As OECD and G-77 countries debate the status of the UN tax committee at the Financing For Development conference in Addis Ababa, the finger has once again been pointed at the UK and US.

This is from today’s Guardian:

The UK joined the US and several other wealthy countries at the UN financing for development conference in Addis Ababa in a manoeuvre to limit discussions on tax policy at the UN, arguing that the Organisation for Economic Cooperation and Development (OECD) was taking the lead on tax issues.

This is from the Guardian in 2008, at the time of the last FFD conference in Doha:

The Observer has established that the UK is lobbying to remove paragraph 10 from the draft Doha Outcome Document…Paragraph 10 focuses on fighting tax evasion. It aims to encourage global tax information-sharing and simplified tax laws. Most crucially, it wants to upgrade the UN’s tax-expert panel to intergovernmental status, elevating the importance of the issue of individual and corporate tax avoidance and evasion. The UK, together with the US, Canada and Australia, are opposed to the measure, according to sources in the UN.

These positions are hardly new. As the memo reproduced below shows, the UK was opposed to the creation of the original ad hoc group of experts, which became the current UN committee, way back in 1967. The UK view then was that this “technical matter” was better discussed in a “more homogenous group” (the OECD), rather than risking “confrontation” between capital-exporting and capital-importing countries.

The current OECD member state argument is mostly about the cost of a parallel bureaucracy at the UN (see, for example, this EU position statement [pdf]). While that was also present in 1967, it’s interesting that today the UK’s main concern, about confrontation at the UN, is no longer articulated by the UK.

Link to the memo on Slideshare.

The global tax body

It’s only a few days until the start of the Third UN Financing for Development summit in Addis Ababa. This is the key crunch point for discussions on if and how the international tax architecture might change to better accommodate developing countries in decision-making. Although the debate about strengthening the UN tax committee (UNTC) from its current impoverished and non- governmental status has been simmering for years, developing countries and NGOs seem to be throwing themselves into it this time round with more enthuisiasm than in the past. Yet the most recent draft of the Addis outcome document has only two modest commitments:

To this end, we will increase the frequency of its meetings to two sessions per year, with a duration of four working days each. We will increase the engagement of the Committee with the Economic and Social Council (ECOSOC) through the Special Meeting on International Cooperation on Tax Matters with a view to enhancing intergovernmental consideration of tax issues.

Over on his ever-insightful Uncounted blog, Alex Cobham points to three possible outcomes: the OECD retaining leadership, a shift towards the IMF, and the creation of the intergovernmental tax body that campaigners want. This builds on the analysis put together by Eurodad [pdf], summarised in a short post. What I intend to do here is to step back a little from the advocacy messages and think both concretely and theoretically about what that ‘stronger UN’ option really is.

What we have

To begin with, there are no binding global tax rules. There are standards and models, but they only have legal force when countries use them as the basis for national law or bilateral treaties. (Although in some instances international tax rules do arguably have a ‘soft law’ role, such as the way courts may refer to the model commentaries when interpreting treaties, or the way a Kenyan court upheld the OECD transfer pricing guidelines in the absence of national guidance [pdf]). But international norms do have two important strengths:

  1. A significant moral weight. It is easier to justify a new law that might otherwise scare investors, or a tax treaty negotiating position, if it complies with international norms.
  2. Technical sophistication. For a developing country with a small bureaucracy, taking an ‘off the shelf’ set of transfer pricing rules is much easier than developing your own.

In the area of information exchange, there is the Global Forum peer review process, which relies on the threat of counter-measures, and there is the Multilateral Convention on Mutual Assistance, which is binding, but far from universal.

Campaigners want to change this situation, I think, in two ways. First, they want non-binding standards that better suit the needs of developing countries. This might mean, for example, transfer pricing rules that are easier to enforce, model treaties that give greater scope for source taxation, or a country-by-country reporting standard that entitles all countries in which a multinational operates to the information. Second, they want to create or expand the category of binding global conventions that would force developed countries and tax havens to comply with developing countries’ preferences. This would include for example mandatory global automatic information exchange, mandatory public country-by-country reporting in the home country of a multinational company, and perhaps some kind of mandatory approach to CFC rules that shields developing countries from profit shifting. You can see these two themes in the Eurodad Q&A document:

The overall purpose of the intergovernmental UN tax body should be to ensure that countries do not erode each other’s tax bases, and that the international tax system is transparent, coherent and supports equality and development. In order to do this, the body would have to address a number of different issues, including base erosion and profit shifting, tax and investment treaties, tax incentives, progressive taxation, taxation of extractive industries, harmful tax practices, beneficial ownership transparency, public country by country reporting, automatic exchange of information for tax purposes and alternatives to the arm’s length principle. In order to ensure that the mandate of the tax body is broad enough to tackle all these issues – as well as new issues that might emerge – it’s important that the mandate is not too narrow and specific.

