The rise of more sophisticated financial products has encouraged tax arbitrage by multinational firms and tax competition between governments. This phenomenon has become a fixation of global governance do-gooders and bureaucrats. Their push for international tax coordination, however, will have costs that are hard to measure.
In a nutshell
- The drive against tax arbitrage is intensifying in the OECD countries, including the U.S.
- Tax havens are crucial to competition among global tax systems to attract investment
- Centralized sharing of tax data can fuel corruption and undermine Western security
The growth of global trade and the simultaneous rise of more sophisticated financial products from the late 1970s led to an increase in tax arbitrage by multinational firms and tax competition between governments. This phenomenon, most commonly known among policymakers as “base erosion and profit shifting” (BEPS), is a fixation of global bureaucrats and global governance do-gooders.
The conventional wisdom is that modern tax systems must ultimately be global. As the European Commissioner for Economic and Financial Affairs Pierre Moscovici succinctly put it: “The future of corporate taxation cannot be a unilateral, national or regional one.”
The seemingly innocuous push for international tax coordination and transparency will have costs that are hard to measure. More transparency means less privacy, slower economic growth and greater compliance costs.
The 1981 “Gordon Report” compiled by the United States Treasury Department, officially titled Tax Havens and Their Use by United States Taxpayers – An Overview, kicked off the first wave of domestic and international hysteria over tax havens. Low-tax countries protect investments from burdensome fiscal levies elsewhere by offering themselves as financial sanctuaries. This dynamic sets in motion competition between countries for lower taxes and favorable rules that allow investors to reduce taxes paid elsewhere.
The naive-populist reaction to such policies is obvious. It is simply not fair for big corporations and the global elite to game the system while the rest of us are left to pick up the tab. The French economist Gabriel Zucman’s recent book, The Hidden Wealth of Nations: The Scourge of Tax Havens (2015),counts the hundreds of billions of dollars of lost tax revenue from offshore wealth and argues that policymakers must do something to fix this problem.
In response to calls like these, the Organisation for Economic Co-operation and Development (OECD) has organized a multiyear initiative against profit shifting. Its aim is to increase taxes collected from multinational businesses – many of them American-based – through better global information sharing, reporting and rules coordination.
New and more intrusive tax compliance regimes are an outgrowth of digitization and globalization.
One part of this multipronged initiative is the OECD’s Protocol amending the Multilateral Convention on Mutual Administrative Assistance in Tax Matters. The Protocol is part of a new information-sharing regime to exchange bulk private taxpayer information with countries around the world. The U.S. has yet to ratify this treaty.
In the U.S., one outgrowth of the popular drive to crack down on tax arbitrage is The Foreign Account Tax Compliance Act (FATCA), which requires foreign financial institutions, such as banks, to identify and report to the U.S. transactions for American clients.
There are still more radical proposals that have yet to be implemented. To combat the rise in global proﬁt shifting, U.S. policymakers proposed a border-adjustable cash-ﬂow tax as part of the 2017 tax reform. Gabriel Zucman has even proposed the creation of a global ﬁnancial register to keep track of the owners of ﬁnancial assets around the world.
New and more intrusive tax compliance regimes are an outgrowth of digitization, globalization and an increasing reliance on hard-to-value intangibles. The OECD project and the Moscovici-Zucman approach to global taxation may not pose an immediate collective threat, but individual countries and states are already acting to combat what they perceive as lost revenue. This patchwork of unilateral taxes will eventually give rise to more forceful calls for a centralized solution.
The European Commission, for example, is seriously considering a 3 percent “digital-transactions tax” on revenues of large multinational technology companies, such as Facebook and Google, based on the location of their customers rather than traditional measures of profit and value creation.
A company could be liable to the tax rules in thousands of tax jurisdictions simply by having a few customers in each.
Some U.S. states are now implementing a similar, destination-based sales tax that would allow them to tax businesses with no physical presence in their tax jurisdiction. As with the European Commission’s proposal to tax Facebook based on where its users are, a company could conceivably be liable to the tax rules in tens of thousands of tax jurisdictions simply for having a few customers in each.
