The political fight over a global minimum corporate tax rate
Empirical evidence suggests that tax competition has indeed contributed to falling corporate taxes
The new Biden administration in the US is planning to increase the statutory corporate tax rate from 21% to 28%. And it is pushing for a global minimum corporate tax rate of 21% calculated on a country-by-country basis to reduce incentives for corporations when it comes to moving to low tax jurisdictions. The increase of the statutory corporate tax rate to 28%, however, would merely reverse some of the tax cuts during the Trump presidency.
But the US pushing for a global minimum tax is a very significant political development, which would also put the model of EU tax havens like Ireland or the Netherlands at risk. In the words of Treasury Secretary Janet Yellen:
France, Germany and the IMF have voiced support when it comes to plans for a global minimum tax rate. The recent political push will now need to be translated into detailed agreement, which will determine how much bite a minimum tax rate actually has.
The empirical evidence on corporate tax competition
Before we discuss the political momentum and current proposals further, we strive to answer the following question: what does US Treasury Secretary Yellen mean when she talks about a “race to the bottom” in corporate taxation over recent decades. And is there actually empirical evidence for this?
With the deepening of economic integration in the context of the globalisation process of recent decades, the transaction costs for the cross-border movement of goods and services, capital and jobs have decreased markedly. This has changed the conditions for corporate taxation. Corporate capital can often be moved across borders more easily and quickly than labour and real estate. And if there is the prospect of lower taxes, it sometimes makes a lot of sense for companies from an individual perspective to relocate their headquarters or parts of their business to other countries. A first look at the data suggests that statutory corporate tax rates have indeed declined strongly over the last decades. But is this really due to tax competition?
Source: Tax Foundation.
From a macroeconomic perspective, strategic interactions between governments in corporate tax policy are of particular interest in the context of globalisation. This is particularly true in economic blocs such as the EU, whose basic idea is actually that its members should benefit economically through cooperation.
The following figure shows that the tax rates for corporate income have indeed fallen markedly within the EU in recent decades. On average, the top corporate tax rate in the EU-27 countries fell from 35% in 1995 to 21.5% in 2020. In more populous countries, corporate taxes are somewhat higher on average. But even in Germany, the top tax rate of 29.9% in 2020 was markedly lower than in 1995, when it was 56.8%. In Ireland, one of the EU’s major tax havens, the statutory corporate tax rate is only 12.5%. Outside Europe, too, a trend of falling corporate tax rates can be observed in many countries.
Source: European Commission (top statutory corporate income tax rate including surcharges); own calculations. EU27 excluding the United Kingdom.
Does tax competition really explain the fall in tax rates?
But can the observed decline in corporate income tax rates really be explained by tax competition? Finding a clean empirical answer to this question is anything but easy. After all, a drop in corporate taxes could be due to a variety of economic, political and institutional factors - for example changing policy preferences of governments.
We can define tax competition broadly as any form of noncooperative tax setting by independent governments interacting with each other. The specific role played by tax competition is a significant question for empirical research. Corporate taxes are an important source of government revenue, and the effects of tax competition are the subject of political controversy.
The US administration has voiced concern about the potential consequences of a "race to the bottom" – based on the argument that declining corporate tax rates result in relative losses in tax revenues and could thus undermine the financing of essential government activities. In fact, the US government wants to use additional revenues from higher corporate taxes to pay for investment in public infrastructure. Others, however, argue that uncooperative cuts in corporate tax rates by individual governments can help countries remain attractive to foreign direct investment, which in turn creates economic growth. Political leaders of tax havens, in particular, will try to defend the model of their countries in terms of tax policy.
But what conclusions does the empirical evidence even allow us to draw about the extent of corporate tax competition? In a study recently published in the European Journal of Political Economy, I provide answers to this question based on a quantitative analysis of the relevant literature.
