On 8 October 2021 Secretary of the Treasury Janet L. Yellen claimed that: “As of this morning, virtually the entire global economy has decided to end the race to the bottom on corporate taxation.” Is Secretary Yellen correct?
Yellen’s claim is based on the OECD/G20 proposal for a global minimum tax found in Pillar 2. This proposal originated in BEPS concerns about profit shifting in the context of the digitalised economy, so the aim of bringing an end to tax competition represents some mission creep. Nevertheless, tax competition amongst countries clearly hampers the ability of individual governments to set their taxes without looking over their shoulders to see what their neighbours - and competitors - are doing. Only those that believe there needs to be external pressure on government to reduce taxes on profit would argue that tax competition is beneficial.
There are different ways of addressing tax competition. One, which I addressed with colleagues in a recent book, is to change the location of taxation, so that the incentive to reduce taxes to attract productive investment is removed. VAT is a good example of this strategy.
By contrast, the minimum tax proposal is more like a cartel that agrees to charge a high price (in this case, a minimum tax rate) to its collective customers, and where each member promises not to undercut the agreed price. This can also be a stable outcome as long as the consequences of reneging on any agreed price outweigh the gains of doing so. It remains to be seen whether this will be true in the context of Pillar 2.
But there is another potential problem for the claim that Pillar 2 will halt tax competition. That depends on relatively technical details about how the substance-based carve-out is incorporated into the proposal. The carve-out can be seen as addressing the concerns of some countries that would like to continue to set low taxes in order to attract inward investment. The basic idea is that it would allow a modest return on “substantive” activities to be exempt from the minimum tax.
But exactly how Pillar 2 incorporates the carve-out matters a great deal for its likely impact on tax competition. The most detailed statement on how the carve-out would operate is in the October 2020 Pillar 2 Blueprint. But that leaves some ambiguity about how it would work. In a recent paper my co-authors and I have analysed the most likely approaches.
Broadly, there are two steps in the calculation of the Pillar 2 top-up charge. The first is to calculate the effective tax rate (ETR) of a multinational company in a specific jurisdiction. If that ETR is less than 15%, then a top-up tax will be levied equal to the difference between the ETR and 15%, applied to profit net of the carve-out for each constituent entity of the multinational in that jurisdiction.
The key uncertainty arises in the definition of the ETR. Two possibilities seem consistent with the Blueprint:
- Model A: the ratio of “covered” taxes to income net of the carve-out; or
- Model B: the ratio of “covered” taxes to income gross of the carve-out.
Model B has an identical outcome to a third model (Model C), in which the numerator and denominator are both adjusted for the carve-out; in this case the adjustments net out, resulting in a ratio – like Model B - that does not depend on the carve-out. Our paper explains this in more detail.
The key point here is how these two alternative models affect tax competition. To understand this, a starting point is to recognise the (marginal) benefits and costs to governments of reducing their domestic tax liability. The cost is simply potential revenue foregone. The benefit is the possible inflow of new investment, which depends in turn on the reduction in the tax liability of the multinational taxpayer. Broadly, the trade-off faced by governments under the existing system (ignoring CFC rules, GILTI and other similar measures), is that a $1 reduction in tax revenue collected is matched by a $1 reduction in the tax paid by the multinational.
This is not true under either of the Pillar 2 models.
Under Model A, if the domestic tax liability is below the Pillar 2 threshold of 15% of profit net of the carve-out, then a $1 reduction in domestic tax does not affect the multinational’s tax liability at all; that tax is simply collected elsewhere. In this case, the incentive of the domestic government to reduce domestic tax to attract new investment disappears; the government has no incentive to set its domestic tax liability below the Pillar 2 threshold. Model A may therefore reasonably be expected to “put an end to the race to the bottom on corporate taxation” – though replacing that perhaps with a race to the Pillar 2 threshold.
This is consistent with what the OECD/G20 said in October: “Pillar Two puts a floor on tax competition on corporate income tax through the introduction of a global minimum corporate tax at a rate of 15% that countries can use to protect their tax bases (the GloBE rules). Pillar Two does not eliminate tax competition, but it does set multilaterally agreed limitations on it”. 1
However, that is not the case under Model B (or C). In that case, if the domestic tax liability is below the Pillar 2 threshold, a $1 reduction in the domestic tax liability does reduce the total tax liability of the multinational, albeit not by as much as $1. Depending on how much it values inward investment, that leaves open the possibility that the government may choose to compete by reducing the domestic tax liability below the Pillar 2 threshold – and even conceivably to zero. Model B therefore seems rather less likely to “put an end to the race to the bottom on corporate taxation”.
The OECD/G20 Inclusive Framework is expected to release further details on Pillar 2 shortly, and it seems likely that a choice will be made between these two models (or Model C). What may appear to be a seemingly arcane and technical issue can have a very significant impact on whether Pillar 2 achieves what is now one of its stated objectives: combatting tax competition. Over the next few months, we are likely to see similar cases where specific design choices have a marked impact on the delivery of the objectives.
1 OECD/G20 Base Erosion and Profit Shifting Project: “Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy”, October 2021, page 4.