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As globalization challenges national borders, governments are discovering that their tax base is eroding, especially their ability to tax corporate profits. The share of total taxes from labor has been increasing while the share on capital has been declining, after social security taxes are removed from the calculation. In the European Union half of all tax receipts were derived from capital in 1980; by the mid-1990s it had fallen to 35%, while the share of taxes collected from labor rose from 35% to over 40%.The gap between higher tax proportions from capital in 1980 and those from labor steadily eroded, as the former fell and the latter rose, until 1991 when they became equal, and subsequently reversed course with the tax proportions from labor exceeding capital. In the United States, which has historically had a lower capital share, there is a similar pattern; from a capital share of 27% in 1965 it has fallen to only 15% in 1999, this minimal corporate share occurring at a moment of historic peaks in corporate profits.1
To a considerable extent, the source of this change can be explained by globalization. Capital is more mobile than labor and can escape taxes by moving to low tax third world countries. By manipulating their books through transfer pricing (to be defined later), corporations are able to show high profits in low tax jurisdictions in the third world and avoid the high tax jurisdictions of Europe and the United States. In developed countries (DCs), financial and tangible forms of capital roam the globe, rendering it difficult either to define profits for tax purposes or decide in which country the taxable profit is earned. Less-developed-countries (LDCs) find themselves under such pressure to grant tax holidays, tax abatements, and generous land giveaways that they cede their tax base in an obsessive competition for foreign investment. Corporations have then used these concessions from LDCs to leverage tax reductions in their home countries in what is by now a well-tuned orchestration of political pressure. "Tax degradation," is the way the IMF's former Director of its Fiscal Affairs Department characterizes this general phenomenon, "whereby some countries change their tax systems to raid the world tax base and export their tax burden." 2
A different spatial alignment defines the new global era. Capital operates both within and beyond states; labor is rooted in the specific space of nation states. A tension arises, therefore, between the unbounded global reach of commerce and a bounded national government. The economic concept of elasticity is relevant here; a higher elasticity of response of capital to taxes, as compared to labor, affords corporations greater power in leveraging their influence against governments. Tax capital, it moves and tax receipts from corporations decline, a high response elasticity. The contrary is true for labor. Simply put, companies can challenge government tax policy by threatening to move to lower taxed jurisdictions, a tactic that is not credible for labor. The technical economic concept of elasticity translates into political power in a global era that venerates the mobile and denigrates the stationary.
The French social critic, Susan George, describes this distinction between the mobile and the stationary as the "fast castes, ... the owners of capital and skilled professionals, [who] are at the top of the global pyramid," echoing Jacques Attali's apt characterization of them as "elite nomads." "Below them," she continues, "is a vast pool of stationary, 'slow people,' whose chief common characteristic is their substitutability, whether the substitution takes place North-North, North-South or South-South." This has changed relative bargaining power and the arena within which negotiations over a social contract once took place. George argues that previously the "negotiating table was geographically grounded. People had to negotiate because they were going to have to go on living with each other in ... the same space." Not so any longer because of the spacial alterations associated with globalization, in which the "key words are speed and mobility," says George.3 Power relations now slice through capital and labor to forge a new division between the fast, mobile people and the slow, stationary ones. The fast and the mobile stay a step ahead of the tax collector, something the slow and the rooted cannot do.
Existing tax policy was designed for defined borders and tax jurisdictions that coincided with nation states. Indeed, that was one of the raison d'etre for states in the first instance when they were formed a half millennium ago. The global era has changed this. Differing mobilities and elasticities of capital and labor reconfigure power relations in the U.S. and Europe and expose third world economies to a competitive race to the bottom.
