The European Commission recently re-launched plans for a compulsory EU-wide tax code for multinationals operating in more than one member state. The scheme, known as the Common Consolidated Corporate Tax Base (CCCTB), would calculate a multinational company’s taxable income across the EU, and then assign shares of it to the different member states where that company operated. Each jurisdiction would then levy tax at its own, nationally set rate. Tax base shares would be calculated according to a formula that would take into account the company’s revenue, payroll and wage bill, as well as its physical assets in each country. The goal is to ensure companies “pay taxes where the revenue is generated.”
The proposal may seem reasonable at first sight, but it has a number of fundamental weaknesses which mean it is likely to do more harm than good.
- It replaces a tax on corporate profits with an arbitrary formula.
Corporation tax targets a company’s earnings, measured as revenue minus costs and allowances for interest, depreciation and amortisation, and other exemptions. This means that, for tax purposes, a corporation’s turnover, headcount and assets are irrelevant – what matters is the money left over after all operating costs have been accounted for. Thus it is quite possible for a large enterprise with thin margins, say, a steel mill with high costs for raw materials and an expensive unionised workforce, to pay a lower absolute amount in tax than a small company with a fraction of its revenue, say, an innovative drug manufacturer. This is also true among the different subsidiaries of a multinational, some of which may be smaller yet more efficient than others.
The CCCTB, however, takes a much cruder approach. Assume a car manufacturer with two subsidiaries, one operating a large factory in Germany, the other running a smaller one in the Czech Republic. Most of the company’s sales are in Germany, where it employs a majority of its workforce at higher wages than in the Czech Republic. Under the current tax regime, the company attributes profits to each subsidiary according to the revenue and costs of each – presumably, its margins are higher in the Czech Republic, so a disproportionately higher amount of overall profits will be taxed there at the national rate. Yet, under the CCCTB, taxable income is calculated by proxy. Because the German subsidiary makes most of the sales, employs most of the workforce and pays the lion’s share of the wages, as well as owning the larger factory, the CCCTB assumes that most of the profit is generated there. This is clearly not the case: the Czech subsidiary is much more efficient. But because taxable income is determined by an arbitrary formula, the CCCTB mistakenly attributes most of it to the German subsidiary, potentially punishing the company if the tax rate is higher in Germany than in the Czech Republic (currently, it is).
- It fails to take account of highly mobile intangible assets.
It is tempting to think that companies’ most valuable property is physical – factories, stores, inventory, and so forth. This may have been true fifty years ago, when the world’s most successful enterprises were manufacturers of physical goods – General Motors, Siemens, Olivetti, etc. But today, a corporation’s most valuable assets are often intangible. Consider Google and Starbucks, two of European tax officials’ bêtes noires. Google does not own any factories, and while it employs 40,000 highly paid people worldwide, a key reason for its success is its search algorithm, developed over years of experience. Of course, while immensely valuable, the algorithm is not tangible. A similar case can be made for Starbucks, which despite owning most of its coffee shops and having a global payroll of 182,000, derives a large part of its income from the recognition and prestige of its brand.
But the CCCTB, by excluding intangible assets from the tax base share formula, would ignore their valuable and growing contribution to a company’s bottom line. This is not a glitch, but a deliberate feature of the scheme. Why? Because intangible assets are, by definition, highly mobile. This means that companies can react to unfavourable tax environments in some EU countries by locating such assets in more welcoming jurisdictions like Ireland. Some income will then be transferred from the company’s other EU subsidiaries to its Irish one, to account for the contribution made by the use of trademarks, intellectual property, and the like. A greater proportion of overall profits will thus be taxed at the Irish corporate rate than was previously the case. The CCCTB seeks to prevent this by removing intangible assets from the calculation of income that is attributable to each jurisdiction, thereby raising overall payable taxes.
This is highly undesirable, as it amounts to denying the reality that intangible assets are a key driver of company profits. Far from constituting illegitimate conduct on the part of multinationals, the location of intangible assets in low-tax jurisdictions is a sound economic decision that results in greater capital investment and lower consumer prices. One should not forget that, from a business’ perspective, corporation tax is just another cost of operating in the EU. Raising that cost cannot be beneficial to anyone in the long term.
