, it is unlikely that a fall in FDI stock would occur – and highly unlikely that such a fall would be of sufficient scale to reduce overall revenues. The strongest impact of the financial crisis came in 2009, which saw positive inflows continue, albeit with a 20% fall in volume.

My take on this, for what it’s worth: the suggestion of a tradeoff is far from prominent in the paper, and UNCTAD exist in part to promote FDI (benefits), so the framing is not particularly surprising.

And nor need it be particularly damaging, if the dominant discourse is reflected by the kind of remarks that James Zhan (Director of the relevant UNCTAD department) made at the UNECE Financing for Development consultation about the importance of MNE tax avoidance, and the need to maximise not investment per se but the broader sustainable development benefits thereof – so that there’s no immediate, actionable avoidance/investment tradeoff as such, but a more holistic conception of the potential for FDI to influence multiple channels of a (much wider again) development strategy.
I don’t think anyone would argue – and the UNCTAD study does not – for promoting avoidance as an investment attraction mechanism (although that is in a sense the game for those jurisdictions that seek to capture the tax base of others.)

Methodological critique: Varying the assumptions

The methodological critique is multifaceted, and I will set aside much of it. Suffice to say, I think there are reasonable criticisms to be made – as with any regression analyses, and any attempt to estimate hidden financial flows on the basis of limited public data – but that the central approach is quite reasonable, and represents a valuable innovation to add to existing work.

A broad point is that the revenue loss number for one form of avoidance alone has been presented as the number for all avoidance – ignoring, for example, transfer pricing abuses of the sort that a Banque de France researcher has estimated to cost France alone tax base of around $8 billion a year. We certainly need to find ways to construct broader numbers of that type, but it’s not what the authors were about here.

The more specific criticisms of the UNCTAD study calculation are interesting, however, and worth showing in order to think about where one should imagine the probable range of MNE revenue contributions, and so the relative scale of avoidance – for the ‘contribution method’ and the ‘FDI-income method’, which are the two complementary approaches proposed and used in the UNCTAD study.

Contribution method

This approach uses countries’ revenue values from the new ICTD dataset, and allocates a proportion of each revenue type from 0-100% to MNEs in order to assess their total contribution.

The critics highlight a range of decisions as potentially difficult to justify (e.g. that MNEs contribute 50% of tax paid on property, or 100% of taxes on imports), and make some different proposals (‘Alternative 1′ in the table). This additionally includes a relaxation of the UNCTAD study’s assumption that MNEs’ share of taxable profit will be equivalent to their share of operating surplus, which will be violated when methods like thin capitalisation are used for profit-shifting. There is also a somewhat arbitrary reduction (by the critics) of the MNEs’ share of corporate tax revenues, apparently to reflect the original study’s recognition that ‘generous discounts on tax rates’ may lead to bias here.

This reduces the total estimated MNE contribution from $723 billion to $391 billion. In addition, the critics point out that the UNCTAD study uses a reference year from the crisis period. Choosing a different reference year (‘Alternative 1b’) leads to a total contribution of $399 billion, but where the share due to corporate income tax is now 43% of revenue contribution, as opposed to 30% in the original.

Here I have to put my hands up – the UNCTAD study (very wisely) uses the ICTD Government Revenue Dataset, as a better source of tax data, and until the upcoming release, the present edition contains only data to 2009/10.

FDI-income method

In this method, the UNCTAD study takes balance of payments data on FDI income, and applies an average effective tax rate to estimate a revenue outcome. Good data on MNEs’ foreign tax payments, never mind effective tax rates, is notoriously difficult to come by – and especially so for lower-income countries.

The critics re-engineer the data in the UNCTAD study to show that an effective rate of 11% is not unreasonable, but more generously apply 15% (compared to nearer 20% and 25% in the original).

The overall effect, combined with the above finding that income tax produces a higher share of the total contribution, is to reduce the estimated total contribution to $291 billion.

Implications?

It is true that the UNCTAD study considers only one form of avoidance – so as they themselves say, one might reasonably add to their $100 billion an estimate of transfer pricing avoidance (for example).
[The reason not to, I imagine, is that there isn’t as rigorous an estimate of this as their estimate of the thin capitalisation avoidance, due to the failure to make available more widely the type of trade data used in the Banque de France study which explicitly contrasts real arm’s length pricing with related party trade prices.]

