Progress on curtailing Base Erosion and Profit Shifting

The OECD released a new report to the G20 leaders on the progress being made against global base erosion and profit shifting (BEPS).   102 countries have joined the Inclusive Framework.   National governments are implementing the four minimum standards.  A number of countries are implementing additional BEPS Action recommendations.

Although still early in the implementation process, anecdotal evidence suggests that MNE's profit shifting behaviors are changing and will change more in the future as a result of the BEPS Project.  I helped contribute to the section of the report (Part I, Section 3) which describes some of the initial business reactions.  The implementation of the BEPS package will make a number of cross-border tax plans previously used either unavailable or no longer financially attractive.  This includes "cash boxes", entities holding valuable assets funding intangible assets with little or no economic substance.  Such cash boxes will no longer earn high taxable returns in tax havens, so more taxable income will be reported in jurisdictions where the real value is created.  

Business surveys indicate global MNEs are focusing on the BEPS Project and its implications for their future tax planning.  A Deloitte survey of tax directors found that "55% agree or strongly agree that their business has changed the way they conduct tax planning for cross-border transactions as a result of proposed changes arising form the BEPS project."  

For more detailed and current developments, EY tracks BEPS developments by Action and by Country on the BEPS Development Tracker.  Stay tuned for more progress as the BEPS implementation, including filing of Country-by-Country Reports by the largest MNEs, starts occurring.  

Tom Neubig

Tax gap: Canada adds an important analytical tool

Canada is joining a number of countries that estimate the amount of tax liability that is not collected, the so-called compliance tax gap.  The Canadian Revenue Agency (CRA) released an excellent conceptual paper on the tax gap last year, as well as tax gap analyses of their personal income tax and goods and services tax.  Last week, the Canadian Tax Foundation, with the involvement of the CRA, hosted a very helpful conference on the tax gap, with representatives from the US IRS, UK HRMC, Sweden, Denmark, the IMF and OECD. 

Similar to tax expenditure budgets, tax gap analyses raise both conceptual and quantification issues.  Albeit with many limitations, tax expenditure and tax gap analyses strengthen countries’ tax policy and tax administration.  Transparency, increased understanding, and the analytical focus from the modeling and presentation help make tax administrations more effective and efficient, and help tax policy incorporate important tax administration issues.

Tax gap analyses must choose whether to distinguish between illegal tax evasion and legal (but often “aggressive”) tax avoidance.  The UK HRMC includes schemes that are contrary to the “spirit of the law.”  I like the IMF graphic above that distinguishes between the “compliance” cap and the “policy” gap.  International base erosion and profit shifting (BEPS) required coordinated policy measures to close gaps in the international tax rules.  In contrast, hidden offshore assets (see new paper by Altstadsaeter, Johannesen and Zucman) are often used for tax evasion. 

Another issue is illegal activity, such as money laundering, terrorism financing, corruption, or hiding assets from a business partner or spouse.  Tax evasion is a result no matter what the underlying motivation.  Initiatives of the international Financial Action Task Force will be important in curtailing such activity in addition to the OECD and G20 initiatives on automatic exchange of information for tax purposes and tighter rules for beneficial ownership information.

If governments do not provide estimates of their compliance tax gaps based on their administrative tax records and research, then outside groups and academics will fill the vacuum with higher-level, more macro-analyses.  To address resource limitations, countries’ tax administrations should consider arrangements with academics under strict confidentiality rules so more analysis of compliance and policy gaps are undertaken, similar to programs in a number of countries, and encouraged by the OECD/G20 BEPS Action 11 report. 

The OECD and IMF should encourage more countries to undertake compliance tax gap and tax expenditure (policy gap) analyses.  Developing a uniform framework will assist countries in their analyses, while also providing comparable estimates.  Countries are hesitant to publish tax gap analyses if they appear less compliant because they have taken a more comprehensive approach to the measurement. 

I applaud the CRA and CTF for moving forward on increased discussion and analysis of the Canadian tax gap; the IMF in helping countries with VAT tax gap analyses; and the OECD for its tax administration work on measures of tax compliance outcomes and biannual tax administration surveys. Exciting future work will challenge government and academic researchers. 

Tom Neubig

The Hugest tax cut in US history: Should that be the goal?

The President on June 8th said, "We have also proposed a historic tax cut — biggest in the history of our country, by the way".  Although details about the plan await, an analysis by Jerry Tempalski of the US Treasury provides some indication of the potential size of the tax cut: at least -2.89% of GDP, the prior record from the Economic Recovery Tax Act of 1981.

A record US tax cut would reduce revenues over the next ten years by at least $7.3 trillion, at -2.89% of GDP.  However, the 1981 Tax Act That Act phased in a 23% reduction in individual tax rates, provided extremely accelerated depreciation of capital assets, and indexed individual tax rate brackets by inflation starting four years later.   By the fourth year after enactment, the reduction was -4.15% of GDP and probably still growing.  If the six out-years are at -4.15% of GDP, the President's total tax cut would be over $9.3 trillion over ten years. 

