Sorting Out the Global Tax Mess

 

The Group of Seven (G-7)—Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States—met last week in Cornwall, England. High on its agenda was establishing basic agreement on three major proposals for remaking the international tax system, whose structure looms ever larger in today’s global economy.

These three proposals are of uneven merit. The first calls for a 15 percent minimum tax on the global income of all international companies. This means that each company will have to pay at least 15 percent of its income in taxes in every nation in which it does business. The second is targeted against various kinds of tax havens. Under today’s law, the corporate tax is localized to the nation that hosts the corporate headquarters. The new proposal allows a limited corporate tax to be imposed in those nations where those company’s products and services are “consumed.” The tax would be imposed only on the 100 largest global companies, to be measured by some future metric, which would be calculated as follows: the first 10 percent of any allocated profits would be taxed as they are under the current system, but 20 percent of the profits above that 10 percent threshold would be taxed under this new regime. Third, as part of the overall deal, each of the various nations agrees to eliminate special taxes on digital sales at the place where the sale is completed, but not at the place where the products are made.

At the outset, it is important to establish a sensible metric by which to judge these proposals. To a classical liberal, the proper approach seeks to move government tax policy to the ideal that has been congenial since the earliest time: low flat taxes on a broad range of economic activities, which seeks to drive up production and income. In the long run, this means taxation imposes fewer economic distortions on underlying market activities.

The Biden administration works within a progressive framework that does not seek to use the tax system to strengthen market institutions. So it took a different line. Secretary of the Treasury Janet Yellen stated that the imposition of the uniform minimum tax is meant to reduce the risk of a corporate “race to the bottom,” a view that insists that all competition across jurisdictions leads firms to move to a place where insiders are best able to exploit outsiders, by rigging the rules in their own favor. The administration then doubled down on this view when the White House announced that the G-7 leaders agree to “continue providing policy support to the global economy for as long as necessary to create a strong, balanced, and inclusive economic recovery.”

These two statements indicate the regrettable preference for tax increases in developed nations to allow for wealth redistribution to poorer ones. Sadly, both these arguments are seriously mistaken. As to the first, the competition to establish lower corporate tax rates is better understood as a race to the top. Taxes always impose administrative costs and create deadweight losses in the economy. Their proper purpose is to maximize social welfare, not government revenues. Accordingly, taxes should be tailored to remedy those failures that markets cannot cure, including providing for defense, domestic law and order, and infrastructure that cannot be financed through voluntary transactions.

In many cases, it is difficult to pinpoint excessive taxes. But one exceedingly valuable tool toward that end is strong rights of entry and exit, such that firms facing high taxes on labor, land, and income in one nation can flee to a second where those rates are lower. That threat of exit (and opportunity for new entry) will encourage states to keep their rates low, which then translates into increased investment, higher wages, and lower consumer prices. With this in mind, the insistence on a set of minimum corporate tax rates worldwide should be understood as a government-sponsored cartel; like a business cartel, it reduces overall market efficiency and inserts governments more firmly into the daily operation of competitive economies.

Similarly, the appeal to “inclusion” offers a broad hint that developed countries should commit to some unspecified subsidy to poorer countries—often for the worst of all reasons: the decisions of governments in poor countries to protect their local businesses from each other and from foreign competition. Over the long haul, these unwise payments prolong the unsound practices that keep these nations as economic also-rans. If there must be foreign subsidies, the far better strategy is to make them contingent on the internal liberalization of the national economy, including the removal of both tariffs on foreign goods and internal subsidies of domestic production.

The G-7’s proposed actions are problematic for other reasons, too. Any minimum tax is an impermissible way to dull the exit rights needed for disciplining local governments, which encourages a second wave of waste through increased local regulation, while simultaneously making efforts at more aggressive wealth distribution ever more likely.

Nor is the G-7’s proposal easy to implement. Within a unitary jurisdiction, the key task is to calculate net income, which is no easy job. It is not a simple matter of calculating net cash receipts less net cash outlays. Large businesses typically report taxes on an accrual basis, so as to allow them, for example, to depreciate wasting assets whether or not they are sold. But the correct rate of depreciation and the proper asset value are both difficult to determine. Worse still, different countries commonly adopt different rules, all of which lead to uncertain fluctuations of national net income levels from year to year.