Source: Heimberger (2021)
Meta-analysis of corporate tax competition
The empirical literature sometimes reports contradictory results. Some studies present results that clearly suggest that tax competition plays a central role in explaining lower corporate tax rates. Other studies, however, point to mixed evidence, seeking to refute that tax competition is important when it comes to explaining tax decisions.
At least in part, differences in reported results could be due to the fact that different studies use different data sets in terms of country groups and time periods, as well as divergent estimation methods. Against this background, it makes sense to conduct a systematic review of all relevant estimates, taking into account, among other things, differences in research designs and databases.
Meta-analysis can be useful in this regard. The basic idea is to compile all relevant estimates from the literature on the basis of criteria clearly defined in advance and to make these estimates directly comparable with each other. Each estimate then enters into a larger statistical picture. By applying econometric methods, conclusions can then be drawn about how strong the average effects of corporate tax competition are, while also incorporating different data and modelling choices.
My meta-analysis of the empirical literature on corporate tax competition includes 33 primary studies that report a total of 604 comparable estimates. All estimates are based on so-called tax reaction functions. These model strategic interactions of governments in tax policy, which are at the core of the concept of tax competition. Here, the corporate tax decisions of the domestic government are modelled as mutually dependent on the chosen tax rates of governments abroad with which the domestic government competes. In this context, one can also control for other possible explanatory factors in the economic and political dimension. A (significant) positive association between corporate tax rates in a given country and tax decisions abroad then serves as an indicator of tax competition.
The following figure shows a selected subsample of the dataset using only corporate tax competition estimates that use statutory corporate tax rates (as in the first figure above). The standardised effect sizes are shown on the horizontal axis and the precision of these estimates on the vertical axis.
Source: Heimberger (2021).
The standardised effect size indicates the average percentage change in domestic corporate tax rates when corporate taxes in countries with which the government competes fall by one percentage point. There are some (imprecise) estimates to the left of the zero vertical effect line. However, it is clear that most of the results reported in the literature lie on the right-hand side of the graph, although these also vary in precision. The estimates with a positive sign point to tax competition: they indicate that domestic tax policy interacts with foreign tax policy by adjusting taxes in the same direction – that is, tax cuts abroad are responded to by tax cuts at home.
But how strong is corporate tax competition based on the estimates available in the literature? The (precision-weighted) average of the effect sizes seen in the subsample in Figure 1 is 0.8, meaning that a reduction in corporate taxes by "competitor" governments abroad by one percentage point is associated with a 0.8% reduction in domestic statutory corporate taxes.
In my study, I show that the average magnitude of the effect is similar when corporate taxes are measured differently. Another important way of measuring corporate tax rates (besides using statutory corporate taxes) are the so-called effective average tax rates. In this context, this means that tax rates are calculated by computing the actual average tax burden of investment projects. However, the statistical analysis reveals that the results on the existence of corporate tax competition do not change significantly when different ways of measuring corporate taxation are considered.
Thus, on average, the empirical evidence provides robust evidence that corporate tax competition plays a role in tax decisions. Of course, this result does not imply that competitive pressures were and are equally strong in all countries. Although the results also suggest that the reported competitive effects based on data samples with European countries are not significantly different on average from those based on samples with non-European countries, competitive pressures may nevertheless vary across countries depending on domestic and institutional factors.
The latter point is also supported by broader results from the analysis, which suggest that country size (measured by economic output or population size) and the ideological orientation of governments moderate the strength of the effect of corporate tax competition, respectively.
This result confirms considerations from the theoretical literature on tax competition: first, competing countries of the same size have similar incentives to reduce corporate taxes. However, when countries differ in size, the incentives for competitive tax cuts are stronger in smaller countries. Second, accounting for domestic factors has extended the basic theoretical model on tax competition. Political determinants and institutional restrictions may contribute to delaying or even preventing the adjustment of tax policy to the pressures of international tax competition - for example, in the case of national governments that reject reductions in corporate tax rates for ideological reasons. Partisan politics and country size thus influence how strongly corporate tax competition is reflected in domestic tax decisions.
