Could curbing tax avoidance in Europe make tax competition worse?

Tuesday, December 8, 2015 - 17:16

A year after the LuxLeaks scandal, the European Union is figuring out how to respond to systemic problems in corporate taxation which have allowed multinationals to avoid billions of euros in taxes. The elaborate tax avoidance schemes revealed by Luxleaks could be curbed to some extent if the European Union adopts the recommendations of the OECD’s new Base Erosion and Profit Shifting (BEPS) project, though we don’t believe BEPS will do much for developing countries.

But there is a danger that Europe’s response to Luxleaks, including the revival of the Common Consolidated Corporate Tax Base (CCCTB) will do little to address a hugely expensive problem which is one of the biggest contributing factors to tax avoidance - tax competition between governments.  This is a problem which affects Europe itself and also has knock-on effects on developing countries which often struggle to collect their fair share of tax from multinationals.

Much cross-border tax avoidance relies on the existence of low-tax regimes that companies can shift their profits into. Many governments have been happy to provide such regimes in the hope of attracting corporate investment. The BEPS project tries to attack the profit-shifting methods used by companies, but it does not try to address the question of how much tax is paid. Yet if multinationals can no longer use highly artificial schemes linked to countries like Luxembourg, the Netherlands and Ireland, then some will lobby governments to cut their tax bills in other ways. Multinationals could indeed end up booking more profit in countries where they have “economic substance” and less profit in paper companies, but without necessarily paying more tax.

“There will be a lot of pressure on both developed and developing countries to reduce further headline rates of corporate tax with a serious risk of a "race to the bottom". We will also see a spread of preferential regimes for highly mobile activities such as patents and intangibles," Jeffrey Owens, former director of the OECD’s Centre for Tax Policy and Administration, tells ActionAid.

More tax competition in Europe would have damaging knock-on effects on developing countries: research from the IMF suggests that most countries lose revenues from tax competition, but developing countries stand to lose two to three times more. The harm is greater because developing countries  typically raise more revenue by taxing corporate profits: 16 per cent of their total revenues, on average, compared to about 8 per cent in developed countries.  Poorer countries need this income more, to pay for public services for citizens and in particular for the poor, and they have fewer alternative sources of revenue to turn to.

Curbing tax competition will require broader measures than those being considered by the European Commission. The CCCTB, for example, could remove the incentive for multinationals to shift profits into lower-tax countries in Europe by making each company file a single tax return for all its European operations and dividing up the taxable profits among the relevant Member States. But this scheme would not stop Member States from competing against each other by applying lower taxes to their allotted share of the tax base. The race to the bottom could continue in a different form, unless the CCCTB is underpinned by a European minimum effective tax rate.

Another big problem for Europe lies with the BEPS proposals for reforming tax breaks on profits linked to intellectual property (IP) – the so-called “patent boxes” and “knowledge boxes”. The proposals could make it harder for multinationals to shift their IP between countries in an artificial fashion in order to claim tax breaks. But this won’t stop Member States from offering ever-larger tax breaks on IP income in the hope that companies will locate scientists and research facilities in their territory, even though the costs of research and development are commonly deductible from tax already. It would be much better to just scrap tax breaks on IP income and invest more revenue in public services which companies need and which also benefit the wider society, such as education.

It would be ironic if Europe succeeded in curbing tax avoidance yet allowed tax competition to flourish, with the result that countries give away more and more revenue in a zero-sum competition against each other for the same corporate investment. And as the IMF’s research has shown, harm is also done to developing countries which have far more to lose than EU Member States.

So Europe’s policymakers need to seize the opportunity, not just to patch up the holes in the tax system but to challenge its underlying problems. This includes being bolder on minimum tax rates, ending special tax deals for IP-rich companies and recognising that the “race to the bottom” is an expensive mistake for Europe and for developing countries we are trying to help out of poverty.