Tax competition: Tax Justice Network and the Oxford University Centre for Business Taxation agree!

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.”

Taxing the digital economy is (going to be) an African issue

This is the second of three posts in which I’m reflecting on the recent report on BEPS and developing countries [pdf] during a short stay in Africa. Today, I’m looking at the digital economy. This visit to Africa has been the first time I’ve really grasped the scale of what mobile internet is doing to Africa. It’s huge. Half of all urban-dwelling Africans have smartphones, and mobile internet use is growing at twice the rate of the rest of the world. Nairobi, Kampala and Lusaka have all been festooned with adverts promising “world class internet”.

Buying a SIM card in Kampala, I commiserated with the vendor about the recent discontinuation of Skype on our outdated Windows Phone devices. Later, I debated the merits of Facebook and Whatsapp with the boy serving breakfast at my guest house. At a music festival I found the best implementation of a Twitter wall that I’ve seen.

Here in Lusaka, I had a long chat with the manager of a hostel about Zambians’ penchant for second hand Japanese cars, only to log on to the internet and find every website plastered with adverts for exactly that. And when you ask for directions, people just say “don’t you have Google maps?”

So I thought it quite odd that the BEPS and developing countries report – unlike the BEPS project itself – pretty much skips over the digital economy. McKinsey think that by 2025 the internet could be the same or even a bigger share of African GDP than it is in the UK – as much as ten percent. It’s precisely because Africa lags behind in everything from telephone lines to bank accounts to textbooks that this might happen: the internet, and particularly the internet on mobile devices, offers the chance to leapfrog that capital-hungry stage.

There are two sides to the digital challenge when it comes to taxation, as the BEPS digital economy report [pdf] outlines. The first is the challenges it creates for getting our current international tax rules to deliver the intended outcome, which is broadly that multinational companies pay tax on their profits where they generate them through a physical presence.

Leaving aside the stratospheric “double Irish” schemes and their like, the report discusses some nuts and bolts areas where companies have gone right to the edge of the definition of a taxable permanent establishment (PE), without crossing it. For example, OECD (but not UN) model treaties exempt a delivery unit from the definition of a PE, which is how Amazon avoided a tax liability in the UK despite its huge warehouses. Zambia is not well prepared for similar developments, as most of its treaties follow the OECD provision on this, not the UN one.

But it’s the second side of the issue that I think is big for Africa. This is the growing irrelevance of physical presence to modern business models. The OECD report talks about problems with ‘nexus’: how digital companies can make a lot of money in a country over the internet without needing any physical presence at all. It moots the idea of supplementing the physically-rooted PE concept with a new concept of “significant digital presence”, levying a withholding tax on digital transactions, or even abandoning PE altogether,

It also talks about the value attached to data: how digital companies can generate significant value in a country from user data without any money changing hands. There’s no mention of the French Colin/Collin report [pdf], which I thought was fascinating on this. Digital companies like Facebook and, I guess, WordPress, have millions of users creating value (and hence, profits) for them for free, so how does that affect a tax system that tries to allocate taxing rights based on where a company’s value is created?

It’s not just the likely size of the digital economy in Africa that makes this an important issue for the future here. It’s also the fact that digital’s exponential growth here is happening precisely because there isn’t the infrastructure to support physical presence. People will be increasingly downloading textbooks instead of buying them, Whatsapping instead of telephoning, faxing or writing, and using Facebook instead of sending out mailshots, Digital will render irrelevant some of the growth of the physical, taxable economy that already exists in more developed regions. (The exception, of course, is the mobile phone companies…but that’s for another day).

I imagine that the more radical ideas mooted in the OECD paper to deal with the challenges of nexus and data will face stiff opposition from certain countries that are big exporters of digital services. After all, this is not strictly speaking base erosion or profit shifting, because it’s about changing what the rules are intended to do, rather than making sure that they work.

Ordinarily, in this kind of situation I would suggest that developing countries band together to implement a home-grown, tailor-made solution to this problem, and add it to their domestic laws and the COMESA/EAC/SADC model treaties. But they are going to need help. The reason is that if companies are making money from their citizens without any physical presence, they don’t have any cash in the country to take the tax from. To collect tax revenue from digital companies, African governments will need the assistance of tax authorities in the home countries of those companies, which will in turn mean a treaty (either bilateral or multilateral) that supports this.