The President’s FY18 budget (Table S-2) claims there will be 10-year $2.1 trillion budget “effect of economic feedback”, some of which will be from tax “reform” as well as from other government initiatives.  Thus, the dynamic macroeconomic effects will only offset a small portion of the huge deficit increase from the tax cut yet to be proposed in sufficient detail to make an actual estimate of its total cost or its economic effects. 

Instead of trying to set a new record on the size of tax reductions, any tax change should focus on the future needs of the American citizens, and establish a tax system that effectively promotes economic growth, is simpler and also fairer. 

Tom Neubig

Does the employer share of payroll taxes matter?

Economic theory concludes that the incidence of a tax doesn’t vary with who has the statutory incidence or remittance responsibility (the “invariance of incidence proposition”.   In the case of employer and employee payroll taxes, the ultimate incidence should depend simply on the supply and demand of labor.  Frictions, however, such as minimum wages, union contracts and evasion differentials from remittance responsibility may affect the final burden.

Given the important role payroll taxes play in funding social security programs and tax policy (26% of total OECD countries’ tax revenues), the question is why do governments differ in their employer and employee shares of social security contributions (SSC).  As shown in the figure above, the average OECD country collected 61% of total SSC from employers in 2014; the employer share varies greatly across countries.  Eleven OECD countries’ maximum employer payroll tax rates are over 10 percentage points greater than their maximum employee tax rate.

Most studies of payroll taxes don’t differentiate between employer and employee payroll taxes.  Two recent studies find that employers bear a non-significant (one-third) share of payroll taxes (Melguizo et al. (2012), Gavrilova et al. (2015)), while Suez et al. (2012 and 2017) and Muller and Neumann (2016) find no employer shifting around contribution limits.  One study finds that small employers are less likely to shift the payroll tax. 

More empirical research is needed to help policymakers better understand the effects of payroll taxes.  If employers bear some of the burden of payroll taxes, and potentially a greater burden of employer payroll taxes, then employer payroll taxes could adversely affect the demand for labor, particularly lower-wage workers, and affect business location decisions.  If employees perceive their employee contributions to provide future social security benefits, then employee contributions may not affect their labor supply as much as other taxes. 

In only six of the 35 OECD countries is the income tax greater than the payroll tax for the countries’ average wage earner, as shown in the figure below based on the new OECD Taxing Wages 2017 publication (AU, DK, IS, IR, NZ, US).   The employer payroll tax is more than half the total tax wedge on average wage earners in 8 OECD countries (CZ, EE, ES, FR, IT, MX, SE).

Where there is a disconnect between economic theory and politicians’ and business’ views, more work is needed to strengthen the empirical backing of the economic theory and/or to better understand the mechanisms causing divergences from the theory.

Tom Neubig

Profit-shifting tax rate differentials continue to increase

The G20/OECD BEPS Project Action 11 report, Measuring and Monitoring BEPS, included a number of insights beyond the widely reported annual global revenue loss range of US$100-240 billion in 2014.  One analysis showed that while the average OECD corporate tax rate was declining, tax rate differentials between OECD countries were increasing.  So the incentives for profit shifting was increasing, not decreasing. 

The trend of increasing tax rate differentials among OECD countries, despite decreasing average corporate statutory or “headline” tax rates, has continued to grow into 2017.  The above chart uses an average OECD rate, weighted by Gross Domestic Product (GDP), unlike many analyses using unweighted averages that give Estonia the same weight as Germany.  The chart presents both the top (“headline”) corporate statutory marginal tax rate as well as special lower tax rates on certain patent income (“patent or innovation boxes”).  The tax rate differential is measured by the standard deviation of tax rates around the weighted mean.   The Action 11 report found similar trends using Foreign Direct Investment and cross-border trade.

The weighted-average headline OECD corporate tax rate has fallen from 38.7% in 2000 to 31.5% in 2017, while the average tax rate on intellectual property (IP) income has fallen from 38.6% in 2000 to 28.1% in 2017.  Meanwhile, the variation in headline corporate rates increased from 5.5% in 2000 to 7.1% in 2017, and the variation in patent income tax rates increased from 5.9% in 2000 to 10.9% in 2017. 

Lower weighted-average statutory corporate tax rates reduce the tax rate differential with zero corporate rate tax havens, but havens’ importance to GDP is minimal, and the incentive to reach a 0% rate is still strong whether from the US headline rate of 39% or Ireland’s rate at 12.5%. 

The U.S. is a big part of the profit shifting story, but not the only part.  The BEPS Action 11 report highlighted many empirical studies that found significant profit shifting among non-US companies.  If the U.S. lowered its combined federal and state corporate headline rate to 25%, the average OECD rate would decline to 26.1%, and the tax rate variation would fall to 4.0%, below the variation in 2000.  A 25% US combined rate would be lower than the GDP-weighted average of the other OECD countries by 1.8 percentage points.