In the longer run, and with a view to ensuring implementation of the decisions of the tax body, we should have a legally binding UN Tax Convention. Developing such an agreement should therefore be one of the key tasks of the intergovernmental body

Why we have it

In international relations thinking, there are broadly three themes that different scholars use to analyse what international institutions are and what function they serve. They boil down to power, preferences and ideas.

Power

From this perspective, international institutions are merely tools through which dominant states exert their power. This would lead us to conclude that any realignment in the politics of international tax will (or will not) happen regardless of what goes on at the UN next week. An upgraded UN committee wouldn’t create change, rather it would simply reflect a shift in the underlying power dynamics. The annex to the UN transfer pricing manual, and the participation of developing countries in the BEPS project, already illustrate this. The way to get better outcomes for developing countries would be to bolster their capabilities, rather than to realign institutions, which would play no causative role in itself.

Preferences

A second way of looking at things is to put power to one side and think about collective action problems. In this view, states create institutions because they need some kind of coordination mechanism to help overcome the natural incentives that make cooperation difficult. Cooperation to deal with double taxation is described by game theorists as a coordination game (also known as a ‘battle of the sexes‘ or ‘Bach or Stravinsky’): everyone wants to reach an agreement, the difficulty is just finding a ‘focal point’ around which to converge. The model treaties are focal points that represent the widest possible agreement at international level, but leave the hard bargaining on non-consensual issues to the bilateral setting.

If this is the case, international tax institutions’ most important roles are entrepreneurship and signalling. They create focal points around equilibrium solutions from which everyone will benefit. Critics of the current regime argue that even when using the UN model treaty, the resulting treaties benefit capital exporters more than developing countries, who have to make most of the sacrifices of taxing rights. They want to see a more radical (or stripped down) UN model. But if the role of the UN model is to signal an equilibrium point, making it more radical might mean that it ceases to play this important role, because in fact it doesn’t represent a possible equilibrium between different groups of countries any more. This might come at the same time as the OECD instruments cease to play that role because developing countries are also beginning to deviate from them. The goal here would be to find a new equilibrium, from which developing countries benefit more, but on which everyone (or enough countries) can still agree.

Ideas

The third lens we can use begins from a fundamentally different point of view: that the international context can change the preferences of diplomats, and hence of countries themselves.

As Sol Picciotto states, in International Business Taxation [pdf]:

Perhaps the most important outcome of the inter-war years was to begin to create a community of international tax specialists…a community within which ideas and perspectives as well as economic advantage could be traded. It was these direct contacts between specialists which filled the gap created by the difficulties of resolving by any general principles the issues of international allocation of the tax base of international business.

If this ideational process among tax diplomats is an important part of the puzzle, what role does the UN committee play? Is it a forum through which delegates from developing countries develop their own shared agenda, or one in which they become complicit in an OECD country-led agenda? Consider two pieces of evidence from British civil service files. This first, from a Ministerial briefing note in 1976 on the stalemate in tax treaty negotiations with Brazil, illustrates that some British officials saw the UN as a tool to ‘educate’ developing countries:

Our view, which is shared by the Americans and the Dutch, has been that it is of little use to try to “educate” developing countries – at the United Nations Expert Group on tax treaties and elsewhere – about acceptable international fiscal standards if, when it comes to the crunch, we are prepared to sacrifice principle in order to secure an agreement.

Here, in contrast, is how Kenyan negotiators used the knowledge they gained from attending UN meetings to bolster their argument for a management fees clause in their 1973 treaty with the UK, even though such a clause is only being added to the UN model some 40 years later:

Mr Cropper [from Kenya] said that Kenya’s proposal was only intended to close a loophole and he did not see why there should be any objection to it. It was a point which had been raised by a number of countries in the UN Group of Experts…Mr Cropper said that there had been a big change in developing countries’ attitudes in the UN Group of Experts…Mr Ihiga [also from Kenya] said that modern thinking was that a withholding tax on management fees was justified.

If ideas are important, the UN should be seen as a community of experts working not just to find solutions that fit the power balance and national preferences of UN member countries, but rather to change international norms and national preferences, towards a more pro-development orientation.

What we might get

How could a restructured UN Tax Committee achieve that? ‘Upgrading’ advocates generally name three categories of reform. Let’s consider each in turn, in the light of the above discussion.

Intergovernmental status

While it would have some effect on the UNTC’s prestige, funding and composition, the major change that this would create would be to politicise the UN committee. It would mean that national members were more accountable to their home governments and to civil society. Like other issues such as trade and climate change, the shifting balance of power between developed and developing countries would probably increase the areas in which there was a stalemate. Politicisation would also allow campaigners in developed and developing countries alike to work at that national level to act as allies of radically positioned developing country officials, potentially increasing their negotiating capabilities, but crucially also changing preferences at national level.

