The Case for an International Tax Organisation

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Capital mobility entails fiscal interdependence. Since the abolition of capital controls in the 1960s and 1970s, and following the widespread abolition of withholding taxes in the wake of the first move in this direction by the Reagan administration in 1984, fiscal interdependence has turned from a policy parameter to an actively targeted policy variable. States strategically use their fiscal policy to compete for mobile tax bases.

Tax competition, defined as the interactive tax setting by independent governments in a non-cooperative, strategic way, poses a double normative challenge. It undermines democratic fiscal choices, and it exacerbates domestic and global inequalities. How should we react to this challenge? This short piece sets out two principles that international fiscal arrangements should respect. It then argues that putting these principles into practice calls for the creation of an International Tax Organisation (ITO). To lay the groundwork for these arguments, we first need to have a brief look at how tax competition works and why it is problematic from a normative viewpoint.[1]

We can distinguish three kinds of tax competition. First, competition for individual or corporate portfolio capital; classical tax havens like the Cayman Islands, Luxembourg or Switzerland offer bank secrecy or certain legal constructs like trusts to ensure that (illegal) tax evasion is not detected by the country of residence of the capital owner. Estimates of the worldwide yearly losses in government revenue from this kind of tax competition alone range from USD155 to 255 billion.[2] Second, competition for paper profits; multinational corporations use a variety of techniques including transfer pricing and thin capitalization to transfer profits from subsidiaries in high-tax jurisdictions to those in low-tax ones.[3] While these operations are not always illegal, this kind of tax avoidance happens in a legal grey zone, where lack of enforcement of regulations by international organisations like the OECD and the WTO is the principal problem. Third, and finally, governments compete for real capital in the form of foreign direct investment (FDI). One classic example here is Ireland. For years, the country had a preferential tax rate of between 10% and 12,5% for foreign corporations (preferential in the sense that Irish firms paid a higher rate), which resulted into an enormous inflow of investment from the United States in particular.

What, if anything, is wrong with tax competition? To start with, any form of tax competition undermines the democratic choices of polities. It is widely accepted in public economics that one of the fiscal prerogatives of political communities consists in choosing the size of the state (level of taxation and government spending) and the level of redistribution (progressivity of the fiscal system). Through the pressure it puts on capital taxation, tax competition undermines these choices. Furthermore, tax competition has distributive consequences both within and across countries. Developed countries have reacted to tax competition by shifting the tax burden onto more immobile factors like labour or consumption. While this has allowed them to stabilise their tax revenues, these forms of taxation tend to be more regressive, thus widening income and wealth inequalities. In developing countries, the impact of tax competition is much closer to the race-to-the-bottom predicted by economic theory. Here, we observe both lower revenues and widening inequalities.

The challenge presented by tax competition calls for regulatory reform. The fiscal cooperation between states that is implicit in such reform should be informed by two principles. First, it should respect a membership principle, that is, the idea that each natural or legal person pays their taxes in the state where they are member. Traditionally, this has been interpreted as residence taxation for individuals and source taxation for multinationals. In effect, international taxation already calls for the membership principle today, but inadequate enforcement opens up the loopholes for tax evasion and tax avoidance described above.

What impact would a proper enforcement of the membership principle have on tax competition? It would rule out the first two kinds of tax competition, that is, tax competition for portfolio capital and for paper profits. Individuals and multinationals would no longer be able to either reside or produce in one place, and pay their taxes in another. They would no longer be able to free-ride on generous public services and infrastructure in one country while paying their taxes elsewhere.[4] As to the states competing for mobile capital, they would no longer be able to engage in what the OECD has labelled the “poaching” of tax base.[5]

This leaves the question of “luring” in foreign capital in the form of FDI. The second principle for regulating tax competition is a constraint on the design of fiscal policy. When fiscal policy changes are both strategically motivated and can be shown to lead to a reduction in the aggregate level of fiscal self-determination of other states, then these policies should be considered illegitimate. This second principle for the governance of international taxation will be more controversial than the membership principle. However, once the membership principle is enforced, the fiscal incentives for moving productive capital will increase considerably. A world in which there are no constraints on competition for such capital is arguably an unjust world.

Note two things on what has been said so far. The above principles in no way call for tax harmonisation. On the contrary, they help to shore up the effective fiscal sovereignty of states, which has been hollowed out by tax competition. Second, some people might object that tax cooperation of the kind advocated here would be economically inefficient. This objection does not stand up to scrutiny, but discussing it would take us too far afield here.

What would it take to enforce the membership principle and fiscal policy constraint? The obvious way to put them into practice is the creation of an International Tax Organisation (ITO). This institution would have the following mandate. First, it would work towards a harmonisation of definitions and tax categories (but not rates) between states. It is these discrepancies that open up loopholes under the status quo. Second, in order to enforce the membership principle, the ITO would work towards the abolition of bank secrecy, legal trusts (or at least the features that render them opaque), and other regulations that stand in the way of automatic information exchange between fiscal authorities. Third, it would serve as a discussion forum for the development and implementation of new forms of fiscal cooperation – like the idea of a consolidated corporate tax base as currently debated by the European Union. Finally, in order to enforce the fiscal policy constraint, the ITO would be equipped with a Dispute Settlement Body (DSB) akin to that of the WTO. Here, states would file cases against fiscal policy changes of other states that violate the fiscal policy constraint. In light of these tasks, one crucial requirement for the ITO is inclusive membership. An organisation with limited scope like the OECD could not succeed in achieving the policy objectives just set out.

The parallel with the WTO not only suggests that creating an ITO is a feasible policy objective, but it also highlights a puzzling inconsistency at the heart of international economic policy: WTO regulations prohibit most forms of subsidies to national industries on grounds of unfair competition. A subsidy is just the flipside of a tax. The project of regulating harmful tax competition, launched and then more or less aborted by the OECD in the early 2000s, should be revived. Creating an ITO along the above lines represents an important step in this direction.



[1] This piece is based on a longer, and more detailed paper: Peter Dietsch & Thomas Rixen, The Journal of Political Philosophy, Article first published online: 23 April 2012, DOI: 10.1111/j.1467-9760.2012.00419.x

[2] Jeffrey Owens, “Written testimony of Jeffrey Owens, Director, OECD Center for Tax Policy and Administration before Senate Finance Committee on Offshore Tax Evasion, 3 May 2007”, http://finance.senate.gov/imo/media/doc/050307testjo1.pdf; Tax Justice Network (TJN), “Tax us if you can: the true story of a global failure,” Tax Justice Network Briefing Paper (London: Tax Justice Network International Secretariat, 2005).

[3] Precise estimates are hard to come by, but the fact that 60% of world trade is intra-firm suggests the stakes are significant.

[4] For individuals, according to the position defended here, it is residence rather than citizenship that is relevant for tax purposes.

[5] In this context, see also the OECD’s latest study on international cooperation on corporate taxation: http://www.oecd.org/newsroom/oecd-urges-stronger-international-co-operation-on-corporate-tax.htm.