I’ve just written a column about something which is, or has the potential to be, enormously important: the US Treasury’s plans to reform business taxes. But as is often the case, I’ve had to compress large parts of the stuff I’ve been researching into a very small space which means there’s quite a lot I didn’t get to add to the column.
But given how much this topic matters, given that we’ll probably be talking about this a lot in the coming weeks/months and given that it’s one of those areas that is, at least from the outside, utterly impenetrable, I figured it might be worth splurging out some of what I’ve learnt about this.
So if you’ve ever wanted to know what the problem is with corporate tax avoidance, what could be done about it and what might actually happen, this might help. I should preface all of the below by pointing out that I am not a tax expert (though I spoke to a few in the process of writing this) and that any mistakes below are my own – and if you spot any, please do leave a comment and I’ll amend them.
That being said, let’s start with this chart.
The key thing to note about this chart – from the Tax Plan documents produced by the Biden Administration– is that black line at the bottom. That’s corporate tax revenue going into the US Treasury. And what you’ll probably have noticed is that it seems to have become dislodged somewhat from the dotted blue and dashed red lines, which is corporate earnings.
That gap is a pretty good way of illustrating one of the big issues facing not just the US but pretty much every developed economy at the moment. Their companies are earning rather a lot but that doesn’t seem to be turning into corporate tax revenue. Now there are a lot of reasons for this. To some extent it’s down to tax policy. Countries around the world have been cutting their business tax rates (the UK included) in recent years, the idea being that this should draw in investment and income.
And in fairness that’s worked pretty well for some countries. Ireland, for instance, has managed to encourage a lot of big multinational companies to set up there, partly thanks to its 12.5% corporate tax rate. It’s worth saying that while many people cast Ireland as a tax haven, and while there’s undoubtedly quite a lot of accounting jiggery pokery that benefits from that low tax rate, that’s not the full story. There’s also a lot of activity in Ireland which is, well, genuine corporate activity: people working for companies, generating activity and profits, which in turn are booked in at that low corporate tax rate of 12.5%. But there’s a lot of the other stuff too.
And by other stuff I mean the profit shifting which has become such a big part of the administration of multinationals these days, which helps explain that chart above.
Before we get much deeper into this, it might help to remember what corporate taxes ultimately are: a charge on profits earned in a given country. And while some people would rather these taxes didn’t exist at all, there is some logic in levying the tax on profits, as opposed to sales (which can be very high without a company making extra money for itself, or very low while the company makes proportionally high profits) or employees, or square footage of premises or some other metric.
But now consider a big company which makes household goods. They have lots of branded products: detergents, deodorants and all that. Let’s say the company designs, makes and sells its goods in a given country where the tax rate is 20 per cent. They make $100,000 profit and they pay $20k in business tax. Simple.
But now let’s imagine it’s an international company. Imagine it makes and sells the same soap in country A, but designs it in country B. How much of the profit should be assigned to country A and how much to B? Now consider the brands of those products (SOAPIE – the best soap in the world!). Which country do they belong to? If the company is selling products all over the world you might make the case that they should reside, well, nowhere. So the brands themselves are incorporated in a country with low tax and your units in other countries pay the brand unit a royalty for every item sold. But how much profit derives from the brand and how much from elsewhere?
You get the idea: this is complicated stuff. And actually a lot of the legal complexity reflects genuinely chewy questions about the nature of intangible profit and the nature of place. The problem is that over the past few decades the accounting jiggery pokery has taken on another level of complexity and it is hard to escape the conclusion that much of this has been done not to devise the fairest reflection of a company’s balance sheet but to reduce tax payments.
The fact that so many of the world’s big companies deal with intangibles these days, from tech giants like Google to retail giants like Amazon to brands like Starbucks to companies like Apple (let’s not forget that while it sells its own branded products, Apple doesn’t actually make them: it is a company whose worth is primarily bound up in ideas and design and intangible services) means this issue has taken on far more significant dimensions. This really matters.
By the way it’s sometimes said that this kind of jiggery pokery is a relatively new concept. But while it’s certainly of a grander scale than ever before, and it’s certainly made easier when companies deal mostly with intangibles, it’s hardly new. Here is a great passage about Anglo Persian – the oil company that later became BP – in Peter Frankopan’s The Silk Roads:
The western oil corporations that controlled the concessions were dextrous and highly creative when it came to making royalty payments. Just as in the modern world, a web of subsidiary companies was set up with the aim of using inter-company loans to create losses that could be used to reduce or even eliminate altogether the apparent trading profits of the operating companies – and therefore manipulate downwards the royalties due under the concession agreement. This was grist to the mill. Angry reports ran in the newspapers that spoke of ‘foreigners [being allowed] to drain the country of her oil resources and deliberately reducing the revenue of Persia by granting illegal and unnecessary exemption from customs duty’.
