Sep 20, 2023 10 min read Taxation

Can OECD's Two-Pillar approach address global tax avoidance effectively?

Short answer - likely not
Written May 2023

Summary

The issue of MNCs using legal methods to avoid paying taxes is a global concern. In 2021, the Organization for Economic Cooperation and Development (OECD) launched a tax proposal on new international corporate tax regulations to address multinational corporations (MNCs) tax avoidance behaviours. However, the proposal has significant shortcomings that would make it unlikely to effectively address the problems arising from tax avoidance and achieve its aims.

Tax avoidance happens when MNCs employ tactics such as transfer pricing to shift profits to low-tax jurisdictions, which decreases their overall tax bills. There are three main problems associated with the widespread tax avoidance practices:

Problem 1:
MNCs free-ride the public goods in countries where they generate economic activities but may not contribute the “fair share of taxes” to support those public resources (Ryding & Voorhoeve, 2022, p.3).

Problem 2:
Tax avoidance by MNCs may negatively impact the fiscal autonomy of countries. Some countries lower tax rates to compete for corporate profits rather than the tax determined by a more meaningful political process.

Problem 3:
Worsening inequality as governments utilise other regressive taxes to compensate for the revenue shortfall. Lower corporate tax rates would lead to higher fiscal pressure from lower revenue.

OECD’s proposal to address tax avoidance has two pillars: Pillar 1 aims to achieve a fairer allocation of profits to avoid free-riding, while Pillar 2 seeks to establish a global minimum tax rate to limit tax competition (OECD, 2021). However, the proposal has four significant issues that limit its effectiveness in addressing the problems of tax avoidance :

Issue 1:
MNCs would still continue to free-ride and not pay their fair share of taxes to the respective countries as the proposal only applies to a few MNCs, and only a fraction of their profits are redistributed. Consequently, Problem 1 would still persist.

Issue 2:
While Pillar 2 could establish a global minimum tax rate, tax competition between countries could still take place due to a technical change in the rule that incentivises governments to continue to do so. Problem 2 is likely to persist in some form.

Issue 3:
Since the proposal would be ineffective in reducing free-riding and tax competition, there would be limited improvement in inequalities (Problem 3). In fact, the proposal could disadvantage some poorer production-based countries, which worsens cross-country inequality.

Issue 4:
The implementation of the proposal itself could affect the fiscal autonomy of countries, adding to Problem 2. Many countries that are not part of the OECD or did not agree to the proposal would eventually face pressure to adopt it.

The article begins by providing a definition of tax avoidance and outlining the three associated problems. Subsequently, it presents the OECD's two-pillar proposal and discusses the four limitations that hinder its ability to effectively tackle the issues stemming from tax avoidance.

What is tax avoidance?

MNCs exploit legal methods to shift profits to tax havens, away from where their customers are, where they produce their goods, or where their main company is located (Ryding & Voorhoeve, 2022). This shifting allows the MNCs to avoid paying taxes at jurisdictions with high corporate tax rates, effectively reducing the overall tax bills. One way MNCs do this is through transfer pricing, where they charge intercompany transactions in a way that shifts profits to low-tax areas. According to Tørsløv et al. (2022), this practice is widespread and estimated that 36% or $600 billion of MNC profits were moved to tax havens. Given the significant opportunity to reduce the tax bill, companies inherently have the incentives to continue the practices.

One issue that arises from tax avoidance is MNCs' free-riding of public goods and services. They benefit from the public goods, such as infrastructure, legal systems, and skilled workforces, provided in the jurisdictions where they conduct management, production, and sales (Ryding & Voorhoeve, 2022). With tax avoidance, MNCs may not pay a “fair share of taxes on their profits” to support the provision of public goods (Ryding & Voorhoeve, 2022, p. 3).

However, Kern (2020) argues that the notion that states must have the right to tax economic activities to prevent free-riding may not be in line with the morality of cooperation. The Principle of Fair Play requires MNCs to play their parts to maintain a cooperative scheme. But it does not determine which parts they should play, given that the tax treaties also allow MNCs to transfer profits to lower tax jurisdictions legally. Nevertheless, according to Dietsch (2016), MNCs have a responsibility to contribute to public goods and fiscal redistribution in any location where they conduct economic activities, such as work, production, and consumption, because they are part of a cooperative venture that requires public goods and infrastructure to function. By benefiting from these resources in the economic nexus, they incur an obligation to help fund them.