A second impact would be that it would allow countries to send the most relevant person for a given discussion, and so the UN committee could expand its work onto a wider variety of issues. I don’t believe that it would deliver an international convention that would bind developed countries and tax havens into new rules any time soon, because the power relations are not yet aligned in that way, and because it’s hard to see a solution around which national preferences are aligned.

Changed composition

With more members from developing countries, we might expect that majority opinions that suit developing countries could be forced through the committee more easily. Or, more practically, developing countries might be able to make their case more forcefully in deliberations. But if the aim is to find an equilibrium point that will work in the real world, simply outnumbering developed countries to produce a more radical set of UN instruments without changing the preferences of developed countries will be of limited effect. This is why “tyranny of the majority” is currently a last resort when the committee takes decisions.

More funding

This would create a more autonomous secretariat that might be able to compensate for developing countries’ more limited technical capacity in UN discussions, doing some of the work to assuage objections from developed countries and so find more developing country-friendly focal points. It would also make the secretariat more visible, enhancing the prestige of UN instruments, just as senior OECD secretariat staff travel the world promoting its instruments. More funding for more frequent meetings might allow the committee to work faster, keeping up with changes at the OECD, but this would depend in part on developing countries’ capacity to participate.

In conclusion, the development case for a better-resourced, more transparent UN committee is compelling. But the committee’s impact will continue to depend on the uptake of its instruments by countries in national laws, bilateral treaties, and adherence to any new binding multilateral convention. For this reason, ideas and preferences in developed and developing countries will need to change, alongside developing countries becoming more capable actors in international negotiations. A more dynamic, politicised UN committee might help to create those things over time, but in the meantime I think it is just as much at the national level that campaigners need to focus their attention if they want to change international outcomes.

The more I think about it, the more I like the idea of policy drift as a way to explain what might at times seem like perverse outcomes in the international tax system. This post is an attempt to road test this idea.

Policy drift seems to originate with this 2004 article by Jacob Hacker [pdf], which was then magnified by the seminal book he co-authored, Winner Take All Politics. It starts from two powerful insights. First: it is much easier for interest groups to defend the status quo than it is for them to change it. Second: if a policy does not adapt in response to changes in the economic or social world, then its effects may change. Combined, these insights show the effects of a policy may change over time because it is too difficult to make the changes needed to adapt it to changing circumstances.

Hacker discusses how economic and social changes in the US from the 1970s onwards, such as the decline in privately provided healthcare, exposed people to new risks. Efforts to adapt government social policies, which had originally been designed to protect people from such risks, were defeated in the political process, so that they no longer achieved the outcomes for which they had been created. As Hacker puts it, “formal policies have been relatively stable but outcomes have not.”

Policy drift is said to happen when it is hard to make formal and informal changes to a policy. There are two other concepts in the same literature that are worth considering. Where it is hard to make formal changes to a policy, but easy to ‘convert’ it by reinterpreting it, there can be an internal adaptation of a policy. Where it is easier to make formal changes but harder to convert existing policies, the outcome may be ‘layering’, in which a new policy is implemented on top of an existing one.

Let’s consider three taxation examples.

Property taxation

It’s 1991, and the UK government introduces a new tax to fund local council services. It is based on house prices, valuing every property in the country and putting it within eight price bands. 24 years later, all properties are still placed in a band based on an estimate of what their value would have been in 1991. There are many arguments for and against this approach, but you can make the case that it achieved a form of horizontal and vertical equity when it was introduced, especially compare with what it replaced.

But over those 24 years, the value of properties has not changed equally in different areas. People living in London, for example, where prices have risen much faster than the UK average, do very well out of a system that is based on what their property was worth in 1991. Successive governments have recognised this, but feared the electoral consequences of a reform that would increase the council tax charges of a large number of people.

It seems that an internal conversion – revaluation of properties – is a harder thing to achieve than a formal layering – the introduction of a new tax on the most valuable properties, which was proposed by some parties at the election just gone. Absent both, the policy has drifted, from a broadly progressive tax on property towards one that is flat at the higher levels.

Tax treaties

It’s 1970, and the government of a recently independent developing country wants to attract foreign investors, who will bring with them much needed capital and technical expertise. It offers them generous tax incentives, but it finds that these incentives are frustrated by the foreign tax credit system of the investors’ home country: the investor pays less tax in the developing country, but this just means they pay more tax in their home country instead. So the two countries conclude a tax treaty. The treaty requires the developed country to grant ‘matching credits’ so that firms can keep the benefits of any tax incentives, but in return the developing country must lower its withholding tax rates on dividends remitted by investors from the treaty partner. These lower rates transfer the burden of double taxation relief away from the developed country, which would otherwise have paid for it through its foreign tax credit, onto the developing country. Maybe that was a fair deal, maybe it wasn’t.

