27 January 2016

How bad economics is poisoning the debate on corporation tax


There is ample reason to believe the international system for taxing corporate profits is in dire need of reform. Corporate income taxes (CITs) were devised at a time when capital was much less mobile, both due to the nature of economic transactions and existing technology, and because international trade was constrained by protectionist barriers. Today, highly mobile capital – intellectual property and trademarks, human capital and financial capital – plays an increasingly important role in wealth creation.

Yet, contrary to what news reports commonly suggest, the problem of tax avoidance by multinationals – or Base Erosion and Profit Shifting (BEPS), as it is known in tax circles – is of relatively little economic significance. James Hines from the University of Michigan recently estimated that a full recovery of all the monies lost to tax avoidance by multinational companies would increase tax revenue in the average OECD country by less than one per cent.

There are many other misconceptions plaguing the corporation tax debate. If we are to come up with effective ways to tax corporate profits while minimising the negative impact on economic activity, it is important to overcome these myths.

1) Legal vs. economic incidence: corporations don’t pay taxes

One of the more damaging consequences of our opaque tax system is the blurring of the distinction between the legal incidence and the economic incidence of a tax. Members of the public – and not a few policymakers – are led to believe that whoever is liable for handing the cheque to HMRC is also bearing the burden of the tax.

Corporation tax is the best example of how this isn’t always the case. Corporations are independent entities for legal liability purposes, but they cannot bear the burden of any tax because only individual people shoulder the burden of taxation. In the case of CITs, the relevant people are the company’s shareholders, workers and customers. Most studies find that most of the tax burden is in fact borne by the former two, in varying proportions. The proportions change depending on whether the country is large or small, open or closed to trade, and whether the factors of production can be easily substituted.

The impact of CITs on workers tends to be greater in small and open economies such as Ireland’s and – to a lesser extent – the UK. It takes the form of lower wages, as capital that would have been invested in the absence of – or under lower rates of – corporation tax is instead redirected elsewhere, lowering the productivity of the workforce.

The notion that corporation tax is paid by faceless multinationals may be politically successful, but economically, it’s a no-go.

2) Corporation tax is a tax on profits, not turnover

Another persistent myth about CITs is that payable taxes can be ascertained on the basis of a company’s turnover. It is in fact irrelevant how much a company sells as far as its corporation tax bill is concerned. The only thing that matters is its income, i.e. revenue minus costs. Loss-making enterprises are not liable for corporation tax, no matter how high their sales or how fat their payroll. Profitable businesses should pay – and do pay – on the basis of the profits attributable to each country.

There have been moves at EU level to use alternative methods to calculate corporation tax owed, most notably a formula which would include physical assets, sales and employment in each Member State. While this proposal aims to prevent firms from playing with profit attributions in order to minimise their tax bill, it would run counter to the logic of the Single Market – free cross-border capital flows – and it would severely disrupt existing investment, as well as introduce uncertainty about the future framework on CITs. Given the trivial amounts involved, one is doubtful that such measures could improve matters.

3) Making companies pay more tax would not be costless

Discussions of corporate tax avoidance often go from the assumption that there is a given amount of tax that can be “recovered” through more active enforcement by the taxman, and that this recovery will have zero impact on investment flows, capital deployment, wages and shareholder returns.
Nothing could be further from the truth. As mentioned, CITs in a globalised economy affect the wages that workers are paid. They are also a factor the decision of whether to invest or spend, meaning that higher effective CITs will reduce investment at the margin. And they have many indirect consequences, for instance, the returns that pension funds can offer savers.

There may be a willingness to increase the amount of revenue raised from corporation tax, but there are important trade-offs to be considered. To think that all will remain the same if the effective tax burden is made heavier is delusional.

4) Good news! Corporation tax is not the only way to tax multinationals

Underlying arguments for more action on tax avoidance by multinationals is a fear of corporate impunity. The supposed rise of the stateless, faceless business giant worries many people who wish for everyone to be subject to the same standards. “Corporations should pay their fair share” is an oft-repeated slogan, and a powerful one.

But we don’t need CITs in order to ensure that corporate profits are taxed. Indeed, taxing distributed profits – dividends – would achieve this aim and have far fewer unintended effects on investment and capital movements. Furthermore, if it is believed that corporations benefitting from a country’s rule of law, contract enforcement and infrastructure should pay for these public services, charges could be introduced. Again, these levies might have an impact on firms’ investment decisions, but it would arguably be smaller than under CITs, and experimentation would tell us whether they were effective or not.

Public policy should evolve with the times. Corporation taxes were devised at a time when most capital was physical and trade was restricted. A century later, innovation and globalisation have increased the scope for productive capital to move around the world, raising millions of people from poverty in the process thanks to foreign investment by private firms. In line with these developments, there are many ways that the international tax system can be reformed for the better. But that requires an understanding of the economic implications of our actions.

Diego Zuluaga is Financial Services Research Fellow at the IEA