It should be noted that the variation in “headline” corporate tax rates between non-US OECD countries declined over the 2000-2017 period along with their average tax rate.  Tax rate differentials between non-US OECD countries and also tax havens continue to incent non-US companies to profit shift. 

As long as country sovereignty in setting their tax rates and origin-based corporate income taxes remain fundamental building blocks of corporate income tax systems, governments will need to use tax systems (non-tax rate/base) measures, such as the anti-BEPS measures proposed in the BEPS project to reduce harmful tax competition between countries and to minimize tax-induced profit shifting by MNEs. 

Tom Neubig

A Tax-Systems Perspective on New Global Tax Initiatives

Some exciting global tax initiatives are presented from Joel Slemrod's tax-systems perspective in a new working paper by Joel and me.  Check out the full paper at: http://ssrn.com/abstract=2906349

We present four important dimensions to international tax policy from a tax-systems perspective, stressing that non-rate/base tax policies can have different cross-jurisdictional spillover effects than changes in tax rates. The dimensions are the allocation of global income among taxing jurisdictions, information sharing between governments about taxpayers, multilateral efforts in tax policy and tax administration, and information sharing about governments’ tax practices.

The paper discusses two recent global tax initiatives, the G20/OECD Automatic Exchange of Information (AEOI) and the Base Erosion and Profit Shifting (BEPS) Project in these four dimensions of tax systems in a cross-border context. As evidenced by these global initiatives using new types of tax-systems policy options, national tax systems and their policy and tax administration designs will also reflect more non-tax-rate/base issues.

With increasing globalization and technological developments in economies, more tax policy and tax administration options will be needed in the future to deliver optimal tax policy. Effective use of tax-systems instruments can protect countries’ tax sovereignty in a world of increasing globalization. 

Tom Neubig

Where’s the competitive disadvantage from other countries’ VAT border adjustments?

The House Ways and Means Committee Republicans’ tax reform plan claims that US companies are at a competitive disadvantage since their exports are taxed in the US by the corporate income tax and also by foreign countries’ value-added taxes (VAT).   They say foreign competitors’ exports to the US are not taxed in their domestic country and also not in the U.S. since there is no US VAT.

“In the absence of border adjustments, exports from the United States implicitly bear the cost of the U.S. income tax while imports into the United States do not bear any U.S. income tax cost. This amounts to a self-imposed unilateral penalty on U.S. exports and a self-imposed unilateral subsidy for U.S. imports. Because this Blueprint reflects a move toward a cash-flow tax approach for businesses, which reflects a consumption-based tax, the United States will be able to compete on a level playing field by applying border adjustments within the context of our transformed business and corporate tax system. For the first time ever, the United States will be able to counter the border adjustments that our trading partners apply in their VATs.” 

The table shows several important facts:

·      The US has significantly lower taxes as a percent of GDP, 25.9%, than the OECD average, 34.2%.  Only Korea and Mexico have a lower tax-to-GDP ratio.

·      Although the US has the highest statutory marginal corporate tax rate, its corporate income tax-to-GDP ratio of 2.2% is 22% lower than the average OECD ratio of 2.8%.  Other countries have corporate income taxes that impose tax on their exports to the U.S.

·      Other countries have higher taxes than the U.S. because they on average have higher payroll and consumption taxes, while the US tends to have higher personal income and property taxes.  

·  OECD countries’ general consumption taxes, principally VATs, account for 7.0% of GDP compared to the US states’ retail sales tax of 2.0%. 

·      Five percentage points of other countries’ 8.3 percentage point higher tax-to-GDP ratio average is due to other countries’ VATs, which apply to domestic consumption in their country.  Similarly, another three-percentage point difference is due to higher payroll taxes in other countries that apply to their domestic workers.  Under conventional economic incidence assumptions, those taxes don’t burden capital owners and shouldn’t affect relative competitiveness.

A border adjustment to a US business cash-flow tax is not needed to make US companies more competitive in their exports to other countries.  The U.S. taxes corporate income from exports similar to how other countries tax corporate income on exports from their countries.  Other countries’ VAT systems don’t subsidize exports or penalize imports.  Rather their destination-based VATs impose similar taxation on household consumption from both domestic and imported goods. 

There are lots of reasons to reform the US corporate income tax system, particularly lowering the high statutory marginal corporate tax rate, broadening the base and protecting the tax base from base erosion and profit shifting.   But border adjustability of a business cash-flow tax base is not one of them. 

If the U.S. enacted a destination-based VAT, it should be border adjustable so US households would pay the VAT on both domestic and imported products equally. Analogies of the DBCFT to a combination of a subtraction-method VAT and a reduction in the employer payroll tax may be beneficial in an attempt to get the World Trade Organization to accept border adjustments to a DBCFT, but the economic effects of a DBCFT would be quite different than a VAT.

