Introduction
Countries compete over productive capital and paper profits. Taxation has been one important element in the set of policy instruments regarding competition.1 Tax instruments include, inter alia, corporate income tax rates and preferential tax regimes that offer a lower tax burden on specific types of income—typically associated with mobile activities or specific geographical areas.2
Tax competition has intensified in the last decades, despite international efforts to contain it. Following a relatively flat trend from 2007 to 2012, statutory corporate income tax rates continued to decline in advanced and developing economies, reaching 22.3 and 24 percent, on average, respectively (see Figure 6.1). Examples of countries that cut their corporate income tax rate in the last five years include G7 members, such as the United States (from 35 to 21 percent)3 and France (from 34 to 25 percent); advanced small open economies, such as Belgium (from 34 to 25 percent) and Norway (from 27 to 22 percent); and developing countries, such as Tunisia (from 30 to 25 percent) and Pakistan (from 34 to 29 percent).
Trends of Statutory Corporate Income Tax Rates
Source: Author’s calculation, using the IMF Fiscal Affairs Department database.International initiatives opt to single out forms of tax competition that are deemed to be harmful—as defined by criteria summarized below. However, the hallmark of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project has been curbing international tax avoidance, rather than tax competition per se, mainly through strengthening anti– tax avoidance rules. Action 5 on combating harmful tax practices, one of the four minimum standards,4 is concerned with constraining preferential tax regimes, in particular, insofar as they facilitate cross-border profit shifting. Other notable similar international arrangements include EU member states’ obligations under state aid rules as well as their commitments under the EU Code of Conduct for Business Taxation.
Under current international corporate income tax arrangements, the tax rate and base are ultimately sovereign choices. However, recent international initiatives put limits on the design of preferential tax regimes, mainly by linking the benefits from such regimes to “substantial activity”; that is, loosely speaking, activities and their generated qualified income should be in the same country and by the same taxpayer (“nexus approach”). The level of the headline corporate income tax rate—no matter how low—thus far remains unconstrained by these initiatives. The presumption appears to be that forms of preferential tax regimes that do not establish substantiality intensify inefficiencies related to tax competition. As this chapter argues, however, this presumption is far from being clear cut in theory or in practice.
An unconstrained outcome (“equilibrium”) of a tax competition game is typically welfare reducing (see “Why Does Tax Competition Lead to Inefficiently Low Tax Rates?” later in this chapter). The pressing question confronting policymakers is what the outcome is of proscribing preferential tax regimes or insisting on the nexus approach? Theory provides important insights. First, in the absence of a preferential tax regime that lowers the tax on profits of mobile activities, the statutory corporate income tax rate and generally applicable tax deductions within any given country become more relevant tax policy instruments to compete for the location of corporations. This leads to lower (statutory and effective) corporate income tax rates and tax revenues from both the mobile and immobile bases, and triggers further strategic tax reactions by other countries. This outcome is possibly inferior to one with preferential tax regimes. The reason is that preferential tax regimes make it possible to restrict competition to the mobile base, thereby enabling higher tax rates on the immobile base, which in turn can be welfare improving compared to the unconstrained tax competition game. A very low tax rate, or even a zero tax per se, however, is not deemed harmful under any existing internationally agreed approaches, thus far. For example, a country with two tax rates (say, a headline rate of over 30 percent and an intellectual property box rate of 15 percent that does not fully satisfy existing criteria) can be deemed as adopting a harmful tax practice (for instance, as found in France; see OECD 2017, page 15), whereas a country that has a uniform but lower corporate income tax rate (even zero) would not.
Second, the nexus approach restrains the design of preferential tax regimes in a manner that can intensify, rather than alleviate, tax competition by expanding the scope of competition to real investment, beyond paper profits. Third, a distinct but related issue is that it remains to be seen whether BEPS Action 5 (at least indirectly) encourages an inefficient instrument—the intellectual property box regime (known as IP box or patent box)—to incentivize research and development activities and innovation, as opposed to cost-based tax incentives.
If current international corporate income tax arrangements were to be reformed, for example by introducing a (preferably internationally coordinated) minimum tax or multilateral destination-based tax (see Chapter 13), then tax competition would be alleviated or even eliminated. Tax competition, however, has not been thus far at the fore of international initiatives.
