Fighting tax dodgers can kill economic growth

This article first appeared in The Edge Financial Daily, on July 26, 2018.
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IT is easy to be outraged about multinational corporations’ shifting of profits to tax havens, but much harder to figure out how to stop them from doing it without hurting the economy.

Evidence exists that curbing tax avoidance opportunities makes these firms move actual jobs, not just accounting profits, overseas.

In a recent paper, Thomas Torslov, Ludvig Wier and Gabriel Zucman argued that governments throughout the world are cutting corporate tax rates (to an average of 24% today compared with 49% in 1985) simply because they have given up on trying to fight profit shifting, defined as the recording of accounting profits in low-tax jurisdictions.

“Machines don’t move to low-tax places; paper profits do,” the economists wrote, estimating that about 40% of multinational profits were artificially shifted to tax havens in 2015.

Scale of profit-shifting
The authors used an ingenious device to describe the scale of the profit-shifting: They calculated the profit recorded by multinationals and local firms in a country per dollar of wages paid.

On average, a company makes 36 US cents (RM1.46) in taxable profit for every US$1 of wages in a non-haven country.

In low-tax jurisdictions, the ratio soars — to more than 100% in Singapore and Hong Kong, to more than 200% in Ireland, Luxembourg and Puerto Rico.

The example of that US territory, coincidentally, is used in another recent paper, by Juan Carlos Suarez Serrato, to study what happens when a government actually tries to curb profit-shifting.

Between 1921 and 2006, US multinationals were exempt from taxes on income earned by their Puerto Rican affiliates under a regulation known as §936, after the relevant section of the US tax code.

In 1996, the exemption was repealed with a 10-year phase-out because legislators decided it was doing more harm in the mainland US than good in Puerto Rico — essentially the same argument Torslov, Wier and Zucman make concerning the shifting of paper profits.

The repeal of §936 contributed to Puerto Rico’s financial crisis — a consequence countries like Ireland and Luxembourg fight to avoid when France, Germany and the US criticise them for facilitating profit shifting.

But it also caused large profit drops for the 682 US firms, including major ones such as General Electric and most of the US pharma industry, that were using the loophole in 1995.

Serrato calculated that the effect on their income was equivalent to that of losing US$232 billion (RM941.92 billion) in combined sales.

That, according to Serrato, triggered a decrease in US investment and the shifting of actual production to cheaper countries. The repeal of §936, according to Serrato, cost the US economy a million jobs.

Causality, of course, is always a concern in studies of this kind. Serrato checked his findings against data on firms that were not exposed to the §936 repeal and confirmed they were robust.

Based on both Zucman’s and Serrato’s research, one might conclude that letting firms shift accounting profits allows them to keep more money for investment and job creation, while at the same time supporting the low-tax countries with extra revenue.

But though that looks like a win-win situation, it is actually imperfect.

Corporations end up sitting on huge piles of cash they do not invest or pay out as taxes. As of March 31, Apple was holding US$267.3 billion of cash and equivalents. Even though the company distributes enormous amounts of the cash to shareholders through dividends and stock buybacks, it still has more than it knows what to do with.

The 2017 US corporate tax reform, which allowed companies to repatriate overseas cash piles formed by profit-shifting at the cost of a 15.5% one-time tax payment.

Quite a few multinationals have done so and followed Apple’s example in showering shareholders, and sometimes employees, with the cash.

And yet they are left with huge, ineffectively used war chests.

Last year, McKinsey estimated the 500 largest non-financial companies had accumulated US$1 trillion more than their businesses needed. The current rate of investment and payouts to investors is nowhere near enough to draw that down.

Policymakers should still keep looking for ways to tax the excess profits — but without creating unwanted effects like those caused by the §936 repeal.

Serrato cautions that moves to curb profit-shifting should not be unilateral.

The US tax reform, for example, imposed a levy on income generated by intangible assets in tax havens; it is a prime candidate for unintended consequences.

Best approach?
The best approach to profit-shifting would involve all countries agreeing on certain taxation principles, a project on which the Organization for Economic Cooperation and Development works with more than 100 jurisdictions.

But in a world where the US prefers to take unilateral action and even fight trade wars, its multinationals are vulnerable to all kinds of one-sided tax actions.

Both Zucman and Serrato believe it could be reasonable to tax profits according to where they were earned, not where the accounting department decided to book them.

If the European Union, whose economies, according to Zucman and collaborators, lose the most tax revenue thanks to profit-shifting, applies this approach unilaterally, US tech and pharmaceutical firms could experience a shock similar to that of the §936 repeal.

Then, their US investment and job creation would suffer, contrary to the intentions behind US President Donald Trump’s tax and trade policies. — Bloomberg