Can We Really End the Race to the Bottom?

People will often conflate tax avoidance and tax competition, as if the two activities often go hand-in-hand. It’s one of my pet peeves.

Moving on-paper profits and moving real jobs or production are unrelated and, in some ways, opposite acts. They’re not just different in terms of the legality and economics of the transactions. They raise different policy and philosophical questions.

The Organization for Economic Cooperation and Development set out on its recent tax overhaul project with the goal to end tax avoidance associated with digital activities. That's clearly a profit-shifting thing. But the mission creeped somewhat, as participants began to talk about "ending the race to the bottom" and stemming the incentives for countries to undercut each other with more and more generous tax breaks. This verges into tax competition--the never-ending battle for real, physical investment and the jobs that come with it.

The final result–the “Two-Pillar” solution, including a 15% global minimum tax–made some gestures towards a grand plan to harmonize global tax rates, but only really addressed tax avoidance in a comprehensive way.

This distinction became very clear during a recent panel discussion at the World Economic Forum in Davis, Switzerland. The speakers, including OECD Secretary-General Mathias Cormann and Berkeley tax professor Gabriel Zucman, debated the merits of the global minimum tax, also known as Pillar Two.

While the panel included a wide range of perspectives, including many who were harshly critical of the overall agreement, all seemed to agree that it dealt with most of the profit-shifting activities in the world today.

“Pure profit-shifting, booking billions of dollars in profits in territories where there are no activities, this will come to an end,” Zucman said. “It’s very important progress.”

That’s actually pretty high praise for the project--even some of its supporters might concede that it won't deal with all tax avoidance.

But Zucman added that Pillar Two was “conceptually and philosophically” flawed, because it would still allow companies to achieve rates well below the 15% agreed-upon rate so long as they were paired with real, substantial activities. The race to the bottom hasn’t ended–if anything, it may have gotten a bit faster. The discussion outlined what some of the future debates on global taxation may look like, if countries continue to protest the incentives which force them to choose between economic growth and adequate taxation.

Interestingly, this debate may end up pushing for increased unilateral actions, rather than the broad consensus and cooperation which has previously been the goal of tax reformers.

The global minimum tax is essentially self-enforced by the countries participating in it. They tax their own companies when they have foreign income that is taxed lower than 15%. A secondary enforcement rule, the UTPR, disincentivizes countries from trying to get new business by neglecting the rules. No matter what hijinks companies use to shift income around the globe, there’s nowhere they can ultimately place the income where it won’t be taxed by someone. In theory.

But to narrowly target the tax on truly mobile income from intangible assets (such as IP), the system includes a “substance-based income exclusion.” The 15% calculation exempts a 5% return on eligible tangible assets and employee payroll. Using logic similar to the U.S. tax on global intangible low-taxed income, the OECD argues that those factors likely indicate that real economic activities are happening in that jurisdiction. That’s not the target of Pillar Two–it’s meant to apply to situations where the profits have been separated from real substance.

As Cormann put it, to leave those factors untouched was a feature, not a bug, of the OECD plan. It's meant to stop the "harmful tax competition" with easily mobile assets and activities, while not creating "harmful distortions" with real economic substance, he said.

To me, the right question isn’t really whether the OECD project should have included a pure 15% minimum rate, to target both phantom profits and real activities. They didn’t, and they couldn’t, because the world just isn’t there yet. Maybe it would be a great idea for all of the countries of the world to unite and find common ranges of income taxation, but until they’re willing to come to the table to consider that it's not going to happen. The OECD doesn't have the means to force them to.

And so long as the world comprises sovereign nations with independent governments, they’ll have the prerogative to set their own tax laws and use them to compete for economic gain. The disparities will exist, one way or another.

Tax policy is very Newtonian. Rarely can you totally eliminate the underlying incentives, but you can find the right levers and cornerstones to push back against them.