In addition to classifying tax regimes, blacklisting of jurisdictions has become a tool to pressure some countries to reform their tax systems. For example, the Global Forum on Transparency and Exchange of Information for Tax Purposes (the Forum) has adopted criteria for listing noncooperative jurisdictions focusing on compliance with tax transparency standards. Also, in December 2017, to “encourage fair competition,” the European Union (EC, 2017) adopted a list of “ non-cooperative jurisdictions” largely based on the implementation of OECD/ G20 BEPS minimum standards, tax transparency standards, and “fair taxation” criteria (summarized in subsequent sections of this chapter). Listed countries can face “defensive measures” at the European Union and member state level. As far as tax competition is concerned, however, the achievements of this watchlist approach are not yet clear. It should be emphasized that remarkable progress has been achieved regarding tax transparency, primarily through the cross-border exchange of tax-related information, thereby significantly strengthening the fight against, inter alia, tax crimes and tax evasion.
The rest of this chapter is organized as follows: The following section briefly discusses major predictions of the theory of tax competition and empirical observations. The chapter then turns to summarizing international efforts to address harmful tax practices and then discusses whether tax competition has become less intense as a result of harmful tax practices initiatives.
What is Harmful in Tax Competition?
Rather than a full survey of the rich literature on tax competition,5 the focus here is on key insights that are relevant for the discussion of harmful tax practices, abstracting from modeling details.
Strategic Tax Interactions: Main Insights
International tax competition mostly leads to suboptimal global welfare outcomes because of inefficiently low tax rates and cross-border spillovers.
Why Does Tax Competition Lead to Inefficiently Low Tax Rates?
An increase in the corporate tax rate in a country lowers its capital and increases capital employed in all other countries. A central result of a prototypical game of strategic tax setting is that in equilibrium all countries would benefit from a small increase in all tax rates. Hence, this outcome is Pareto inefficient and the low tax rates lead to underprovision of public goods. The robustness of this general result has been examined in a number of extensions and theoretical setups (Keen and Konrad 2013). Despite some model-dependent specificities, and in some cases involving conditions, the implications of this result have proved to be valid in most models.6
Some theoretical models predict that tax competition has a positive welfare impact in the sense that reducing the size of inefficient governments would lead to more efficient provision of public inputs. However, as mentioned in the previous paragraph, most classes of tax competition models suggest that tax rates will be too low in a Nash equilibrium, leading to underprovision of public goods. Gomes and Pouget (2008) find empirical evidence that a corporate income tax rate cut of 15 percentage points has led to a reduction in public investment in OECD countries of between 0.6 and 1.1 percent of GDP.
Regarding the distinction between competition over real investment and competition over paper profits, it is important to underscore the distinction between effective and statutory tax rates. Effective tax rates take into account tax deductions, tax credits, and depreciation allowances in addition to the statutory corporate income tax rate. What matters for the size of the aggregate capital stock is the marginal effective tax rate—that is, the tax rate on an investment that just yields the required return to be undertaken. The average effective tax rate is important for decisions regarding location made by multinational enterprises (that is, firms with firm-specific rent). This rate is a measure of the tax burden on a profitable inframarginal investment defined as the proportion of the present value of pretax profit that would be taken in tax in a country.7
Paper profits react to the statutory corporate income tax rate. Lowering the statutory corporate income tax rate reduces the incentives for outbound profit shifting and lowers the tax burden on marginal investments (including by purely domestic firms). However, a cut in the statutory corporate income tax rate is more valuable for firms that generate relatively high firm-specific rents (the case for many multinational enterprises), thereby lowering the tax burden on their entire profit. Hence, a lower statutory corporate income tax rate attracts highly profitable firms. In contrast, investment allowances are more valuable for relatively low-profit activities. Thus, in competing over profitable multinational enterprises (whether their investment or their profits), the tax rate applied to profits (whether the statutory corporate income tax rate or the preferential tax regime rate) is relatively more important than tax base instruments.
Thus, overall, the tax reaction function of a country includes not only the statutory corporate income tax rate but also effective tax rates (including preferential tax regimes). The empirical evidence documented in Devereux, Lockwood, and Redoano (2008) and Leibrecht and Hochgatterer (2012) suggests that countries compete using these tax measures.
Why Spillovers?
Cross-border spillover effects from tax competition result from relocating paper profits or investments in response to a change in taxation in one country. That is, given the tax system in country i, lowering the tax burden in country j, say by cutting the corporate income tax rate or adopting a preferential tax regime, can have a negative effect on the tax base of country i. Empirical evidence suggests that spillovers from corporate income tax competition are sizable and tend to be larger for developing countries. For example, Crivelli, De Mooij, and Keen (2017), based on a large panel of countries, find that the cost of tax base spillovers from avoidance activities are larger in non-OECD countries (about 1.3 percent of GDP, on average) than in OECD countries (about 1 percent of GDP). It is empirically challenging, however, to fully disentangle the investment effect from the profit reallocation effect.