I’ve realised in my interviews here that developing countries are running just to keep up with the changes to model tax treaties. All their energy is taken up trying to understand, obtain and implement the newer treaty provisions, transfer pricing rules, and information exchange standards. What they aren’t doing so much is evaluating them. So I’d suggest that countries such as Zambia stop, take a breath, and think about what they are likely to want to tax in ten or twenty years’ time. Then they’ll be ready to throw themselves into building a future-proofed set of international tax rules that works for them.

Satellites in geostationary orbit: a new tax justice issue?

Side view of Geostationary 3D of 2 satellites ...

Side view of Geostationary 3D of 2 satellites of Earth (Photo credit: Wikipedia)

When I made an amused reference to item on satellites in the new UN tax committee’s agenda, I wasn’t really sure what it was about. Richard Murphy thought it might be a plan to create tax havens in space. But, now that the UN secretariat have released some preliminary documents for the committee meeting next month, I think it may be a very good example of the differing interests of developed and developing countries in international tax.

In the most recent update of the OECD’s model tax treaty, there’s a discussion about whether a satellite in geostationary orbit (that is, always above the same point on the earth’s surface) could be a permanent establishment (taxable entity) in the country over which it orbits, or to which it transmits signals. Here is the full quote from the OECD model treaty as given in the UN document [pdf]:

5.5 Clearly, a permanent establishment may only be considered to be situated in a Contracting State if the relevant place of business is situated in the territory of that State. The question of whether a satellite in geostationary orbit could constitute a permanent establishment for the satellite operator relates in part to how far the territory of a State extends into space. No member country would agree that the location of these satellites can be part of the territory of a Contracting State under the applicable rules of international law and could therefore be considered to be a permanent establishment situated therein. Also, the particular area over which a satellite’s signals may be received (the satellite’s “footprint”) cannot be considered to be at the disposal of the operator of the satellite so as to make that area a place of business of the satellite’s operator

The OECD position is unanimous and, so it suggests, inevitable based on other aspects of international law. But consider this: most of the world’s commercial satellites are owned by companies resident in OECD countries. Many (perhaps all) developing countries have satellites permanently orbiting over them and broadcasting signals onto their territory, while down at ground level they have no companies making profits from this industry. Under the OECD position, there is no possibility of developing countries raising corporate income tax from this sector.

There may be a philosophical discussion that is much broader than tax, as the OECD commentary suggests, about ‘how far the territory of a State extends into space’. But I imagine that the consequence of the point about the satellite’s ‘footprint’ is that a state has no right to treat a satellite as a taxable entity if it is, say, broadcasting commercial TV to its residents, or providing GPS positioning to people on its territory.

If my assumptions are correct, that makes for quite an interesting discussion. A quick hunt around online suggests, for example, that the fixed position of a satellite in geostationary orbit means that it is not considered as movable property as far as US state tax is concerned – which might imply that it is a fixed place of business for international tax purposes. What would be the positions of the BRICS, some of which have their own burgeoning space sectors? Already, an OECD consultation document [pdf] implies that there were disagreements on this issue among its members.

I would guess that smaller developing countries have not considered this matter at all. In any event, I will certainly look forward to the discussion in October!

BEPS Part 2: international politics and developing countries

sluto | beps

This graffiti is definitely about Base Erosion and Profit Shifting (Photo credit: feck_aRt_post)

I wrote earlier this week with some questions about UK tax policy and the OECD’s Action Plan on Base Erosion and Profit Shifting. A lot of the areas that it’s looking at are probably not going to affect smaller developing countries very much, but there are a few things worth highlighting. I also recommend Chris Lenon’s comments on the action plan, to which I’ll refer below.

Beyond the arm’s length principle

I thought it very interesting that the action plan concedes that some of the current problem with tax planning derives from the transfer pricing rules themselves:

multinationals have been able to use and/or misapply those rules to separate income from the economic activities that produce that income and to shift it into low-tax environments.

But the more significant rhetorical shift from the OECD is that it now appears to believe that solutions within the arm’s length principle (ALP) may not be enough. The ALP’s self-sufficiency has seemed to me to be an article of faith for the OECD secretariat every since I began working on tax. The action plan says:

special measures, either within or beyond the arm’s length principle, may be required with respect to intangible assets, risk and over-capitalisation to address these flaws.

Some academics are fond of arguing that the OECD abandoned the ALP in all bit name some time ago. So I wonder whether this is really a substantive change or just a rhetorical shift designed to underline that BEPS is a ‘radical rethink’.

