By Marie Ruschmeyer
In March 2021, the Biden Administration revived the discussions about reforming the global tax system. Last October, 136 countries out of 140 involved, agreed to the global tax reform which aims to address tax competition and tax avoidance in the digitalized economy by 2023. This issue is all the more important today as public spending increased a lot during the pandemic notably because governments financially supported firms. So, this raises the question of how States can make firms contribute to the tax revenues.
Corporate income taxes have been consistently shrinking over the last four decades
The worldwide average statutory corporate income tax rate decreased from 39% in 1980 to 23% in 2020. This is a trend that has been observable in every region. There were several economic benefits that motivated governments to lower their rate, indeed lower corporate tax rate encourages investment, risk-taking and maximizes job creation and productivity.
This decline in corporate tax rates also results from tax competition between States. Indeed, lower corporate tax rates are a factor of a country’s economic attractiveness and competitiveness for foreign direct investments. For some countries, low corporate income tax rates were a key factor in their development. For example, it’s by lowering its corporate income tax rate to 12,5% that Ireland managed to attract over 1,600 companies that employ 250,000 people and this allowed Ireland to surpass Britain in terms of living standards. However, when a country lowers its corporate tax rate, other neighboring countries tend to do the same. Today, there is a consensus that aggressive tax competition needs to end. It’s time to put an end to the “race to the bottom” with an overhaul of the international tax system.
An overhaul of the international tax system, the reversal of a four-decade long trend?
The need to reform the international tax system
The current international tax rules date back from the 1920s and aren’t well adapted to today’s digitalized economy and its new business models. The first problem is that under the current international tax system, the profits made by a company can only be taxed where the company has a physical presence. However, with the digitalization of the economy, many MNEs generate profits in places where they have no physical presence. Furthermore, most governments only tax domestic profits and not foreign profits because profits are taxed where they are earned. But this constitutes a problem because companies are shifting profits to countries where few or no taxes are levied and are therefore escaping taxation.
Nonetheless, one should bear in mind that corporate taxation is not only a fiscal policy but also a social one which affects public spending, health, and education. The corporate income tax can be considered as a pre-tax on capital income and can also prevent people from hiding their income in a firm to avoid income tax. It can also be seen as a way of financing the public services used by a firm that operates in a country.
For some countries, corporate income taxes represent a very large part of their tax revenues. Tax competition and tax avoidance clearly affects the ability of a country to collect the tax, but it also affects inequalities. In addition, tax optimization techniques used by MNEs have created tensions between countries. Indeed, some countries like France made unilateral decisions and decided to implement Digital Services Taxes (DST) to make sure that large digital companies would contribute to tax revenues, and this led to tensions with the US.
A two-pillar deal to address the tax challenges
The first pillar aims to adapt the international income tax system to the digitalized economy and to ensure fair profit distribution among countries. It consists in expanding the taxing rights of market jurisdictions and reallocating profits in countries where companies sell their goods and services rather than only where they produce. Indeed, in this new system, subsidiaries of MNEs wouldn’t be considered as independent entities, in the contrary, a unitary tax system would be applied on the profits of MNEs. Income tax revenues would be distributed among countries, according to the number of assets, employees, sales, or users a company possesses in each country. This pillar only concerns the largest MNEs. Such a system would certainly dissuade businesses to shift their profits to tax havens.
Pillar two aims to implement a global minimum corporate tax rate of 15% regardless of where companies operate but it would only concern companies an annual global turnover exceeding EUR 750 million. Under Pillar two, this minimum taxing right of 15% would be given to the country where the headquarters of the company are located. However, if companies do not pay the minimum effective tax rate of 15%, their home governments could top up their taxes. For instance, if a subsidiary of a German MNE only pays 10% of taxes in a foreign country then the German tax authorities could claim the 5% difference to reach the minimum corporate tax. This global minimum tax is expected to generate more than EUR 150 billion in new tax revenues globally. Pillar two would help to restore the balance between developed and developing countries in the tax field because if few MNEs originate from developing countries, a lot of them operate in developing countries and therefore a minimum corporate tax rate would enable developing countries to gain power during negotiations with firms.
Also, under this two-pillar deal, governments wouldn’t be able to impose unilateral Digital Services Tax.
What were the reactions following the proposal of this global tax deal? Is this deal really going to end tax competition and ensure a fairer distribution of profits?
The OECD global tax deal was first proposed in July 2021. Back in July, 130 countries out of 139 (representing more than 90% GDP) agreed to this deal but since then it has been reviewed and in October 2021, 136 countries finally agreed to it. Big tech companies and government officials welcome the deal and described it as “historic” and “significant”. In July, the nine countries that opted out were three EU members – Ireland, Estonia, and Hungary and the other countries were Kenya, Nigeria, Peru and Sri Lanka as well as two Caribbean Islands: Saint Vincent and the Grenadines and Barbados. The three EU members argued that deciding their own corporate tax is a way to compensate for advantages of scale, resources, and location. Indeed, it is undeniable that large and developed economies have a considerable advantage over small economies world when competing for investments. Since last July, the deal has been revised and the mention of a “at least” 15% minimum corporate tax disappeared, and therefore Ireland finally came back on its decision and joined the agreement. Nonetheless, this deal was criticized, Oxfam International called it a “mockery of fairness”. Indeed, they argue that a 15% corporate tax rate is not sufficient because some countries already have higher rates and that the initial proposition of 25% was better to ensure fairer distribution of profits for poorer countries.