Corporate Taxation in a Global Economy

The standard approach to taxing MNEs is embedded in the broaderfirm/market dichotomy, which still serves as the building block of an economic analytical thinking (Demsetz 1988; Penrose 2009). The firm is considered‘a unit of plan-ning’(Penrose, 2009) and coordinator of factors of production (Coase R. H. 2007), operating within decentralized self-equilibrating economic systems. The preoccu-pation of economists with the price system, notes Harold Demsetz gives‘serious consideration of thefirm as a problem solving institution’(Demsetz 1988, p. 141).

As a result, for a long time there was no theory of afirm to speak of. One implication of what became known as‘the law of diminishing returns to scale’was that most businesses would remain relatively small (Beck 2004). Firms were not simply neglected; they were not supposed to play an important role in economic life.

Clearly, this assumption proved wrong. The history of the twentieth century had been the history of the rise of large multinational corporate organizations. It

took decades until economists began to seriously address this purported anomaly (Boudreaux and Holcombe 1989; Coase R. H. 2007; Demsetz 1988). From about the late 1930s on, the very growth offirms, let alone the emergence of powerful multinational enterprises, has attracted growing attention (Buckley and Ghauri 1999; Jones 1988; Penrose 2009).

Equally puzzling from the standard economic perspective had been the issue of corporate taxation. The law of supply and demand in self-equilibrating markets was supposed to ensure that profits were paper-thin. Corporate taxation should not have been an issue of public concern because,firms should have remained on the whole very small businesses, and in any case, they should not be making a great deal of profits. It turned out that the second assumption was wrong as well;

many largefirms were highly profitable.

Economics had to live with these two puzzles. The puzzle of corporate growth was resolved of sorts by Ronald Coase and Frank Knight, with a sprinkling of the empirical work of Alfred Chandler. From Knight we have learned of the add-itional costs involved in handling risks and uncertainties, unlikely to be settled by small businesses (Boudreaux and Holcombe 1989). From Coase we have learned about a whole swathe of costs of productions, transaction costs, that are better handled within the firm (Coase R. H. 2007). From Chandler we have learned about the economies of scale and scope (Chandler et al. 2009). The logic of scale would be further advanced after the collapse of the Bretton Woods agreement in 1973. Exchange rate volatility, rising costs of insurance, and the development of hedging techniques, on the one hand, put pressure on monetary regulations (such as Basel I, II, and III, FATCA, and now MiFID I and MiFID II,) and money laundering regulations on the other, increasing the costs and complexity of com-pliance (see Chapter 13 on money laundering regulation). Large firms have increasingly responded by incorporating those treasury operations in-house (Polak et al. 2011).

The puzzle of corporate profitability, in contrast, was never truly resolved.

Economists came up with two sets of theories that may explain excess profits, both predicated on the assumption that anything but paper-thin profits must be the result of temporary disequilibria in markets. One theory associated extra profits with monopoly (Fisher and McGowan 1983; Shepherd 1983)—and would presumably not be averse to tax. The other associated market temporary disequilibria with technical and technological innovation (Armour and Teece 1980). The implication of this theory was that corporate taxation was, in effect, a penalty on successful and innovativefirms. Corporate taxation created perverse even-playingfield, rewarding the less efficient and less innovativefirms, discour-aging innovation, and introducing unnecessary distortions to markets. Public discourse notwithstanding, many economists, and treasury departments that tend to follow mainstream economic approaches, were never wholly convinced by the concept of corporate taxation.

The political economic argument for corporate taxation does not address any of the above quandaries directly. The political economic argument for corporate taxation works more or less as follows: an economy is embedded in an institu-tional environment which, in turn, provides the political security, safety of contract, and other public goods such as good infrastructure, education, and the like (North 1990; Williamson 1999). The corporate world benefits from the provision of such public goods, and should help pay for it. The political economic argument for corporate taxation is couched, therefore, in normative terms, of legitimacy, fairness, and the rule of law (OECD 1998). That makes sense, but the problem with corporate taxation is that it introduces a new technique for tem-porary disequilibria and excess profits. The imposition of corporate tax raises the theoretical equilibrium point of marginal profitability, and changes the competi-tive dynamics among players. As a result,firms that are able to reduce their tax footprint benefit from a cushion of excess profitability in their competition with otherfirms in the sector. Considering the difficulties of generating market dis-equilibria through either monopolization or innovation, the temptation to invest in the third method, techniques of tax mitigation, must be considerable. Not surprisingly, considering the value of avoidance to group’s survival in a competi-tive market, let alone success, resources are often shifted from one type of productive activities, such as R&D or infrastructural development to non-productive expenses on lawyers, accountants, and financiers coming up with ever more sophisticated tax shelters schemes (Bankman 2004). Taxation, there-fore, is a market distortive mechanism which, in a competitive market, favours the tax avoider—another reason for economists to be critical of the system of corpor-ate taxation.

