Before You Reform The International Corporate Tax System You Really Need To Understand This One
17 September 2013
Posted by: Author: Tim Worstoll (Forbes)
Author: Tim Worstoll (Forbes)
Another day and another report telling us all about how appalling it is that multinational corporations are able to avoid the various nationally based systems of taxing corporate profits. And, of course, another plan to make sure that they cannot continue to do so. Not that I would be or am against people coming up with ideas to try and make the world a better place it’s just that I would very much prefer people understood the one we’re in before they did so. You know, I’d rather they tried to improve cucumber seeds as a method of making cucumbers, rather than trying to distill them out of moonlight. The latter shows a distressing lack of knowledge about what a cucumber is and where it comes from.
So it is with this latest attempt to discuss corporate taxation, specifically the taxation of companies that operate across many tax jurisdictions. The paper is very interesting as a report on the history of the various attempts to organise an international taxation system. However, it fails, and fails badly, when discussing the economics of corporate taxation. Here’s one crucial paragraph:
"For both developed and developing countries, the road to improved governance depends on re-establishing the efficacy and legitimacy of general taxes, especially on income. This has generally extended to the income of both natural and legal persons, i.e. companies. Arguments have often been made, from an economic perspective, to exclude corporate profits from income taxation, usually on the grounds that it is a cost that is just passed on to consumers. This idea is based on theview that companies do not really exist, they are no more than a bundle of contracts between shareholders, other lenders and the company’s officers and employees, as well as its suppliers and customers. But firms are real organisations, and are protected by the state as separate legal persons, because of the economic advantages of combining activity (especially labour) under centralised direction (Coase 1988:39-40). To encourage this, states grant companies special privileges, especially limited liability. These rights should also carry responsibilities, particularly the payment of taxes on the profits earned by the company, to help pay for the collective services and infrastructure which help to generate those profits. More pragmatically, corporate income tax revenue accounts for an average of 8-10 per cent of the tax take in developed countries, and generally double that percentage in developing countries. Ending corporate taxation would mean either enormous cuts in public expenditure or large increases in taxes on individuals. It would also open the door to all kinds of avoidance, as people could form companies through which to carry on their trade or profession. This would shift the burden of income taxes to employees."
The problem here is that this is not the argument about corporate taxation at all. We do not, ever, think that it is passed along to consumers for example. We do think it is passed along to some mixture of the shareholders and the workers in that taxing jurisdiction (note, not the workers in the specific corporation being taxed). Further, with reference to corporate taxes in developing economies we’re absolutely certain that more of that tax burden falls upon said workers than it does in the more economically advanced countries.
A correct understanding of the economics of "tax incidence” would show us that far from wanting to ensure that multinationals working in developing economies are charged more tax, we want them to be charged less.
The basic set up, and this has been around since Seligman back in 1899, is that there is some world return to capital. This is analagous to Adam Smith’s normal rate of return. Imagine, just imagine as an example, that this rate is 10%. These days we would add " risk adjusted” for completeness but the example works without worrying about that. You invest $100 and on average, across a number of such investments, you’re going to get $10 back each year for each $100 invested. Wonderful: now introduce a tax on the returns to investment in just one taxing jurisdiction or country. Say, 50%: it’s obvious now that the returns from investing in that jurisdiction are now lower than the world average. In this case they’re 5%, or half the world average.
What will happen next is that some of the investment in that country will leave it for better returns elsewhere. And most certainly residents of that taxing jurisdiction will, when deciding where to invest, prefer to do so elsewhere, where they can get the 10%, not the 5%. As of course will foreigners reduce their incoming investments and invest elsewhere to get that 10% not the 5%.
Note that this is any taxation of the returns to investment.
So the amount of investment in an economy that taxes the returns to investment will fall over time. This isn’t a particularly good idea: for average wages across an economy are determined by the average productivity in that economy. The way you increase labour productivity is by adding more capital to that labour. So, less investment, lower average productivity and thus lower wages.