Problem 2: Fiscal autonomy affected by tax competition

Fiscal authorities' attempts to book the MNCs' profits in their jurisdiction by lowering the corporate tax rates could trigger competition for corporate profits with other countries. The competition for corporate profits is a collective action problem (Ryding & Voorhoeve, 2022). Many countries face a dilemma where each country is motivated to act in a way that would lead to a worse outcome if they all collaborated. The competition often results in lower tax rates than what would have been agreed upon if authorities had worked together to establish rules for taxation. As a result of this competition, the “OECD Tax Database” (2023) reported that the average corporate tax rate of OECD countries has declined from 32.3% in 2000 to 22.9% in 2021 (Ryding & Voorhoeve, 2022). Lower tax rates translate to lower fiscal revenue for given profits due to this collective action problem.

The fiscal autonomy of countries may be affected due to MNCs’ tax avoidance behaviours and other countries lowering tax rates to compete for corporate profits. Fiscal autonomy is the government's ability to raise revenue, undertake redistribution policies, and provide public services based on the citizens' collective decisions (Ryding & Voorhoeve, 2022). This autonomy is crucial for meaningful political debate, self-governance, and justice within that jurisdiction (Ryding & Voorhoeve, 2022). Interfering with other countries' right to tax what they can rightfully tax by competing for corporate profits undermines their ability to tax profits generated in their countries by MNCs. Promoting other countries' fiscal autonomy where possible and establishing equitable agreements will help solve collective action problems in taxation (Ryding & Voorhoeve, 2022).

Problem 3: Worsening inequality as governments rely upon other regressive tools to make up lost revenue

Large tax avoidance will also lead to higher inequalities as governments often replace the lost revenue with regressive taxes. Capital income, including profits, is more unequally distributed than labour income (Ryding & Voorhoeve, 2022). The Gini coefficient, which measures inequality, is much higher for gross capital income than for gross labour income. To evaluate the final bearer of the tax, one needs to evaluate beyond the entity or individual on which the tax is imposed (Ryding & Voorhoeve, 2022). This metric is called the "effective incidence", which assesses the effect of taxation on equality between agents (Devereux & Vella, 2022, p.2). Market conditions and country circumstances will dictate how much the capital bearer pays for the final cost of taxes on corporate profits (Ryding & Voorhoeve, 2022). However, lowering the corporate tax rate increases inequality as it translates to lower tax on capital income that is on an already unequal distribution. Inequality worsens as governments use regressive taxes, such as the value-added tax, to replace the lost revenue (Ryding & Voorhoeve, 2022). A regressive tax increases the tax burden more for lower-income individuals than the rich (Tanzi & Zee, 2001). Therefore, the tax incidence of lowering corporate tax effectively falls on the general public, particularly the less affluent, who bear a greater burden from the changes in taxation policies.

The OECD’s solution

In 2021, the OECD launched a proposal to establish a minimum tax rate of 15% for MNCs and redistribute the profits of the most profitable and largest MNCs globally (OECD, 2021). This proposal has support from 136 countries and jurisdictions, which make up more than 90% of the global GDP.

Pillar 1 seeks a fairer allocation of profits by allowing some countries to tax MNCs without physical presence; however, limited to companies with over 20 billion euros in global revenue and profitability above 10%. Pillar 2 aims to limit tax competition by imposing a global minimum tax of 15% for MNCs over 750 euros in global revenue.

The implementation of pillars 1 and 2 on a global scale would have limitations concerning the number of MNCs covered. According to Ryding and Voorhoeve (2022), only around 100 MNCs and 10-15% of MNCs will be subjected to pillars 1 and 2, respectively. Since most MNCs fall outside the policy's scope, they would continue to free-ride the system (Problem 1 likely to persist).

In addition, the issue of paying the fair share might not be resolved even with global implementation as the share of MNCs’ profits that would be subject to the reallocation of tax rights may be small. Only 20-30% of profit exceeding 10% of revenue would be redistributed for MNCs falling under the scope of Pillar 1 (Ryding & Voorhoeve, 2022). There is no guarantee that this portion of profits, even if reallocated efficiently, would pay for the fair share of taxes in the different jurisdictions where economic activities occurred.

Issue 2: Countries can still compete on tax rates given technical changes in Pillar 2

The OECD introduced significant changes to the Pillar 2 proposal in a follow-up publication in late 2021. It introduced a new concept of a Qualified Domestic Minimum Top-up Tax (QDMTT). QDMTT allows countries to collect the difference between the effective and minimum tax, which are prioritised during the tax collection process (Devereux et al., 2022).