Tom Neubig

Cash flow taxation and “excess” (but still marginal) returns

Setting aside the issue of border adjustability, the cash-flow tax on domestic producers would replace the current CIT’s tax on total corporate equity income with a business tax on so-called “excess” returns.  To see this, consider expensing of business investment is similar to a traditional Individual Retirement Account (IRA) deduction.  A traditional IRA provides an immediate tax benefit that is equivalent to exempting the expected “normal” return on the retirement savings.  The present value of the immediate tax savings offsets the expected present value of the future taxes on the payouts of both the principal and expected investment return.  But since all future payouts are subject to tax, any “excess” capital returns would be taxed in the future.  Unlike a Roth IRA that provides no upfront deduction but exempts all future payouts, the traditional IRA (expensing) taxes “excess" returns.  

Expensing eliminates the so-called “normal” return to capital, but a recent US Treasury empirical study found that three-quarters of corporate income was "excess" returns.  (See Nov. 21, 2016 blog on "normal" and "excess" returns.) Businesses and investors aren’t taking risks and exerting significant efforts to earn “normal” returns, which often are equated to government bond rates.  Businesses and investors are still concerned about taxes on "excess" returns.  Taxes on “excess” returns can reduce the expected return below their high hurdles rates that reflect risk and entrepreneurial effort.  

The return may be "excess" but it isn't necessarily "infra-marginal" to investors and entrepreneurs. That is why many corporations were more interested in a lower corporate tax rate than expensing after a similar tax reform proposal was made in 2005.

Tom Neubig

Border adjustability will affect imports and exports

Border adjustability in the House Ways and Means Republicans’ destination-based cash-flow tax reform proposal will not result in an immediate and full offsetting exchange rate change as recently claimed by Martin Feldstein, significantly increasing the value of the US dollar relative to foreign currencies.  As noted in the January 6, 2017 blog, Feldstein made a different argument in 1990. 

Alan Viard has made a persuasive case that border adjustability will not permanently change the trade balance, given the assumption that the present value of imports and exports must balance over the life of a country!  However, in the near term, Alan notes that a new and/or non-comprehensive border-adjusted tax can cause sectorial changes discouraging some imports and encouraging some exports.  The magnitude and distribution of those changes need more analysis rather than assuming they won't happen. 

Alan also emphasizes that an increase in the US dollar will have a significant transition effect reducing the value of Americans’ holdings of foreign assets.  That wealth effect would reduce the well-being of American households and should also be subject to additional analysis. Both the trade and wealth effects may be offset by other advantages of the proposed tax reform, but should be explicitly considered by our policymakers.

Tom Neubig

Fiscal federalism affects multinational decisions: new approach to winners & losers?

The recent news of Carrier Corporation’s choice of locating jobs in Indiana vs. Mexico highlights that state taxes also matter in multinational corporations’ investment decisions. As noted in our January 6th blog, origin-based US state and local businesses taxes, such as property taxes and sales taxes on business inputs, are greater than the US federal corporate income tax.  Those origin-based taxes affect business location decisions.

What is newsworthy about the Carrier decision is that it may signal a growing recognition by the U.S. federal government of the importance of state and local business taxes in U.S. business location decisions (“competitiveness”).  The Carrier decision was significantly based on additional state tax incentives.  The negotiations were the result of the Twitter-pulpit of President-elect Trump and his Vice-President Elect and then-current Indiana Governor Pence.

From the perspective of state government policymakers the Carrier negotiations may be seen as a mixed blessing.  States have always strongly defended their "independence" from federal involvement in state tax policy. The new federal Administration may result in the federal government attempting to have more influence on which states benefit from new business jobs and investment.  In addition to choosing winners or losers among businesses, the federal government may exercise more influence in choosing which states are winners or losers.  States may be understandably concerned if this happens. 

Multistate corporations' extensive domestic tax legislative activities highlight the importance of state and local taxes to business.  These have included on-going challenges to assessed values of taxable business property at the local level, support for reduced sales taxation at business input at the state level, and advocacy for lower rates and more generous general as well as targeted tax credits or incentives.  Individual negotiated "deals" already common in many states may occur more often as a result of a presidential Twitter blast.   

The new federal Administration may signal a more proactive policy of encouraging particular business behaviors, such as locating economic activity in the U.S.  It may also signal a stronger federal role in the U.S. fiscal federalism, contrary to Republicans’ conventional backing of greater states’ rights, at least in the area of tax and business incentives.

Robert Cline and Tom Neubig

All business taxes matter: Not just corporate income tax

Tax policy economists spend an inordinate amount of time analyzing the effects of corporate income taxes (CIT).  They are important, but so are many other government policies affecting business, including other taxes on business. 

A recent study, the 14th annual EY/Council on State Taxation study of total US state and local business taxes remitted by both corporate and non-corporate businesses reported a total $707 billion in 2015.  State CIT of $67 billion was less than 10% of total state and local business taxes.   

Total US federal CIT in 2015 was $345 billion (according to US BEA NIPA accounts, less Federal Reserve earnings), which is less than one-half of the $707 billion in total state and local business taxes.  Property taxes on business of $258 billion and sales taxes on business inputs of $151 billion were the same size as total US corporate income taxes in 2015.  Employer contributions to federal government social insurance totaled $568 billion.  With roughly half of total US business income not subject to corporate income tax, a focus on CIT is missing a lot of the business tax action.

