An International Fiscal Revolution in the Making? Some Musings on Tax Policy and its Economic Foundations

A revolution of sorts is underway in international fiscal affairs.  The lightning rod is tax planning by global businesses.  Perceptions and judgments about this planning have become the focus of a multi-faceted international political, economic and fiscal inquiry.  Although more prominent in the last  eighteen months, the undercurrents of this debate have flowed for as long as countries have attempted to rationalize economic, trade and business relations straddling  borders,  in order to avoid unwarranted trade distortions attributable to excessive (“double”) taxation.  But the revolution, if it be one, is not just, or necessarily even mostly, about tax planning and business tax avoidance, though these are certainly the present preoccupation as outcomes arising from the imperfect intersection of countries’ tax and private law regimes attract broad attention.  International taxation fundamentally influences, and is influenced by, countries’ economic and social choices that define them as nations.  Through that lens, the current fascination with, and even incredulity about, corporate tax planning has a natural destination in the need by and among countries to evaluate the economic and social choices each makes, possibly in relation to the others, that define them as nations.

Do we understand well enough the incidence of business taxation so as to be able to draw hard economic conclusions about how it is influenced as a revenue source by international tax planning?

I am speaking, in particular, about the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) initiative, for which the fiscal and economic, and related political imperatives of the G-20, are the catalyst.  Even more specifically, I refer to the public record of debates concerning  international tax planning by enterprises like Starbucks, Google, Apple and  other global businesses,  reduced to very basic public judgments  of “acceptable” and “unacceptable” outcomes.  While also the subject of scholarly examination, for example by Edward Kleinbard (2011, 2012 and 2013)  as he confronts the notion of “stateless income” and Stephen Shay (2013) who comments on the “coherence” of international taxation dominated by bilateral rules in a multilateral world,  these developments have also occupied much more visible forums, which include political hearings in the U.S and U.K., and have been featured prominently in the ongoing (and, indeed, seemingly urgent) work of the G-20.  The stuff of international tax planning has even become fodder for dinner time conversations at home.  The curiosity of “non-specialists” about its seeming mysteries has been piqued by day-to-day familiarity with pervasive consumer products and an expectation among their users – a presumption, really – that purveyors of those products are so financially successful that they must pay a lot of tax somewhere.   Faith and social action organizations are actively involved in, and engaging with their constituencies about international tax analysis, challenging conventional tax policy and legislation addressed to international business.  Who would have thought that was possible?  Pass the potatoes and what do you think about offshore royalties?  That is something of a revolution!

The last tax revolution of this kind, as the OECD notes in its BEPS reporting, was in the 1920’s and 1930’s, when our present “international tax rules” and modern thinking about international tax relations formed.  In work initiated by the League of Nations after the First World War, the focus was the possibility, or in fact the reality, that trading relations between countries could be distorted by conflicting taxation of economic actors and their income by countries whose tax systems could sustain a principled tax claim but had no need or means to accommodate each other.   The “sorting out” of trade and tax issues resulted in an income tax – oriented approach for which the ”residence” of taxpayers and the origin (“source”) of business and other income became guiding notions.  This was not inevitable. Indeed, some of the perceived vulnerability of existing international tax rules and customary practices (including the general law on which they result) may be attributable to obvious and inevitable imbalances in trade flows between counties, which become manifest in income tax bases that depend, essentially, on reliable measures of the volume and characteristics of trade and investment activity and of presence in a country to justify income taxation.   Formerly, particularly in Europe, other kinds of property —  and consumption – oriented taxation, capturing measures of observable “fixed” presence in a country to which some now refer as a justification for increased reliance on consumption taxation,  had existed, even prevailed.  These were essentially displaced by distributional income tax rules of the sort, typically found in tax treaties (J F Avery Jones, 1997, 1999, 2001), which essentially organize how competing tax claims should be rationalized according to common principles and expectations,   so as to avoid trade distortions caused by excessive taxation as a “cost”.

These international rules and practices, as the current BEPS discussion recognizes, are fundamentally unchanged in the last eighty or so years, even though they have undergone refinement – albeit, within their own parameters.

So, what has changed?  And in policy terms, is the change fundamental?