This is not a criticism of the UNCTAD study – just a caution against presenting the $100 billion as if it were an assessment of all avoidance.

A genuine, but as yet untested criticism relates to the potential sensitivity of the assessment of the revenue contribution of MNEs in developing countries, to the necessary set of assumptions made.

Is MNEs’ revenue contribution $300 billion or $700 billion?

You wouldn’t stand full square behind either, it seems to me, but that feels a more or less inevitable result of current data problems (yet one more that would be solved, of course, by public country-by-country reporting).

The UNCTAD study provides justification for the various choices it makes. It would be useful to have a broader discussion of these, and to onsider the range of movement in the estimate level of contributions.

What does this all mean for policy? One response to the UNCTAD study would be to acknowledge that it provides confirmation, at a minimum, of the ‘scale-reasonableness’ of NGO estimates of revenue losses of this scale. Another would be to note, as I did in the previous post on this report, that $100bn is small in relation to total revenues.

If the critics were right, and the total MNE contribution is half of what we thought, perhaps this whole area of tax should be even less of a priority. Alternatively, if the MNE contribution could be doubled from what it is – without any unreasonable impositions – that would suggest a much bigger prize…

The one form of avoidance (thin capitalisation) in the UNCTAD study seems likely to be joined by several significantly sized other mechanisms – as the evidence for Europe suggests fairly strongly may be the case; and see also the new OECD survey paper on evidence on an even broader range of BEPS channels.

So the total developing country revenue losses to MNE avoidance could be several times that $100 billion – which could be half of, or the same as MNEs’ total contribution, if the original or the critics’ assumptions are used.

The authors of the study have very kindly agreed to provide a response to some of the points raised, which I’ll post here when I have it. I think it will help the rest of us to understand more about the range of possible revenue contributions we should consider reasonable.

06/05/2015

Tax Justice Research Bulletin 1(4)

April-ish 2015. The fourth Tax Justice Research Bulletin is out (a monthly series dedicated to tracking the latest developments in policy-relevant research on national and international taxation). Find it all together, as it should be, at its TJN home.

Zidar 2015 fig5 This issue looks at some striking results from the US on the employment impact of cutting taxes for the top 10%; and at ‘inefficient and unjust’ Greek tax policy since 1995. The Spotlight looks at the literature on base erosion and profit shifting by multinational companies, drawing on a handy study from the OECD BEPS 11 people, and a new Banque de France working paper.

This month’s backing track probably refers more to Greek policymakers than the CTPA: the late, great Lucky Dube’s Mr Taxman (“What have you done for me lately?”).

For your future research needs, the updating of the ICTD Government Revenue Dataset is almost complete, so with a bit of luck it will be published in June. Discussions about a major 2016 conference and call for papers using the data are underway.

As ever, submissions for the Bulletin – substantial and musical – are most welcome.

06/05/201513/07/2015

Base erosion and profit-shifting: What do we know?

[From the Tax Justice Research Bulletin 1(4)]

The OECD was mandated by the G8 and G20 to revise its international tax rules in order to combat multinational corporate tax dodging – known in OECD jargon as “Base Erosion and Profit-Shifting (BEPS). The final deliverables due later this year, and because of the complexity of international tax, it has been broken down into 15 “Action Points.” (On Monday, TJN blogged Action Points 3 and 12, as discussed by the BEPS Monitoring Group, or BMG.)

The geeks’ Action Point of choice has always been number 11, which requires the collation of baseline data on how far profits are misaligned away from genuine economic activity: e.g. by being shoveled into tax havens where nothing really happens. Action Point 11 also involves continuous tracking of progress in this area.

The team working on BEPS 11 has now published a discussion draft, which sets out not only their thinking on questions of data and measurement (check back later with the BMG for our response to these) but also a broad survey of the literature on the scale and channels of BEPS.