Whether capital owners, consumers or workers bear the burden of specific taxes remitted by businesses is important in analyzing the economic effects of business taxes.  More work on the incidence of all business taxes, including the CIT, is needed.  

The geographic incident of tax matters for business decisions on where to locate economic activity: whether source (origin)-based or market (destination)-based.  Property taxes, sales or VAT on business inputs, employment taxes, withholding taxes, and other miscellaneous taxes and charges are typically origin based.  These affect the cost of operating in a particular country or jurisdiction to the extent those taxes are not offset by government benefits received.  

Origin-based non-CIT taxes should be expected to have similar negative effects on business location decisions ("competitiveness") as origin-based components of a CIT.  Thus, considerations of competitiveness need to be more comprehensive in terms of all business taxes and at all levels of government. 

It is not just taxes but also other government incentives, regulations, infrastructure and services that affect firms' production costs in a particular jurisdiction.  Empirical analyses of CIT that ignore non-corporate income taxes and other government support or costs to business are missing important economic factors in businesses' location decisions. 

Tom Neubig and Robert Cline

Tax Exchange Rate Offset?

Many academic economists argue that a destination-based tax, such as a value-added tax (VAT) or cash-flow tax, will not have competitive effects due to offsetting changes in exchange rates.  Many businesses are concerned about the economic effects of a destination-based tax that includes a “tax on imports.” 

An old paper by Martin Feldstein and Paul Krugman, “International Trade Effects of a Value-Added Taxation”, helps explain some of the disconnect between the thinking of academic economists and business.  Academic economists generally assume that a VAT would apply to 100% of final household purchases.  In fact, few VATs are comprehensive.  The most recent OECD Consumption Tax Trends publication reports that only 56% of final household purchases are subject to VAT in OECD countries with a VAT.  Thus, a VAT causes distortions across products, services, and industries, plus any exchange rate adjustment is not fully offsetting the tax paid by importers.

A destination-based cash-flow tax (DBCFT), similar to the House Ways and Means Republican’s A Better Way tax reform proposal, would introduce another reason why exchange rates would not adjust for the full tax rate.  Unlike a VAT, a DBCFT provides a deduction for origin-based employment compensation.  While an imported good would be taxed on the full sales price (or not deducted by an importer), a similar domestically produced good would only be taxed on the non-labor value added.  Again, the academic argument is that exchange rates will offset the difference, but since labor intensity differs across products, services and industries, an exchange rate offset may occur on average, but with differing effects across products, services and industries.

Thus, similar to most tax reforms, there will be winners and losers depending on the specifics of the actual tax design.  For instance, a comprehensive VAT, similar to New Zealand’s, will have fewer distortions than the typical VAT.  It should be noted, that the typical credit-invoice method VAT prevents a zero-rated or exempt activity earlier in the supply chain from reducing the final tax on household consumption goods or services.  A subtraction method VAT, similar to a DBCFT with a deduction for labor, however, results in differential final good prices depending on the amount of exempt or zero-rate activities in the value-chain.  In addition, tax losses to exporters are often not refunded fully, and the differential effect of the taxes or spending replaced, will also differ by industry.

Businesses should focus on both the positive and negative economic effects of a destination-based tax, since exchange rate changes are unlikely to fully offset non-uniform features of the tax.  Academics are correct in noting that some of the effects will be offset by a change in exchange rates, but an ideal tax is unlikely to be the tax businesses will have to live with, and there will be winners and losers. 

Tom Neubig

EU’s State Aid Case: Real Issue is Unfair Competition Between Countries

One of my takeaways from working on the G20/OECD BEPS Project was that it often took two players for base erosion and profit shifting (BEPS) to occur: a tax-planning multinational enterprise and a facilitating country or countries.  BEPS was facilitated by some national governments to increase jobs, investment and revenues in their country.  Thus, competition is not just between companies, but also between countries. 

EU “Competition policy is about applying rules to make sure companies compete fairly with each other.”  The EU State Aid rules do not address the issue of competition between countries. 

There are many affected parties in the EU State Aid case against Ireland and Apple.  Reduced effective tax rates (ETRs) can affect the relative competitiveness of companies.  Interestingly, the EU ruling (currently only a 4 page press release) gave no examples of competitive harm to other companies.  The OECD BEPS Action 11 report notes that the incidence of corporate tax avoidance from BEPS may be more likely to increase rents to shareholders than lower prices to consumers or higher wages to workers.  Without lower consumer prices, the potential harm to other companies is quite limited.

Reduced average ETRs have been shown to affect the location decisions of companies.  A lower average tax rate in Ireland encourages more investment, jobs and tax revenue in Ireland.   The shifting of investment and jobs due to a reduced ETR comes at the expense of jobs and investment in other countries.  BEPS affects the revenue collected by other countries, so other taxpayers, both individuals and companies, have to pay more taxes for a given level of government services.  Thus, it is more likely that any State Aid harmed citizens in other countries, rather than other companies’ shareholders.