Now it’s 2014, and most developed countries have moved from a foreign tax credit system to a dividend exemption. The tax sparing credits are no longer necessary, because the developed country doesn’t tax its outward investors’ foreign profits. Meanwhile the lower dividend withholding tax rates no longer shift the burden of double tax relief from the devloped to the developing country, since the developed country has foregone the revenue either way. So now the agreement serves a very different function: it makes it cheaper for the investor to repatriate profits from the developing country, an effect that is paid for by the developing country. It distorts the market for inward investment by treating investors from this one country differently, and it might have become a conduit through which investors from third countries divert their investments to obtain the more generous treaty.

Maybe these present day effects are good for the developing country, or maybe they aren’t. But the policy has drifted, because the treaty certainly has very different effects from those intended when it was signed; furthemore, the original bargain between the two countries is no longer relevant, and the distribution of the costs and benefits between the two partners may have changed dramatically. There could perhaps be an internal conversion, by chosing to interpet the treaty in certain ways, but this would be difficult; formal change is tricky too, because it requires cancellation or renegotiation of the treaty, which might scare investors, and because if one country loses out from the shift in costs and benefits, the other country generally has no incentive to renegotiate!

International tax rules

For much of the 20th century, government representatives and technical experts sat in rooms developing the component parts of the international tax system. Let’s simplify and say that the purpose of this exercise was to reach a situation in which multinational companies’ tax bases were distributed among the countries in which they operated according to the contribution their operations in each country made to their overall profits. The deal was reached at a time when, broadly speaking, you needed a physical presence in a country to do that. (The arguments made for a withholding tax on management fees in the 1970s tended to be about preventing tax avoidance, not fair distribution of taxing rights). So the concepts and tools developed in the past all require some kind of physical presence.

In the 21st century, it’s become apparent that a physical presence is no longer a prerequisite for significant value-added in a country. So the system does not achieve this original purpose. Instead, it gives an advantage to those countries that are home to the physical establishments of businesses that generate a lot of value in other countries without one. Arguably, the source/residence balance has shifted in favour of residence countries. Certainly, the policy has drifted.

The OECD’s desire not to open up the source/residence discussion during its BEPS process illustrates the difficulty in achieving any formal change in these existing policies. That China and India have been attempting to re-interpret the core concepts that they’ve already signed up to, including through changes in the commentary to the UN model treaty, suggests that there may be some internal conversion afoot.

In any event, I think these concepts of drift, conversion and layering – and especially drift – are quite helpful in understanding the path-dependent development of national and international tax systems. There are, of course, proposals to rebuild both from the ground up. But such proposals need to take into account the political constraints and the economic and social developments that have moulded the status quo.

The Folketinget (Danish parliament) chamber

The Folketinget (Danish parliament) chamber

At the risk of turning this into a travel blog, here I am in Denmark’s parliament building, the Borgen, a treat for aficionados of the TV programme. I spoke yesterday at a hearing organised by the parliament’s fiscal affairs committee on Denmark’s tax treaties with developing countries. The hearing was provoked by ActionAid Denmark’s questioning of the Denmark-Ghana tax treaty, which was ratified recently by the Danish parliament.

The British Public Accounts Committee this was not, and there was some good natured discussion between the different sides. Everyone agreed that businesses prefer there to be more tax treaties in place. The MPs, business and NGO representatives all agreed that there should be more transparency in the negotiation process.

We all agreed that having a treaty might improve the prospect of Danish investment into a developing country. Denmark’s tax minister and the industry representatives all said that a key consideration – perhaps the main consideration – for Danish treaty policy was to help make Danish companies competitive in the markets in which they invest. All of these arguments fell short, in my view, of establishing a clear cut, generalisable and evidence-based case that this is to the benefit of developing countries themselves.

Another point that I took from the discussion was the need to untangle the main things that tax treaties achieve, in a world where the most significant forms of double taxation are generally relieved unilaterally in the absence of an agreement:

  1. Clarifying definitions, providing dispute resolution, and other technical matters that make double taxation less likely.
  2. Giving tax authorities the legal basis for cooperation in enforcement matters.
  3. Offering businesses the reassurance of a credible commitment to fair and ‘civilised’ (not my word) tax treatment in the future.
  4. Reducing the taxing rights of the developing (ie source) country.

The case that treaties are necessary to provide items 1, 2 and perhaps 3 is strong. There is a (debatable) economic case for reducing source taxation to attract investment, made well by Clive Baxter from Maersk yesterday. But why respond to that case through bilateral treaties, which are harder to alter if the facts change, and which distort the inward investment market by treating investors from different countries differently? Why should the quid pro quo for items 1-3 be item 4? The fallacy, it seems to me, is to conflate the case for cooperation through treaties with the case for lower source taxation.

Here is my presentation. I’ll update this post when the others are all online, but they will only be of use to Danish speakers!

