Earlier this month, the United Kingdom announced a new “diverted profits” tax on the profits of foreign companies operating in the United Kingdom. The government’s parliamentary majority will allow the government to implement the tax with few delays. Doing so would be a mistake, however. Although the new tax tries to address a real problem with the implementation of corporate taxes in the modern economy, a new international process led by the OECD already exists to deal with exactly this kind of issue. The effort recently issued a series of major reports and is scheduled to make final recommendations next year. The British government should delay implementation of its new tax so that it can act within a multilateral context designed to deal with the larger issues involved.
The issue of tax competition, like that of inversions, has become confused recently, with both legitimate and illegitimate activity getting thrown into the same category. Despite the unease of some countries, there is nothing illegitimate about a sovereign country lowering its corporate tax rate in order to attract foreign companies. It is immaterial whether in doing so they reduce the size of government within their economy or increase other revenues, such as consumption taxes, to compensate.
It is less legitimate for countries to set up rules that allow companies to source a large part of their profits in the country even though the firms’ activities in the country are minimal. But even without so-called tax havens, problems would exist. The complexity of corporate finance has created a serious problem for international tax officials. Companies are increasingly able to structure their legal and financial arrangements to avoid taxes by using strategies such as selling intellectual property rights, setting up new companies, and transferring financial instruments back and forth between related firms.
Even if tax officials could draft and enforce regulations detailed enough to address this problem, the connection between physical activity within a country and profits earned in that country is breaking down. Traditionally, corporate tax has been closely linked to a physical presence in the country. But technological change, including a growing share of commerce being conducted over the Internet has weakened, if not in some cases severed, this connection. For example, when most of a company’s value is accounted for by intellectual property, the transfer of that property has significant tax implications. Yet it can be almost impossible to accurately value the worth of this property when it is sold. Similarly, Internet companies are often able to deliver significant value to a nation’s consumers while having almost no physical presence in that country. If all of the data servers, programmers, warehouses, and telephone operators are in another country, then traditionally that would be where the profits are declared even if the company earned large revenues in other nations.
Of course, countries are free to tax these transactions on the consumer side. European consumption taxes, including Value Added Taxes, already tend to be much higher than those in the United States. But consumption taxes are highly visible (making them harder to implement politically than corporate incomes taxes) and tax evasion may increase if rates are raised too high. The British government is trying to address this problem with a new 25 percent tax on profits that a designated UK tax official determines were inappropriately shifted to lower-tax countries. Because the new rate is higher than the normal 21 percent corporate rate, the government apparently hopes that the threat of the tax will cause companies to take a more conservative approach to tax accounting. But the legal standards for profits are almost certain to be vague.
At the end of 2013, the Organization for Economic Cooperation and Development set up a process to deal with exactly this type of problem. The Base Erosion and Profit Shifting (BEPS) process has already resulted in a series of reports analyzing a wide range of problems and laying out a number of proposed solutions. The BEPS effort recognizes that the combination of complex national tax laws and a tangled set of treaties designed to avoid double taxation has created opportunities for companies to reduce their tax bill without significantly changing the substance of their operations. The treaties have also made it more difficult for individual countries to address the problem on their own.
The BEPS process is scheduled to make final recommendations by the end of 2015. In some cases these recommendations will then have to be implemented by national governments through regulation, legislation or treaties. But the process is moving quickly. By moving early, the British government puts itself in danger of violating tax treaties with many of its trading partners.
But the BEPS process highlights a more basic problem with corporate taxes. In today’s world, companies are moving away from fixed assets and becoming much more mobile in both their corporate structure and physical location. As companies outsource more of their activities, it will become increasingly easy for them to move the most valuable parts of their production process to low-tax jurisdictions. As a result, it will be increasingly difficult to tax corporate profits, especially when the concept of profits is becoming more difficult to define. For this reason, governments would be wiser to shift the burden of taxes more toward less mobile sources of revenue (such as consumption and property) and/or activity associated with social harms (such as greenhouse emissions and use of tobacco). The greater visibility of these taxes is actually a benefit for making better policy. The regressivity of these taxes can also easily be addressed whereas the corporate tax’s burden on workers and consumers is often hidden from view.