The current EU State Aid rules require recovery of the reduced taxes by Ireland.  Ireland could use the additional money to reduce its current 12.5% corporate tax rate, further reduce its Knowledge Development Box 6.25% tax rate, and/or increase its spending on education or infrastructure, further enhancing its competitive position vis-à-vis other countries.  It could be a winner twice with jobs and investment from the initial State Aid, and then with future jobs and investment from spending of the State Aid recovery.  The recommended recovery is equivalent to three years worth of Irish corporate tax collections.  

The EU ruling notes “If other countries were to require Apple to pay more tax on profits of the two companies over the same period under their national taxation rules, this would reduce the amount to be recovered by Ireland.”  This statement likely reflects the EU’s real concern in the Apple case, which is competition between countries and their harmful tax practices.  Distribution of recovered amounts to adversely affected stakeholders would require many assumptions about the incidence of the favorable tax treatment, but clearly the facilitating government is not a negatively impacted stakeholder.  With the current lack of understanding of the effects of corporate tax incidence, such an attempt would be a fool’s errand, and new audits by multiple governments based on then existing transfer pricing guidance for tax years 2003-2013 are neither realistic nor desirable.

In my experience with tax policy issues, it is more important to get the future rules improved rather than attempting to recover past tax benefits.  Fortunately, the G20/OECD BEPS Project and the EU’s Anti-Avoidance Directive are important steps in reducing corporate tax avoidance in the future with improved transfer pricing guidance and improved governmental transparency with spontaneous exchange of information on governmental tax rulings.   Future coordinated multilateral standards to reduce BEPS and reduce personal tax evasion through Automatic Exchange of Information will reduce governments’ use of tax systems to benefit select taxpayers will reduce countries’ harmful tax practices.

Tom Neubig

Tax certainty new focus of G20

Risk is often characterized as the different likelihoods within a known distribution (eg. knowing the rules of the game), while uncertainty is the existence of possible multiple distributions (eg. not knowing which game will be played).

Best available data (BAD) and its use in policy analysis

Policy analysts are continuously striving to find new insights with new sources and types of data.  Analysts are looking for the “best available data”.  This is important for improving policy analysis, but sometimes analysts are more interested in publishing results than understanding exactly what is in the underlying data.  Sages know that databases need to be reviewed carefully before placing great weight on the subsequent analysis.  A database might be the “best available”, but still have significant limitations needed to caveat any analytical results.

Running regressions is fun, but an analyst should know what the underlying data includes.  Interpreting regression results requires a thorough understanding of what the included variables measure and what key observations are missing from the data. 

In the case of Base Erosion and Profit Shifting analyses, the OECD Action 11 report on Measuring and Monitoring BEPS spent the first chapter highlighting the caveats and limitations of current existing databases for analyzing BEPS.  All of the databases have limitations, and company-level data has many advantages for analyzing BEPS issues.  Several empirical studies have used company financial data from Bureau van Dijk’s ORBIS (global) or AMADEUS (European) databases.   Whilst possibly the “best available”, the ORBIS financial report data is not truly global and is incomplete in many respects.

The BEPS Action 13 Country-by-Country reports for the largest MNEs with actual tax, rather than financial, data, will significantly improve the available data for tax agency researchers. Until 2019 at the earliest, ORBIS or AMADEUS databases may remain the “best available.” However, economists from the US Joint Committee on Taxation demonstrated what can be done with comprehensive tax data from MNEs and their subsidiaries available from one country’s tax data. (Dowd, Landesfeld and Moore, 2015, see link).

We would caution analysts to caveat results from the ORBIS database carefully, as the following table from the BEPS Action 11 report shows the ORBIS database is highly skewed to European companies and European headquarters, and a careful look will reveal the absence of many significant tax entities that have been shown to have engaged in BEPS behaviors. 

Because the ORBIS database includes only available financial information, it does not have financial information about most unconsolidated subsidiaries of US-headquartered companies, which file consolidated financial reports.  It includes some entities in tax havens, but generally without any detailed financial information.  Also, when evaluating an available database, it is important to check some of the largest and most important key entities with other available data.  For example, we were not surprised to find that the ORBIS database did not include Apples Sales International for many years, and when a record for the entity was included it included just the name of the entity, not financial information.   Yet it was clear from parliamentary inquiries (and confirmed by the recently released EU illegal state-aid ruling involving Apple’s taxes in Ireland) that Apples Sales International would be a significant MNE observation in estimating the potential tax revenue lost through BEPS. 

The fact there may be several million observations for analysis does not overcome the fundamental data limitation of incomplete, unrepresentative and key missing companies. However, incompleteness and unrepresentativeness does not prevent good analysis from being done when reported with appropriate limitations.  Clearly policy analysts should also follow the Hippocratic oath of Do no harm.  And analysts should be humble with respect to their empirical findings with best available, but compromised, data.