According to Devereux et al. (2022), the implications of this new rule indicate that implementing Pillar 2 would not diminish the tax competitiveness of low-tax jurisdictions implementing the QDMTT. Since countries with QDMTT will be prioritised when collecting tax, low-tax jurisdictions are incentivised to lower their corporate tax rates and meet the QDMTT requirements. Countries can decrease their corporate tax by potentially implementing lower tax rates or expanding allowances, with the possibility of reaching a complete elimination of corporation taxes (Devereux et al., 2022).

Many low-tax jurisdictions like Ireland and Mauritius are considering implementing the QDMTT (Ryding & Voorhoeve, 2022). While this policy could successfully create a floor for the low-tax jurisdictions, the corporate tax rate competition would still remain, and profits will still be directed to low-tax jurisdictions (Devereux et al., 2022). In fact, Pillar 2 might be another factor that further contributes to global tax competition, which continues to affect the fiscal autonomy of countries (Problem 2 likely to persist in some form).

Issue 3: The proposal has minimal effect on reducing inequality while being disadvantageous to production-based countries

The implementation of the proposal is likely to have minimal effect on reducing corporate profit competition among the countries, which means that the proposal will not be able to address the inequality-enhancing effects of lowering tax rates to capture corporate profits (Problem 3 would remain unaddressed).

Furthermore, both Pillar 1 and Pillar 2 allocate taxable profits based on sales rather than production location (Ryding & Voorhoeve, 2022). This element can be perceived as unfavourable for smaller and poorer developing countries as production is usually outsourced to access cheaper labour (Amiti & Wei, 2004). Consequently, these countries are not able to reap the benefits from profits they helped to generate even though they were involved in valued added activities of those companies.

Issue 4: Fiscal autonomy could be affected by the implementation of the proposal – “Two wrongs do not make a right”

The degree of national fiscal autonomy can also be impacted if countries that have not agreed to the OECD rules are subjected to them without a meaningful political process (Ryding & Voorhoeve, 2022). More than one-third of the countries in the world did not participate in the OECD discussions: the majority are developing and least developed countries. Additionally, four countries that participated in the OECD negotiations, namely Nigeria, Kenya, Sri Lanka, and Pakistan, did not support the proposal. These countries that were not in the negotiations or did not agree to the deal could face pressure to conform to the OECD proposal in other ways (Ryding & Voorhoeve, 2022). For example, suppose the European Union (EU) adopts the OECD recommendations. In that case, other countries might be obliged to cooperate on a deal they disagree with or are not involved in. In the past, the EU had blacklisted countries that did not adopt the previous OECD tax policy, which carries sanction risks (Ryding & Voorhoeve, 2022). Therefore, some countries face fiscal autonomy issues as they are pressured to comply with the OECD policy, even if they are not involved with the rule-making process or disagree with it and without a meaningful political process. A more inclusive platform, like the United Nations and its efforts to formulate a tax convention, would be a better policy forum to set global tax norms (OHCHR, 2022) (The proposal may contribute to other complications related to Problem 2)

Conclusion

Tax avoidance by the MNCs through transfer pricing and profit shifting has significant global implications. The three main problems that arise from the practice include MNCs free-riding on public goods without adequately contributing to the countries where they operate, tax competition leading to lower tax rates and reduced fiscal autonomy, and worsening of inequality as governments resort to regressive tax measures to compensate for lost revenue.

While the OECD has introduced a two-Pillar proposal to address these issues, there are significant challenges that limit its effectiveness. The proposal's limited scope means that many MNCs could still continue their tax avoidance behaviours. Furthermore, the introduction of QDMTT under Pillar 2 could still perpetuate tax rate competition among countries. There would be limited effect to improving inequalities given the potential ineffectiveness of the proposal to reduce tax competition. The proposal might exacerbate cross-country inequality as it disadvantages poorer production-based countries. Lastly, the implementation of the proposal itself could undermine the fiscal autonomy of countries that have not participated in the OECD negotiations or disagree with it.

In light of these challenges, it is evident that the current OECD proposal falls short of effectively addressing the problems of tax avoidance at the global scale. A more inclusive platform, such as the United Nations, should be considered a better policy forum to establish global tax norms and ensure an inclusive and more equitable international tax system.

References

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