As the BEPS debate recognizes, frequently and increasingly trading limitations that underlie international tax experience are no longer limitations; the short form for this is that income, and its most valuable inputs, are much more mobile than when international tax rules were in gestation.  This does not bode well, necessarily, for income taxation that, as a formative matter, needs to know “where” and “by whom” income is earned, and is oriented around the “earners” and not consumers or others supplying inputs to production.  The most prominent example of this, one that is a focal point of the BEPS project, is the “digital economy” – the ability to organize and conduct business, including with customers, electronically, with the same effect as the business interactions formerly encumbered by the requirements of physical presence, physical transfers, human intervention of various kinds in various places and the like, but with none of those.   Original concerns about “double taxation” intervening to distort trade are being extended to contemplate the novel possibility of “double non-taxation” – a notion that is hard to define in the absence of international tax relations among countries amounting to an “international tax system” and common legal systems, and the administration on which it would rest.

International tax policy, if that is not too lofty a term, originated when trading relations were much more “physical” – when goods in fact had  to be transported from one place to another, when what were thought to be all of the key features of economic behavior were readily observable and more or less clearly assignable to particular countries, when the most valuable business inputs were not “intangible” or financial,  and when selling in markets actually required some sort of palpable engagement in those markets between the sellers and customers . “Contracts” assuredly evidenced economic and business relations and income resulted from their performance.  But, they were not, themselves, seen as the entirety of those relations or, in other words, as the “business assets,” such that, as the OECD and G-20 are concerned, entrepreneurial income is thought by some to be  as easily mobile as related paper contracts may be created or are assignable.  Things are different.  They are less constrained by tangible manifestations of business presence, and even products may be" virtual" in the digital economy.  It is often no longer necessary, in many respects, to be “anywhere” still to be “everywhere”. The “nature of business” – commonly called “globalization” but which social geographers more insightfully describe as “time and space compression” (Harvey 2010) , has eclipsed the business experience underlying the international tax rules.

Stepping back from the BEPS  constellation of debated issues, have  we merely returned – in tax policy terms — to the future; is this the 1920’s and 1930’s redux, without being limited in our thinking or responses by  physical transformations that formerly defined how business was conducted ? Aside from freedom from those limitations, fundamentally, are there few other “real” economic changes?

One response is to conclude that, indeed, there is a revolution, and that a new international consensus informed by new – substantively and directionally new – standards is needed.  There is a flavour of that in the current BEPS debate.  Another, more nuanced and interesting, is to acknowledge that, apart from the absence, or possibly irrelevance, of former or customary physical and legal limitations about how business value is realized, its substantial economic features are not so different; the “old” rules are directionally sound, but some renovation – which could be simply a recalibration about how we interpret and apply them – is desirable to align them with modern manifestation of what fundamentally are unchanged economic transfers and transactions.  In fact, there is some of that sense, too, in the current debate.  Even so, potentially far reaching changes are being  considered concerning  how international business income should be tied to a taxpayer’s “presence” in a country and, in fact, what “presence” means in contemporary business, whether there is a normative level or standard of “global taxation”  needing to be satisfied before international tax planning benefits anywhere will be allowed to be sustained, and whether and how international businesses should make information about their businesses routinely accessible by  tax authorities in “real time” without procedural or other restrictions.  But the real revolution may be more subtle. Possibly, the tax planning and perceived tax avoidance through “double non-taxation” that dominate the present debate are symptomatic of a much harder inter-nation debate percolating beneath the surface.  The policy parameters of this latent debate are much more difficult to establish and explain; quite possibly there are fewer seemingly ready responses even though countries might agree conceptually on how to address particular and highly visible instances of perceived structured and structural tax avoidance.

These tax developments, in fact, engage all dimensions of public policy. How could this not be so?  Key roles of taxation are to fund public consumption and to direct economic behavior, both presumably in the public interest according to choices made by a country as to what constitutes – for it — civil society.  Intrinsically, these features of taxation, one a payment mode and the other a stimulant of economic and social development, are instruments that convert political, social and economic choices into a national personality – key tools to effectuate standards for, among other things, healthcare, education, social assistance, retirement support,  intergenerational transfers, and the like.