A Banque de France researcher found that measured deviations from the Arm’s Length Principle may have cost France $8 billion of its ~~revenue~~tax base in 2008 alone – and this is just one aspect of profit-shifting

Some of the main findings:

There is broad consensus (regardless of time period, country or data source) that there has been widespread tax-motivated BEPS activity by multinationals — though the intensity varies.
BEPS via manipulation of debt and interest payments is particularly important (and relatively well-studied: e.g. Huizinga, Laeven and Nicodeme (2008).)
Transfer pricing studies of various kinds show consistently, again, that prices are manipulated for tax reasons; and that intangible assets are important here. We might also point to the more recent study by Banque de France researcher Vincent Vicard, finding that the deviation between intra-firm pricing and true arm’s length prices may result in a ~~revenue~~tax base loss to France of $8bn in 2008, having grown over the decade – and this remains just a part of estimated total profit-shifting. [Phew!]
Treaty shopping is estimated to reduce withholding tax rates ‘by more than five percentage points from nearly 8% to 3%.’
Transparency: evidence on the role of disclosure and transparency – i.e. measures such as BEPS 11 itself – is limited but striking. Most obviously, Dyreng, Hoopes and Wilder (2014) found that ActionAid’s revelations about FTSE100 companies failing to meet a rule on disclosure of subsidiaries resulted in greater disclosure, a reduction in ‘tax haven’ subsidiaries and a reduction in avoidance [Kudos to Actionaid!].

ActionAid’s revelations about FTSE100 companies failing to meet a rule on disclosure of subsidiaries resulted in greater disclosure, a reduction in ‘tax haven’ subsidiaries and a reduction in avoidance

Developing country scale: only two studies provide a comparative assessment of the likely scale of BEPS in developing as opposed to higher-income countries. The first, by authors including long-standing critics of NGO estimates in the broad area, finds that profit-shifting (in this case, only that of German multinationals and via debt manipulations) is roughly double the size in developing countries. The IMF, meanwhile, recently presented evidence that the revenue losses of developing countries may be several times higher than elsewhere (as a share of corporate tax revenue).

Without wishing to prejudge the BEPS Monitoring Group’s analysis (oh go on then), it is clear even from this chapter of the OECD study alone that the authors have reached a point very similar to that which motivated Richard Murphy to elaborate the first TJN proposal for country-by-country reporting back in the day: namely, that existing data sources can only provide parts of the picture, and to develop a comprehensive understanding of BEPS will require consistent and comprehensive data on global multinational activity. [Well done Richard!]

To this we might add, in the spirit of Uncounted, that current data availability has “non-random weaknesses” which will systematically result in disproportionately lower tax revenues in lower-income countries. BEPS 11, if it delivers that comprehensive data, might just be the greatest contribution to fairer international tax that is compatible with the insistence on separate accounting.

26/03/201520/07/2015

UNCTAD study on corporate tax in developing countries

UNCTAD, the UN body that tracks trade and investment with the aim of improving development impacts, has published a major new study on corporate tax. [Link broken as at 20 July 2015, thanks Lisa, so see World Investment Report 2015 chapter 5 and annexes instead – this is the updated version.] Much attention will go to the estimate of $100 billion in developing country revenue losses due to MNEs’ tax avoidance, but the study contains much more of value:

The first comprehensive overview of MNEs’ revenue contribution in developing countries;
A relatively detailed overview of the use of ‘offshore hubs’ as conduits for investment;
Regression analysis of the profit-shifting impact of conduit use, and an estimate of the revenue losses; and
A discussion of potential policy responses that emphasise the value of investment but also recognise the damage of tax avoidance.

This (long) post will summarise each area in turn, then offer a few thoughts on the importance of the study, and future research directions. [Full disclosure: I’m on the expert group for the upcoming World Investment Report, of which this study is a part; which is to say that I may be biased, but certainly not that I can take any credit.]

MNEs’ revenue contribution

The first major element of the paper consists of creating a baseline for the revenue contribution of (the foreign affiliates of) MNEs, drawing primarily on the ICTD Government Revenue Dataset.

The authors break down the pattern of revenues overall (figure 3 – click for full size), and then focus on the contribution of MNEs.

Figure 6 shows the results of the ‘contribution method’, where each component of revenues is decomposed into a corporate and a non-corporate element, and the former again into a domestic and foreign affiliate element (see Annex I for full details). This allows an overall estimate of the contribution of MNEs’ foreign affiliates, of around $725 billion or 10% of total revenues. Around 3% of revenues derives from MNEs’ corporate income tax.

As a cross-check, the authors use balance of payments data to construct the ‘FDI-income method’ which involves estimating the total revenue contribution from both unctad draft fig7 corporate income taxation and non-income items. Per figure 7 (click to enlarge), this yields an overall contribution of $730 billion. There is perhaps more uncertainty in this approach, since it rests on the estimated tax rate and on the extrapolated rate of other (non-income tax) revenue contributions. Nonetheless, the full approach (again detailed in Annex I) is plausible, and the cross-check on the contribution approach is valuable.