The patchwork of different state sales tax rules in the U.S. has already precipitated calls for a federal solution, which might involve imposing uniform national standards or creating a central tax clearinghouse. Internationally, the European Union is pursuing an open strategy to leverage the temporary digital-transactions tax into more “ambitious reforms of the international tax system.”
The seemingly inevitable rise of multilateral compliance regimes would come with increasing costs to economic growth, including a heavy burden of compliance and state expropriation.
The current international tax system is imperfect. It allows for tax planning and does not tax 100 percent of profits, but, for the most part, these are features, not flaws. The existence of tax havens and a relatively porous international tax system has fostered international pressure that keep capital taxes relatively low – a boon for economic growth and investment.
Tax havens are crucial for international competition to attract investment through better tax systems. This rivalry has facilitated economic growth and trade, producing benefits for consumers around the world with little harm to revenue collections. Tax competition, for example, has forced corporate tax rates among OECD countries to fall from more than 45 percent to less than 25 percent over the past three decades – while revenues have been relatively stable.
Furthermore, a recent academic working paper found that “eﬀorts to combat proﬁt shifting can backﬁre.” A policy change that limited certain U.S. companies from artificially shifting profits to Puerto Rico under Section 936 of the Internal Revenue Code was found to have also limited their global investment and, more importantly, reduced their U.S. domestic investment by a measured 38 percent (which translates to reducing domestic employment by 1 million jobs).
Tax havens can act like a pressure release valve that puts a check on overly burdensome capital taxes. If the global proliferation of more sophisticated and intrusive tax regimes continues, these release valves will become less effective and competition between countries for more efficient tax systems will diminish. Global tax burdens will increase, slowing economic growth around the world.
Compliance costs will also continue to increase. Information tracking and reporting initiatives are costly to both taxpayers and tax collectors. The estimated revenue gains from increased information exchange under FATCA, for example, are projected to be about equal to the private expenditures necessary to comply with the law. These costs are not just borne by rich tax dodgers. The cost of complying with FATCA hits every American living overseas, not just those targeted by the legislation. Americans living abroad who are fully compliant with U.S. tax laws have lost their mortgages, business bank accounts and personal banking services because their international bank cannot afford the U.S. regulatory burden. The costs of overly burdensome compliance slow international commerce.
Existing OECD data sharing includes many governments that are corrupt or hostile to Western countries.
Centralization and bulk sharing of taxpayer information as proposed by the OECD would also have governance costs outside the developed world. A World Bank working paper titled “The Dark Side of Disclosure” says that disclosing financial information is a “double-edged sword,” because it exposes firms to “a significantly higher level of corruption.” Most countries do not have the same robust institutions relied upon in OECD countries. The study finds that “once firm information is disclosed, the threat of government expropriation is widespread,” allowing “bureaucrats to gain access to the disclosed information and use it to extract bribes.”
Assembling new centralized databases of highly sensitive corporate and personal financial information could fuel corruption in developing countries and undermine the national security interests of the West. Existing OECD information exchange programs already include many governments (among them China, Russia and Nigeria) that are corrupt or hostile to the U.S. and other Western countries.
For more than 40 years, the OECD has been attempting to expand the global power to tax, thus far with limited success. Its initiatives, however, may finally be paying off as destination-based taxes, unilateral digital taxes and increases in bulk information exchanges become more popular and widespread. If fully implemented, these measures will have unseen and often unquantifiable costs.
The greatest burden will ultimately fall on working people through lost jobs and slower wage growth. Access to investment capital will decrease and the world will become less stable as financial data are used in information warfare and institutions in developing countries are undermined.
Even so, the vision of a unified global tax compliance regime is likely to remain elusive. Systematic, long-term cooperation on a global basis is prone to breakdowns, as has been shown by past OECD efforts to create blacklists for tax havens. The enthusiasm of national governments for relinquishing power to distant global bureaucrats quickly wanes. Even so, each new tax initiative layers additional costs on taxpayers and incrementally lessens financial privacy.
The truly wealthy will probably continue to find innovative ways to protect their wealth, if at greater cost, while ordinary citizens pay the economic and social price for a misguided, populist effort to eliminate low-tax investments.