How Can Preferential Tax Regimes Make Tax Competition Less Harmful?
Keen (2001) shows that deploying preferential tax regimes has positive impacts on revenues and welfare. One key factor behind this result stems from the different degrees of mobility of tax bases. In the presence of preferential tax regimes, competition between countries becomes concentrated and more intense over the mobile base, leading to a loss in revenues from this base. However, the immobile base remains to be taxed at a higher rate (using the headline corporate income tax rate) than the preferential tax regime rate for the mobile base. In contrast, repealing preferential tax regimes restricts the competition entirely to using the corporate income tax rate (applied to all bases), leading to lower tax revenues from the immobile base, which may (in Keen’s model always) outweigh the gain from less intense tax competition over the mobile base. Thus, preferential tax regimes can be viewed as a mechanism of price discrimination that lowers the intensity of tax competition. Janeba and Smart (2003) show that Keen’s result may not hold under some conditions, specifically if the aggregate tax base responds to a coordinated tax change.
How Does Profit Shifting Affect Tax Competition?
Somewhat similar to the logic of the foregoing discussion—but still distinct from directly discriminating tax bases based on their degrees of mobility—tightening anti– tax avoidance rules in high-tax countries may lead to more aggressive tax rate competition (see also Chapter 9). In the model of Becker and Fuest (2012), tightening anti-avoidance rules prompts low-tax jurisdictions to engage in more aggressive tax rate competition. Peralta, Wauthy, and Ypersele (2006) show that the possibility of profit shifting diverts tax competition from the location of multinational companies to their profits, while enabling countries to collect higher revenues from domestic companies (because they are subject to the corporate income tax rate and have few opportunities to avoid it). Thus, stricter anti-avoidance rules make the location choice of multinational enterprises more sensitive to international differences in tax rates. In the same vein, De Mooij and Liu (2018) find empirical evidence that affiliates of multinationals reduce their investment by over 11 percent as a result of adopting transfer pricing regulations.
Welfare Effects of Shutting Down Low-Tax and Secrecy Jurisdictions
Thus far, the discussion here has ignored differences in country characteristics, especially those regarding country size. Larger economies tend to have a larger immobile base than small countries. Hence, a tax competition game that leads to lower tax rates is costlier for larger economies (Kanbur and Keen 1993). In line with this argument, empirical evidence suggests that country size and stable governance are important determinants for being a low-tax jurisdiction (Dharmapala and Hines 2009).
“Tax havens” is a vague expression—without a universally accepted definition—broadly used in the media and by academics, among others, to refer to jurisdictions that impose low or no taxes on income, or imperfectly share (or do not share) information with other jurisdictions, thereby enabling foreigners to minimize (or escape) taxation at home or abroad (see Hebous 2018). But for welfare analysis, it is much more useful to focus explicitly on these two aspects separately: cross-border information sharing and low taxation. The OECD used the term in its work on the Forum on Harmful Tax Practices in 1998, but international organizations such as the IMF and the United Nations nowadays avoid using the term altogether.
It is tempting to conclude that in a world without low-tax jurisdictions global welfare would be unambiguously higher. Regarding the low-taxation aspect, intuitively, low-tax jurisdictions attract paper profits from high-tax jurisdictions, and hence negatively impact their revenues. Shutting down this mechanism should be welfare improving (Slemrod and Wilson 2009). However, the existence of low-tax jurisdictions can have countereffects that can offset this effect or may even lead to a net positive global welfare. Such jurisdictions may support an equilibrium with less intense tax competition between larger high-tax countries, whereby they set the same (high) tax rate and hence raise revenues (see, for example, Johannesen 2010). Another welfare channel is related to the foregoing argument that strict anti-avoidance rules can aggravate tax competition. When a firm has the possibility to shift profits, for example by borrowing from affiliates in low-tax jurisdictions, the efficiency of the firm is increased; in turn, this increases the firm’s investment at home while enabling the high-tax country to apply a really high tax rate on the immobile base (Hong and Smart 2010).8
At a general level, in principle, cross-border exchange of information—the other aspect—has two opposing effects in a tax competition model (Keen and Konrad 2013). First, it becomes less attractive to use the low-tax jurisdiction for tax evasion. Second, to the extent that taxes in the high-tax country rise, the motives for evasion increase. It is ultimately an empirical matter to understand which effect dominates. However, there are additional mechanisms. The lack of transparency in some jurisdictions negatively impacts welfare in other jurisdictions, particularly in developing countries. This is formally shown in Hebous and Lipatov (2014), where the authors explicitly model the role of supplying secrecy services in facilitating the concealment of proceeds of corruption and firm bribery. Eliminating secrecy makes it harder to conceal corrupt officials’ bribes and illegal income, which unambiguously increases the provision of public goods. Schjelderup (2016) and Torvik (2009) argue that secrecy jurisdictions reduce the costs and negative consequences of entering illegal businesses, particularly for resource-rich countries.