Current negotiations on combating tax competition
The issue of tax competition, which puts pressure on the financing of the welfare state, has been addressed at the European and international level for some time. But the recent moves by the US government create political momentum for reaching an agreement within the existing international negotiating framework. The OECD, in cooperation with the G20, has recently developed concrete proposals to improve tax coordination between countries.
The OECD-G20 proposals consist of two pillars: first, they would give individual governments some rights to tax the profits of multinational corporations - taxing rights would be partially shifted to where the consumers are located. This would apply, for example, to the foreign operations of U.S. tech giants, which could partly be taxed in Europe. But implementing the OECD plans would also give the U.S., for its part, the right to tax many European corporations.
The second pillar is an effective global minimum tax rate for corporations – which is the core of the recent public messaging and political push by US Treasury Secretary Janet Yellen. This minimum tax rate aims to ensure that corporate profits - regardless of the jurisdiction in which they were generated - can no longer be taxed below a certain minimum rate. In this context, countries would be allowed to tax the income of domestic companies generated abroad if the foreign effective tax rate was below the agreed minimum tax rate. This would make tax avoidance through profit shifting more difficult. And it would also reduce incentives for governments to reduce corporate tax rates below the minimum rate to lure corporate headquarters to their country. This would be a step toward getting to the root of tax competition. The level of the minimum tax rate remains undecided, but the US administration has proposed 21%.
A global minimum tax rate is intended to reduce corporate tax differentials between low and normal tax countries. The OECD assumes that this would also lead to a reduction in tax dodging by multinational corporations because the minimum tax rate would run against profit-shifting strategies. This would generate additional tax revenue.
Incidentally, the OECD does not see any significant negative economic effects in terms of investment and employment if the plans are implemented. This is because the increased investment costs and administrative burden for companies resulting from implementation would be offset by better capital allocation (due to limited tax competition) and greater legal certainty.
A minimum tax alone will not be enough
But side effects cannot be wiped off the table: Administrative and tax compliance costs would rise. Of course, this would not only affect multinational corporations, which partly engage in profit shifting, but also companies that have not previously engaged in profit shifting at all, thus also influencing their decisions. This could result in negative investment and liquidity effects for numerous companies, which must be taken into account, especially in view of the effects of the COVID-19 crisis.
The US administration has also tried to revive negotiations on the first pillar - the reallocation of taxing rights. In particular, the US administration calls for the world’s biggest businesses to pay levies to national governments based on their sales in each country as part of a deal on a global minimum tax. This would apply to the global profits of the largest companies, including big US tech firms, regardless of their physical presence in a given country. The Trump’s administration had insisted on a provision that would have made compliance by US tech firms voluntary, but Biden dropped that demand. However, views by other governments regarding the details of pillar 1 remain very different, so that negotiating a package of pillar 1 together with the global minimum tax rate could prove impossible.
A political agreement with regard to the introduction of a minimum tax rate for companies would certainly be a major step toward limiting tax competition. However, even if a political agreement were to be reached soon, it would certainly not be the end of the debates on tax competition. After all, implementing the US administration’s or the OECD’s current plans would restrict corporate tax competition, but not abolish it. The extent to which the business models of tax havens are actually curtailed will depend to a large extent on the details of the minimum tax rate – but also on negotiations on harmonising tax bases in the future, i.e. to standardise not only the minimum tax rate but also what is actually being taxed (There are also proposals on this in the OECD-G20 document.). More comprehensive steps will be needed in the future to put a stop to the profit shifting strategies of increasingly powerful multinational corporations.
Even though the new US administration is now pushing the agenda for fighting a “race to the bottom” in corporate taxation – with support of Germany and France –, negotiations on the details of a global minimum tax rate and other pillars will remain politically controversial. Nevertheless, this is now the window of opportunity. The Financial Times reports: “Talks on how to make it difficult for international companies to shift profits round the world to minimise tax have been stuck at the OECD for years, but are now progressing rapidly.” Some of the signs are good, but the fight still needs to be won.