Last week’s Global Tax Policy Conference at Maastricht University on “international spillovers in taxation” has got me thinking. In particular, I was fascinated by Belema Obuoforibo’s presentation on the IBFD’s methodology for ‘spillover analyses’ (here is a link to an IBFD Powerpoint describing it). The term ‘spillover’ comes from the IMF, a term they use in economic analysis more generally to refer to “the impact of policy actions in one country on others” and around which the IMF framed a whole policy paper. Since its mention in the famous international organisations’ report to the G-20 [pdf], spillover analysis has become a common civil society demand, and the Netherlands and Ireland have gone on to commission them, with a focus on the interplay between their tax treaties with developing countries and certain provisions of their domestic tax law.

But a ‘spillover analysis’ is not the same as an ‘impact assessment’, and I think it’s important to understand the distinction.

The IMF’s recent paper on spillovers in international taxation distinguishes between ‘base’ spillovers, in which an action by one country affects another country without that country doing anything in response, and ‘strategic’ spillovers, in which the change creates an incentive for the second country to change its own policies – tax competition being the obvious example. All very interesting, but I sometimes find it tricky to see how the IMF’s definition applies to the specific areas discussed later on the same report.

One reason for this is that a ‘spillover’ effect from one country on another implies that the affected country is a passive victim. This is not the only way in which one country’s tax system might affect another’s. The decision by a developing country to sign a treaty, or to adopt an international norm, makes it an active participant, but that doesn’t diminish the impact on it of doing so.

A second issue is that ‘spillover analysis’ in practice has tended to focus on how one individual country’s tax system might be different to the norm. Following the Dutch spillover analysis, the government noted that Dutch treaties with developing countries were generally on the same terms as those countries had secured with comparable treaty partners. The IBFD’s methodology is based on how aspects of one country’s tax system compare with similar countries. So the growing practice of spillover analysis, it seems, considers impacts relative to the international average, not absolute impacts. It is a way of finding out if a country is worse or better than average, rather than seeking out all positive or negative impacts.

Let’s consider some examples from the area of tax treaties, to illustrate how these limitations play out in practice:

1. Is it a ‘spillover’ if the affected country actively opened itself up to the vulnerability?

Ireland didn’t used to be a tax haven. It used to be a ‘high tax’ jurisdiction like most OECD countries. Its transformation into a hub used for base erosion and profit shifting is relatively recent, and many of its tax treaties predate this. The changes to Ireland’s tax system transformed its tax treaty network into a major headache for countries such as Zambia, and it seems quite right to describe these effects as spillovers: treaty partners could not have anticipated them when agreeing terms in their tax treaties.

The same could probably be said of the Mauritius-India treaty, which originally predates Mauritius’ generous offshore regime. But it couldn’t be said of Mauritius’ treaties with many African countries, which they signed up to at a time when the risk of treaty shopping through Mauritius would have been clear. This is not a ‘spillover’ of Mauritius’ tax system, because it was a conscious choice taken by the developing countries. But it would be a shame if any analysis of the impact of Mauritius’ treaty network didn’t consider these costs.

2. Is precedent in tax treaty negotiations a strategic spillover?

When Zambia signed a treaty with China containing much lower withholding rates than it had previously agreed to, it may not have anticipated the British reaction, which was to request a renegotiated treaty on similar terms. Zambia also wanted to renegotiate with the UK, mainly to seek improved powers for cooperation and information exchange with the British tax authorities. The implication of the Chinese treaty, however, was that the UK expected similar terms in return for Zambia’s demands, significantly lowering the Zambian tax take from British investors. It seems to me that this was a ‘spillover’ effect of China’s aggressive negotiating position…but I suspect it would be unlikely to be picked up in any ‘spillover analysis’.

3. Are most-favoured-nation effects spillovers?

In April 2003, Venezuela and Spain signed a treaty with a most favoured-nation (MFN) clause in its interest article, which would be triggered if either country subsequently signed a treaty with a lower maximum rate in the interest article. In May 2006, the bilateral MFN clause in its interest article was triggered through a kind of domino effect: Estonia and the Netherlands signed a treaty granting exclusive residence taxation rights over interest; this activated the MFN clause in the September 2003 Spain-Estonia treaty, which in turn activated the MFN clause in the Venezuela-Spain treaty. As a result, according to an article in Tax Notes International, “Venezuela’s treaty with Spain has undoubtedly become the most favorable tax treaty executed by Venezuela to date.”

This was a policy action by two countries that had ramifications for two other countries, but which they should have anticipated when they agreed to the clause. The inclusion of a symmetrical clause, which could be activated by Spain as well as Venezuela, may have been a negotiating error by the latter. But was the MFN activation a spillover?

4. Is it a spillover if a country is just an aggressive negotiator?

The countries that have tended to do spillover analysis so far are those facing accusations that they’re used for treaty shopping. And the main policy response, at least from the Netherlands, seems to have focused on adding anti-abuse provisions into its treaties. What if there is no treaty shopping, but instead just a set of treaties that take most of the taxing rights away from developing countries? As I noted in point 1, the developing countries actively signed up to these treaties at some point in their histories. The IMF spillover paper sounds a cautious note about tax treaties because of the fiscal costs to developing countries of limiting their source taxing rights, but it’s not clear (to me at least) how the plain vanilla impact of the source/residence split could meet the definition of a spillover.