Overall, the literature indicates that, to the extent that enhancing tax transparency curbs tax evasion and tax crimes and strengthens the fight against corruption, it is welfare improving. Closing the business of low-tax jurisdictions, however, as long as tax competition between the rest of the countries remains unconstrained, can aggravate competition, resulting in negative welfare impacts.
Why Is Tax Coordination (Cooperation) Challenging?
Tax coordination is challenging because interests of countries widely diverge. As discussed earlier, one way to illustrate the asymmetry is to recall that a 1 percentage point cut in the tax rate in a small country to attract a foreign tax base is less costly than in a large country. Difficulties of tax coordination arise in the various reform contexts, including minimum taxes, fundamental tax reforms, and the possibility of compensating losers by agreeing on a revenue-sharing mechanism. One example illustrating this difficulty in practice is the failure to reach an agreement on a common tax base in the European Union, as proposed by the European Commission. There are, however, cases of tax coordination, such as the agreement on a minimum corporate income tax rate of 25 percent in the West African Economic and Monetary Union. A similar proposal for the European Union, put forth in 1992, failed.
The OECD/G20 Project is a partial coordination regarding specific aspects to strengthen the tax base against profit shifting, and so is the EU Anti-Tax Avoidance Directive. A question arises, however, about whether countries will compete more intensely using the uncoordinated aspects that remain outside the ambit of the OECD/G20 BEPS Project. Keen (2018) suggests that corporate income tax rates will be lower as a result of the collective reduction in tax avoidance if a lower tax rate is a strategic substitute for stricter anti– tax avoidance rules. The main lesson to be drawn in this context is that benefits from partial cooperation, for example the OECD/G20 BEPS Project, hinge on the assumption that the unconstrained tax competition instruments will not change. The point is that strategic reaction using the unconstrained instruments can to some degree offset the benefits from partial coordination.
International Initiatives on Harmful Tax Practices
OECD Initiatives—From the Forum on Harmful Tax Practices to the BEPS Project
The two major events in the OECD work on harmful tax practices are the 1998 report that established the Forum on Harmful Tax Practices, and Action 5 of the OECD/G20 BEPS Project that was adopted in 2015. Relatedly, in somewhat parallel efforts, since 2002 there has been development in the exchange of information for tax purposes. Figure 6.2 presents a timeline summarizing selected key publications and progress made since 1998.
Timeline of Major Events of the OECD Work on Harmful Tax Practices and Exchange of Information
Source: Author’s illustration.Note: This timeline is not meant to give a complete summary of important events; rather, it selectively presents key progress steps.Forum on Harmful Tax Practices
The Forum on Harmful Tax Practices was established with two primary objectives:
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1. Identify harmful tax regimes in OECD countries: The Forum on Harmful Tax Practices had the mandate to monitor and review preferential tax regimes in OECD countries for income from geographically mobile activities. The criteria are listed in Table 6.1. The first key factor—low or zero effective tax rate on the relevant income—is a gateway criterion to determine those situations in which an analysis of the other key criteria is necessary, but zero tax per se is not deemed harmful. The main three criteria are ring fencing lack of tax transparency, and offering tax benefits in the absence of substantial activities. Eventually, in 2006, reviewing preferential tax regimes was completed, and the progress report stated, “The Committee considers that this part of the project has fully achieved its initial aims and that the mandate given by the Council on dealing with harmful preferential tax regimes in Member Countries has therefore been met” (OECD 2006, page 6).
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2. Identify non-OECD tax havens: In 2001, the OECD analyzed 47 jurisdictions and publicly identified 35 tax havens. Eventually, as of May 2009, all jurisdictions were removed from the list.
