Reversing a downhill race on tax

Cash Management, Regulation

Reversing a downhill race on tax

December 2019

State finances are weak, yet while many companies can afford to pay more rich countries have almost halved their corporate tax rates over three decades. OECD proposals for global tax coordination, which it aims to progress in 2020, could turn this tide suggest Deutsche Bank’s Corporate Bank Focus Research team

The world is saddled with both a debt problem and a corporate tax problem. State finances in developed countries are increasingly precarious, yet while many companies are enjoying robust revenue growth the headline tax rates that they pay has almost halved over the past three decades.

On both sides of the Atlantic that situation could now be about to reverse. Events in 2020 will determine whether what follows next is a slow reversal in the near 40-year trend of lower taxes, or a more abrupt change to the corporate landscape. US presidential hopeful Elizabeth Warren is among those arguing for higher corporate taxes, while incoming European Commission president Ursula von der Leyen has pledged to target firms that “play our tax system”.

 

A coordinated effort

A major feature of the next 12 months will be the Organisation for Economic Cooperation and Development’s continuing drive towards global tax coordination. The OECD is about to seek approval for its proposals, which are being worked on by over 100 countries and are based on introducing a minimum corporate tax rate as part of a globally coordinated regime. This could lead to corporates paying tax in each country where they are active, regardless of whether that includes a physical presence.

Some argue that actually implementing higher corporate taxes will prove too politically difficult, particularly in countries such as the US where gaining cross-party consent appears to be a sizeable challenge. While these concerns are valid, Deutsche Bank’s Corporate Focus Research team suggests that the general direction of travel is more important. Although 2020 might not actually mark the end of a “race to the bottom”, if momentum builds towards support for politicians who advocate higher corporate taxes and towards the OECD proposals we could still be at a turning point.

In their recently-published report ‘2020: An inflection point in global corporate tax?’, Deutsche Bank Analyst, Thematic Research, Luke Templeman and Global Head of Fundamental Credit Strategy and Thematic Research Jim Reid note that the pressures of global debt are intensified by low levels of economic growth.

 

Jim Reid

Jim Reid

Head of Deutsche Bank Corporate Bank Research
Luke Templeman

Luke Templeman

Analyst at Deutsche Bank Corporate Research

Figure 1 Median government debt-to-GDP

Chart: Median government debt-to-GDP

Source: IMF, GFD, Deutsche Bank 

Even if interest rates continue at their current low levels – or fall further – governments in developed countries can expect their debt loads to grow even heavier in the years ahead, even if conditions stay favourable. Yet against this background, and as economic clouds gather, reducing corporate tax rates has continued with the US introducing particularly heavy cuts in late 2017.

 

Change in thinking

Yet decades of tax breaks mean that many companies are in relatively great shape. As the report notes, US corporate profits have comfortably outpaced economic growth and wages and it’s a similar story in other developed countries. This partly reflects the declining start-up rates and consolidation among existing players that has reduced competition. In the US, a revised set of merger guidelines issued in the mid-1980s has encouraged industry concentration across various sectors.

 

Figure 2: Race to the bottom

Corporate income tax rates have fallen significantly over the past three decades.
(combined corporate income tax rates by country group, in percent)

Race to the bottom: Corporate income tax rates have fallen significantly over the past three decades.(combined corporate income tax rates by country group. in percent)

Source: IMF, GFD, Deutsche Bank 

More recently, corporations and their contributions to society have become a rallying point for politicians and activists both in North America and Europe. And if politicians who advocate higher corporate taxes get elected, the public support on which they ride will make it harder for their opponents to dissent – particularly if the changes introduced are small and iterative, to avoid any exodus of companies to lower tax rate locations.

At the same time the reluctance of cities and countries to raise corporate tax is lessening, as the assumption that lower rates benefit the wider economy is increasingly challenged. A growing body of evidence suggests that tax cuts don’t provide the expected boost to revenues in the medium term. Consumers, who are becoming more willing to challenge a company’s environmental credentials helped by social media, are also ready to protest against corporates seen to be avoiding their fair share of tax.

 

It is true that many corporates are responding to public pressure to be more socially aware. The recent decision by the US business roundtable to ditch the “shareholder first” mantra is just one example.

Luke Templeman and Jim Reid

A more modern regime

As the OECD’s tax reform proposals steadily attract support, the International Monetary Fund (IMF) has weighed in with moves to place limits on the international shifting of profits by multinationals. Last May, the 129 members of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) agreed to push ahead with work for the proposals. Issued in October, they appear to have quickly secured backing from leading economies in the organisation and an in-principle agreement from the G20 will be sought by January 2020.

So corporate tax could look very different in the medium term; one major change being that it will be increasingly coordinated at a global level. That will enable individual countries to tax company activities regardless of whether or not the company has any physical presence in that country. The current principles behind tax rules date back to the days when a physical presence was required for a company to operate in a country, but globalisation, communications and digitalisation have rendered them outmoded.

The proposed new regime promises to have a significant financial impact on digital companies, although other companies that are “consumer facing” or sell into a country from a base elsewhere will be affected. “Essentially, the “nexus” between the company and its liability for the new tax regime will be largely based on sales, even though the tax will be applied to “residual profits” after appropriate cost allocations are made,” explain Templeman and Reid. “Enforcement may be made via a withholding tax.”

 

 

Three success factors

Many argue that reallocating taxes is a zero-sum game and as some countries will win and others will lose it will thwart any agreement to implement globally-coordinated tax policies, which would have to happen simultaneously across countries. However, the report gives three reasons why countries are incentivised to implement a common tax regime:

  1. The new regime will not necessarily be a zero-sum game: some corporates will simply have to pay more tax and many of the largest countries stand to benefit, which even opponents of the OECD’s scheme admit. Although some low-tax countries could lose tax revenue, if the largest, richest countries support the initiative its momentum will be hard to stop.
  2. Some of the largest companies that will be affected by the change support it. Amazon calls the initiative “an important step forward”. While some companies may make similar noises simply to promote good public relations, it reflects the fact but that public opinion is an increasingly powerful voice in corporate debates.
  3. The new regime will lessen the prevailing competitive pressure between countries to lower their tax rate. As corporate profits will be taxed in the country in which the business activity takes place it should, in theory, matter little where a company has its headquarters or legal domicile.

Once relieved of the pressure to be ‘competitive’ on corporate tax rates, politicians will find it easier to respond to the electorate’s request for higher corporate tax. As an added bonus, the new regime promises to boost government coffers without the risk of companies threatening to move countries and export local jobs suggests the report.

It concludes with a seven-point action plan outlining how corporates can prepare themselves for higher taxes. Measures include considering both domestic and international decentralisation, reviewing their capital expenditure strategy and also reassessing their performance metrics and reversing a two-decade decline in their return on assets.

 

Data and sources

The full report, 2020: An inflection point in global corporate tax? can be downloaded here.

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