A global minimum corporate tax rate: goodbye tax avoidance?

“Together we can use a global minimum tax to make sure the global economy thrives based on a more level playing field in the taxation of multinational corporations, and spurs innovation, growth and prosperity”. These words are taken from a speech that Janet Yellen, current U.S. Secretary of the Treasury, pronounced on Monday at the Chicago Council on Global Affairs.

The former central banker is referring to the talks that are taking place at the OECD and G20 level around proposals of reform to the system of international taxation. In this article, we will examine what this “global minimum tax” is, the reasons put forward for its introduction and the main criticisms by its detractors.

As you may recall, we have already talked about the developments in drafting an international agreement on a digital service tax, which is based on the same premises. Let me restate them here for the sake of clarity, as they are crucial to grasp the rationale behind these proposals.

Tax avoidance explained

Research by the Tax Justice Network shows that, globally, countries are losing out around $427 billion a year in revenues from tax avoidance by the rich and by multinationals.

In particular, the mechanism that allows it is called “profit-shifting” and exploits loopholes in the international tax system. What takes place in practice is that multinationals manage to record sales as if they were made in other countries, especially low-tax jurisdictions. A way to implement this is to establish a subsidiary in one of such so-called “tax havens” and to make it the owner of the company’s intellectual property rights. Hence, the subsidiary can record large royalty payments for the use of such rights from the subsidiary that actually sells the goods or services. This allows the actual revenue-generating subsidiary to deduct high costs from its income and, thus, to have artificially low profits, on which very few taxes will be paid, while the other subsidiary will record the majority of profits in the tax haven jurisdiction.

While these techniques are used by companies having a physical presence in the place where their customers reside, for digital service companies tax avoidance is even easier, as current international rules allow them to just record revenues in the place where they have their “permanent establishment”, as explained in the aforementioned article.

"Protest Against Tax Avoidance . 21.09.2012" by wheelzwheeler is licensed under CC BY-NC-SA 2.0

OECD talks: the two “pillars”

Hence, to address both issues, international discussions at the OECD revolve around two pillars.

Pillar one aims at addressing tax avoidance by digital service companies. The measures under discussion include reallocating taxing rights on profits based on customers’ country of residence, regardless of whether the company actually has a physical presence in the country or not. Negotiations have recently restarted after Secretary Yellen announced that the United States will drop their demand for a provision to include in the agreement which would allow impacted companies to conform to the new rules on an exclusively voluntary basis. This claim by the Trump administration was clearly dismissed as inadmissible by many countries, especially in Europe, among the most vocal supporters of the reform, and developments had been stalling until Yellen’s recent remarks.

Finally, pillar two is the “global tax” mentioned at the beginning. Under this hypothetical regime, a minimum corporate tax rate would be established and the US are advocating for a 21% level. Each country would still be free to set their preferred local corporate tax rate, but if this rate were lower than the minimum, home countries of the multinationals operating in that country would be given the right to claim the difference between the two, so that companies end up paying a total equal to the minimum. In concrete terms, let’s imagine the minimum were actually 21% and a US company set up a subsidiary in Hungary, which currently has a corporate tax rate of 9%. If pillar two were to be implemented, the US company, through its Hungarian subsidiary, would still be required to pay 9% of profits to the Hungarian authorities, but the United States would be entitled to claim a “top-up” to the tax floor of 21%, equal to 12%, thus effectively eliminating the advantage of tax avoidance by shifting profits to tax havens.

To briefly provide some context, the trend in the past decades has been for countries to progressively decrease their rates, a “30-year race to the bottom”, using Yellen’s words. Countries wishing to become more competitive and attract foreign investment used to lower their corporate tax rates. As we are not in a static world, however, and players strategically update their preferences after taking into account others’ decisions, this “game” caused a domino effect whereby, through the years, everyone brought down their rates in fear of losing companies to others.

What about the EU?

The European Union has officially backed the US’s call for the global minimum tax but has not commented on the specific rate level. An agreement will probably be very difficult to achieve, as the corporate tax rates in Member States are far from homogeneous and range from 9% in Hungary to 32% in France. Indeed, for quite some time the European Commission has been trying to bring harmonization in this field, not in the form of a common tax rate, but rather in uniforming the corporate tax base, that is what companies are taxed on. Attempts in this regard have systematically failed because taxation is still regarded as a national competence and because low-tax jurisdictions fear any form of harmonization of rules as this could lead them to lose their tax haven status.

Criticisms

Let us now discuss what the main downsides of a global minimum tax are, according to its detractors.

Some argue that the “30-year race to the bottom” is actually a race to the middle and that the downward trend was actually overestimated. Indeed, an analysis made by the Tax Foundation shows that the world average of corporate tax rates in 2020 was 24%.

Moreover, a recent OECD report suggests that corporate income taxes are the most harmful for growth, followed by personal income taxes and, lastly, consumption taxes, which prompts critics to advocate for a low level overall.

Related to this, others see a minimum global rate as a threat to flexibility. In other words, a minimum rate would prevent many countries from exercising their autonomy in using tax policies (namely, tax cuts) to incentivize investment. In the context of the current economic downturn caused by pandemic, this issue is particularly highlighted as a potential obstacle to full economic recovery.

These are all points that will have to be discussed in the negotiations but, nevertheless, we can safely argue that the path towards an international agreement seems more plausible now that the Biden administration took office, although still a distant one.

Cover picture: "Rethinking Macro Policy II: First Steps and Early Lessons" by International Monetary Fund is licensed under CC BY-NC-ND 2.0