Similarly, suggestions that an empirical finding is “robust” because the underlying data has been tortured in multiple ways and similar results have been found by a number of researchers using the same databases should not be believed if the underlying data is incomplete and unrepresentative.

Working with the best available data is important for continued progress in analyzing BEPS and other issues.  But the old adage of garbage-in, garbage-out still applies.  Another adage could be: cavalier use of “best available data” could be BAD analysis. 

Tom Neubig and Bob Cline

Economic Incidence Analysis of Digital Economy Tax Options

Tax policy analysts may have missed an important incidence analysis in the OECD/G20 BEPS Action 1 Report: Addressing the Tax Challenges of the Digital Economy.  Appendix E.  Economic incidence of the options to address the broader direct tax challenges of the digital economy, p. 275-285. The analysis examines the expected economic incidence of three different taxes designed to impose uniform taxes on both remote and domestic sellers of digital goods and services. The analysis highlights the importance of the market structure of the goods and services in countries in which foreign companies compete without taxable status and the potential response of affected foreign companies to the specific tax policies. 

The Action 1 report concluded that “it would be difficult, if not impossible, to ring-fence the digital economy from the rest of the economy for tax purposes.” It also noted that key features of the digital economy may exacerbate BEPS risks, many of which could be addressed by proposed BEPS changes in the permanent establishment (PE), transfer pricing, and controlled foreign corporation (CFC) tax rules. The digital economy also raises broader challenges in the areas of nexus, data and characterization for direct taxes (and also challenges for value added tax collections, which will be discussed in a future blog).

The Action 1 report analyzed, but did not recommend, three potential options: (i) a new corporate income tax nexus in the form of a significant economic presence for remote sellers, (ii) a withholding tax on certain types of digital transactions, and (iii) an equalization levy. Countries could introduce any of these three options in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or in their bilateral tax treaties.

In the first half of 2016, Israel and Turkey proposed changes to their permanent establishment rules affecting some companies with "significant digital presence" or with an "electronic place of business", respectively. India enacted a 6% Equalization Levy chargeable on the gross payment for specified digital services and facilities received by a nonresident who does not have a PE in India. (See EY Tax Alert)

Given countries’ consideration of digital economy tax options, the economic incidence analysis of the options is worth highlighting.  The analysis considers the expected economic incidence in open-border economies, but with particular attention paid to the fact that the options represent tax changes only for foreign providers without a permanent establishment (PE) making remote sales of digital goods and services to in-country customers.

“The tax change options are:

·      a corporate income tax on the net income generated from remote sales of digital goods and services to in-country customers by a foreign producer without a PE to which such income is attributed under current law

·      an equalisation levy (“excise tax”) imposed on the remote sales of digital goods and services to in-country customers by the same providers, and

·      a withholding tax on the gross receipts from the remote sale of digital goods and services to in-country customers by the same providers.”

The key policy finding is, given the assumptions, the expected economic incidence of the three tax options for taxing the activities of affected remote sellers related to the sales of digital goods and services by foreign suppliers without a PE would be the same.  In other words, the form of the tax options does not alter the incidence of the new taxes.

·      “In the case of a perfectly competitive market for digital goods and services, the incidence of the corporate income tax increase is likely to be borne by labour in the affected foreign suppliers’ production country and consumers in market countries, depending on the importance of the affected suppliers in the particular market and the availability of replacement suppliers with similar cost structures and the availability of alternative goods and services.

·      If the market is imperfectly competitive, the corporate income tax increase is likely to be borne principally by the equity owners of the affected foreign suppliers.

It should be noted that there will be a difference in the geographic distributions of the tax burdens borne by capital owners, labour and consumers. Any portion of a CIT increase that would be borne by reductions in the income of equity shareholders of foreign suppliers without a PE will occur in countries where the shareholders are located. The distribution of the burden on labour will reflect the geographic distribution of production by the affected suppliers. In contrast, any portion of the tax burden borne by consumers will be spread over market countries where the foreign producers without a PE have market power in setting the domestic price of particular digital goods and services. Therefore, the share of the total worldwide increase in tax burdens borne by consumers, workers and capital owners will vary from country-to-country.

As a final point, further analysis of the economic characteristics of the affected remote producers and the market for particular digital goods and services would need to be analysed to determine whether perfect competition or imperfect competition, in the short and medium term, is the most accurate to use in the incidence analysis. The analysis also does not provide any insights into the distribution of tax burdens by household income levels. In addition, the incidence results for the three tax policy options depend heavily upon the key assumptions about the responsiveness of foreign suppliers of digital goods and services without a PE that will become subject to the alternative tax options.”

Thus, depending on market conditions for the specific services on which the Indian Equalization Levy is imposed, the burden could be borne by Indian consumers in higher prices, IT workers in other countries in lower wages or reduced jobs, and/or global shareholders in lower capital returns.  

