Behind the scenes of the G7 tax reform proposals, an old battle between states and corporations is taking place. But even if multinational corporations end up paying tax somewhere, where they pay it is still up for grabs. The battle then becomes one between rich and developing countries, Peter Dietsch argues.
The headlines from the G7 summit in Cornwall might suggest that the groundwork has just been laid for the most fundamental overhaul of the international tax regime in decades. The twin proposal accords additional taxing rights to states with large consumer markets and introduces a global minimum tax rate of 15%. It has been heralded as a game-changer to the way multinational corporations are taxed. Yet, such an optimistic reading of events would be premature.
To assess the merits of the plan tabled by the G7 as well as to evaluate its chances of success, it is useful to recall the double challenge faced by the international tax regime: first, under conditions where capital is mobile across borders, states have an interest in cooperating to make sure that capital and its returns are taxed somewhere; second, once the joint fiscal net is cast, every individual state has an interest in maximizing its individual share of the tax base. In other words, there are two simultaneous battles to catch mobile capital in the fiscal system: one to tax multinational corporations; and one to maximise one’s national tax base in doing so. The second of these battles has proven to be a formidable obstacle to states finding the consensus necessary to winning the first battle.
There are two simultaneous battles to catch mobile capital in the fiscal system: one to tax multinational corporations; and one to maximise one’s national tax base in doing so.
A long time in the making
The G7 proposal is merely a snapshot of where negotiations of the international tax regime are at after years of looking for an elusive consensus to the question of who should pay what tax and where. It is too early to tell where this process will end up in part because the members of the G7 need other nations to buy into their plan to make it reality. And other states have every reason to meet parts of the G7 plan with skepticism. While the proposal would lead to a more effective taxation of multinationals and undermine the role of tax havens, the distribution of benefits risks being skewed in favour of rich countries.
The last time the rules of international taxation were fundamentally revised to respond to these challenges was at the end of the 1920s. It was back then that the basic consensus, roughly speaking, of residence taxation for individuals and source taxation for multinational enterprises was hammered out. Arguably, the many updates to this system that have been implemented since amount to cosmetic adjustments.
The paradigm that has governed international taxation for almost a century since suffers from one important shortcoming: Designed with the primary objective of avoiding double taxation in two countries for fears this would discourage investment, the international tax regime is hindered by the problem of double non-taxation. That is, no one pays, anywhere. While evading taxes is illegal for individuals, many legal loopholes exist for multinationals to shift either their profits or their actual economic activity to low-tax jurisdictions. In recent decades, multinationals assisted by a tax avoidance industry of bankers, accountants and lawyers have continuously improved their techniques of exploiting loopholes in this system, to the point where the effective tax rate in some cases is close to zero.
For decades, there was limited appetite to fix this problem. Multinationals made full use of a plethora of available tax avoidance strategies. Tax havens, often small countries well positioned to benefit from the inflow of capital in response to their lower tax rates without losing much domestic tax revenue, have repeatedly blocked any reform efforts. Moreover, a fact often underappreciated, large rich states tolerated profit shifting despite their official lamenting of tax avoidance. In particular, they were reluctant to stamp out the shifting of profits whereby multinationals make money in one jurisdiction to then use a variety of strategies to declare these profits in a low- or zero-tax jurisdiction instead. After all, closing the door to profit-shifting risked an outflow of real capital and the jobs attached to it. Importantly, all of this was supported by an ideology that lower taxes stimulate investment in the real economy.
Cracks appeared in the consensus underpinning the low-tax ideology in response to the financial crisis of 2007. Information leaks revealing that many firms’ effective tax rates were close to zero while regular citizens suffered the consequences of austerity measures were met with public outrage. Six years later, the OECD’s action plan on Base Erosion and Profit Shifting launched an attempt to fix the system. As the name suggests, the ambition of BEPS was limited to curtailing profit-shifting, while leaving tax competition for real capital intact. The launch of BEPS coincided with the creation of the OECD’s Inclusive Framework, a dialogue of more than 135 states on tax cooperation and the implementation of BEPS.