Criteria for Identifying Harmful Tax Regimes
Criteria for Identifying Harmful Tax Regimes
| Forum on Harmful Tax Practices: 1998 Report | BEPS: Action 5 |
|---|---|
| Four main criteria: (1) No or low effective tax rates (gateway criterion) (2) Ring-fencing of regimes (3) Lack of transparency (4) Lack of effective exchange of information Eight other factors: (1) Artificial definition of the tax base (2) Failure to adhere to international transfer pricing principles (3) Foreign source exempt from residence country tax (4) Negotiable tax rate or tax base (5) Existence of secrecy provisions (6) Access to a wide network of tax treaties (7) Regimes that are promoted as tax-minimization vehicles (8) Regimes that encourage purely tax-driven operations |
Revamp and work on harmful tax practices, with a priority and renewed focus on two criteria: (1) Requirement of substantial activity (2) Improvement of transparency, including compulsory spontaneous exchange of information on ruling related to preferential regimes |
Criteria for Identifying Harmful Tax Regimes
| Forum on Harmful Tax Practices: 1998 Report | BEPS: Action 5 |
|---|---|
| Four main criteria: (1) No or low effective tax rates (gateway criterion) (2) Ring-fencing of regimes (3) Lack of transparency (4) Lack of effective exchange of information Eight other factors: (1) Artificial definition of the tax base (2) Failure to adhere to international transfer pricing principles (3) Foreign source exempt from residence country tax (4) Negotiable tax rate or tax base (5) Existence of secrecy provisions (6) Access to a wide network of tax treaties (7) Regimes that are promoted as tax-minimization vehicles (8) Regimes that encourage purely tax-driven operations |
Revamp and work on harmful tax practices, with a priority and renewed focus on two criteria: (1) Requirement of substantial activity (2) Improvement of transparency, including compulsory spontaneous exchange of information on ruling related to preferential regimes |
Note that Switzerland and Luxembourg rejected the 1998 report, which stated, “As far as Switzerland is concerned, it shall not be bound in any manner by the Report or its Recommendations (page 78),” and “Luxembourg shall not be bound by the Report nor by the Recommendations to counteract harmful tax competition (page 75).”
Action 5 of the BEPS Project and Current Standards on the Design of Preferential Tax Regimes
Action 5 of the OECD/G20 BEPS Project—one of the four minimum standards to which the Inclusive Framework members commit subject to peer review—requires substantial activity by the taxpayer (also known as the nexus approach) as a qualification for a preferential tax regime. As documented in Table 6.1, despite the fact that Action 5 builds on the previous work of the Forum on Harmful Tax Practices, the concept of harmful tax practices has evolved to primarily focus on the nexus approach. Preferential regimes that fail to conform to the nexus approach are deemed harmful. In November 2018 Inclusive Framework members adopted revised criteria for the substantial activities requirement for “no or only nominal tax” jurisdictions. However, this revision does not imply that the absence of a corporate income tax is harmful per se (OECD 2018a, para. 20).
It should be emphasized that Action 5 differs from the 1998 report in two important ways. First, in contrast to the 1998 report, preferential tax regimes are reviewed in non-OECD countries as long as they are members of the Inclusive Framework (137 members as of December 2019). Second, Action 5 of the BEPS initiative does not per se aim at producing a list of tax havens or noncooperative jurisdictions.
There are two broad categories of preferential tax regimes (that can be deemed harmful or not under Action 5):
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1. Intellectual Property Box regimes: Also known as patent box regimes, these offer a reduced tax on income from intellectual property, such as patents, trademarks, and other know-how assets. The nexus approach requires a link between a taxpayer’s expenditures on the intellectual property and the qualified intellectual property income. This requirement is meant to address multinational enterprises’ practices of profit shifting through cross-border relocation of ( hard-to-price) patents and other intangibles within the multinational group, that is, locating the legal ownership of the know-how asset in a low-tax jurisdiction after developing the patent in a different jurisdiction to benefit from lower taxation of royalties generated by the know-how asset (see, for example, Alstadsæter and others 2018).
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2. Non–intellectual property regimes: The focus is on preferential tax regimes for geographically mobile activities. Examples include headquarter regimes (that is, companies that provide management services for the multinational enterprise group); preferential tax regimes for financing and leasing activities; distribution center regimes (that is, activities of purchasing from other affiliates and reselling for a percentage of profit); shipping regimes; and holding company regimes (that is, companies that hold equity participation or a variety of assets that generate royalties and other income). The nexus approach applies to non– intellectual property regimes, but the determination of qualified income is specific to each category of regimes. Generally, as stated in the OECD 2017 progress report, “Core income generating activities presuppose having an adequate number of full-time employees with necessary qualifications and incurring an adequate amount of operating expenditures to undertake such activities” (OECD 2017, 40).