Chris thinks that “[t]his is a clear indication that apportionment may be considered as the way to deal with high value intangibles.” It does seem to imply that the OECD may come more into line with the Chinese approach.

Tax reporting

Noting that “timely, comprehensive and relevant information on tax planning strategies is often unavailable to tax administrations”, the action plan proposes to:

Develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business. The rules to be developed will include a requirement that MNE’s provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template.

Chris thinks that this is “very significant”, and that “business needs to develop a strategic response to the issue of transparency”. I think that it is worth considering in the context of the report to the OECD task force on tax and development last year [pdf], which outlined the information challenges faced by developing country tax authorities. The main value of a global report as proposed would be to give tax authority in country A some readily available information on a multinational’s operations in country B, if neither country is the head office. At the moment this is difficult to obtain, because the subsidiary in country A can’t be required to provide information on a sister company in country B, despite them being under common control. Tackling this problem through global documentation seems sensible.

A multilateral treaty and mandatory arbitration

I said when the original BEPS report came out that a multilateral treaty designed to update current treaties in one fell swoop has potential dangers for developing countries. They’re mostly excluded form the BEPS process, but a multilateral treaty could gain such momentum that it becomes obligatory for them to sign up, despite the difference of interests acknowledged by the existence of separate UN and OECD model bilateral treaties. The new UN tax committee‘s response to any multilateral treaty will surely be very significant.

As an example, the Action Plan implies that one area for change is in the area of mutual agreement procedures (MAPs) and arbitration:

Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under MAP, including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.

Alison Christians has written about her concerns about this in the past. Experience with investment treaties shows that developing countries should be wary of mandatory arbitration, yet they may find themselves with little choice if this makes it into a multilateral treaty.

G20 versus OECD

The new model of G20-OECD cooperation is intriguing. The Action Plan explains it as follows:

interested G20 countries that are not members of the OECD will be invited to be part of the project as Associates, i.e. on an equal footing with OECD members (including at the level of the subsidiary bodies involved in the work on BEPS), and will be expected to associate themselves with the outcome of the BEPS Project.

The equal footing part is new and unusual, but that last clause means that countries who have got used to stating their difference of opinion with the OECD will presumably want to think carefully. I will be very interested to see which of the non-OECD G20 members take up this invitation.

Britain’s fracking tax incentives: do they pass the test?

It’s funny, if you’ve only ever thought about an issue in terms of other places, when it suddenly it pops up in you back yard. Gives you a different perspective. So the announcement today that the Britain is going to create the “world’s most generous shale tax regime” [£] to encourage ‘fracking’ is a chance to think about all the pontificating I’ve done about tax incentives.

As far as I can tell, we don’t yet know the details of what is being proposed, only the headline. If there’s more today I’ll update this post. But the key message is a slashing of the corporation tax rate from 62% to 30%, and compensation for local communities hosting a well of £100,000 plus 1% of revenues.

Below I have posted two sets of recommendations on tax incentives, one from the OECD, and one from ActionAid’s new campaign. Looking through them, it seems most are unlikely to create any trouble, since these are statutory incentives that will be passed through legislation. But two thoughts emerge initially.

First, will there be a published, transparent analysis of the revenue expected to be foregone, and predicted benefits? This is usually done in the UK through a “tax information and impact note” attached to proposed legislation, but I wonder how detailed it will be, and whether there will be any way to test the assumptions about how much investment the incentives will bring in. Peter Lilley, a conservative MP with an industry background, said yesterday, “I think tax breaks are unnecessary for fracking, based on my knowledge of the oil and gas industry.”

Second, from the “most competitive in the world” headline, it seems these British incentives are not simply designed to tip the investment past the point at which it has a viable net present value, but quite explicitly to entice investment away from other countries. So it’s tax competition. Why isn’t there a statement that incentives should only be designed to make investments viable, as opposed to making already-viable investments more attractive than those in other countries? Is that too vague?

