South Africa is considering the introduction of regulations to force corporates to pay their fair share to the public purse. It is not alone. The 2008 crisis threw the unequal distribution of income into stark relief, which has sparked public protest in many parts of the world. This disgruntlement has been fuelled by the revelation that well-known multinational enterprises pay little or no taxes despite having significant business interests in many countries.
Tax dodging by big firms, particularly in developing countries with a relatively large number of poor people, is seen as an egregious denial of a fair distribution of wealth.
The intense scrutiny of possible regulations that has followed is unsurprising, and the widespread resistance to tax avoidance eventually prompted a G20 initiative at the end of last year to counter base erosion and profit shifting. The initiative is being driven by the Organisation of Economic Co-operation and Development.
Issues of fairness are not the only consideration. Concerns about global development are adding impetus to finding a constructive way forward. Work on the formulation of the post-2015 development agenda has highlighted the concomitant need for financing to fund the development goals. This underscores the importance of fiscal contributions by multinationals as a source of revenue for governments. But meaningful progress of the development goals can only be achieved with increased participation of the private sector, which places policymakers in a catch-22.
Maintaining attractive investment climate
The dilemma is clear: How can policymakers tackle tax avoidance and make multinationals pay the right amount of tax at the right time and in the right place without tightening fiscal regulations excessively, which might reduce investment? In other words, how can policymakers maximise tax revenue from international investment and still maintain an attractive investment climate to protect their existing and future tax base?
If sustainable development requires both public and private investment, for investors, the fiscal climate must be balanced to ensure sufficient revenue to support public investment and adequate returns to maintain private investment. The dilemma is especially pertinent for developing and least-developed countries, where investment for basic development is often more acute.
How much do multinationals contribute to government revenues in developing countries, and how much is at stake if action is taken against tax avoidance?
A new study by the United Nations Conference on Trade and Development (Unctad) estimates the contribution of foreign multinational affiliates to government budgets in developing countries is $730-billion annually. This represents, on average, about 23% of corporate payments and 10% of total government revenues.
In developed countries, the shares are about 15% and 5%, respectively. For African countries, foreign affiliate contributions are more than a quarter of corporate contributions and 14% of total government revenues.
The Unctad study also shows that the level of economic development and degree of informality are significant causes for the variations in revenue collection among countries.
As a general rule, the lower a country is on the development ladder, the higher is the corporates’ share of contributions to government revenue, and the greater the importance of non-income tax revenue streams contributed by firms.
Corporate income taxes
For foreign affiliates, on average, contributions made by royalties on natural resources, tariffs, payroll taxes and social contributions, and other types of taxes and levies are twice as important as corporate income taxes. But corporate income taxes are at the centre of the debate on tax avoidance and it is important to consider some additional context.
Multinationals, like all firms, aim to minimise taxes. They build their corporate structures through cross-border investment in the most tax-efficient manner possible, within the confines of their business and operational needs. The size and direction of foreign direct investment flows are therefore often influenced by tax considerations, because the structure of initial investments enables tax avoidance opportunities on subsequent investment income.
When tackling tax avoidance, policymakers focus naturally on tax rules and transparency – that is, on accounting rules for income. But the fundamental role of investment to avoid tax has received scant or no attention.
When the role of investment and tax avoidance is considered, the spotlight inevitably shifts to the role of offshore investment hubs – or tax havens – as major determinants in global investment. At least 30% of cross-border corporate investment is routed through offshore hubs (tax havens and letterbox companies in other countries) before reaching its destination. The growth of this form of transit investment has accelerated sharply in the past 10 years.
The root cause of the outsized role of offshore hubs in global corporate investments is tax planning. Multinationals employ a wide range of tax avoidance measures, which are enabled by tax rate differentials between different jurisdictions, legislative mismatches and tax treaties. Multinational tax planning involves complex multilayered corporate structures, which very often use entities in offshore investment hubs.
Tax avoidance by multinationals affects all countries. To be sure, the exposure to investments from offshore hubs is broadly similar for developing and developed countries.
But shifting profits from developing countries can be more negative because of the implications for development objectives, and developing countries are often less well-equipped to deal with highly complex tax avoidance practices because of resource constraints or lack of technical expertise.
Leakage of funds
This leakage of funds for development is significant. Unctad’s study puts the loss of tax revenues for developing countries, related to inward investment stocks directly linked to offshore hubs, at about $100-billion annually. On average, in developing economies, an additional 10% share of inward investment stock originating from offshore investment hubs is associated with a decrease in the reported (taxable) rate of return of more than one percentage point. The estimated tax losses represent about one-third of the corporate income taxes that would be due if profits were not shifted.
Tax avoidance by multinationals raises basic questions of fairness about the distribution of tax revenues. Countries with limited tax collection capabilities are at a particular disadvantage, because of their greater reliance on tax from corporate investors and their growing exposure to offshore investments. The effect on development is exacerbated by the fact that higher after-tax profits can provide multinationals with an unfair advantage over domestic firms. This has a direct effect on market competition and suppresses the survival and growth of the small- and medium-sized businesses that are so vital for development.
But, in tackling tax avoidance, policymakers should be aware that the potential value at stake – taking into account the total contribution of multinationals and the fiscal discounts actively provided by governments in the form of incentives to attract investment – is almost 10 times larger than the revenue leakage. And that does not take into consideration the potential effect on investment of a tightening of the fiscal regime for multinationals.
Taking action on tax avoidance will have effects on international investment that must be considered carefully.
Currently, offshore investment hubs play a systemic role in international investment flows. Any measures at the international level that might affect the “investment facilitation” role of offshore hubs, or that might affect key investment facilitation means, such as tax treaties, must take into account the potential effect on global investment and include an investment policy perspective.
Ongoing anti-avoidance discussions at the international level pay limited attention to investment policy. The role of investment in building the corporate structures that enable tax avoidance is fundamental. Therefore, investment policy should form an integral part of any solution.
Richard Bolwijn is the chief of the business facilitation section, investment and enterprise division, at the United Nations Conference on Trade and Development