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Has Tax Competition Become Less Harmful?

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Has Tax Competition Become Less Harmful? CHAPTER 6 Has Tax Competition Become Less Harmful? Shafik Hebous INTRODUCTION Countries compete over productive capital and paper profits. Taxation has been one important element in the set of policy instruments regarding competition.1 Tax instruments include, inter alia, corporate income tax rates and preferential tax regimes that offer a lower tax burden on specific types of income— typically asso- ciated with mobile activities or specific geographical areas.2 Tax competition has intensified in the last decades, despite international efforts to contain it. Following a relatively flat trend from 2007 to 2012, statutory corporate income tax rates continued to decline in advanced and developing economies, reaching 22.3 and 24 percent, on average, respectively (see Figure 6.1). Examples of countries that cut their corporate income tax rate in the last five years include G7 members, such as the United States (from 35 to 21 percent)3 and France (from 34 to 25 percent); advanced small open economies, such as Belgium (from 34 to 25 percent) and Norway (from 27 to 22 percent); and developing countries, such as Tunisia (from 30 to 25 percent) and Pakistan (from 34 to 29 percent). International initiatives opt to single out forms of tax competition that are deemed to be harmful— as defined by criteria summarized below. However, the hallmark of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project has been curbing international tax avoidance, rather than tax competition per se, mainly through strengthening anti– tax avoidance rules. Action 5 on combating 1 Other policy tools include, for example, public spending and regulations. See also Schön (2005) and Sinn (1997). 2 Generally, preferential tax regimes include also those that offer lower personal income taxes (for example, for employing foreign experts or attracting wealthy retirees). This paper predominantly focuses on corporate taxation. 3 On top of the federal rate, there are state taxes that bring the combined corporate income tax rate in the United States to 26 percent, on average. 87 ©International Monetary Fund. Not for Redistribution 88 Corporate Income Taxes under Pressure Figure 6.1. Trends of Statutory Corporate Income Tax Rates 50 Advanced economies Emerging and developing economies 45 40 35 30 25 Percent 20 15 10 5 0 1981 83 85 87 89 91 93 95 97 99 2001 03 05 07 09 11 13 15 17 Source: Author’s calculation, using the IMF Fiscal Affairs Department database. harmful tax practices, one of the four minimum standards,4 is concerned with constraining preferential tax regimes, in particular, insofar as they facilitate cross- border profit shifting. Other notable similar international arrangements include EU member states’ obligations under state aid rules as well as their com- mitments under the EU Code of Conduct for Business Taxation. Under current international corporate income tax arrangements, the tax rate and base are ultimately sovereign choices. However, recent international initia- tives put limits on the design of preferential tax regimes, mainly by linking the benefits from such regimes to “substantial activity”; that is, loosely speaking, activities and their generated qualified income should be in the same country and by the same taxpayer (“nexus approach”). The level of the headline corpo- rate income tax rate— no matter how low— thus far remains unconstrained by these initiatives. The presumption appears to be that forms of preferential tax regimes that do not establish substantiality intensify inefficiencies related to tax competition. As this chapter argues, however, this presumption is far from being clear cut in theory or in practice. An unconstrained outcome (“equilibrium”) of a tax competition game is typ- ically welfare reducing (see “Why Does Tax Competition Lead to Inefficiently Low Tax Rates?” later in this chapter). The pressing question confronting 4 The other minimum standards are regarding country- by- country reporting requirements for large multinational enterprises, tax treaty abuse, and tax treaty– related dispute resolution mechanisms. See Beer, De Mooij, and Liu (forthcoming) and Tørsløv, Wier, and Zucman (2018) for studies on profit shifting; see Chapter 4 of this volume for a discussion about the rise of multinational enterprises. ©International Monetary Fund. Not for Redistribution Chapter 6 Has Tax Competition Become Less Harmful? 