On top of that, no one quite knows how best to allocate revenues from goods and services to the places where they are consumed. Assume that a business asset of uncertain value is sold, and that this asset is used to generate sales not only in the country where the business is located but also in the many other nations to which its goods are sold, sometimes for consumption, sometimes for further production. How, for these purposes, is the 15 percent tax rate for each nation to be determined year after year? The mechanics of this enterprise are formidable; anyone who is familiar with the complex valuation rules governing transactions between related corporations in different countries should be reluctant to place even greater stresses on the system.

This is not to give the current system an unconditional blessing. The G-7 is surely onto something when it notes that undue significance can easily be attached to the nation in which a business is incorporated. The choice of a tax home is always suspect—it generally has few consequences for the worldwide operations of a firm but huge consequences for allowing a company, like Apple, to reduce its tax burdens by funneling its net earnings into, say, Ireland, where they are taxed at minimal rates. But the better way to deal with these issues is to apply, with some rigor on a global scale, rules like Section 107 of the key European Union treaty. That rule treats any aid as unacceptable that “distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods.” A principled extension of these treaty rules outside the EU reaches many of the worst corporate practices, without embracing highly interventionist theories of taxation.

A similar approach should be taken toward the G-7’s proposal to reallocate the excessive profits of the top 100 global corporations. In general, this particular rule could lead to the worst of both possible worlds. It may not raise much revenue. But even if it does, the rule creates an unjustified distortion of economic markets that penalizes large corporations who earn substantial profits by the excellence of their overall operations and not by any tax or business intrigue. The only parties who benefit from this arrangement are inferior competitors. Putting this program in place, moreover, involves the familiar nightmare of administrative ranking. What really separates the 101st-ranked firm from the 99th-ranked firm? What adjustments have to be made, given that the list of 100 firms won’t remain constant from year to year? Indeed, one of the strongest tenets of the classical liberal position is its hostility to special taxes based on firm size or firm profit, precisely to eliminate this distortion.

At this point, the best part of the proposed G-7 plan is the elimination of the potential spate of ad hoc taxes that various nations wish to impose on foreign producers who sell goods locally. The vast proliferation of ad hoc taxes has to be constrained by some principle, which is likely to be highly elusive. The short-term course of action thus seems to favor the negative over the positive: to stop all of these actions—including retaliations—unless and until a sensible transnational solution can be cooperatively reached. Taxation is always a complex art form, where the Hippocratic Oath is operative: first, do no harm. Given the choice between higher output versus higher taxation, it commands the former.

© 2021 by the Board of Trustees of Leland Stanford Junior University.

Published in Economics, Foreign Policy, Law
Like this post? Want to comment? Join Ricochet’s community of conservatives and be part of the conversation. Join Ricochet for Free.

There are 3 comments.

Become a member to join the conversation. Or sign in if you're already a member.
  1. DonG (2+2=5. Say it!) Coolidge
    DonG (2+2=5. Say it!)
    @DonG

    I know the devil is in the details, but I like the idea of taxing companies that use odd ownership structure to avoid taxes.  I don’t like that Google makes billions in profits based on American consumers and American courts and American law and yet when it comes time to pay taxes, they are suddenly a Caribbean holding company.   It was annoying, when these companies were pro-American.  Now that they are actively anti-American, screw ’em.  Make the tax retroactive 10 years and if they complain, break them up.

    • #1
  2. RushBabe49 Thatcher
    RushBabe49
    @RushBabe49

    Taxation as punishment for success.  In the past, I got upset when reading about European countries wanting to sue and tax the American tech giants.  Now, I say “let them do it”.  I have no sympathy for them any more.

    • #2
  3. Bryan G. Stephens Thatcher
    Bryan G. Stephens
    @BryanGStephens

    I continue to be against all income taxes. Sales taxes seem cleanest to me.

    • #3
Become a member to join the conversation. Or sign in if you're already a member.