From this perspective, then, possibly our focus might, and in any event should, shift a bit.    As a well-known paper by Charles Kingson (1981) reflects, countries use their tax resources effectively as “currency” to “buy” economic “goods” from each other, in the form, for example of “inbound” capital to fund domestic expansion, and economic advantage for the international (“outbound”) operations of their “tax citizens” presumably in the expectation that through their business success future domestic economic value will be created for the sponsoring nation.   In very basic terms, this is what international trade, at a “macro” level, is about.  Taxation is in the nature of applied economics and engineering , to borrow a science metaphor, to help a country release latent economic advantage according to national priorities and public choices that define that country as a nation – which may or may not intersect with or match those of other political jurisdictions.   Right away, we can imagine that if countries’ societies are different, their outlook on taxation also might not be homogeneous even though, within limits, they still might agree on whether particular features of tax planning and international tax avoidance need to be confronted  with a common outlook underlying particular national tax system responses.

If that’s a useful metaphor for what underlies the BEPS debate – sometimes referred to unflatteringly as “tax competition” among nations  — then some very difficult questions emerge or may yet emerge to be more prominent in that debate than so far seems to be the case.  If countries have different standards for what constitutes a civil society, should their views about international taxation, as either a funding mechanism or an economic stimulant, necessarily be uniform; are common standards even achievable and if so how, according to what particular terms?   Are countries actually enriched, in economic terms, to the extent that their tax citizens do not pay tax elsewhere – foreign tax that would reduce, by tax credit or exemption, “home country” taxation?  Is this sort of determination one that can be made only between countries who have carefully considered their immediate or direct mutual economic relations and priorities, rather than according to a more comprehensive international standard that, though broad enough to accommodate broad agreement as fiscal diplomacy, is not specific enough to address particular instances of economic and fiscal dislocation between countries whose mutual encounters are frequent and specific?  Countries may also have very different perspectives on “acceptable” tax reduction.  Much of the BEPS focus is on highly structured tax planning and the absence of common legal and tax outcomes among countries of the same economic event – “hybridity” in BEPS terms.  But what about more direct ways in which countries seek economic advantage using their tax systems as economic generators – for example, the “patent box” recently adopted by the U.K.

The BEPS debate is fundamentally about business income taxation, its practice and, more insidiously in fact, its usefulness and reliability as a revenue source for countries.   Yet, do we understand well enough the incidence of business taxation so as to be able to draw hard economic conclusions about how it is influenced as a revenue source by international tax planning?   Do tax systems sacrifice present taxation on purpose in order to stimulate – subsidize (?) – business activity of its business citizens to result, it is hoped, in future taxation through the generation of incremental economic value?  How is this “present value” versus “future value” calculus performed?   What factors bear on the corporate tax, and how, in economic terms, does taxpayers’ tax planning actually translate into economic potential?   These seem to be important questions in the present international tax debate.  International tax involves countries essentially trading their tax bases with each other, via how trade and investment are taxed.  Is it not necessary, then, to have a reliable sense of what the “tax trade” entails, and in turn what national economic and social choices are sustainable?  Might the outcome of this analysis influence reactions, country by country and generally, to particular instances of perceived business tax avoidance?

The present focus on business tax planning is certainly important, but it may be too narrow.  There is a fundamental economic axis of interest, reflecting “tax competition” among countries that may need to be more prominent in the BEPS-induced debate (OECD, Harmful Tax Competition, 1998). Though “tax competition” seems a dangerous and inflammatory fiscal notion, a more benign perspective might focus on the role of taxation in   fostering an economic environment in which a country and its citizens prepare to prosper according to the “best” use of its economic resources and the talents and experience of its citizens.  Possibly, must this be addressed more directly before the modalities and limitations of business taxation can be recalibrated?

This way of looking at the BEPS debate presents profound challenges for the economic and fiscal inquiry underlying BEPS and evolving tax policy, with very immediate and practical outcomes, including for the relationship between “developed” and “developing” countries as manifest through the activities of global business actors.  The BEPS conversation is focused on what it mostly sees, the symptoms of international economic (and fiscal) collisions, or maybe  more challenging, their tectonic interactions.  But, possibly, there are larger institutional questions to address, which draw the outcomes of economic choices – taxation and tax planning – back to those choices themselves.  It will be interesting to see how, and with what expectations of each other, countries address their roles and responsibilities as “fiscal traders” with and “fiscal actors” in relation to  each other.  It will be even more interesting if BEPS becomes the point of departure it should be for a more fundamental re-examination of accepted “truths” of business taxation.

Scott Wilkie is an Executive Fellow at The School of Public Policy.