Furthermore, the recommendations generally talk about regional agreements to limit tax competition, but in this case that doesn’t seem relevant: I think it’s less about regional partners/competitors and more about other countries with shale gas potential. Maybe the recommendations should extend beyond regional proximity to cooperation between countries with similar resource endowments

Here are the ActionAid recommendations:

  • Eliminate all tax holidays.
  • Publicly review all tax incentives, assessing tax expenditure (the amount of tax foregone from incentives), ensuring incentives are well targeted and commensurate with the benefits expected to citizens.
  • Ensure that all phases of new incentives require parliamentary approval, and also that any new incentive offered is grounded in legislation which makes it available to all qualifying investors, foreign or domestic. This would effectively mean an end to discretionary tax incentives.
  • Publish a costing and justification for each incentive offered, followed by monitoring of conditions and a tally of costs and benefits, so the public can see the impact of tax incentives.
  • Grant the Finance Ministry (not solely the Investment Promotion Authority) powers over tax incentive decisions.
  • Refrain from entering into stability clauses (which lock in tax incentives long term) when negotiating new tax incentives and investment agreements.
  • Ensure that tax incentives are audited to check that the investment for which an incentive is offered has actually been carried out.
  • Co-ordinate statutory tax incentives with groups of neighbouring countries, in order to counter tax competition.

Here are the OECD principles [pdf]:

  1. Make public a statement of all tax incentives for investment and their objectives within a governing framework.
  2. Provide tax incentives for investment through tax laws only.
  3. Consolidate all tax incentives for investment under the authority of one government body, where possible.
  4. Ensure tax incentives for investment are ratified through the law making body or parliament.
  5. Administer tax incentives for investment in a transparent manner.
  6. Calculate the amount of revenue forgone attributable to tax incentives for investment and publicly release a statement of tax expenditures.
  7. Carry out periodic review of the continuance of existing tax incentives by assessing the extent to which they meet the stated objectives.
  8. Highlight the largest beneficiaries of tax incentives for investment by specific tax provision in a regular statement of tax expenditures, where possible.
  9. Collect data systematically to underpin the statement of tax expenditures for investment and to monitor the overall effects and effectiveness of individual tax incentives.
  10. Enhance regional cooperation to avoid harmful tax competition.

Tax incentives cost $138 billion…?

#taxpaysfor my PhDCongratulations to ActionAid on the launch of its new Tax Power campaign – an impressively internationalised version of the work ActionAid UK has been doing for five years now. I love the gallery of #taxpaysfor photos.

As part of the campaign launch, ActionAid asked me to help them come up with an estimate for the revenue foregone by governments in developing countries through corporate tax incentives. As the campaign briefing says, there is mounting evidence that such incentives are often ineffective at attracting the kind of investment that leads to sustainable economic growth. (This is distinct from the general rate of corporation tax, which is a whole other debate…) Certainly they are rarely put in place with any kind of cost-benefit analysis, which is why there’s so little reliable data out there.

We decided to come up with a ‘ballpark’ average figure for the revenue foregone as a share of GDP, and apply this to the total GDP of all developing countries. The scaling up part is obviously quite a simple approach, but I was quite pleased with the way we arrived at the average figure to begin with, so I thought I’d share it.

Data on ‘tax expenditures’ – that’s the revenue lost through tax incentives – is quite sparse, and where it does exist it’s plagued with inconsistencies. After quite a lot of hunting around, I managed to find about 20 developing countries where the government had published tax expenditure data, either directly or via a civil society organisation. I took the most recent year I could find in each case. I was particularly proud to have dug up a figure for Bhutan!

Tax expenditure reports can include the cost of everything from VAT exemptions to free trade zones, so it was essential to a) find something consistent and b) focus only on the kinds of expenditures that ActionAid is campaigning on. I’ve seen a few organisations cite massive figures for the cost of tax exemptions in a country where, if you go to the original source, you see that most of these go directly to ordinary people, not multinational companies. An IMF paper [pdf] says that tax expenditures probably amount to a couple of percent of GDP, but that refers to all types of exemption.

Although a few countries give one aggregate figure for direct taxes, which annoyingly makes personal and corporate income tax indistinguishable, there were 16 where I could find, or at least make a good guess at, the share of tax expenditures coming from corporate income tax (sometimes that involved running line-by-line through an itemised expenditure). So that’s the figure I used.

I ignored all other taxes from which companies get exemptions. I also excluded the expenditure on deferrals (i.e. accelerated depreciation) because in theory at least this just creates a timing difference – I presumed that in any given year the government foregoes some revenue in this way, but also receives some extra because of past deferrals. Maybe other tax brains out there can tell me if that was the right thing to do!

The data after all this processing is given in this Google spreadsheet.