As of July 2019, 324 intellectual property and non– intellectual property regimes were reviewed by the Inclusive Framework members. Fifty-nine preferential tax regimes were found nonharmful, 53 were found nonharmful after amendment, 7 were considered “potentially” harmful, and 30 were deemed out of the scope of the review. Most of the remaining reviewed preferential tax regimes are in the process of being reviewed or abolished (OECD 2018b). Some of the abolished regimes have been reinvigorated. For example, Luxembourg, reflecting its commitmment to the BEPS project, abolished its older intellectual property box regime but introduced a new, compliant one.
Tax Transparency and Noncooperative Jurisdictions
What Is Tax Transparency?
Initiatives and measures to improve tax transparency can be broadly summarized as follows:
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The Global Forum: This forum, with 160 members, was established in 2000 and restructured in 2009 as a multilateral framework to carry out work on exchange of information, with the two international standards: (1) exchange of information on request; and (2) automatic exchange of financial account information in tax matters.
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The minimum standards of OECD/G20 BEPS initiative: Minimum standards of the BEPS initiative notably include the requirement of country-by-country reporting for multinationals and exchange of information on tax rulings under Action 5.
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Other transparency initiatives: These initiatives include the extractive industry transparency initiative. While these do not comprise international standards, the extractive industry transparency initiative, for instance, requests the disclosure of information along the extractive industry value chain. Standards of the Financial Action Task Force were upgraded in 2012 to include tax crimes, and they request that firms make information about beneficial ownership available to competent authorities, including tax authorities.
Noncooperative Jurisdictions for Tax Purposes
Tearing down the veil of secrecy is important for curbing tax evasion, especially by individuals, and one may argue it is an important aspect of competition over the wealth of individuals as opposed to large corporations. In any case, tax transparency is one of the three criteria endorsed in 2017 by the European Council to list noncooperative jurisdictions for tax purposes (the so-called blacklist). The other two criteria for the listing are fair tax competition, in line with the European Union’s Code of Conduct or the OECD’s Forum on Harmful Tax
Practices (as in Action 5, jurisdictions with a zero corporate income tax rate should implement the nexus approach), and implementing the OECD/G20 BEPS minimum standards. Selected jurisdictions that do not commit to address EU concerns are listed as noncooperative jurisdictions. As of October 2020, the list contained 12 jurisdictions. The European Council also adopts a watchlist of noncooperative jurisdictions that have agreed to modify their regimes ( informally known as the grey list).
The Forum itself publishes compliance ratings for jurisdictions following a peer review. Its focus has been on tax transparency and not the effective level of the corporate income tax. A jurisdiction is identified as noncooperative if it does not meet at least two of the following three benchmarks: (1) at least a “Largely Compliant” rating with respect to exchange of information on request, (2) a commitment to implement automatic exchange of financial account information in tax matters, and (3) participation in the Multilateral Convention on Mutual Administrative Assistance on Tax Matters or a sufficiently broad exchange network permitting both exchange of information on request and automatic exchange of financial account information in tax matters. As of December 2020, only three percent of members were listed as noncompliant (OECD 2019).
Has Tax Competition Become Less Harmful? will It?
In light of this overview of international initiatives, theory, and empirics, it becomes natural to ask, Will tax competition stop or became less harmful? Without further reforms to international corporate income tax arrangements, the answer is most likely no.
A Zero or Very Low Tax Rate Is Not Less Harmful Than a Higher Rate Applied Only to Profits
As mentioned earlier, criteria for harmful tax practices do not consider a zero or very low corporate income tax rate per se as harmful,9 and mainly focus on the nexus approach. This approach for classifying preferential tax regimes leads to suboptimal and paradoxical outcomes. As mentioned in the introduction to this chapter, a country with two relatively high corporate income tax rates could be deemed as employing a harmful tax practice, if, for example, the lower of the two rates applies in an intellectual property box that does not fully satisfy existing criteria. Another country’s policy, with only one low—possibly zero—tax rate, would not be deemed harmful, even though spillovers could be significant.