The route to an analysis of tax distortion and its consequences runs through a discussion of the conceptualization of globalization and the confusions surrounding that buzz word. Globalization's specific characteristic requires a definition that captures both the quantitative and the qualitative, its spatial transformation, and power structures. One example is from The Economist: "a minimum definition would include a diminishing role for national borders and a gradual fusing of separate national markets into a single global market."4 To this should be added the import and export not only of tangibles, but intangibles such as policy ideas, culminating in the single policy formula, the pensee unique, replacing a matrix of varying policies in varying settings. Broadening this, my colleague at American University, Colin Bradford, has delved into literature and art to find a means to capture the essence of globalization. Inspired by the work of the Mexican Nobel Prize winner, Octavio Paz, he borrows his literary symbolism of "roots and wings," the tension between national identity (roots) and universality (wings), between the concrete space where life is lived and the abstract space of the cyberworld, the stationary and the mobile, the slow and the fast, or in Paz's words the separation of writers into those "air-borne and those deeply rooted."5
Taxation and Factor Mobility
"The heart of the problem," of tax distortion according to The Economist, derives from the fact that "modern tax systems were developed after the second world war when cross-border movements in goods, capital and labor were relatively small. Now, firms and people are more mobile -- and can exploit tax differences between countries."6 To firms and people, a third is added: land. Historically, tax systems were developed along with the creation of the nation state. Indeed, one of the motivations for state creation and defined geographical jurisdiction was the desire of authorities to capture the tax base which was originally land, the most reliable and predictable tax base, because it cannot be moved to another tax entity. Land's tax base is virtually inelastic with respect to any tax rate.
Governments can more effectively tax factors of production if there is a high degree of inelasticity with respect to the tax base following on an increase in tax rates. Factor mobility erodes this. The taxed factor cannot escape by fleeing the tax jurisdiction if there is immobility and inelasticity. As the most mobile factor of production capital can more readily jettison an unfavorable tax jurisdiction and seek refuge in a third world tax haven. A government can raise the tax rate on capital but discover its tax receipts have declined because the base on which the tax is calculated drops proportionally more than the rate has risen.
Profits are a moving target; labor is stationary and more readily targeted for taxation. Even if labor wanted to move to another tax entity, it cannot do so easily. Immigration laws restrict labor mobility, but fewer restrictions are placed on capital movements and recent proposals for a new Multilateral Agreement on Investment (MAI) aim to increase further the ease of fixed and financial capital movements. There are also other reasons: language, culture, cost of moving and reversing the move, and risk. Picking up and relocating half way around the world is not as easy for humans as it is for stateless and root-less capital, which is specifically aided by the modern marvels of information technology. The difference in opportunities for movement of capital as opposed to labor, therefore, accounts for the shifting of taxes onto labor and away from capital, with consequences for unemployment, equity, and efficiency.
A corporate "underground economy" avoids taxes but absorbs benefits from other's tax payments. The OECD seemed to surrender to this reality in 1994 when in a staff paper it observed that "with growing international mobility of both fixed investment and financial investment there may be a need to reduce taxes on income from capital. Thus, most of the tax burden will have to fall on labor as this is the less mobile factor.7a Four years later, however, the same OECD had reversed itself and now found what it calls "tax competition" to be harmful when countries can develop tax policies "aimed at diverting financial and other geographically mobile capital ... shifting part of the tax burden from mobile to relatively immobile factors and from income to consumption, ... [creating] 'free riders' who benefit from public spending in their home country and yet avoid contributing to its financing."8b
Competing for foreign direct investment (FDI) by a third world country that offers low taxes on profits may appear to be wise policy. However, it can be a trap, a cul de sac that pits one poor country against another in an inevitable race to the bottom, a "prisoner's dilemma" in which each third world government would prosper by not giving away its tax collecting potential but cannot do so without a collaboration that is precluded by the character of competition for FDI. Through the prism of neutral parties in the advanced countries, it becomes a form of poaching on taxes from profits, shifting internal tax burdens, and producing free riders in the most productive sectors.