- It requires the merging of national legal systems.
While a far cry from the full harmonisation of corporation tax rates that some have advocated, the introduction of the CCCTB would amount to creating a new, EU-wide tax code for multinationals. This means that some harmonisation in the tax treatment of debt and equity, as well as allowances and exemptions, would need to occur. As and when consolidation of national tax codes occurs, some procedure for cross-border profit-and-loss accounting would have to be devised in order to avoid the double taxation of profits. Otherwise, companies would be unable to offset the tax on profits made in one country against losses incurred in another, which would defeat the purpose of a unified tax code and deter investment.
The Commission claims that the changes required will make life easier for multinationals as well as governments, by requiring the former to file a single tax return while preventing them from taking advantage of divergent national codes with varying tax treatments to minimise their tax bill (so-called “hybrid mismatching”). Regardless of whether one thinks current transfer pricing (cross-border intra-company purchase) arrangements are suitable – and they are subject to complex international rules applied by each jurisdiction – it cannot be denied that the sort of legal consolidation pursued with the CCCTB will entail significant transition costs. It will likely expose multinationals in the EU to unanticipated taxes, while requiring them to adapt to the new system at some expense. Such costs are hard to quantify but they certainly cannot be wished away.
- It will undermine tax competition between countries.
Low taxes work. They are not the be-all-and-end-all of public policy – open product markets, flexible labour markets and limited regulation are also important – but corporation tax rates have a measurable impact on companies’ decisions over whether and how much to invest in a particular country. The problem is that politicians have an incentive to raise taxes to pay for expensive projects and handouts, regardless of the long-term consequences of their actions. The only thing preventing them from acting upon that incentive is the threat of businesses moving elsewhere to cut their tax bill. Tax competition between countries thus leads to more sensible public policy and a lower tax burden.
The CCCTB, however, would undermine tax competition between EU member states. Since the tax base is calculated at EU level and then apportioned according to a formula, the incentive for individual governments to keep sensible tax policies is substantially weakened. It is true that some of the elements in the formula – employee numbers and wages, the location of physical assets – are decided by the company, but due to large fixed costs the effects are only felt in the long run. Moreover, the fact that sales count for a third of the attributable tax base in each country means that member states are effectively guaranteed some portion of a company’s profits in tax, unless the company decides to cease operating in that country altogether. And the exclusion of intangible assets from the calculation means countries’ ability to lure mobile capital in through low taxes will be diminished.
- It ignores the fundamental weaknesses of corporation taxes.
While the problems of taxing profits at the corporate level are becoming increasingly apparent as capital mobility improves, the truth is that it was never a particularly good idea. There is widespread confusion about who actually pays corporation tax, which comes from the tendency to conflate its legal and its economic incidence. Corporations are the ones handing over the check to HMRC, but who actually bears the burden? It cannot be the corporation itself, as it is a construct for legal liability purposes and only real people pay taxes. So, it must fall upon some individual or group of individuals.
Studies of the economic incidence of corporate taxation find that it falls, in varying proportions, on the company’s owners and workers. The share borne by each depends on the size of the relevant economy, how open or closed it is, how competitive markets are and how easily capital can be substituted across sectors, among other factors. In general, the more open an economy and the more highly mobile capital is, the greater the burden borne by native workers in the form of lower wages. This is because corporation tax targets returns on capital, which means that the higher the tax, the lower expected returns. Companies react by moving their capital elsewhere, and since capital investment makes workers more productive, lower investment means lower worker productivity, and in turn lower wages.
One can hardly imagine that national governments, or indeed the European Commission, would want EU workers to be less productive than they otherwise could be. The real, i.e. economic, incidence of corporation tax is just not readily apparent. But it does have an impact on employee wages. There is therefore need and ample scope for reform, but it needs to involve shifting the legal incidence of the tax to the individual level. If the goal is to tax investment returns, then a dividend tax on shareholders will do. That would remove the harmful distortions that any corporation tax will always involve and eliminate any need for tax or legal harmonisation, as profits would be taxed where capital owners lived. Importantly, it would also allow companies to focus on delivering value to consumers and shareholders, rather than spending resources on tax optimisation.