The investment role of ‘offshore’

The second contribution of the study is to assess the (jurisdiction) sources of investment. 42 jurisdictions are identified as either ‘tax havens’ (“small jurisdictions whose economy is entirely, or almost entirely, dedicated to the provision of offshore financial services”) or ‘SPEs’ (jurisdictions offering SPEs or other entities facilitating transit investment. Larger jurisdictions with substantial real economic activity that act as major global investment hubs for MNEs due to favorable tax and investment conditions”).

This might be considered a rather blunt approach; as I’ve written elsewhere, there are serious issues with any ‘tax haven’ definition, and the intuition of the Financial Secrecy Index is that it makes more sense to think of jurisdictions on a spectrum, rather than being either ‘havens’ or not. Nonetheless, it’s clear that the approach here identifies the major players one way or another.

Figure 13 (click to enlarge) shows the specific picture in the US. The difference in relative tax rates is striking: averages of 3% (‘tax havens’) and 2% (‘SPE countries’) versus 17% elsewhere.

In this light, the growth in use of these conduit jurisdictions for investment in developing countries which figure 17 illustrates is of clear concern.

Estimate of MNE tax avoidance

The logical next step of the paper is to consider the likely effect of using conduit jurisdictions for investment into developing countries on MNEs’ revenue contribution. It seems inevitable that this calculation will draw the most attention.

The estimate is based on (fixed effects OLS) regression analysis of the relationship, at the national level, between the aggregate use of investment conduits and the rate of (taxable) return on the investment stock. On the basis of a variety of specifications, the authors conclude that

“an additional 10% share of inward investment stock originating from offshore investment hubs is associated with a decrease in the rate of return of 1-1.5 percentage point” (p.34).

Extrapolating to all (non-haven) developing countries generates a range of revenue loss estimates from $70 billion to $120 billion. Figure 20 shows the central estimate of $100 billion in revenue losses: towards half of the actual tax paid.

The $100 billion is also around a tenth of the ‘potential value at stake’ – in effect, the total development finance associated with the activities of MNEs’ foreign affiliates. As an earlier draft had noted, the leakage of development resources is not limited to the loss of domestic fiscal revenues but it also affects overall GDP (as the profit component of value added is reduced) and potentially the reinvested earnings component of FDI. As companies shift away profits from the recipient country they may also undermine the development opportunities related to reinvestment of those profits for productive purposes.

Applying an average reinvestment rate of 50%, for example, to the calculated (after-tax) profit shifting of $330 – $450 billion would yield lost reinvested earnings in the range of $165- $225 billion. Summing up the revenue loss component and the reinvested earnings component the total leakage of development financing resources would then be in the order of $250 billion and $300 billion – in other words, between a quarter and third of the potential value at stake.

The pot of gold, however, should not be overstated: although this is likely to be a lower bound, since it does not capture all forms of corporate tax reducing behaviour, we’re talking about something like 1.5 percent of developing country government revenues on average. The absolute amount involved is clearly worth pursuing, and can have a substantial benefit in revenue terms and beyond; but the tax justice agenda cannot be boiled down to this alone. Much broader improvements, with both domestic and international components, are required to achieve a step change in effective taxation for development.

Policy recommendations

The study concludes with a range of policy recommendations, focused on improving the sustainable development impact of investment into developing countries. These are summarised in figure 21.

Multiple measures are set out, each worthy of more detailed discussion. A particular strength is the clarity of intent to ‘Ban tolerance or facilitation of tax avoidance as a means to attract investment’. If such an aim could be made operational and effective, it would imply an end to ‘competition’ among jurisdictions to take the tax base arising from economic activity elsewhere, of the type so clearly exposed in LuxLeaks.

I would have liked to see more emphasis on transparency measures – including, crucially, public country-by-country reporting – that would not only make the analysis here much more of a calculation and less of an estimation, but also provide an ongoing tool for accountability to ensure progress in reducing avoidance.

Summary

The UNCTAD study marks a major step forward in our understanding of the scale and nature of multinational tax avoidance in developing countries. Both the baseline for multinationals’ revenue contribution, and the assessment of the losses to avoidance, are likely to become part of the literature and the policy discussion for a good time to come.