5. Is it a spillover if it’s no different to the norm?

Consider many developed countries’ unwillingness to share the right to tax their shipping firms with the developing countries whose waters they use, and who are in some cases very keen to tax the profits from shipping. Developed countries have been relatively united on this, so even if we accepted that the case described in point 4 above was a ‘spillover’ effect, I think the implication of the IBFD’s methodology would be to find no negative spillover from the hardline stance taken by, say, the UK. But just because this ‘policy action’ is consistent with comparable treaties and with the model conventions, does that mean countries should not assess the impact on developing countries of the policy stance?

In conclusion, it seems to me there is a risk that the focus on the concept of ‘spillover effects’ might lead to an overly narrow analysis of the impacts of a jurisdiction’s tax policy actions on developing countries. Or, to put it another way, could the choice of terms used to discuss this issue have linguistic spillover effects?

Update: Joe Stead points out that I have slightly undersold the 2011 International Organisations’ report to the G-20:

The [corporate tax] system allows countries to compete with one another in a manner that destabilises the system itself. Countries compete to attract economic activity and to favour ‘domestic’ companies…Such a goal is not easily reconciled with another goal often explicitly held by governments: ensuring that companies should pay to some country or countries a fair amount of tax on their global profits.

– Michael Devereux and John Vella

The effective tax rates on multinational corporations are being pushed steadily downwards, allowing multinationals increasingly to free-ride on the public services that everyone else pays for.

– Tax Justice Network

My term’s teaching is over, which means a return to blogging. Conveniently, several new – and related – papers popped into my inbox this week. There’s “Ten Reasons to Defend the Corporate Income Tax” from the Tax Justice Network, and two from the Oxford University Centre for Business Taxation, “Business Taxation under the Coalition Government” [pdf] and “Are we heading towards a corporate tax system fit for the 21st century?” No love lost between these two organisations, so it’s interesting to see how much common ground they share.

TJN’s paper, written by Nick Shaxson, is typically polemical, smartly designed and peppered with quotes from authoritative sources in support of its case, which is of course that corporation tax is good, and under threat. Shaxson marshals an impressive battery of sources in support of his argument, although the polemical tone, natural from a campaigning organisation, often left me suspecting that the other side of the argument had not been done justice. For example, a lengthy footnote convinced me that “numerous independent bodies have concluded after exhaustive studies that the burden [of corporation tax] largely falls on the owners of capital — that is, predominantly wealthy people”, with a split between capital and labour of something like 75/25. The claim is that numerous, not all, studies find this, and numerous papers are indeed cited, but I still wish that the studies finding a different result had been included, too, even if only to debunk them.

This point came up at the launch event for “Business Taxation under the Coalition Government”, a collective publication of the OUCBT. Chris Wales from PWC, who was a special adviser to Gordon Brown and now advises Labour on corporation tax, was there to suggest what Labour might do in government. When the Treasury minister David Gauke asserted that the incidence of corporation tax falls predominantly on (small-L) labour, Wales retorted that the cut in UK corporation tax rates over the past five years does not appear to have been passed on to workers, given the stagnation in wages over the same period.

Tax cuts in the UK

“The UK’s tax-cutting corporate model since 2010 is a terrible model for anyone to copy – for all the evidence so far suggests that the experiment has been a disaster,” says TJN, citing Reuters research suggesting the creation of just 50 jobs. Because TJN’s argument is about growth, it doesn’t rely on the absence of a link between taxation and investment, and indeed Shaxson is happy to concede the existence of such evidence. His case is as follows:

Many of these studies focus on gross benefits stemming from a tax cut (i.e. they measure investment levels), without also considering all the tax and other costs as outlined in the rest of this document: lost revenue, damage to other parts of the tax system, steeper inequality, greater rent-seeking and externalities, and so on. From the perspective of those designing national tax policies – which is the perspective that matters most – it’s the benefits net of these costs that matter.

The OUCBT report agrees with TJN that it’s near impossible to isolate the effect of the UK reforms on investment, and seems to accept TJN’s point in a footnote to its discussion on the effects of different tax rate measures:

Such measures help in comparing the UK to other countries, but only relative to the costs associated to the corporate tax system: they tell us whether the UK corporate tax burden is low enough to attract and foster investment in competition with other countries, ceteris paribus. They are not suitable to derive conclusions on the broader welfare implications of tax policy measures or on the broader economic performance of the UK.

Earlier on, the report finds an annual tax cost for the next financial year of £7.5 billion, noting that “[b]y any standards, these represent large costs, which must be met either by other taxes raising more revenue, lower spending or a higher deficit. This represents a clear trade-off with the gains in competitiveness.”

