How to bring corporate tax systems into the 21st century

Existing corporate tax structures are enabling base erosion, lowering investment and stifling prosperity. If the G20 is serious about fiscal sustainability, its leaders must first agree on big reforms.

East Asia Forum

Attempting to address the ‘great corporate tax dodge’ is high on the G20 leaders’ agenda, having endorsed the OECD’s Action Plan on Base Erosion and Profit Shifting at its St Petersburg summit in September 2013.

Leaders were prompted by global public anger over multinational companies’ failure to pay their ‘fair share’, and their own concerns about weak tax collections. The real question is whether these issues can be resolved by simply patching up the current system or whether more fundamental reform is needed.

While governments have for decades tried to address aggressive corporate tax minimisation through cross-border mechanisms, the need to do so has become more pressing since the global financial and eurozone crises. These events and responses to them have resulted in a serious deterioration in the fiscal positions of most advanced economies. This has led governments in many countries to impose strict fiscal austerity measures, including searching for ‘elusive’ revenue.

Corporate tax has received particular attention because receipts have been slow to recover after the crisis. Cross-border minimisation might have something to do with this, but there are other reasons too. These include temporary factors -- such as the use of accumulated prior year losses and relatively small capital gains tax takes --and possibly structural changes affecting the ongoing profitability of the financial sector.

This is just the beginning of the fiscal challenges G20 economies will face over coming decades. The fiscal challenges of the crisis itself will be dwarfed by those of ageing populations, climate change and changing community expectations over public services such as education and health care.

Leaders therefore face the dual problems of needing to raise revenue and trying to stimulate investment and growth.

Times have changed since corporate tax arrangements were introduced in the early 1900s.

Globalisation has left tax authorities struggling to find a coherent approach about whom and what they should be taxing. Gone are the days of corporates residing in a single ‘home’ country. Today’s multinational enterprises can access finance from almost anywhere in the world and commonly make use of integrated global supply chains.

The rise of e-commerce and the service economy has also expanded the boundaries of what is tradable and made it easier for firms to establish themselves in locations different from their consumers.

While companies are embracing globalisation, our tax systems have evolved with insufficient coordination and little sense of direction. Countries competing for mobile investment have undermined their tax systems. Tax concessions such as preferential capital allowance arrangements, patent boxes and income exemptions have eroded the tax base in some countries. Others have lowered statutory tax rates to attract mobile capital.

Combined with uncoordinated tax treaty arrangements, these measures have contributed to undermining domestic and international tax frameworks, distorted resource allocation -- that has been their purpose after all -- and presented tax arbitrage opportunities for multinational companies.

Perhaps the best examples are the way companies can use their global footprint to shift value from their intellectual property to lower tax jurisdictions; use intra-company lending from subsidiaries in low tax jurisdictions to subsidiaries in high-tax ones; or use hybrid instruments that treat finance as debt in the country in which ‘interest’ is paid, and equity where it is received.

These legal activities, and others in the same vein, are at the centre of the BEPS problem.

Initial responses to the problem have been to name and shame offenders.

Google, Starbucks and Apple have all found themselves in the headlines. Criticisms that these companies were not living up to their ‘social contract’ or paying their ‘fair share’ have inflamed public concern. Perhaps such public shaming will induce companies to pay more tax voluntarily, at least temporarily, in order to avoid short-term reputational damage.

But naming and shaming does not address the underlying problems.

The OECD is attempting to do this with its BEPS Action Plan, which looks at the most aggressive forms of tax planning.

To date the main focus of the G20 and OECD has been on improving transparency and tax information sharing, and ‘better align[ing] rights to tax with economic activity’.

Measures to improve transparency and tax information sharing are welcome. To be effective, reporting needs to take place under a set of consistent standards, otherwise there is a risk the information will be manipulated by the provider and misinterpreted by the recipient. The costs of complying and of administration must also not be overly burdensome. In particular, attention has to be paid to the capacity of tax administrators in developing countries.

It is clear the main corporate tax challenge lies with the allocation of taxing rights, but what is less clear is whether this can be addressed within existing corporate tax structures.

The fundamental problem is determining where a multinational’s profitable economic activity actually takes place.

Even if these issues can be resolved and a global agreement can be reached, the question is whether such measures will address the main concerns of the G20 leaders: namely, ensuring corporations both pay their fair share and provide a sustainable revenue source.

Unfortunately, the answer is likely to be no.

First, what is a ‘fair share’ of corporate tax?

While companies may be required by law to pay tax, they cannot bear the tax burden. Instead, an increase in company tax will be borne by some combination of shareholders, other owners of capital, workers and consumers. Exactly how the tax is borne across these different groups will depend on a number of factors and will vary across countries. Whether the outcome is fair in any country, or among countries, is far from certain.

Second, the proposals are unlikely to provide a sustainable source of revenue. The BEPS Action Plan will not diminish the increasingly intense international competition for mobile capital. Pressure will remain for countries to cut their statutory corporate tax rates and to introduce additional targeted concessions. These pressures are likely to intensify over time.

This raises a bigger question. Can existing corporate tax systems survive in the long-term? Should they?

In addition to the BEPS issues, existing corporate tax systems are relatively inefficient, misallocating resources and lowering investment.

While these issues have been known for some time, they were a focus of the Mirrlees Review in the United Kingdom and the Australia’s Future Tax System Review. Both reviews suggested fundamental reform to existing corporate tax systems was needed, with movement towards rent based taxes identified as the most promising.

It is here, looking at the design and implementation issues of bringing corporate tax systems into the twenty-first century -- including how they would operate in a global context -- that the G20 and the OECD could provide valuable guidance and leadership.

But are we being too adventurous to ask why one would consider the corporate tax alone?

If G20 leaders are serious about improving the fiscal sustainability of their economies, as well as improving the prospects for economic growth, they should first agree on the need for fundamental reform of the overall tax and transfer system.

Originally published at East Asia Forum. Reproduced with permission.