Following the financial crisis and ensuing austerity, politicians discovered the problem of tax avoidance. On the corporate tax avoidance front, the OECD and G20 launched the Base Erosion and Profit Shifting (BEPS) project in 2013, and this has in October, 2015 culminated with the release of a series of action steps that the OECD and G20 countries have undertaken to adopt.
OECD Secretary-General Angel Gurria has stated that:
Base erosion and profit shifting affects all countries, not only economically, but also as a matter of trust. BEPS is depriving countries of precious resources to jump-start growth, tackle the effects of the global economic crisis and create more and better opportunities for all. But beyond this, BEPS has been also eroding the trust of citizens in the fairness of tax systems worldwide. The measures we are presenting today represent the most fundamental changes to international tax rules in almost a century: they will put an end to double non-taxation, facilitate a better alignment of taxation with economic activity and value creation, and when fully implemented, these measures will render BEPS-inspired tax planning structures ineffective.
Is Mr. Gurria justified in his optimism? We do not think so. These efforts are commendable and to some extent have an impact. But in our opinion they are inadequate. The basic problem is that they take as a given the fundamental consensus underlying the international tax regime, also known as the “benefits principle.”
Under the benefits principle, active (business) income should be taxed primarily at source while passive (investment) income should be taxed primarily at residence. This compromise between the claims of residence and source countries was reached by the four economists in 1923 and still serves as the foundation of the international tax regime. It is embedded in over 3,000 bilateral tax treaties and in the domestic laws of the US and most other countries. Not surprisingly, it is also reflected in BEPS, which is an attempt to improve source-based taxation of active income.
In our opinion, the benefits principle should be reconsidered, because the reliance on source-based taxation for active income and residence-based taxation for passive income requires cooperation by too many jurisdictions. The problems of BEPS stem from its reliance on the benefits principle.
In the case of active income, the justification for taxation at source has been that most such income is earned by corporations that have no fixed residence. However, since the 1980s, tax competition has led many source jurisdictions to offer tax holidays to multinationals, and residence jurisdictions are reluctant to tax their multinational of their global income so as not to put them at a competitive disadvantage. The result has been that most multinationals are not taxed currently at source or at residence.
The fundamental problem of BEPS stems from its reliance on the benefits principle. BEPS seeks to bolster source-based taxation of active income, but it does not apply to countries outside the OECD/G20, and its scope is quite limited.
To preserve the income tax in the 21st century, multilateral solutions are needed. BEPS is multilateral, but it is hampered by the fact that there are too many source jurisdictions for active income. If we reversed the benefits principle so that passive income is taxed primarily at source and active income at residence, far fewer jurisdictions will need to cooperate.
For passive income, the number of source jurisdictions is much smaller than residence jurisdictions. Because most individuals are relatively risk averse, portfolio investment flows overwhelmingly to a small number of countries ‒ the US, the EU and Japan. Even the BRICS mostly attract portfolio investment through mutual funds that are relatively easy to tax. Thus, if the “big three” can coordinate to reinstate a withholding tax on interest, dividends and royalties flowing from them, most of the problem of taxing passive income can be solved. Crucially, money cannot stay in tax havens and earn decent rates of return, so the cooperation of tax havens is not needed.
For active income, about 90% of large multinationals are headquartered in the G20, and none of those countries have a tax rate below 20%, so if they taxed their multinationals currently on a coordinated basis and restricted the ability to move out, most of the problem would be resolved.
We would therefore suggest that we reconsider the benefits principle in light of the reality of globalization. We should tax passive income primarily at source and active income primarily at residence.
Importantly, like under current rules, this does not preclude the alternative. Once passive income is taxed at source, taxpayers may be able to credit the tax upon declaring it to their residence country. And once active income is taxed at residence, a credit can be given to source country taxes if the source country responds to the limitation of tax competition by re-imposing its tax. But the key is that the income has already been taxed, so that no double non-taxation ensues even if taxpayers do not declare the income (in the case of passive income, where the residence rate may be higher) or source countries choose not to tax in the case of active income.
It is imperative for the West to find ways to strengthen the ability of the state to provide adequate social insurance and to reduce inequality before these forces lead to the closing of the borders and to pressures that could result in the end of the current era of globalization. But the response so far, as embodied in BEPS, has unfortunately not been adequate. We can and should do better.
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