89 policymakers is what the outcome is of proscribing preferential tax regimes or insisting on the nexus approach? Theory provides important insights. First, in the absence of a preferential tax regime that lowers the tax on profits of mobile activ- ities, the statutory corporate income tax rate and generally applicable tax deduc- tions within any given country become more relevant tax policy instruments to compete for the location of corporations. This leads to lower (statutory and effective) corporate income tax rates and tax revenues from both the mobile and immobile bases, and triggers further strategic tax reactions by other countries. This outcome is possibly inferior to one with preferential tax regimes. The reason is that preferential tax regimes make it possible to restrict competition to the mobile base, thereby enabling higher tax rates on the immobile base, which in turn can be welfare improving compared to the unconstrained tax competition game. A very low tax rate, or even a zero tax per se, however, is not deemed harm- ful under any existing internationally agreed approaches, thus far. For example, a country with two tax rates (say, a headline rate of over 30 percent and an intellec- tual property box rate of 15 percent that does not fully satisfy existing criteria) can be deemed as adopting a harmful tax practice (for instance, as found in France; see OECD 2017, page 15), whereas a country that has a uniform but lower corporate income tax rate (even zero) would not. Second, the nexus approach restrains the design of preferential tax regimes in a manner that can intensify, rather than alleviate, tax competition by expanding the scope of competition to real investment, beyond paper profits. Third, a dis- tinct but related issue is that it remains to be seen whether BEPS Action 5 (at least indirectly) encourages an inefficient instrument— the intellectual property box regime (known as IP box or patent box)—to incentivize research and develop- ment activities and innovation, as opposed to cost- based tax incentives. If current international corporate income tax arrangements were to be reformed, for example by introducing a (preferably internationally coordinated) minimum tax or multilateral destination- based tax (see Chapter 13), then tax competition would be alleviated or even eliminated. Tax competition, however, has not been thus far at the fore of international initiatives. In addition to classifying tax regimes, blacklisting of jurisdictions has become a tool to pressure some countries to reform their tax systems. For example, the Global Forum on Transparency and Exchange of Information for Tax Purposes (the Forum) has adopted criteria for listing noncooperative jurisdictions focusing on compliance with tax transparency standards. Also, in December 2017, to “encourage fair competition,” the European Union (EC, 2017) adopted a list of “ non- cooperative jurisdictions” largely based on the implementation of OECD/ G20 BEPS minimum standards, tax transparency standards, and “fair taxation” criteria (summarized in subsequent sections of this chapter). Listed countries can face “defensive measures” at the European Union and member state level. As far as tax competition is concerned, however, the achievements of this watchlist approach are not yet clear. It should be emphasized that remarkable progress has been achieved regarding tax transparency, primarily through the cross- border ©International Monetary Fund. Not for Redistribution 90 Corporate Income Taxes under Pressure exchange of tax- related information, thereby significantly strengthening the fight against, inter alia, tax crimes and tax evasion. The rest of this chapter is organized as follows: The following section briefly discusses major predictions of the theory of tax competition and empirical obser- vations. The chapter then turns to summarizing international efforts to address harmful tax practices and then discusses whether tax competition has become less intense as a result of harmful tax practices initiatives. WHAT IS HARMFUL IN TAX COMPETITION? Rather than a full survey of the rich literature on tax competition,5 the focus here is on key insights that are relevant for the discussion of harmful tax practices, abstracting from modeling details. Strategic Tax Interactions: Main Insights International tax competition mostly leads to suboptimal global welfare outcomes because of inefficiently low tax rates and cross- border spillovers. Why Does Tax Competition Lead to Inefficiently Low Tax Rates? An increase in the corporate tax rate in a country lowers its capital and increases capital employed in all other countries. A central result of a prototypical game of strategic tax setting is that in equilibrium all countries would benefit from a small increase in all tax rates. Hence, this outcome is Pareto inefficient and the low tax rates lead to underprovision of public goods. The robustness of this general result has been examined in a number of extensions and theoretical setups (Keen and Konrad 2013). Despite some model- dependent specificities, and in some cases involving conditions, the implications of this result have proved
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