No doubt some of the approaches will be challenged, including the regression results (when aren’t they?); and data will evolve over time (for example, the updating of the ICTD dataset in a few months’ time). But the pioneering approaches in the contribution method and the FDI-income method, as well as the model for the avoidance estimate, are likely to endure.

The policy recommendations are likely to have influence, perhaps including in the FfD process, and provide a valuable reminder of the importance of maximising not investment, nor revenues, but the development benefits that result. Better tools to resist avoidance will improve the ability of governments to make any necessary trade-offs.

03/03/2015

Modelling #LuxLeaks

Republished from the Tax Justice Research Bulletin – find it all at TJN, with added Afrobeat.

The industrial economics literature on FDI has tended to separate two elements: where multinational enterprises (MNEs) decide to locate, and where profit is subsequently declared. On the location question, the 1999 model of Haufler & Wootton has been influential. This shows that ‘competition’ between states to attract FDI, using tax breaks and subsidies, is likely to result in most or all of the benefits of the investment being captured by the MNE; but the market size advantage of a larger state ‘may even’ allow it to charge a positive tax rate and still attract the investment.

A new paper by Ma & Raimondos-Moller challenges this finding, by including the potential for profit-shifting as a factor in the location decision. Unsurprisingly, perhaps, this changes the set of possible equilibria in favour of a smaller state which is willing and able to apply transfer pricing rules more leniently – that is, to make it easier to shift in profits arising from economic activity located elsewhere.

Figures 1 and 2 show the position facing the MNE, in terms of the tax rates in the small country (t_A) and in the large country (t_B). The dotted black 45° line shows where these are equal. The blue line represents the iso-profit curve in the Haufler & Wootton model. Because this is above the 45° line, the MNE is only indifferent between investing in country A or country B if the former has a lower tax rate – so the large country can have a positive tax rate and still be more attractive.

The new (red) isoprofit line in Figure 1 shows that allowing for profit-shifting reduces the large country’s advantage – the red line is closer to 45° line in the cases of interest (tax below 50%). But the striking finding is the shift of the red line in figure 2, once ‘competition’ on transfer pricing laxness is included. Now for most likely tax rates, the isoprofit line has flipped to lie below the 45° line – so that the MNE will be indifferent about location only when the large country offers a lower tax rate than the small country, because the small country’s profit-shifting advantages now outweigh the market size advantage of the large country.

Of course a model is only a model, and inevitably lacks complexity. In this case, there is obvious scope for improvement. It is assumed that the location decision is ‘real’, so that locating in the small country (say Luxembourg) will imply transport costs in order to service the large country market (say the UK); and it is also treated as an either/or decision. In practice the structure in Luxembourg is unlikely to have any contact with physical product, and the decision is likely to be both/and. (TJN’s work shows the extent of the divorce, most strongly in Luxembourg, between profits declared and real economic activity.)

Nonetheless, the paper is important. As Ma and Raimondos-Moller point out, it is the first time that profit-shifting has been incorporated in MNE location decision modelling. We can surely look forward to further developments on similar lines, including empirical testing.

17/12/2014

Four Futures for International Tax Rules

This post was first published on Views from the Center.

Consensus on the reform of international tax rules may be splintering under the combined pressures of post-crisis austerity and revelations about cut-throat tax ‘competition’ (see my discussion on thishere). In light of this, I sketch out four possible directions for international rules and one major trend common to all, and then assess the likely implications for developing countries.

1. Staying the BEPS course

The Base Erosion and Profit Shifting initiative (BEPS), led by the OECD at the behest of the G-8 and G-20 countries, aims to create better alignment between multinational profits and the location of their actual economic activity. The OECD’s remit, set out in a detailed action plan, is to deliver progress in a set of largely discrete areas to make the current system function better.

The BEPS approach rests on a commitment to “arm’s length pricing” (ALP) for transactions among members of the same multinational group, which is intended to give rise in turn to the real (market-equivalent) distribution of profit across the group. Setting aside whether this is an economically sensible way of looking at a group of related parties with common control, the approach simply may not be consistent with the aim – there is no evidence to suggest that ALP, if effective, would necessarily align profit with economic activity.

The UK’s proposed ‘diverted profits tax’ embodies the challenge for BEPS. Despite playing an important role in bringing BEPS into being, the UK government’s frustration with the inability of ALP to deliver politically acceptable taxation of major multinationals has led it to take a quite different tack: in effect, to require explicitly some degree of alignment of profits and activity (sales).