Foreign direct investment to third world economies stood at $190 billion in 2000, the same as it was in 1999. This represents a trend reversal following on the 1997 Asian financial crisis and its attendant spread to Latin America. Before 1997, FDI had been growing rapidly in the third world, its share of total FDI growing from around 17% in 1990 to a peak of 40% by 1994.9
Transfer Pricing and Tax Distortion
Transfer pricing is the device corporations use to locate their profits worldwide so as to minimize their global tax payments. It was first discovered by analysts in the early 1970s, applicable to only a slice of corporate activity that had become multinationalized.10 Today, however, transfer pricing is so widespread that it has caused the erosion of the profits tax base.2 A corporation operating globally has considerable transactions internal to the company, where the cost and price of those transactions is not set on an external market but established by the corporation itself. A company can, therefore, manipulate these internal prices so as to show high profits in low tax jurisdictions and low profits in high tax jurisdictions. The typical template yields high prices for headquarter activities, normally conducted in high tax jurisdictions, such as marketing, research and development, production and inventory management, legal, intellectual property, accounting and financial services, some of which are used to manage the internal transfer pricing mechanism. Low market prices are placed on those direct production activities conducted in low tax third world countries. External markets will dictate these basic price differentials.
However, when a multinational corporation (MNC) "imports and exports" products and services within its worldwide affiliates, it flips these differentials. It charges a lower internal price than that on the external market for headquarter activity "exports," in order to show high profits in low taxed third world countries. Higher internal "import" prices are charged than those in the external market for the direct production undertaken in third world affiliates to show lower profits in the high taxed country. By pricing this way for its imports and exports internal to the company, under-invoicing headquarter prices and over-invoicing foreign costs, the multinational establishes transfer prices that allows it to conduct a profit location strategy, minimizing its global tax liability. Transfer prices for exports and imports internal to the company permit the multinational to optimize its placement of profits with the goal of minimizing tax payments, constrained by a band of price differentials that does not invite the suspicion of the tax collector in the high tax country.11
The problem for taxing authorities arises from the nature of profits, the base on which taxes are levied on corporations and financial institutions. Profits represent the difference between revenues and costs, but the question raised by transfer pricing in a global theater is what are costs and which institution defines them: the external and tax-neutral market or the biased internal transfer pricing "market" of the tax-paying entity itself? Moreover, in which country, taxing jurisdiction do profits originate? Although governments attempt to audit the transfer pricing mechanism of tax avoidance, the problems are acute and the costs of enforcement high. In theory MNCs are supposed to use the external market price test, called "arms length" pricing, when they price internally for tax purposes, but disputes inevitably arise and the ability of tax auditors to challenge prices is constrained by enforcement costs.*
When the profits tax was introduced as a major revenue source for national governments, during and after World War II, the corporate entity was more or less geographically bounded and coincident with the nation state. Globalization, by definition, changes this. Although legally based in a nation state, corporate economic activities are now so globalized that pursuing a moving profit target becomes an almost impossible task for the state. This is revealed by the statistics on intra-firm trade in international markets, exports and imports among affiliates within a multinational. Of the nearly $700 billion in imports of products and services in 1994, 43% were "sales" within a company, intra-firm trade that reflects worldwide production and the movements of products and services internal to companies from activity elsewhere that is imported back to the U.S.12 Intra-firm exports from the U.S. MNCs to their affiliates around the world amounted to 36% of total U.S. exports, around $272 billion in 1994. The $301 billion in intra-firm imports and $272 billion in exports represent the magnitude of what the multinationals have to play with when they establish costs and the location of profits. Based on 1992 data, 43% of intra-firm exports went to LDCs and 49% of imports were intra-firm from LDCs.13
The problem arises from a uni-dimensional and dated definition of profits. This was an effective tax base for several decades after World War II, and corporate taxes on profits produced a fair share of revenues for governments. Globalization, however, has rendered profit taxes increasingly difficult for governments to capture because of the mobility of capital and the ability of MNCs to escape high tax jurisdictions through transfer pricing, buying and selling to itself with more or less fictive prices. What results is tax arbitrage, an opportunity which no rational company should pass up, playing one country's tax rate against another to minimize tax responsibilities worldwide.
