A key feature of the Centre’s research is to understand the origins of the problems of the existing international tax system; only with such an understanding will it be possible to evaluate potential reforms as to whether they could create a stable system for the future, reducing the distortions created to business decisions, and removing the basis for the widespread misunderstanding of the system.
There are three important features of the development of the existing system that create significant problems. First, the underlying “1920s compromise” for allocating the rights to tax active business income in a source country and passive income in a residence country is both arbitrary and increasingly hard to justify or implement in a modern economic setting. Second, over time, the reliance on the arm’s length pricing principle has led the OECD and governments away from a system with any serious underlying economic rationale. Third, because the system is based on taxing mobile activities, it invites countries to compete with each other to attract economic activity and to favour “domestic” companies. This undermines any international consensus.
The OECD Base Erosion and Profit Shifting (BEPS) initiative essentially seeks to close loopholes rather than to re-examine these fundamental problems. It does appear to set out a principle by which tax should be levied where economic substance or activity is present. This may be a reasonable principle, but it should be recognised as being inconsistent with existing principles. As a consequence, the OECD approach is likely to create more complexity, rather than to generate a stable long-run tax system.
We briefly consider some more fundamental alternative reforms.
Michael Devereux and John Vella, CBT Working Paper 14/25