Setting that to one side for a minute, the OUCBT discussion of the effects of different tax rate measures on investment was new to me and certainly interesting. The authors distinguish between three different tax rates:

  • the headline rate, which they say is what incentivises profit-shifting;
  • the effective average tax rate (EATR), which they say affects the number of investments (the extensive margin); and
  • the effective marginal tax rate (EMTR), which they say affects the size of investments (the intensive margin).

The UK is now very competitive in terms of the EATR, but not so much the EMTR. This should have a positive effect on investment into the UK, because,

There is strong empirical evidence that differences in the EATR across countries affect the location of investment projects. The EATR is relevant in a context where a firm needs to decide among a set of mutually exclusive projects. This is the typical decision faced by a multinational choosing to locate investment in one of the OECD countries.

In contrast, the higher EMTR might discourage investment from capital-intensive sectors:

The UK tax component of the user cost of capital (EMTR) has historically been higher than the OECD average and this has not changed under the Coalition. For large companies, the UK capital allowances regime remains one of the least generous in the OECD. This affects firms’ cost of capital negatively, especially for businesses with substantial investment in physical assets such as plant and machinery and buildings.

According to the report, the UK has actually tightened its capital allowance regime for large companies during the past five years. So pointing to headline rates alone is not enough to demonstrate the death of corporation tax. The tax base needs to be considered, and in the UK case changes here seem to have slightly mitigated the impact of the falling rate.

Effective Average tax RatesEffective Marginal Tax Rates

The nature of competition

“Tax ‘competition’ has nothing to do with competition but has more in common with currency wars or trade wars,” says TJN. “We prefer the term ‘tax wars,’ which is more economically literate and more accurately reflects the harm that the process causes.” The OUCBT is a common target for this vein of criticism from TJN (see for example this blog by Nick Shaxson on its origins), and its Business Tax report is certainly laced with the term ‘competitiveness’. But the new paper “Are we heading towards a corporate tax system fit for the 21st century?” by the Centre’s Michael Devereux and John Vella is actually much closer to TJN’s position than one might expect.

The paper examines the OECD’s BEPS process in the light of two criticisms of the current system. First, it argues that the “arbitrary compromise for the allocation of profit between countries first agreed in the 1920s is wholly inappropriate for taxing modern multinational companies.” That discussion is for another day. Its second argument, the relevant one for our discussion here, is that the international tax system is undermined by tax competition, and BEPS will only succeed if it “contain[s] the power of existing competitive forces”:

Recognising the power of this competition is key to creating a stable long-run system for taxing the profits of multinational companies. Even if existing governments were to reach an agreement to preserve the basics of the existing system, while tightening anti-avoidance rules, there will still be an incentive for future governments to undermine that system, as their predecessors have done in the past. A stable system must remove the incentives for governments to undercut each other.

Importantly, Devereux and Vella argue that tax competition is not merely about attracting foreign companies to invest into a country. It is also about giving domestic companies a competitive advantage over their foreign competitors. Both the UK’s Finance Company Partial Exemption and the US ‘Check the Box’ rules are seen in this light, as instruments that confer a competitive advantage on firms headquartered in those countries at a potential cost to the countries in which they invest. The paper even goes as far as to question the “underlying rationale for providing a competitive advantage to domestic multinationals,” since if the beneficiaries are shareholders, many or indeed most of them may be foreign citizens.

A final thought

I’ve compared here three papers, two from academics, who have academic freedom but are nonetheless funded by multinational firms, and one from campaigners who consider the behaviour of those same firms (and to some extent those same academics) to be a threat to democracy and prosperity. They all agree that corporate tax competition is a problem that should be tackled. But they all stand outside the system looking in.

What about those engaged in tax competition? At the OUCBT event to mark the launch of its Business Tax report, Michael Devereux tried and failed to identify some “clear blue water” between the British Conservative and Labour parties. The only difference – at a time when the Labour party is seeking to differentiate itself from the Conservatives as the champion of responsible capitalism and fair taxation – appeared to be a single percentage point on the corporation tax rate. No mainstream political actor in the UK is proposing to move away from the structural changes made to the UK tax system, some of which are characterised by Devereux and Vella as “state-approved base erosion.”

This week I am trying to help the undergraduate students that I teach to understand a range of scholarship that uses social constructivism to study the political economy. When you go back to first principles to teach something you often see some of your own work in a new light, and that is what I am going to write about today. I’m briefly going to sketch out some social constructivist thoughts about multinational firms’ tax behaviour.