But Zucman is correct that the rich, powerful nations of the world could do something about it, if they really wanted. He used the U.S. Foreign Account Tax Compliance Act–which essentially forced banks to turn over identifying information on taxpayers to the U.S. government–as an example. FATCA leveraged the U.S. status as the holder of the world’s reserve currency, and the issuer of top-rated debt, to better enforce its tax laws. It sparked a new global standard to do that in a multilateral way, the Common Reporting Standard. But the U.S. got the ball rolling unilaterally. (And it still hasn’t joined CRS.)

In his book, “The Triumph of Injustice,” Zucman laid out how something similar might work for corporate taxes. He proposed a 25% global minimum tax, which he said the U.S. could apply to both its own corporations and foreign ones that operate here. For foreign companies, the U.S. could apply a 25% tax based on the percentage of the company’s sales in the U.S. That percentage could be used to divide up the company’s income, or its percentage of the “tax deficit,” Zucman’s term for the amount of global profits that are taxed below the 25% rate. This would require companies to submit not only payments but top-down information about their global operations. To enforce this, Zucman would enact penalties, up to shutting off the U.S. market altogether to companies which refuse to comply.

This way, most global companies would find that they can't reduce their taxes by chasing lower rates. Whatever they do to put profits in a lower-tax jurisdiction, the U.S. would automatically pick up some or all of the difference.

That’s one way to do it. You could also imagine the Western “residence” countries–where companies are based–imposing stronger controlled foreign corporation rules that negate whatever tax benefits they get from lower foreign rates. That would put pressure on the companies to move–again, think of Newtonian physics–but there’d be plenty of reasons why they’d still choose to stay, and countries could enact more restrictions on inversions or expatriations.

The U.S. actually advocated for something like this, by opposing the substance-based carveout in Pillar Two. That’s likely less out of pure altruism than politics–Democrats and President Biden have long claimed that GILTI’s exemption for tangible assets is encouraging companies to move jobs from the U.S. to other countries. (There isn’t a ton of evidence for that–and if it’s true, it would seem to contradict Dems’ other contention about GILTI, that it’s toothless as an anti-abuse rule.)

It would have looked pretty hypocritical if the administration supported that other countries enact a similar exemption, while pushing Congress to eliminate the U.S. version. Regardless, the administration failed at both changing GILTI or the OECD policy, so the substance-based carveout is here to stay.

But would the U.S. ever use its tax rules in such a muscular way, to try to equalize global tax rates? And should it? Usually that kind of aggressive foreign policy provokes a strong backlash in the rest of the world. And there’s a debate on whether totally eliminating tax competition is the correct goal, anyways–who's to say what the correct level of taxation is?

Sometimes I like to joke, we could solve all of the international tax problems at once by establishing a world government. But until we do, the system is going to have to deal with disparities.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• The OECD released its latest batch of comments on Tuesday, this time on its preliminary language for the Pillar One multilateral treaty to deal with unilateral digital service taxes, which countries would be required to repeal when they adopt it. (At some point in the distant future.) A common theme from business groups: the definition of DST is too narrow and will leave some similar measures intact.
• Several business groups, including the National Foreign Trade Council, the Information Technology Industry Council, and the Alliance for Competitive Taxation, pushed the U.S. Treasury Department on controversial new proposed regulations on foreign tax credits. The groups all noted that the rules could be problematic for companies doing business in Brazil, which has a unique tax system that doesn’t mesh well with the U.S. (And thus, Brazilian taxes would not be creditable under the new FTC rules.) But the country has committed to updating its rules as it tries to join the OECD.
• Remember Amount B? The African Tax Administration Forum recently issued a "technical note" on the policy, which is expected to be a major revenue-raiser for smaller developing nations. The document is mainly to aid countries with implementation, but it also includes ATAF comments. Of note: the ATAF agrees with the proposal to exclude some commodities from Amount B, even though it acknowledges that many African tax authorities struggle with commodity pricing.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Tomboy, appearing first in Captain Flash #1 in 1954. Janie Jackson maintains a façade as a demure, feminine, proper girl while secretly fighting crime as the masked Tomboy. (In an icky Back To The Future-ish twist, her brother has also developed a crush on Tomboy.) According to the database, she may be the first female superhero who isn’t a sidekick.

Contact the author at amparkerdc@gmail.com.