Kevin Bi. Originally published in Spring 2018.
President Trump has long maintained that the United States is engaged in an economic competition with the world and that globalization has only heightened that competition. He is correct—at least with regards to tax policy. The Republican tax reform has understandably drawn intense reactions from across the domestic political spectrum, but the international community has also been paying close attention. The US decision to lower the corporate income tax rate from 35 percent to 20 percent presages similar efforts worldwide, with members of the international community already indicating that they will modify their tax policies in response. However, the United States is far from the sole, or even primary, driver of lower global tax rates. Many countries around the world have contributed to the collective decline in tax rates by competing with each other to have the lowest tax rates. This phenomenon has almost certainly benefited corporations and their profits in the short term, but it is a troubling development for governments and their citizens in the long term.
When countries manipulate corporate tax rates for competitive purposes, they do so for two broad reasons: to attract business activity and to raise tax revenues. But the actual role that tax rates play is unclear. Even though the United States has had higher corporate tax rates than much of the developed world, the comparative lack of regulations as well as the existing business community mean that businesses have still been more likely to locate in the United States than in European countries. Indeed, a multitude of factors like a country’s governance quality, education level, and existing infrastructure can play a much larger role than the corporate tax rate in determining where companies decide to locate their business activity. Furthermore, Eric Toder of the Tax Policy Center suggests that although higher corporate tax rates might cause capital to leave the country, this decrease in revenue could be offset by an increase in pre-tax returns. When the supply of capital in a country is lower, the returns on that capital increase. As a result, the capital outflows associated with higher tax rates could have matching capital inflows with investors seeking the higher rate of return on their capital.
The role of cutting taxes in attracting tax revenues is somewhat more straightforward: if a country is a more attractive location for companies to declare their taxable income, then the increase in taxed income offsets the decrease in the tax rate. Michael Keen and Kai Konrad wrote in the Handbook of Public Economics that it is much easier for corporations to shift their profits on paper than it is to shift their real business activity. The corporation can thus benefit from the aforementioned factors that make a country attractive for business while paying lower taxes in a separate jurisdiction. For individual countries, the decision to lower taxes thus seems sensible. The problem arises when all countries pursue the same strategy.
The rise of international tax competition is inexorably linked to the increase in globalization. Multinational corporations have developed a global reach with subsidiaries in many countries around the world. Corporations thus tend to declare their profits as originating from a subsidiary in a lower tax jurisdiction, evading taxes where the real business activity takes place. One common way to carry out this practice has been to declare that profits originate from a piece of intellectual property, selling that intellectual property relatively cheaply to a subsidiary in a low-tax country, and then paying global royalties for the use of that intellectual property to the subsidiary. Taxable profits from high tax jurisdictions decline as a result of the royalty payments, while profits garnered for the subsidiary in the low-tax jurisdiction increases. Of course, the subsidiary is still a part of the multinational corporation, increasing the corporation’s overall profits.
Similarly, the growth of communications technology makes the physical location of company’s headquarters much less relevant, and the development of financial technology makes it much easier for a corporation to move and hide its profits around the world. Other common strategies for multinational corporations have included taking on debt from a low-tax subsidiary and paying tax-deductible interest payments to that subsidiary, merging with a foreign company in a low tax country and moving the global corporate headquarters to that country, and executing even more complex maneuvers that have allowed companies like Apple to avoid paying taxes entirely. As globalization continues, the prevalence of profit shifting will only increase and, without absent meaningful action, so will international tax competition.
While tax havens and corporate inversions receive substantial press coverage in the United States, wealthy and developed countries are hardly the greatest victims of global tax competition. Unlike the developed world, developing countries do not possess many of the non-tax factors for attracting businesses. Reduced taxes are among the only competitive advantages that their governments can offer. Moreover, as Thomas Rixen writes in Global Governance, developed countries keep tax revenues steady by lowering tax rates while expanding the tax base, an option that most developing countries do not have because of their already narrow corporate tax base. Rixen further explains that because income taxes are more difficult to collect and enforce, corporate tax revenues comprise a major source of revenue for the governments of developing countries. Unfortunately, from the early 1990s to 2001, developing countries have experienced corporate tax revenue declines of nearly 20 percent because of the need to keep up with low tax rates. Developing countries have therefore lost hundreds of billions of dollars that could have been invested in infrastructure, economic growth, and the betterment of their citizens’ lives.
So far, most countries have attempted a unilateral approach to resolving tax competition. In the United States, this has often taken the form of politicians vowing to close tax loopholes. However, due to vested interests in the government and the strong incentive for corporate profit maximization, companies will inevitably find, or lobby for, more loopholes than the government can realistically close. Other proposed unilateral solutions are a value-added tax (VAT) and formulary apportionment taxation. A VAT is essentially a sales tax imposed at each step of the production process, instead of only at the final sale point. Under this method, each country would tax the actual activity that happens inside their borders. Formulary apportionment takes a similar approach, except it calculates the tax that a corporation should pay based on the share of global profits that arise from final sales in a country. Under both systems, companies are taxed based on actual activity, which is much harder to move than
paper profits. However, these taxes also have a more distortionary effect, thereby discouraging business activity in a country. Furthermore, neither taxation approach is progressive as small businesses shoulder an equal, if not larger, burden as multinational corporations.
More promising is an international-oriented approach, where countries coordinate with each other to avoid cutting tax rates excessively. Such an approach would require strong sanctioning capacities, likely through a transnational group like the World Trade Organization, to punish countries that renege on the agreement. Without a coercive mechanism, political leaders would be incentivized to undermine tax cooperation for their short-sighted benefit. In order to induce cooperation on tax issues, the economic costs of undermining a potential agreement must be greater than the potential benefits from increased tax revenue and business activity.
Even with effective enforcement mechanisms, the multilateral approach is not without its disadvantages. Among the primary concerns is that countries will lack the flexibility to meet their specific economic needs. Tax cuts are often used as a form of economic stimulus, especially in the case of economic downturn. A country with a slowing economy may have a legitimate, non-competitive reason for lowering taxes below those of the international community as a whole. The international community could incorporate more flexibility into the agreement, allowing countries to respond to their specific challenges, but such leeway could also be abused in attempts to gain a competitive edge.
Of course, there also remains the question of whether eliminating international tax competition is entirely desirable. Some, especially free-market oriented economists, would argue that the competition drives the world toward a more optimal tax policy. Yet even if tax competition creates a more business-friendly world, the current regime inevitably creates deadweight loss through the cost of tax avoidance. Keen and Konrad write that to avoid one dollar of taxes, a corporation should be willing to expend up to 99 cents, because doing so would still increase their profits. Spending money to shift and hide profits for tax evasion can hardly be considered productive economic activity, especially when that money could either be spent to spur business growth or collected as tax revenues to benefit a country’s citizens.
In the past, tax policy has been considered a largely domestic concern, but today, changes in the tax code have global ramifications. While the world’s corporations grow their profits, governments are deprived of the very tax revenue that creates an environment suitable for business and improves the lives of their citizens. As multinational corporations continue to expand, the challenge posed by tax competition will only grow. There has yet to be a solution to the problem that the international community can agree on. Yet for the sake of economic growth and global welfare, governments must cooperate to find one.