Will leading states maintain their commitment to the OECD approach? The answer may depend on a return to stronger economic performance, and the easing of broader fiscal pressure. Continuing anaemic growth may lead to continuing political pressure and proliferation of work-around measures like the Google tax that cut across the ALP by requiring some alignment of profits and activity.

2. A bigger fix for BEPS

A more consensual future for BEPS can also be envisaged (hat tip to a necessarily anonymous official at a major ministry of finance), involving a rather broader fix but maintaining the fundamental nature of the current system.

This would involve countries signing up to three basic principles, which it has been suggested could eliminate 90 percent of the BEPS problem in one stroke:

A common tax base (so there is no incentive for arbitrage on the base)
Minimum tax rates (limiting, though not eliminating, the incentive for arbitrage on rates)
Elimination of preferential regimes (such as the patent box)

This would require a substantial shift in perceptions of the problem. Since some policymakers see this type of harmonization as a threat to sovereignty, progress seems likely only if such a view is eclipsed by the perception of tax ‘competition’ as the greater threat.

3. Unitary tax revolution

The most dramatic change conceivable would involve broad agreement to adopt the major alternative to the ALP, which is unitary taxation with formulary apportionment. In other words, the new approach would take the multinational group as the unit for taxation purposes, rather than individual companies within it, and apply a formula based on the location of economic activity to apportion the group’s tax base between different jurisdictions, where each may apply whatever level of tax they choose.

Given this approach is explicitly designed to align profits with economic activity, progress towards the agreed aim of the BEPS initiative is highly likely, and would benefit lower-income countries. While pressure for lower rates might build over time, the increase in tax sovereignty – the ability to make policy changes that matter – would remain.

However, political opposition has hindered the prospect of a global agreement to rip up the rules and start afresh. EU attempts to move towards an apportionment basis under the Common Consolidated Corporate Tax Base project appear stalled, and major powers like the US (despite its largely positive experience using unitary taxation among its own states), and the vast bulk of the multinational and accounting sectors continue to oppose, rendering a revolution unlikely in the medium term at least.

4. Unitary tax evolution

A more likely scenario is one where the current system evolves gradually towards something more consistent with unitary taxation (UT). There are two main, complementary channels through which this could occur.

First, continuing dissatisfaction with the ALP – and the sense that developing countries’ concerns are not well reflected in BEPS – may give rise to a breakaway. Developing countries will soon be able to examine country-by-country reporting from multinationals operating in their jurisdiction, which will highlight the misalignment between the shares of activity hosted and shares of profits declared.

A single developing country or a regional grouping could reach a tipping point and decide to switch unilaterally to taking as tax base some formulary apportionment of the global profit. The demonstration effect could be powerful and drive others to follow suit.

The second channel is even more gradual. It involves the ongoing growth in the diversity of methods allowed under OECD rules and the use of methods that include some profit attribution on the basis of activity, as distinct from any ALP or other pricing decision.

Between the two channels, the world seems likely – ceteris paribus – to move at least a little further in this direction over time. Again, this scenario would offer the possibility of greater tax sovereignty for many developing countries.

Development prospects and a common trend

Lower-income countries obtain, on average, much smaller shares of GDP in corporate tax revenue. In no small part this is due to a combination of limits to states’ technical capacity and negotiating power with large multinationals, and to the incentives that the international system provides for profit-shifting. As such, the four futures can be considered in terms of their likely impact on these two factors.

Source (columns A and B): McNabb & LeMay-Boucher, 2014; data from ICTD Government Revenue Dataset.

The BEPS course (future 1) address specific weaknesses in the rules, which may reduce profit-shifting incentives somewhat, but at a broader level will do little to diminish the complexity of rules that make technical capacity such a constraint. The ‘bigger fix’ (2) offers the possibility of greatly reduced incentives for multinationals, and so could have an appreciable benefit.

The unitary revolution (3) could change the power dynamic for lower-income countries entirely, both in relation to multinationals but also vis-à-vis higher-income countries – but partly for this reason is an implausible scenario. Evolutionary steps towards UT (4), however, seem likely, and have the potential to sharply reduce the importance of capacity constraints and to change the balance of negotiating power also.

In fact, the common trend in all four futures is in this direction. The presence of country-by-country reporting information, now established as OECD standard, provides a simple risk mechanism by allowing a check on the profit misalignment of each taxpayer. Any tax authority requiring this information from multinationals will be in a position, regardless of the range of possible outcomes under ALP (or directly under UT), to set effective limits on the extent of profit misalignment that they are willing to accept. This has the potential to change the relative negotiating power of even the least well-resourced tax authorities.