Please do note that this is not some outre, nor outrageous, theory. This is the basic and standard analysis of the incidence of taxes upon the returns to capital. The shareholders will bear some burden of the tax (they have seen their returns fall from 10% to 5% after all) and all the workers in that economy applying the tax will have incomes lower than they would have been in the absence of the tax. The true burden of the tax is thus split between the shareholders and the workers.
We also know what it is that influences who carries the bulk of the burden, the shareholders or the workers. It is the size of that taxing economy relative to the world economy plus how open that economy is to the global economy. For one effect of the tax is going to be that above mentioned lower level of investment: and this will mean, ceteris paribus, that the internal return to capital in that economy will rise. In theory, so that the post tax return is again 10%, although Adam Smith did point out that this wouldn’t ever quite happen in practice (it’s in that quote about "invisible hand” from Wealth of Nations. This is what he’s referring to, that even if foreign investment is better financially than domestic, there will always be some who still prefer domestic investment). The larger the economy that is taxing and the less open it is to international capital transfers, then the less likely that it is that the post tax rate will rise up to the global profit rate. Thus the shareholders carry more of the burden, the workers less.
The implication of this is therefore that a large economy, like the US, can have a higher profits tax rate than a small one like, say, Estonia. Further, for any given tax rate more of it will be carried by the shareholders in the US than by the shareholders in Estonia: where the workers are always going to carry more of the corporate tax burden.
Now think of what happens in a developing economy and the taxation of multinationals. First and most obviously developing economies are tiny in regard to the global economy. The economy of the entirety of the Central African Republic is about the same size as a single English county, Herefordshire. London alone is around the size of Nigeria. Thus we would see the shifting of any capital taxation to the workers, away from the shareholders. And of course, we’re talking about foreign investment by multinationals: by definition this is something that is open to the global economy. So again we would expect the shifting of the burden of this taxation to take place: to the workers.
This is what is so annoying about this line:
"This would shift the burden of income taxes to employees."
That burden is already on employees in that economy. It was Joe Stiglitz who pointed out that in fact this burden would be greater than 100%: that the workers could lose more in wages than was raised in the original taxation.
What truly grates is that the above is not some great secret. It’s the absolutely standard discussion of the who actually carries the burden of capital or corporate taxation. And yet here we have a reformer of the international taxation who, by not understanding these basics, wishes to increase the tax burden on those poor workers in the poor countries of the world. For he’s deliberately designing a tax system which would increase the amount of tax captured from multinationals working in poor countries: exactly where we know that the greatest shifting to the workers takes place. And he’s justifying his actions by stating that not to do so would mean the workers would have to pay tax. Ignoring the very point that they are already paying this tax in the form of lower wages.
Which is why my title to this piece is as it is. I’ve no problem with anyone and everyone coming up with ideas to try and make the world a better place. But creation of such plans does rather require that one understands how the world works at present.
To show that I’m not entirely negative about such plans the best thing that such developing countries could do is to simply abolish corporation tax altogether. This will, given that near everywhere has a corporate tax of some sort, raise the returns to capital in those countries above the world average and thus encourage investment. Along with all of the development and rising productivity, thus rising average wages, this brings.
Finally, please do note, taxes on corporations and capital are entirely different from taxes on natural resources, upon so-called Ricardian Rents. These types of taxes should be as high as the market will bear, high enough to make the pips squeak, for the effect upon incentives are entirely different. Tax oil, or copper, or iron ore, at whatever gargantuan rate you think you can get away with, for as long as the rates are at least market based then all that one is arguing over is who gets the profits from the mere existence of these resources in that territory, the government (and by association the people) or the shareholders of the companies extracting them. And there’s absolutely no reason why the shareholders should get rich simply from the mere existence of something laid down geologically. From the extraction of it, from the application of their capital to doing so, most certainly they should profit, but not from the simple existence. Royalties from minerals are an entirely different matter than taxes upon the returns to capital.