Some academic thoughts on international tax reform

Since my post last week on unitary taxation, I’ve read a couple of academic papers that give useful perspectives on some of the questions I raised.

US states and unitary taxation

First up, Lessons for International Tax Reform from the U.S. State Experience Under Formulary Apportionment by Kimberly Clausing. One of the concerns I raised last week was that, if a unitary approach has fewer loopholes for companies to exploit, and if countries were to adopt it without reaching an international consensus on a formula, that might increase the pressure on smaller developing countries to adopt formulae that are more competitive – that is, to give up some of their potential tax base in order to attract investment.

Clausing cites a paper by Jack Mintz and Michael Smart, which takes advantage of a natural experiment whereby some firms operating across Canada have their tax base allocated between states using transfer pricing, and others through a formulary apportionment. Under transfer pricing, taxable income can be shifted and is twice as sensitive to the tax rate than under formulary apportionment. In the latter case, to reduce their tax bills firms would need to resort to more intensive lobbying, with the threat of moving their investment if their effective rate wasn’t reduced.

That is indeed what seems to have happened among US states, where there’s been a gradual drift away from the ‘three factor’ formula of sales, assets and payroll towards ones that reduce or eliminate the role of the latter two factors. This is plain old tax competition, with state governments reducing the tax burden on capital investment and job creation; instead they increase the emphasis on sales, since their consumer market is much less mobile. At the same time, state corporation tax revenue has fallen, even as corporate profits have risen.

Clausing’s regression analyses suggest that when states have reduced the role of assets and payroll in their formulae, this has not created an increase in investment and jobs, respectively – or at least not for any states beyond the first few to do so. It has, however, led to a reduction in corporation tax revenue.

The implication for developing countries is this: while unitary taxation may be made more viable if the (probably impossible, and possibly undesirable) requirement for an internationally agreed formula is relaxed, it appears that this could bring about a new kind of tax competition, over the selection of formulae by developing countries. Those seeking to attract labour-intensive manufacturing might adopt a formula with a reduced role for labour, for example. I suppose that this could be partly addressed through agreement of formulae at regional level, since much (but not all) tax competition takes place among neighbours.

What is the international tax system for?

The second paper I enjoyed was an essay by Arthur Cockfield entitled The Limits of the International Tax Regime as a Commitment Projector. In his analysis,

the [international tax regime] can be understood as institutions and institutional arrangements that provide signals to relevant actors, mainly multinational businesses, that international double taxation and other conflicts will be resolved.

I think ‘signalling’ is a good explanation of many aspects of international tax. In the context of my own research, why would a developing country sign a tax treaty with a country from whom it expects no investment, or put the arm’s length principle into law without any plans to enforce compliance with it? One reason might be that it sends a message that the country will abide by international norms in the future.

Cockfield discusses ‘credible commitment’, the idea that governments, which may only be in office for a few years, can’t promise stability, because they can’t make binding commitments on behalf of their successors. Treaties and other international institutions are a way to do so, because they can only be changed if all parties agree, or through the dramatic and unlikely step of repudiation. The investment-promoting benefits to a developing country of signing a tax treaty go beyond the immediate tax treatment of investors, to include the credible commitment that future governments are unlikely to change this treatment to the investor’s detriment.

But some problems have emerged – two, in particular. First, the system allows significant undertaxation (the acknowledged reason for the OECD’s BEPS project), and second, transaction costs are being increased by the US’s unilateral enforcement of FATCA. Cockfield argues that we have reached this point as a result of three factors:

• Path dependency (the transaction costs to governments of reform exceed those of working within the current system – or perhaps, he suggests, the growth benefits of the current system exceed the cost of under-taxation).
• ‘Capture’ by multinationals (As an interesting example, he cites Canadian policymakers, who justify laws that allow ‘double dipping’ by Canadian companies overseas, “on the basis that they reduce the cost of debt capital for [Canadian] multinational firms and hence promote [their] ‘competitiveness’.”)
• Information gaps (“governments do not properly understand the world in which they design and implement international tax laws and policies”).

The focus in this paper is on credible commitments to firms to ‘inhibit overtaxation’, in particular double taxation. It argues that the pressure from multinational firms for these commitments is probably stronger than pressure from any other constituents to deal with the other problems that have emerged. But I think that international tax institutions need more than double taxation to explain them. I think they can be about the effective tax rate on multinational businesses under single taxation as well. To take the most obvious example, when the government of a developing country signs up to a tax treaty, it binds its successors into maximum rates of withholding tax. Because multinationals’ foreign income is increasingly untaxed by home countries such as the UK, this is unnecessary to eliminate double taxation, and instead it reduces the single tax rate. In other words, the credible commitment by a developing country under a tax treaty may not be to inhibit overtaxation, but to set a cap on the tax rates that future governments can impose. I think it’s possible that some developments in international tax institutions are better explained in this way.