My Say: Myths and lobbies block international tax cooperation

This article first appeared in Forum, The Edge Malaysia Weekly, on July 5, 2021 - July 11, 2021.
My Say: Myths and lobbies block international tax cooperation
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Too many have swallowed the myth that lowering corporate income tax (CIT) is necessary to attract foreign direct investment (FDI) for growth. Although contradicted by their own research, this has long been promoted by influential international economic institutions.

The early 1980s’ economics “counter-revolution” impacted the “Washington Consensus” of the US federal government and the two Washington-based Bretton Woods institutions (BWIs) — the International Monetary Fund (IMF) and World Bank.

Thus, the rise of supply-side economics in the US — advocating lower direct taxes on income and wealth — influenced the world. Without evidence, IMF researchers justified its policy advice thus: “The complete abolition of CIT would be the most direct application of the theoretical result that small open economies should not tax capital income.”

Noting that capital is highly mobile, and can more easily evade taxes than labour, IMF economists even recommended that “small countries should not levy source-based taxes on capital income”. Meanwhile, the World Bank’s highly influential, but dubious Doing Business Report recommended tax incentives without evidence.

To get BWI approval, developing country governments have undertaken tax reforms, reducing progressive direct taxation. Instead, they have favoured more regressive indirect taxes, such as the Value-Added Tax (VAT), sometimes dubbed the Goods and Services Tax.

Consequently, IMF tax policy recommendations to Sub-Saharan African (SSA) countries from 1998 to 2008 reduced corporate and personal income tax rates while promoting VAT. And following the World Bank’s advice, Tanzania — Africa’s third largest gold producer — ended up subsidising, not taxing, foreign mining companies!

Evidence contradicts advice

World Bank research and surveys have long found that tax incentives do not really attract FDI inflows. A World Bank report found no strong evidence that tax incentives attracted non-resource “greenfield” or additional new FDI.

It also found “tax incentives impose significant costs on the countries using them”, including fiscal losses, rent-seeking, tax evasion, administrative costs, economic distortions and “retaliation against new or more generous incentives” by competitors.

An earlier World Bank brief noted that “tax incentives are not the most influential factor for multinationals in selecting investment locations. More important are factors such as basic infrastructure, political stability and the cost and availability of labour”.

It also argued that tax incentives do not compensate well “for negative factors in a country’s investment climate”. Meanwhile, the “race to the bottom … may end up in a bidding war, favouring multinational firms at the expense of the state and the welfare of its citizens”.

Researchers have not unearthed any strong evidence that tax incentives are beneficial. While some incentives may attract FDI, they crowd out other investments. Hence, overall investment and growth do not improve.

An IMF report noted, “Tax incentives generally rank low in investment climate surveys in low-income countries … investment would have been undertaken even without them. And their fiscal cost can be high, reducing opportunities for much-needed public spending … or requiring higher taxes on other activities.”

Even research by the Organisation for Economic Co-operation and Development (OECD) confirmed BWI findings that tax incentives hardly attracted FDI. The Economist also found a weak relationship between tax rates and business investment, as well as growth rates.

A UK government report cast more doubt: “Effectively attracting FDI needs public spending, so narrowing the tax base works with tax incentives for low-income countries could be contra-productive”.

Race to bottom hurts all

IMF findings confirm that “beggar-thy-neighbour” tax competition worsened avoidable revenue losses. Such ill-advised efforts to attract investment inevitably accelerated CIT rates’ “race to the bottom”.

BWI advice to governments has undoubtedly lowered CIT rates. But despite the lower rates, transnational corporations (TNCs) still minimise paying tax, for example, by shifting profits to tax havens and exploiting loopholes.

CIT rate averages for high-income countries (HICs) have dropped 20 percentage points since 1980, falling from 38% in 1990 to 23% in 2018. Meanwhile, they fell from 40% to 25% in middle-income countries, and from over 45% to 30% in low-income countries (LICs).

Cut-throat competition has especially hurt developing countries, which rely much more on CIT than developed economies. IMF research found that a one-point average CIT rate cut in other countries reduces a developing country’s CIT revenue by two-thirds of a point.

Such tax cuts induce other concessions, further eroding the base for corporate taxation. Thus, tax revenue is doubly lost by both rate and base cuts. Fund staff estimated revenue loss at 1.3% of GDP in developing countries, due to base erosion and rate reductions — much worse than in developed countries.

The UK government estimated global revenue loss due to TNC tax minimisation at US$500 billion to US$650 billion annually. Such adverse effects were two to three times higher in LICs than in HICs. SSA countries lost the most revenue relative to GDP, followed by Latin America and the Caribbean, and South Asia.

A third of global revenue loss — US$167 billion to US$200 billion — is from low- and middle-income countries (LMICs), costing them 1% to 1.5% of national income. With better tax administrations and larger formal sectors, HICs can replace such losses more easily than LMICs with generally weaker tax systems and larger informal sectors.

Tax breakthrough

The IMF and others now agree that an international minimum CIT rate can stop this race to the bottom and TNC profit shifting. The group of seven largest rich countries (G7) recently agreed to a minimum 15% rate, rejecting US Treasury Secretary Janet Yellen’s proposed 21%. Even The Economist agrees that the G7 proposal favours rich countries.

Earlier, the Independent Commission for the Reform of International Corporate Taxation had recommended a 25% minimum and fairer revenue distribution to developing countries.

Finance ministers from Indonesia, Mexico, South Africa and Germany joined Yellen in welcoming the recent G7 agreement for a minimum global CIT rate, while expressing confidence “that the rate can ultimately be pushed higher than 15%”.

An influential piece (by Joseph W Sullivan, a senior adviser at the Lindsey Group) says a global minimum corporate tax is a “bad idea”, again citing the myth that low taxes will attract FDI. Invoking new Cold War fears, it also claimed that China and Russia would gain an unfair advantage in luring “even more” FDI.

Donald Trump-appointed World Bank president David Malpass opposes the agreement, saying it would undermine poor countries’ ability to attract investment despite World Bank research showing otherwise. Pro-Trump governments in Hungary and Poland also object to the G7 deal. Developing countries cannot allow such tax-cutters to speak for them.

Developing country members of the G20 must insist on a higher minimum and fairer revenue distribution at its forthcoming finance ministers meeting. If the G7 refuses to start with anything more than 15%, an agreed rate increase schedule of an additional 1% annually would get to 25% in a decade.

International tax rules are currently set by rich countries through the OECD. Developing countries participate at a disadvantage. Instead of allowing it to control the process, they must urgently insist on an inclusive, balanced and fair multilateral process for international tax cooperation.

Anis Chowdhury, a former professor of economics at the University of Western Sydney, held senior United Nations positions from 2008 to 2015 in New York and Bangkok. Jomo Kwame Sundaram, a former economics professor, was United Nations assistant secretary-general for economic development. He is the recipient of the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought.

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