A body of literature starting in 1971 affirms the successful use of transfer pricing in allocating profits so as to minimize tax responsibilities. In a 1998 econometric study, that builds on earlier research, Clausing concludes that "intrafirm trade may be different from international trade conducted at arms-length. Intrafirm trade flows are influenced by the tax minimization strategy of multinational firms."14 In another cross-section study of 33 countries, using 1982 data, Grubert and Mutti find that a reduction in the profit tax rate from 20% to 10% increases the net capital stock of a U.S. foreign affiliate by 65% and more than doubles after-tax profits on sales.15
In another review of empirical literature on taxes and transfer pricing, Hines concludes that the "econometric work of the last 15 years provides ample evidence of the sensitivity of the level and location of FDI to its tax treatment," with a typical estimate indicating that a lower tax rate of 10% results in an increase of FDI of 6%, after controlling for other influences on the location of FDI.16 Other research focuses on the impact of lower taxes on expanded internal trade within a MNC, affirming the appeal of transfer pricing for a global tax strategy. A tax differential of 10% is associated with an increase of net internal trade of 4.4%.17 Evidence that FDI shifts investment from the home country to the foreign country comes from a summary of several empirical studies, in which Hines concludes that for each dollar of FDI there is a transfer of investment from the domestic economy to the foreign economy of from 20 to 40 cents.18 In another study he conducted on shifting of foreign FDI from high to low tax foreign countries, Hines found that the 41 identified tax havens account for about one-fifth of all FDI and 30% of foreign source income.19 The fundamental problem, concludes one of the principal researchers in this field, is that the "basic structure of federal income taxation was in place before the American economy acquired the kind of international position it has in the last few decades; as a consequence, international considerations are afterthoughts in its design."20
Fixing Tax Distortion
What are governments to do in the face of a globalization that has sundered their profits tax base? The answer is found in a variant of unitary taxes that has been used in some dozen states in the United States, where each state has attempted to define profits originating in its taxing jurisdiction based on a formula that apportions total company profits by sales occurring in the state. Elevated to a global arena, here is how it works.
The unitary tax starts with accounting categories that are known and cannot easily be fudged: aggregate worldwide profits, total global revenues received, and revenues earned in a particular tax jurisdiction.* To discover the profit base for tax purposes, this calculation would be made: Divide revenues acquired through sales in a country by total worldwide revenues. To identify profits earned in the country's tax jurisdiction, apply this percentage to global profits. This becomes the profits base on which a national tax is levied.21
For example, assume Nike makes worldwide profits of $500 million. It receives 40% of its worldwide revenues from sales in the United States. The profit earned in the U.S. is then $200 million and the corporate profit tax rate is applied to that base. The advantage of this unitary tax is that the problem of transfer pricing disappears. The three statistics - profits and sales revenue worldwide and sales revenues in the country tax jurisdiction - are known or can readily be obtained by tax authorities. Opportunities for evasion are few. The unitary tax system is an option for the headquarters country and a third world recipient of FDI can continue to tax local profits as it has been doing. Tax collections, therefore, need not change in the third world producing country.