Bob Cline and Tom Neubig

Extending OECD's Tax and Growth Analysis to Inclusive Growth

Important new OECD Working Paper (WP), "Tax Design for Inclusive Growth," by four former colleagues at the Centre for Tax Policy and Administration's Tax Policy and Statistics Division. The WP adds critical new dimensions to the prior OECD Tax and Growth work. No longer focused just on economic growth, tax policy and administration designs for both equity and efficiency considerations are discussed.  Many areas for future research are noted.

An important insight highlighted is when tax avoidance and evasion opportunities are closed, the supposed "mobility" of capital is reduced, thus weakening the argument for lower tax rates for "mobile" capital. The OECD/G20 BEPS Project, which will reduce corporate tax avoidance (see OECD BEPS website), and the establishment of a single common global standard on automatic exchange of financial account information  (see OECD AEOI website), while will reduce personal tax evasion, are important tax system changes that will positively affect tax policy for inclusive growth.

Tom Neubig

Future Research Issues for Better Understanding BEPS

Many researchers may have missed a significant contribution of the BEPS Action 11 report identifying important areas for future economic research.  These are some of the questions that arose in the course of the progress made in measuring BEPS.  A good analysis often raises more questions than answers.  Hopefully this report provided both. See the text of the BEPS Action 11 report on pages 122-124 of Chapter 3. 

"Future areas for economic research to better measure the scale and economic impact of BEPS with better data

The mandate for Action 11 included developing an economic analysis of the scale and impact of BEPS (including spillover effects across countries) and actions to address it. This chapter summarises the current understanding of the scale and impact of BEPS based on academic studies, other international organisations’ analyses, as well as some new OECD research. Progress is being made in better understanding BEPS and countermeasures, and the economic analysis show that BEPS is significant and affects many economic decisions of both taxpayers and governments. The issue of BEPS and appropriate geographic allocation of income and expenses relative to measures of value creating activities is important not only to the current corporate income tax, but also would affect other taxes proposed by some academics such as a business cash-flow tax or a comprehensive business income tax.

The current body of empirical research into the fiscal and economic impacts of BEPS demonstrates that the stakes are high, but there is still much further research needed to be undertaken. ... A number of areas for future research beyond the Action 11 mandate but which will add to the understanding of BEPS and MNEs are highlighted, since better data alone will not be sufficient for the best possible analysis of BEPS.

The following are some of the areas where additional analysis is needed:

·      The prevalence and intensity of BEPS. How pervasive are BEPS behaviours? Is BEPS limited to a small number of MNEs or more widespread? Are some MNEs more intensively exploiting BEPS than other MNEs, and if so why (e.g. costs of tax planning, corporate governance, risk profile)? Would largely unrestricted BEPS encourage smaller MNEs to start engaging in BEPS and encourage domestic companies to go global for the BEPS tax benefits?

·      Differences in the profitability of MNEs vs. comparable domestic entities. Are there inherent economic differences between MNEs and domestic entities which make comparisons of ETR difficult? If so, how can competitiveness between MNEs and domestic entities be evaluated?

·      Factors contributing to group profitability. What contributes to the profitability of a global consolidated MNE? How much can be explained by tangible capital, labour and/or sales compared to other factors such as different types of intangible assets, public infrastructure, country risk diversification, etc.

·      Factors contributing to affiliate profitability. What contributes to the profitability of individual MNE entities? How can functions, assets and risks be incorporated in future analyses of BEPS, since they are the basis of arm’s length pricing? How much can be explained simply by tangible capital, labour and/or sales compared to other factors such as the intangible assets of their global MNE, public infrastructure, labour force qualities and stability in a country, etc.? How can these other factors which may change over time be incorporated more fully than just dummy variables?

·      Other tax factors in location decisions. Corporate taxes are only one source- based tax affecting location decisions. How do these other business taxes affect MNEs’ tax decisions? How can measures of profit shifting separate the effects of non-BEPS tax preferences from BEPS?

·      Effects of uncertainty, reputation and compliance costs, and disclosure. Companies face the equivalent of implicit taxes from uncertainty, reputation and compliance costs. Can these be measured and included in the economic analysis of taxes and BEPS? What effects do disclosures to tax administrations have?

·      Mobility of different types of labour and capital. How mobile are different forms of real economic activity, such as top level executives, R&D scientists, production workers, back-office workers, buildings, equipment, different types of intangible assets, etc.?

·      Governments’ strategic behaviours. How do different institutional settings affect countries’ co-operative versus competitive behaviours? How multilateral do agreements need to be to achieve effective co-operative outcomes?

The analysis of BEPS and countermeasures has advanced since 2013, providing more evidence of BEPS and insights into specific BEPS channels and potential effects of BEPS countermeasures. As analysts can only observe the current world with BEPS, any analysis of BEPS and countermeasures must estimate a comparison point, whether it be a world without BEPS, a future world without co-ordinated multilateral action, or a future world with proposed countermeasures. Future analysis of BEPS, MNEs’ BEPS behaviours, and tax competition with improved estimation methodologies are needed to complement improvements in the available data relevant for analysing BEPS and BEPS countermeasures."

Tom Neubig and Bob Cline