Tax Competition in Statutory and Effective Rates Has Continued
In line with the theoretical predictions, proscribing preferential tax regimes, in some cases, has made the corporate income tax rate the most relevant tax policy instrument. For example, between 1999 and 2003 Ireland lowered its top corporate income tax rate from 32 to 12.5 percent, coinciding with abolishing a preferential rate of 10 percent under EU pressure. In 2019 Switzerland passed a reform to abolish Swiss cantonal preferential tax regimes to conform with Action 5 standards. Swiss cantons have lowered their cantonal corporate income tax rates or are expected to do so in the near future (see Hebous and Shay 2018). This decreases the average Swiss (combined federal, cantonal, and municipal) rate from about 17.3 to 14.2 percent (and to 10.86 percent taking into account the maximum allowed tax relief with the newly introduced measures, that is, intellectual property box regimes and super research and development deductions).
Providing tax deductions is also an important tool in tax competition over real investment, but as argued earlier, less important for attracting highly profitable multinationals than corporate income tax rates. Canada announced in November 2018 a provision allowing firms to immediately and fully write off the cost of machinery and equipment, referring to international tax competition as the motivation for this measure. In a statement, the Canadian Finance Department noted: “The U.S. federal tax reform has significantly reduced the overall tax advantage that Canada had built over the years, posing important challenges that, if left unaddressed, could have significant impacts on investment, jobs and the economic prospects of middle-class Canadians.” The 2019 Swiss tax reform allowed cantons to offer research and development deductions and obliges them to provide intellectual property box regimes.
One measure of effective taxation that is relevant for multinational enterprises’ decisions regarding discrete locations is the average effective tax rate—a measure of the tax burden on a profitable inframarginal investment defined as the proportion of the present value of pretax profit that would be taken in tax in a country. As shown in Figure 6.3, average effective tax rates have been declining, also reflecting the decline in the statutory corporate income tax rates. There have been several base-broadening and base-narrowing measures in OECD countries in the last years. Kawano and Slemrod (2016) document 331 country-year corporate tax base changes during 1980–2004 in OECD countries and report that 161 changes broadened the base, 108 narrowed the base, and 62 changes simultaneously entailed base-broadening and base-narrowing measures.
Average Effective Tax Rates
Source: Database of the Oxford University Center for Business Taxation.Note: The sample includes 46 countries.The elasticity of corporate income with respect to the corporate income tax rate appears to have increased. Beer, De Mooij, and Liu (2020) find that, on average, a 1 percentage point lower corporate tax rate will expand before-tax income by 1.5 percent.
In sum, as of 2019 there has been no indication that countries may raise the corporate income tax rate or that the downward trend in statutory or effective corporate income tax rates will end soon. Moreover, the use of intellectual property box regimes is on the rise (see Figure 6.4)—with recent adopters including
Selected Intellectual Property Box Tax Rates, Year of Introduction, and Statutory Corporate Income Tax Rates
Source: Author’s estimates.Note: Above the bar is the year of introduction of an intellectual property box regime. Data labels useInternational Organization for Standardization (ISO) country codes.
Lithuania, Poland, and Serbia. Multinational enterprises are becoming more sensitive to international differences in taxation (see Chapter 4). Based on these observations, it is fair to say that, at least, tax competition has not stopped, and some argue it will become more intense.
The Nexus Approach Exacerbates Competition over Real Investment
A country that is found to have adopted a harmful preferential tax regime is faced with a menu of mutually nonexclusive options: (1) modify the harmful regime to comply with the nexus approach, (2) lower the statutory corporate income tax rate, or (3) introduce new tax allowances. Any combination of these responses implies a lower tax burden on real investment that will trigger strategic action by other countries. Even a modest scenario of responding by only modifying the preferential tax regime without cutting the corporate income tax rate could affect the investment location decision. For example, a compliant intellectual property box regime with a tax rate of less than 5 percent (and a nexus requirement) provides strong incentives for companies to relocate real activities. This, in turn, puts pressure on countries to also introduce intellectual property box regimes or cut the corporate income tax rate.
Shortcomings of Existing Standards
Intellectual property box regimes are inefficient and inferior to research and development tax deductions.10 Empirical evidence suggests that one dollar spent by the government on research and development tax incentives, on average, increases domestic private research and development by one dollar, whereas one dollar spent on an intellectual property box can, at best, increase research and development by less than one dollar (IMF 2016). There are fundamental conceptual concerns with intellectual property boxes:
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The intellectual property tax relief rewards only success. Successful research and development outputs are a function of many nonrelated inputs (including management) that are not characterized with market failure. Intellectual property regimes may discriminate against potentially important research and development activities that may not be successful quickly.
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The tax relief is not connected to the level of research and development expenditure but proportional to the amount of qualifying intellectual property income. That is, two patents may generate the same income, thereby receiving the same benefits from the intellectual property regime despite having different levels of research and development inputs.