For a successful tax reform, this one has multiple merit. It is easy to administer and clear as to its purposes. A political constituency could be mobilized on the grounds of tax fairness, especially after examples of transfer pricing fiddles were publicly exposed. It collects large sums of money which today escape taxation by any government, either the headquarter where foreign direct investment originates or the third world tax haven. It does not involve any new tax, only a new way to identify and administer an old tax. It engages the North and the South and reduces the pressures on third world countries to offer tax havens, because there are no longer ways to avoid profit taxes. As to the argument that this will discourage foreign investment and tax collections in third world countries, this may happen to some extent in the short run. Companies, however, will continue to engage in direct foreign investment to third world countries but now based on organic comparative advantages that reflect market-based variances in wages and regulatory differentials. This promotes a "high road" form of competition among third world recipients of investment to provide the most educated labor force, the most efficient governmental institutions, and reliable receptacles for production. The unintended consequences of removing tax abatements from the table may be salutary for poor countries in a way not presently capable of being understood because of the way tax competition now works. It will encourage them to create comparative advantages that are growth enhancing and elevating of life for their poorest rather than engage in an unproductive competition over which country can be poorest.22
For the headquarters countries, the EU and the United States, the unitary global tax will restore a modicum of fairness to tax proportions between capital and labor, one that prevailed for nearly half a century before globalization magnified and transformed a wedge into a large chasm. It corrects a distortion so widely accepted in the economics' literature that one of the principal empirical studies concludes by lamenting the fact that the "international mobility of economic activity now looms over any attempt to tax domestic income-producing activity too heavily. Indeed, the importance of this consideration raises the very real question of whether there any longer exists such a thing as purely domestic tax policy."23 By removing costs and their ambiguity from the taxing equation, transfer pricing is rendered ineffective in siting profits by the unitary tax
There are precedents for the unitary tax. California introduced it in the 1970s.* At the national level, the unitary tax was seriously considered in the form presented here in 1962 and supported by the Kennedy administration but ultimately failed to gain approval.24 Today a corner of the corporate tax system partially uses the unitary tax principle. Since the tax changes of 1986, a portion of research and development costs must be allocated in a complicated formula that uses fractions of sales and assets located in the U.S.25
That there has been tax distortion directly derived from the essence of globalization is not in doubt. The only question is what can be done to restore a degree of tax proportionality between the mobile and immobile, capital and labor, the fast and the slow, the winged and the rooted. The solution is more political and ideological than technical. For the past quarter century, with increasing intensity, the fundamentalism of the market has overtaken the secular appeals of regulation, re-ordering, and restoration through political economy. Market fundamentalism is an evangelical faith that has been sold to its converts as a doctrine from which straying is as close to a mortal sin as we have in life today. But ideologies and belief systems do not endure forever. A 25-year run of hegemony is about its limit before a new period of testing and challenge begins, followed by political tensions, and a new policy envelope.26
At a time when political debate over tax reductions, their equitable allocation, and distributive fairness is once again on the public's agenda a review of corporate tax policy in the light of globalization should intrude on this debate. By challenging transfer pricing devices through the unitary tax, this objective is accomplished.
1 *Professor of Economics, American University and Fellow, Transnational Institute (Amsterdam). Many of the ideas for this paper were developed at the American Academy in Berlin, where I was a Distinguished Visiting Scholar in Fall 1999. I am grateful for comments from the members of American University's Inter-Disciplinary Council on the Global Economy, where this paper was presented in Fall 2000.
a In this staff paper, the OECD reviewed the empirical research on capital mobility and conducted its own econometric study of capital mobility. It concluded that "capital mobility is substantially higher than suggested [by other research] and ... has increased over time." (p.22)
b In a survey on "Globalization and Tax," The Economist echoes the OECD's sentiment: "Footloose capital is free-riding on less mobile taxpayers, getting the benefit of services provided by governments in higher-taxing countries while paying taxes in low-tax jurisdictions, if at all." (January 29, 2000), p.5.
2 *Transfer pricing pertains to non-financial enterprises. A different mechanism for tax avoidance is used by financial corporations and discussed in: Howard M. Wachtel, The Money Mandarins. The Making of a Supranational Economic Order (New York: Pantheon Books, 1986), pp. 116-117. *
Technically, foreign income is taxed in the U.S. when the profits are repatriated. However, legal and accounting loopholes allow corporations to avoid this obligation.
* The reference to sales as the basis for the formula is illustrative. It is simple to understand and calculate. Instead of sales, value added may be a more precise indicator of the origins of profits but is a bit more complicated to calculate and subject to more valuation challenges.
* After Congressional action that outlawed the practice and a subsequent reversal by a Supreme Court ruling in favor of California, the tax was reinstated, and it has been introduced in about 10 other states. An altered ideological and political climate, however, has essentially rendered the unitary tax mute, because states have given corporations the option of using a unitary tax computation or the standard profits tax basis for choosing which method they want to employ.