Frankopan, Peter. The Silk Roads (pp. 353-354). Bloomsbury Publishing
Anyway, while the companies are indeed following the law, and for that matter doing what they believe to be their fiduciary duty to their shareholders, there are nonetheless some issues. One is that chart above: tax revenues going down. Another is the chart below.
This chart, from Gabriel Zucman, shows you that more and more money is going into low tax jurisdictions (how you categorise what is and isn’t a tax haven by the way is another v v long story for another day). The issue here is not companies breaking the law by the way. The issue is that the laws that surround corporation tax make profit shifting something of a no brainer. If the US corporate tax rate is over 20 percent and the rate in Ireland is half that and many of your profits might plausibly have been generated in nowheresville, well, what would you do?
So what to do about this?
Broadly speaking there are two potential paths.
Path 1: Improve and clarify the way you determine how taxes are calculated
If you look at the balance sheet of a large tech company operating in, say, the UK, what you might see is that while their sales in the UK might be high, their profits are invariably low. Hence why corporate tax receipts are low. One way around this is to take a somewhat more circumspect view and say: well, you’re generating a lot of sales in that country, so really you should be paying more tax.
How? Well there are a few ways you could do it. One way would be to look at the company’s consolidated global accounts, work out the global profits as a proportion of sales, work out how much of that is excess profit as opposed to routine profit (I’m assured this can be done though I suspect it’s not quite as simple an operation as that) and then apply some of that percentage to the sales figure in each country.
The upshot is that these companies would end up paying more tax in each of the countries where they operate. And since sales are far less footloose than profits (you as an Amazon customer are not likely to move away from the UK even if Amazon determines that the profit from your purchase belongs in another country) this is a pretty good path to reduce avoidance. A lot of smart sensible tax experts see this as the future.
Path 2: introduce a global floor on tax rates
The problem with path one is that as long as there are countries around the world with lower tax rates, there will always be the risk of a race to the bottom, with some countries undercutting each other to attract investment and profits. So path 2 is to cut out the middleman and prevent that from happening by persuading every country in the world to raise their corporate tax rate to a certain level.
The benefits of this approach are pretty clear: if the tax rate is 28% in the US but closer to zero somewhere else then it makes sense to shift your profits elsewhere. If the tax rate everywhere is no lower than 21%, well there’s still a comparative difference but it’s significantly smaller. The incentive to shift profits diminishes.
Now if you follow tax you’ll probably be familiar with these two paths because they represent the two “pillars” the OECD has been discussing recently on tax reform. You’ll also probably be aware that the OECD has been pushing for corporate tax reform for a long, long time through something called BEPS (Base Erosion and Profit Shifting – both of which are kinds of avoidance measures). You might also be aware that up until recently a lot of people (myself included, for what it’s worth) had assumed that this enterprise was ultimately doomed, in much the same way as the Doha Round of multilateral trade talks seems to have gone to its maker.
The point of specifying these two routes is that either might work. And there are some countries who will prefer path 1 while others (notably those with lower tax rates) will prefer path 2.
Well, the new news this week is that Joe Biden and his Treasury Secretary Janet Yellen seem to be pushing for both of these paths at the same time. This is, in case it wasn’t already obvious, a big deal.
Before we get into this international stuff and how it might or might not work, it’s worth underlining that there are actually a couple of things going on here, which are easy to conflate but are quite distinct. On the one hand there’s Biden’s plans for American corporate taxation (for US companies inc those operating overseas). These are broadly as follows: Biden will raise the corporate tax rate from 21% to 28% (note this is still lower than the 35% rate that was in place before Donald Trump came into office – though most companies end up paying far less thanks to the numerous loopholes and exceptions built into the system).
Biden’s plans for American corporate taxes also involve increasing the “floor” US companies will face if they’re earning money overseas. This is a complicated system which was actually set up by the Trump Administration called GILTI (Global Intangible Low Tax Income). This involved setting a global minimum rate of between 10.5% and 13.125%, the idea being that if companies were paying lower tax rates than that then they’d have to pay the difference to the US in taxes.