While research and development deductions do not infringe on existing commitments to international standards, as they are inherently tied to expenditure, explicitly setting standards for an inefficient policy instrument is in some respects popularizing it. Some might argue it could even make research and development deductions a less favored tool for policymakers.
Tax Incentives in Developing Countries
It is important to recognize the vast literature on tax incentives, especially those common in developing and low-income countries in the form of income tax holidays and other often ill-targeted tax breaks, to attract foreign real investment (for example, competition over hosting hotels in the Caribbean or the garment industry in the ASEAN region). These are typically found to be inefficient (for example, often covering investments that would have taken place in the absence of incentives); are in many cases poorly governed; and undermine domestic revenues (IMF 2014; Klemm and Van Parys 2012). Action 5 is not designed to address this type of incentive and form of tax competition between developing countries, which frequently appear in an environment of low tax enforcement. Action 5 will not lead to abolishing these regimes or improving their designs. Some are out of its scope (for example, in the case of special economic zones), whereas others, if reviewed with the potential to be harmful, will be amended to enact the nexus approach. In this sense, competition over real investment in developing countries will continue.
Conclusion
In 2006, when the Forum on Harmful Tax Practices concluded its work on harmful preferential tax regimes, the average statutory corporate income tax rate in OECD countries was 27.1 percent (with rates close to 39 percent in Germany, Japan, and the United States) and there were perhaps two or three intellectual property box regimes. In 2020 the average OECD statutory corporate income tax rate will be about 23 percent, and there will be more than 80 compliant intellectual property box regimes, including those with tax rates of 5 percent and lower. Other non– intellectual property (including headquarters and financing) regimes are still around. These simple observations do not indicate a decreasing intensity of tax competition. Going forward, while compliant intellectual property regimes and other non– intellectual property “nexus regimes” make it harder to shift profits, they incentivize shifting real activities, prompting strategic reactions in the form of lowering the corporate income tax rate or introducing such regimes elsewhere.
Fighting profit shifting per se does not mitigate tax competition, and it may even intensify it. And while acknowledging that it is still too early to evaluate recent initiatives, as long as international differences in tax rates exist, they will pay a role in investment location decisions and profit shifting will be possible—for instance, in the form of limiting the physical presence of a firm in the source country and strategic evaluation of intangibles. And as long as there are benefits for countries from lowering taxes in the form of attracting investment and profits, tax competition continues. Containing tax competition requires broad tax reforms such as minimum taxes (Chapters 11 and 12) or destination-based rent taxes (Chapter 13; Auerbach and others, 2017).
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Other policy tools include, for example, public spending and regulations. See also Schön (2005) and Sinn (1997).
Generally, preferential tax regimes include also those that offer lower personal income taxes (for example, for employing foreign experts or attracting wealthy retirees). This paper predominantly focuses on corporate taxation.
On top of the federal rate, there are state taxes that bring the combined corporate income tax rate in the United States to 26 percent, on average.
The other minimum standards are regarding country-by-country reporting requirements for large multinational enterprises, tax treaty abuse, and tax treaty– related dispute resolution mechanisms. See Beer, De Mooij, and Liu (forthcoming) and Tørsløv, Wier, and Zucman (2018) for studies on profit shifting; see Chapter 4 of this volume for a discussion about the rise of multinational enterprises.
Keen and Konrad (2013) and Zodrow (2010) survey this literature.
Another effect that is typically not explicitly modeled in this literature is that a lower corporate income tax rate puts downward pressure on the top personal income tax rate as the tax system struggles to avoid a disparity between the taxation of corporations and other legal forms of businesses.
See Devereux, Grifth, and Klemm (2002) for stylized facts about the developments of all of these rates. They argue that there are greater declines in average effective tax rates than in marginal effective tax rates, which suggests that countries have designed their tax structures to attract more profitable and mobile businesses, while becoming more distortive for less profitable, and often smaller, domestic businesses.
Weichenrieder and Xu (2019) challenge the results of Hong and Smart (2010) in the presence of round-tripping investment (that is, domestic firms camoufaging as foreign investors) because the supply of concealment services in some jurisdictions makes it more difficult to discriminate between domestic and foreign-owned firms and therefore has a negative impact on high-tax countries’ welfare. One implication of this model is that the exchange of information is welfare improving for the high-tax countries.
A zero corporate income tax rate is a gateway criterion for non– intellectual property regimes to be considered for the peer review.
The social benefits from research and development investments generally exceed the private bene-fts, which justifies governmental intervention to correct for this positive externality.