1. "Taxing Matters," The Economist, April 5, 1997, p.33 and U. S. Council of Economic Advisers, Economic Report of the President 2001 (Washington: Government Printing Office, 2001), p. 369.
2. Vito Tanzi, "Globalization, Tax Competition and the Future of Tax Systems," IMF Working Paper (1996) , p. 3.
3. Susan George, The Lugano Report (London: Pluto Press, 1999), p. 179.
4. " Globalisation and Tax. The Mystery of the Vanishing Taxpayer," The Economist, January 29, 2000, p. 2.
5. Colin I. Bradford, Jr., "Being and Becoming Bound. The Nexus between Globalization, Culture and Economics" (unpublished), pp. 16-17. The reference to Octavio Paz is from his: Convergences. Essays on Art and Literature (London: Bloomsbury, 1987), p. 221.
6. "Disappearing Taxes," The Economist, May 31, 1997, p. 21.
7. Organization for Economic Cooperation and Development, "Taxation and Economic Performance" (unpublished paper, 1997), p. 22.
8. Organization for Economic Cooperation and Development, Harmful Tax Competition. An Emerging Global Issue (Paris: OECD, 1998), p. 14. This report is directed at the financial sector, but it notes that similar conclusions apply to direct foreign investment.
9. World Trade Organization, "Trade and Foreign Direct Investment" (unpublished, 1996), pp. 2-8 and United Nations, World Economic Situation and Prospects 2001 (New York: United Nations, 2001), pp. 23 and 51.
10. One of the earliest theoretical studies of transfer pricing and taxes is: Thomas Horst, "The Theory of the Multinational Firm: Optimal Behavior Under Different Tariff and Tax Rates," Journal of Political Economy, 79, 5 (1971), pp. 1059-1072.
11.Vito Tanzi, Taxation in an Integrating World (Washington: The Brookings Institution, 1995), chap. 7.
12. U. S. Council of Economic Advisers, Economic Report of the President 2001, p. 392 and Kimberly A. Clausing, "The Impact of Transfer Pricing in Intrafirm Trade," NBER Working Paper 6688 (August 1998), p. 1.
13. William J. Zeile, "U.S. Intrafirm Trade in Goods," Survey of Current Business, 77, 2 (February 1997), pp. 32-33.
14. Clausing, p. 15. The statistical work is based on the years, 1982-1994.The 1971 study is by Horst cited above.
15. Harry Grubert and John Mutti, "Taxes, Tariffs and Transfer Pricing in Multinational
Corporate Decision Making," Review of Economics and Statistics, VLXXIII, 12 (May 1991), pp.285, 287, 289, and 290.
16. James R. Hines, Jr., "Lessons from Behavioral Responses to International Taxation," National Tax Journal, 52, 2 (June 1999), p. 312.
17. Clausing, p. 15.
18. James R. Hines, Jr., "Tax Policy and the Activities of Multinational Corporations," NBER Working Paper 5589 (May 1996), p. 20.
19. James R. Hines, Jr. and Eric M. Rice, "Fiscal Paradise: Foreign Tax Havens and American Business," Quarterly Journal of Economics, CIX, 1 (Feb. 1994), p.151.
20. Hines, "Tax Policy ...," p. 1.
21. Howard M. Wachtel, "Tobin and other Global Taxes," Review of International Political Economy, 7:2 (Summer 2000), p.349.
22. I discuss the "criteria" for a successful tax in: Howard M. Wachtel, "Trois Taxes Globales pour Maitriser la Speculation," Le Monde Diplomatique (October 1998), pp. 20-21.
23. Hines, "Lessons from Behavioral ...," p. 319.
24. C. Fred Bergsten, Thomas Horst, and Theodore H. Moran, American Multinationals and American Interests (Washington, D.C.: The Brookings Institution, 1978), pp. 172-173.
25. Hines, "Tax Policy ...." p. 36. 26. I discuss this further in Howard M. Wachtel, "World Trade Order and the Beginning of the Decline of the Washington Consensus," Politik und Gesellschaft, 3, 2000, pp. 247-253.
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