1 November 2019

The international tax system is changing – should the US sign up?

By Scott Hodge and Daniel Bunn

The United States has often been asked to pay a price for peace. Today is no different, but this time the price is particularly taxing.

When France adopted its digital services tax in July, it triggered initial retaliatory moves from the U.S. government. More than a dozen other countries around the world are considering similar policies, including the UK, which, if it models its tax policy too closely on France, could face an American backlash.

Meanwhile, the Organisation for Economic Co-operation and Development (OECD) has been working on a path forward for changing international tax rules, in order to better prevent tax avoidance and account for the digitalization of the economy.

Rewriting the international rules means facing up to multiple challenges. For example, current international tax rules focus on taxing profits where goods or services are designed or produced. But profits from intellectual property and digital products can be difficult to tax because, at the moment, companies can often shift their profits to lower tax jurisdictions.

So at the most basic level, a rewrite is about addressing the question of how to divide the international tax “pie”. If one country’s slice of tax revenue from international companies grows, other countries’ slices necessarily shrink.

The OECD’s new approach does address this, but it is narrowly focused on highly profitable businesses that deal in intellectual property and digital services. One element looks likely to be that so-called market countries (where sales occur) would gain a larger share of taxable profits from multinational companies.

Critically, the U.S. is the country most exposed to any rearrangement of the international tax system. According to data analyzed by the IMF, the U.S. has the largest share of profits that could potentially be taxed by other countries under the OECD approach.

In theory, because the U.S. has a large market, whatever tax revenues they give up on from their domestic businesses could be offset by revenues they would gain by taxing foreign companies. Only in theory, though.

In 2018, the U.S. had a $72 billion trade surplus in intellectual property services, meaning they export more high-valued technology services than they import. If other countries are given the rights to tax those profits, they have much more to lose than could possibly be gained back. When the right to tax some of our digital giants goes to France, that loss is unlikely to be offset by their ability to tax French fashion brands.

A broader, more neutral proposal to tax all corporate income based on market principles was imagined in 2016 by House Republicans and would have facilitated a better international solution.

There is some hope that the OECD process will result in more tax certainty, but there are serious risks that should be considered before any decision is made.

First, a full analysis of the impact of the OECD proposal on the U.S. needs to be done. Initial research from the OECD has apparently been shared with policymakers, but those reports should be disclosed for public scrutiny. If the U.S. is going to pay a price for peace, the price should be known.

Second, the peace will only be meaningful if contrary measures like the digital tax from France and the proposal from the UK are abandoned. At one point, the French digital tax was written to expire at the end of 2021. This provision did not make it into the final legislation. Additionally, the UK tax is scheduled to apply beginning in April 2020 and is not scheduled to expire, but instead will be reviewed in 2025. It seems possible that the digital taxes will persist even if the OECD does successfully rewrite the rules on where companies pay taxes.

Because of the current level of uncertainty, the U.S. should not risk agreeing to a difficult change in the international tax system without fully assessing the cost, and then only if unilateral measures are guaranteed to be dropped. As countries around the world assess their own positions relative to the French digital tax and the OECD proposals, it will be important for the U.S. to lead by recognizing the price we are willing to pay for peace and working to ensure that peace is lasting.

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Scott Hodge is President of the Tax Foundation, and Daniel Bunn is their Director of Global Projects