There is some evidence that these distortive market mechanisms are out of control. Researchers at the IMF came up with the startlingfigures indicating that about 30 per cent of all foreign direct investments are phantom investments, operating through shell corporations (Damgaard et al. 2019). Whereas such phantom investments may benefit thosefirms, the societal effect of such behav-iour is a waste of resources. These are the tell-tale signs of the rise of a non-productive industry devoted to tax avoidance. Indeed, a niche industry has emerged devoted to the development of techniques of tax shelters.³ Most shelters use domestically generated tax loopholes, but a good number would create international corporate structures traversing a number of jurisdictions (Bankman 2004; Department of the Treasury 1999; Graham and Tucker 2006;

Robé 2011; Weisbach 2001). A UK parliamentary committee estimated the value

³ Tax shelters can be defined as products or structures developed either internally by thefirm’s legal and accounting departments, or by investment banks, small tax shelter shops, and the large accounting firms (Bankman 2004, p. 12).

of the global tax avoidance industry at about £25 billion annual income (HM Treasury 2014).

At this point in the narrative, or the narrative that we are familiar with, we end up with two powerful forces squaring to one another, the industry of tax avoid-ance and the regulators. But is this the case? We think the picture is more complicated. The economics of tax avoidance is one of differential avoidance.

Whereas shareholders may be interested in maximizing post-tax profits, manage-ment has a somewhat different perspective. In competitive market conditions, the nominalfigure for tax avoidance may be less important than differential avoid-ance within the sector. In other words, Volkswagen would be at a disadvantage if Ford or Toyota were able to mitigate tax more efficiently than they are able to.

Mechanisms of corporate tax avoidance introduce, therefore, temporary disequi-libria in the markets, and are highly prized by the corporate sector. At the same time, the techniques of tax avoidance themselves are subject to negative evolu-tionary processes. As with other techniques of market disruption, the key to success here is the advantage of the prime mover. After, for example, a new tax avoidance technique is invented, thefirst to use it is at an advantage compared to the rest in the market. Over time, the technique is emulated and spreads across the industry. Eventually, just as the regulators begin to pay attention to the new technique, the advantage of differential avoidance is eroded. Thefirm, however, is already establishing an edge with a new technique. With nearly 80 per cent of global trade being intra-firm, the temptation to affect transfers between different arms of the same group in order to move ‘taxable events’ to low or no tax jurisdictions is too powerful.

Considering the conflicting theories and motivation for corporate taxation, treasury departments of many countries have reached a kind of perverse com-promise. They tend to insist on taxation at home, but are known broadly to be less concerned with tax avoidance by ‘their’ ownfirms abroad (Avi-Yonah 2005).⁴ These dynamics are not alien to the European Union. The complex interplay of 28 EU Member States—each competing with one another in support of not only

‘their’MNEs but also competing over the privilege of serving as points of entry into the single market; each, with varying degree of sophistication and success— does not exactly bode well.

The European Union has, however, a centralized authority, the Commission, which further complicates these types of geopolitical calculations. On the one hand, the Commission seems to be engaged in a high-stake geopolitical game with the US. Not surprisingly perhaps, the US legal system has focused its attention on

⁴ Most governments, or at the very least the majority of treasury departments, are still working with an assumption that their role is to strengthen the domestic economy, and they seem to hold on to the somewhat anachronistic view that the‘domestic’economy consists of national businesses competing in the world market. The fact that the link between MNE and home nation is increasingly highly tenuous (Desai 2009) does not seem to interfere with geopolitical considerations.

the foreign banks, particularly European banks and their role in facilitating tax evasion, avoidance, and money laundering. No US banks were ever charged. The EU commission, in turn, responded by focusing attention largely on the US corporate sector, charging many MNEs for avoiding EU taxes. The commission, however, finds it much more difficult to engage with internal politics among members. The result, as we will see Section 3.2, is that the Europeanfiscal regime is particularly vulnerable to arbitraging schemes, or schemes that are taking advantage of diverging national rules and regulations within the market.