Publishing the data would provide a powerful accountability mechanism for both multinationals and tax authorities, in respect of each other and for civil society; but even held privately, this is information that can support substantial change. Not all transparency is equal; in this particular case, information is indeed power.

17/12/2014

#Luxleaks: The Reality of Tax ‘Competition’

This post was first published on Views from the Center.

Aside from lurid revelations about individual companies and the big four accounting firms, the leaks of multinationals’ tax deals with Luxembourg confirm—and expose to a wider audience—the true nature of the tax ‘competition’ that prevents the emergence of effective international rules.

#Luxleaks

The International Consortium of Investigative Journalists published the second tranche of leaked files, showing tax agreements the big four accounting firms reached, on behalf of their clients, with Luxembourg. The general pattern is of establishing internal corporate finance companies in Luxembourg and using these to shift in billions of dollars of profits earned elsewhere, after obtaining confidential rulings from officials that ensure a very low effective tax rate — in many cases less than one percent.

The ICIJ’s reporting and detailed analysis of documents on individual companies from Disney to IKEA is outstanding. It clearly shows a systematic pattern of behaviour in Luxembourg, and adds to a range of other evidence suggesting the pattern is systematic across multiple jurisdictions.

Widespread tax base poaching

Several recent examples show other countries doing deals knowingly to shift in, and not (fully) tax, profits that arose elsewhere. The European Commission has initiated proceedings against Ireland for allegedly providing “State Aid” to Apple since the 1990s through unjustifiably beneficial tax treatment. This had effectively capped the level of profit Ireland would recognize as tax base, leaving untouched the vast majority of profit shifted in. Meanwhile, a more formalized version of this approach dating back 10 years, Belgium’s system of ‘excess profits rulings’, has also come under scrutiny.

In all three cases—Luxembourg, Ireland, and Belgium—the pattern is consistent. Companies, through their big four accounting firm advisers, have obtained advance agreement not to tax profits that arise, but are not taxed, elsewhere.

A less blatant but increasingly common instrument is the patent box, or knowledge box, which provides a very low tax rate in relation to R&D. There are already generous tax breaks for R&D in most countries. A patent box can, controversially, allow one country to capture the tax base associated with the R&D that was supported by taxpayers in another.

Such tax incentives for intellectual property exist in Belgium, Cyprus, France, Hungary, Ireland, Luxembourg, Netherlands, and Spain. In addition, the UK, which had introduced the measure from 2013, recently bowed to German pressure to phase it out (albeit not fully until 2021). The decision came after initially resisting, along with Luxembourg, Netherlands, and Spain, the suggestion that the tax break should only apply to R&D actually carried out in the country offering the patent box.

Google tax

Less than a month after its compromise over the patent box tax break, the UK government proposed a measure designed to protect its own tax base against similar poaching. The ‘diverted profits tax’ (DPT), now subject to public consultation, seeks to ensure profit arising from sales in the UK do not escape taxation by claiming to have no permanent establishment in the UK, nor through ‘certain arrangements which lack economic substance’. Perhaps unsurprisingly, given criticism of theapparent disconnect between Google’s UK profitability and tax payments, media are calling the measure the ‘Google tax’.

The expected revenue impact is small. Despite a marginally penal rate of 25 percent (compared to a standard 21 percent), the forecast is to raise around £1.3 billion over five years. The highest forecast annual take of £350 million implies a base of £1.4 billion of ‘diverted’ profits, which is equivalent to just 1.4 percent of the most recent quarterly UK corporate profits. (The basis for these estimates hasnot been published.)

The change of direction may nonetheless be important. During his announcement of the DPT, UK Chancellor George Osborne stressed “the government’s commitment to an internationally competitive tax system.” However, the DPT reflects an understanding that, too often, countries are competing not to attract real economic activity but only the taxable profit that arises from activity taking place in another jurisdiction.

The tension between playing this game, while trying to limit the counter-success of others, in large part explains the failure to develop more effective international rules – and hence the tilting of benefits towards multinationals rather than to (especially lower-income) states. Still, pressure is growing, and the eventual direction of travel will have important implications for developing countries. A companion post explores future scenarios for international tax rules, and the implications for developing countries.