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The G7 proposal
Spurred on by the fiscal pressure created by the Covid-19 crisis, G7 states are now recognizing that BEPS did not go far enough. The two pillars of the current proposal clearly indicate where more work is needed.
To start with, consider the idea of a 15% global minimum tax rate on multinational enterprises. With proper enforcement, this represents an effective response to the first challenge of tax competition introduced above. It would ensure that mobile capital is indeed taxed somewhere. It effectively introduces a floor to the race-to-the-bottom in tax rates to attract corporate capital. As such, it is a necessary condition for states to win their fiscal battle with multinational.
Critics point out that 15% is too low, and they have a point. However, the significance of this proposal even at a relatively low rate is hard to overestimate. Not only does it recognize that tackling profit shifting on its own was always going to be a half-way house plagued by enforcement issues, but it implicitly puts into perspective the fiscal sovereignty of states, too. If one state’s right to impose taxes is conditional on respecting the rights of other states to do the same, then agreeing on a global minimum tax rate might undermine the formal fiscal sovereignty of states, but it boosts their effective fiscal sovereignty. In short, the only aspect your fiscal sovereignty that you might lose under the new proposal is the capacity to act as a tax haven.
The second aspect of the proposal is to allow market jurisdictions to tax the bracket of 20% of profits above a threshold of “normal” profits of 10%. Market jurisdiction here refers to the place where the sales activity of the MNE in question takes place. Taxing profits depending on where sales are located is just one possible to way to define the tax base. Other approaches track the assets of companies or their payroll. Hybrid models are also possible, and even favoured by tax experts.
This aspect of the G7 plan takes us to the heart of the second challenge of international tax governance identified earlier. Once states decide to cooperate in order to tax mobile capital, everyone will want to maximize their slice of the cake, a.k.a. tax base. Given that the G7 economies represent huge markets, it is hardly surprising that they intend to tilt the balance of taxing rights in favour of market jurisdictions. From Washington’s perspective, which plays a decisive role in the negotiations, you might say: “Look, if we tax these most profitable multinational enterprises, a lot of whom happen to be American-based corporations, let’s at least make sure that we get a decent portion of the tax base.”
Developing nations have long held the short end of the stick in international tax governance because the definition and allocation of the tax base suited the interests of rich countries.
The debate about the GAFAs, the large and profitable digital MNEs, is a mere symptom of the underlying distributive struggle in this context. If we agree to tax capital more (the first challenge), how do we define the tax base that different countries get a right to tax (second challenge)? On the one hand, when thinking about digital companies specifically, a shift to tax where sales take place makes sense, because these MNEs tend to have a relatively slim structure when it comes to productive assets and payroll. On the other hand, a general shift towards market jurisdiction favours the rich countries where sales are concentrated over developing countries where other potential tax bases of assets and payroll tend to be located. Here, we are not talking about small country tax havens that sabotage the system, but about the large countries such as China, India, or Malaysia where most of the stuff that gets sold in Western markets is actually made. The G7 proposal is short on detail at this point to assess to what extent it represents a general shift of this kind, but this is where the battle lines will be drawn going forward.
Bargaining power versus equity
So, watch for the reception of the G7 proposal in the wider international community. In a way, this will be an important litmus test for the Inclusive Framework of the OECD. Observers have long wondered whether creating this wider circle is merely a strategy by rich nations to give the emerging fiscal order a veneer of legitimacy, or whether it offers developing nations not just a seat at the table but an actual say in shaping international tax governance.
If it’s the latter, that is bringing developing nations to the table as equal partners, then expect the second component of the G7 plan with its proposed shift in favour of market jurisdiction to generate quite a bit of controversy. Developing nations, large countries among them in particular, have long held the short end of the stick in international tax governance because the definition and allocation of the tax base suited the interests of rich countries. While they will welcome the move towards a minimum global tax rate as progress, they will rightly see the shift towards market jurisdiction as an attempt by rich countries to protect their (unjust) privileges. The question is whether developing nations have enough bargaining power to resist this move.