Tax avoidance by corporations is on the agenda for this weekend’s meeting in Moscow of finance ministers from the Group of 20 advanced and emerging economies. It is a real problem, and its scale is getting difficult to ignore. The answer, though, isn’t further tax-code complication, as some governments favor, but a shift of taxes from profits to investment income.
To a comical degree, governments are of two minds when it comes to taxing profits. They have to do it, they say, for reasons of fairness and to meet their revenue needs. They deplore the aggressive efforts companies make to lighten the load. At the same time, governments write tax laws to attract multinational companies to their jurisdictions. That promotes the very tax arbitrage they abhor.
This absurdity has reached new heights in countries such as the U.K., where shaming companies for legal tax avoidance has become an instrument of tax policy. Starbucks Corp. recently pledged to make “voluntary” payments to the U.K., after accounting maneuvers resulted in the coffee-shop owner paying little or no tax on its British operations for years. The authorities allege no wrongdoing on Starbucks’s part. After an outcry in which the government joined, the company agreed to write checks to Her Majesty’s Revenue and Customs this year and next.
What’s shocking about that episode isn’t that Starbucks found legal ways to reduce its taxes -- every company does that, and managers would be failing in their duty to shareholders if they didn’t -- but that the government allied itself with a populist campaign to extort money from the company. In a way, it’s a sign of sheer despair: The tax laws don’t work, so governments have to try pleading or blackmail instead.
Governments are right about one thing: Corporate tax avoidance can’t be ignored. The Organization for Economic Co-operation and Development, in a report coinciding with the G-20 meeting, concludes that tax-base erosion is a large and growing problem arising out of a mismatch of anachronistic tax rules and economic realities. Tax codes are still grounded in a closed-economy model that the world has largely abandoned.
What’s the answer? There are two basic approaches. One is harmonization. Governments could aim to coordinate their tax policies so that legal avoidance is harder. The other is competition. Let governments’ rivalries for investment drive corporate taxes ever lower -- until the problem actually disappears -- and make up the revenue some other way.
Tax competition may sound like anarchy, but there’s more to be said for it than you might think. International companies have so much discretion in allocating costs and revenues across their dispersed units that the corporate tax base is unavoidably slippery -- all the more so when governments promote that very slipperiness in an effort to attract investment.
Why fight it? The best strategy to deal with international tax avoidance is what we have recommended: Cut corporate taxes and increase taxes on individual investment income (dividends and capital gains) instead. It’s much harder for individuals to arbitrage away their tax obligations than it is for companies operating across borders. This way, corporate profits are still taxed -- but on a simpler, less distorting basis than the typical corporate tax code provides.
The main problem with the other approach -- harmonization - - is that governments are likely to commit to the principle and then renege. The logic that drives them to attract capital with tax breaks and then deplore the tax arbitrage that follows isn’t going away.
Harmonization, though, appeals strongly to the bureaucratic mind. An extreme variant of this approach is to create a shared international tax base. The European Union is exploring this possibility with its perpetually recycled plan for a “Tobin tax,” or a levy on financial transactions. The practical difficulties are so great that the idea is all but inoperable. The EU is rarely deflected by that consideration.
Many EU members say they won’t go along -- a crippling defect in itself. But that’s not all. To deal with the flight of transactions that would tend to nullify a less-than-global plan, the newest version proposes to tax transactions on EU-issued instruments worldwide. So U.S. banks would be taxed by the EU for trading French-issued securities in New York. If you think that will ever happen, you might be interested in our plan for mining cheese on the moon.
Governments need revenue, and capital should pay its share. With that in mind, the best approach to international tax competition is to let it happen -- and reform domestic codes so that investment income is brought into the tax base in the simplest and fairest way.
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