For a side project I’ve been reading some of the academic literature on tax compliance. There’s a great summary of the different theoretical perspectives on tax compliance in this working paper by Odd-Helge Fjeldstad and colleagues. The authors divide them into five:

  1. Economic deterrance. This is the classic rational choice framework, in which taxpayers weigh up the incentives, essentially the tax rate versus the penalty and the probability of being caught.
  2. Fiscal exchange. This is where the notion of ‘quasi-voluntary compliance’ comes in. If taxpayers think they will receive something in return – public services, in other words – they are more likely to pay. Although the evidence for this, according to the ICTD paper, is weak.
  3. Social influences. The final three positions, which I am going to appropriate into the social constructivist field, have stronger evidence to support them than fiscal exchange. The first is that tax compliance relates to perceived social norms: if they think their neighbours are honest, people are more likely to be honest themselves.
  4. Comparative treatment. From this perspective, people are more likely to comply with tax rules if they think the system treats them fairly relative to their compatriots.
  5. Political legitimacy. The final constructivist view is that if people trust the government and the tax authority, they are more likely to comply.

There are loads of empirical studies looking into the determinants of tax compliance behaviour among individuals and small businesses. It’s fascinating, but I think I found a big gap: I didn’t find a single study explaining the attitude to compliance among large businesses (or, to clarify, I found studies about staff compliance with management decisions, but not about compliance with externally-derived rules and regulations).

What do I mean by compliance? Trying to define this could easily veer into a discussion about tax morality, but that’s not where I want to go. We know that multinational businesses have a degree of choice over how aggressive their tax position is, and I want to ask, empirically, “what determines this?” Most of the existing work examining multinational firms’ decisions about their tax affairs tends, I think, to be situated in the rational choice, economic deterrance framework. According to that view, the first theoretical position listed above just needs to be adjusted to reflect the additional risks faced by businesses, in particular the reputation risk attached to aggressive tax planning (here is a paper that tries to do this empirically). Current discourse suggests that this risk is increasing, and businesses are revising their positions in response.

John Maynard Keynes

It all starts with Keynes…

This is where my undergraduate class comes in. We could argue that large business decision-making is more likely to be rational than that by small companies and individuals, because a successful large organisation has to create systems that obtain the right information and use it effectively. But a growing trend of political economy work, especially since the financial crisis, has focused very much on the fact that behaviour in financial markets (often by actors who are part of very large companies) can’t be explained solely through rational choices. My students are reading Andre Broome’s excellent introduction to constructivist international political economy, which refers to work in this vein on capital account liberalisation, european monetary union, and behaviour within financial markets.

Economic constructivist thought is often traced back to John Maynard Keynes’ analysis of how actors in financial markets deal with their inherent uncertainty. According to another useful book chapter by Rawi Abdelal and colleagues [pdf]:

Keynes lists “three techniques” economic agents have devised for dealing with this situation, all of which are inherently constructivist. First, “we assume that the present is a much more serviceable guide to the future than a candid examination of the past would show it to have been hitherto.” Second, “we assume that the existing state of opinion … is based on a correct summing up of future prospects.” Third, “knowing that our own judgment is worthless, we endeavor to fall back on the judgment of the rest of the world … that is, we endeavor to conform with the behavior of the majority or average…to copy the others … [to follow] … a conventional judgment.” In short, Keynes’ macro-economy rests upon conventions, that is, shared ideas about how the economy should work.

As the works cited by Broome show, this insight has been applied beyond financial markets to many other processes involving decision-makers and market actors. So why not multinational taxation? If we decide to do so, we can come back round to the theoretical perspectives I set out at the start. Perhaps the calculation about how much uncertainty to build into a company’s tax position is subject to the kinds of conventions identified by Keynes. And perhaps, beyond just uncertainty, the social conventions that influence business decision-making about taxation incorporate perceptions of social norms among decision-makers’ peers, as well as notions of comparative treatment and political legitimacy.

Here is one example, a quote from a survey of corporate tax directors [pdf] conducted by Judith Freedman and colleagues back in 2007 (and which it would be interesting to repeat now). There are remarks here that might support the fiscal exchange, social influence and political legitimacy theories:

One respondent said that his firm’s CSR policy does not extend to paying more tax than is due under the law; they are not interested in ‘making donations to Government’. Others echoed this view, arguing that they could spend their tax savings more wisely than the Government could. At least two firms suggested that there would be a greater social aspect to taxpaying if the amounts collected were earmarked for particular public services, rather than going into general revenue.

Social constructivists devote a lot of time to identifying and analysing the different groups among which social conventions form. There will be overlapping communities within and across companies, including for example the Davos elite, the tax function, social classes, nationality, and so on. I’ve written previously about a paper that touches on transfer pricing practitioners as a social group.

Corporate decisionmakers will have different information depending on their membership of different communities, but they may also be influenced by different social norms within their communities. This morning, for example, Chris Lenon suggests that corporate tax advisers are frustrated by what they see as a lack of rationality on the part of their boards, reporting “a gap between [tax advisers’] perception of the direction of travel in this debate and the denial of this at Board level because of the impact on earnings.”

I understand the normative case against using social norms to make up for deficiencies in the law, as well as the populist argument to the contrary. But I wonder if that debate might be seen in a different light if we begin from a constructivist ontology, in which, like it or not, social norms of one kind or another have always conditioned corporate tax behaviour.