One of the problems with GILTI is that (like much of corporate tax codes) it’s riddled with loopholes, meaning in the end it’s not clear it prevented all that much avoidance – though it did perhaps encourage some companies to repatriate some of the money they’d had sitting offshore for years, waiting for a change in US tax policy (the previous system had put a very high tax rate on repatriated profits).
Anyway, one of Biden’s plans is to raise the GILTI rate up to 21%. So this means US companies based overseas will have to “top up” their tax payments with money sent to the US Treasury if they’re paying lower rates overseas. And it sounds as if the plan is to remove many of the loopholes on the tax and to widen it out so it’s paid by more companies from more sectors.
This is a pretty big deal but, as I say, it’s somewhat separate from what we’re discussing here, which is international co-ordinated action rather than country-by-country measures. Though you can see how the two things intersect. If you’re a US multinational and you’re now facing a far higher and less porous GILTI rate (eg the US will tax you more on your foreign earnings in low tax jurisdictions) then you might be tempted to relocate away from the US altogether. Which might explain why the US now wants every other country to raise their rates so American companies won’t be tempted to up sticks.
Still, that doesn’t quite answer why the US is reportedly pushing not just for pillar 2 (the international minimum rate) but for both paths or pillars. Here’s a story from the FT this week about the pillar 1 bit and here’s an NYT story about the pillar 2 bit.
Why are the Biden administration pushing for both pillars? One argument is that it’s a sign of how serious they are that they want to confront corporate tax avoidance. A more cynical take is that it represents a form of realpolitik, given some countries are set against one or other of the pillars.
Either way, the fact that the White House is pushing for these reforms will make the next few months very interesting indeed. Broadly speaking, for most of the last century it has been hard to imagine much multilateral action on this or indeed anything unless the US is in the driving seat. Now it is, perhaps that means these kinds of revolutionary reforms could take place.
And revolutionary they are – especially the notion of a global minimum level of corporate tax rates. There has never been anything like this before. We have had global deals on the state of the monetary system and on climate change and military matters but never a global accord to set tax at a given level. Even the EU, which has long pondered harmonised tax rates, has never got them off the ground. How ironic it would be if the US managed to outdo the world’s tightest political alliance.
Still: one has to assume at this stage that this will be an extraordinarily tough one for Biden to pull off. Leaving aside the fact that nations jealously guard their right to levy taxes at a given rate and that nothing like this has ever been attempted, many countries (notably Ireland, but others too) view a low corporate tax rate as a crucial part of their economic strategy.
We don’t yet know how the US or others would enforce this plan. One lever could be refusing to give companies tax relief on the royalties they pay to low tax jurisdictions. Another would be tariffs or trade measures of some sort. But we’re getting ahead of ourselves now. The deeper issue facing Joe Biden is that the US is no longer the unchallenged superpower it once was.
For most of the post-war period America dominated geopolitics – sometimes through multilateral organisations like the UN and IMF, sometimes via bodies like the G20 or G7 or even bilaterally. Even before Donald Trump took, well, a different stance on how to manage international relations, this influence was waning. The world is multipolar in a way it wasn’t even in 2008, when Biden first became Vice President.
It is unclear in other words whether the US can dominate and influence these discussions in the way it did for much of the past few decades. But it seems Joe Biden and Janet Yellen are planning to try anyway. And they’ve picked one of the trickiest of all issues as their first target. It’ll be fascinating to see what happens next.
UPDATE: If you’re interested in other ways the global tax system could be reformed, can I point you towards this new book, Taxing Profit in a Global Economy (available to download for free via that link). It’s by some of the world’s leading academics on tax policy, including Michael Devereux from Oxford, who’s come up with some of the pioneering policies on corporate tax – taken up by policymakers on both sides of the Atlantic – and others including Alan Auerbach. Highly recommended.
UPDATE 2 (5 June 2021): Since writing this blog there has been plenty of movement internationally. The G7 has agreed to support a global minimum corporate tax rate, provided the US also implements both of the pillars above. And the US has cut the rate it’s negotiating for down from 21% to 15%. This of course makes it less ambitious, but it also means it is considerably more likely to happen. Consider: a 21% floor would have caught quite a few countries in its net, while a 15% floor will only affect three OECD members directly (one of which being Ireland). But there’s still a lot to be ironed out…