I used some whizzy regression software from the LSE to check whether there was any connection between the proportion of revenue foregone and the amount raised, or GDP per capita, or the size of an economy, but I couldn’t find any meaningful relationship. That’s why it seemed like a simple average, 0.60% of GDP, would be the best way to go. Interestingly it’s pretty much the same as the figure for India, which is also by far the biggest economy in the sample.

When you think about it, rough though it is, that’s a huge ‘ballpark’ to be in.

Clamping down on Google’s tax avoidance: don’t hold your breath

Image representing Eric Schmidt as depicted in...

Eric Schmidt. Image by Charles Haynes via CrunchBase

This is a post I wrote for the LSE Policy & Politics blog.

Google’s executive chairman Eric Schmidt will stand up to give a talk at the LSE this evening after a week of unprecedented criticism of the search giant. I wonder if he still feels the same way today as he did last October, when he told journalists:

“I am very proud of the [tax] structure that we set up. We did it based on the incentives that the governments offered us to operate…It’s called capitalism. We are proudly capitalistic. I’m not confused about this.

Last Thursday Matt Brittin, the company’s vice president, was told “I think you do evil” by the chair of parliament’s Public Accounts Committee when he made a second appearance to defend what he had openly admitted were the company’s tax avoidance activities.

Coverage of a pre-G8 summit meeting for business leaders at 10 Downing Street on Mondayattended by Schmidt, focused on the tax avoidance questions, and whether the company’s tax practices had been discussed. David Cameron and Nick Clegg did indeed claim to have challenged Schmidt for his aggressive tax position. Just yesterday, Ed Miliband took the fight to the belly of the beast, throwing the company’s own words back at it. He said:

“I can’t be the only person here who feels disappointed that such a great company as Google, with such great founding principles, will be reduced to arguing that when it employs thousands of people in Britain, makes billions of pounds of revenue in Britain, it’s fair that it should pay just a fraction of one per cent of that in tax.”

The political consensus appears to be that the international tax system is broken and needs to be fixed by governments – to change those incentives identified by Schmidt – but also that, in Miliband’s words, responsible companies should “do more than obey the letter of the law.”

Here’s the problem with this analysis: the reason that Google (and Amazon, Apple and Starbucks for that matter) pay so little tax in the UK is not simply a matter of exploiting weaknesses in the system. It’s also because that’s how the system is designed. We’ve built a set of global rules that define a company’s tax liability not by how much stuff it sells in Britain, but by where it locates the business functions that add most value to the things it sells.

And the reason we did this is because we thought it suited us. On the global stage, Britain is a reasonably sized, but not huge, consumer market. But British businesses have a lot of customers overseas. So we figured that we would be better off with a system that’s biased towards – in the language of international tax – a multinational company’s place of residence, rather than the source of its revenue. It’s that bias that allows US companies to sell billions in Britain while incurring a relatively small tax liability here – a liability that they can reduce further through tax avoidance.

What our political leaders rarely mention is that the difficulties that e-commerce would create for our tax system were foreseen as early as 1997, and supposedly resolved as early as 2001 (pdf). The crucial agreement here was that the sale of a product over the internet would be treated just like the sale of its physical equivalent. If I stand on the other side of the UK-French border, stretch my arms across it and sell you a book, I’m running a business in France and my profits are taxed in France, even though you, my customer, are in the UK. The same would be true no matter how many books I sold. Under the rules agreed in 2001, exactly the same rule applies if I sit in an office in Luxembourg and transfer a book to your Amazon Kindle, no matter how far away I am.

At a meeting debating international tax rules last year, the UK and US opposed efforts by India and other developing countries to change precisely this kind of rule. They wanted to be able to tax the profits of foreign companies that sell services into their huge and growing markets without needing a physical presence. The UK said no, outright, because it would be a “fundamental change in the balance of source and residence taxation.” The OECD, which is in charge of the current review of international tax rules, says it isn’t aiming to change this balance.

The system as it stands suits countries like the US and UK, which are home to large multinationals that sell services abroad without needing a big physical presence.  Many companies selling services into developing countries are either British or providing the services from Britain, and our government doesn’t want to surrender the right to tax these companies. A side-effect of this decision is that it also means getting less tax from the foreign companies with the biggest consumer presence and visibility here.

David Cameron says he’s going to sort the system out, and no doubt there will be some changes that tighten up some of the areas most exploited for tax avoidance. But untangling the costs and benefits of international tax reform is complex, and it’s unlikely that the outcome will put an end to all of the counter-intuitive tax results.