A Primer on International Capital Taxation and Its De fi ciencies

According to the principles of international taxation enshrined in the OECD’s model tax convention (MTC), passive income from cross-border investment can be taxed where the investment is made (source country) and where the investor resides (residence country) (OECD 2017, Art. 10 and 11). To avoid double taxation, governments enter into bilateral tax treaties (BTTs) in which they agree on lower or zero withholding taxes applicable to investors from the partner country. Most OECD countries grant tax relief for taxes paid abroad but assert the right to tax households on their worldwide receipts of passive income (OECD 2018b, p. 24ff.). Otherwise, the government would advantage the recipients of foreign income over the recipients of domestic income, thereby violating the equal treatment and ability to pay principles underpinning most income tax systems (Scheve and Stasavage 2016, pp. 25–40).

Owing to the financial secrecy offered by tax havens, this is precisely what happened in practice. While households are legally obliged to include their worldwide capital income in their income tax statement, tax authorities tradition-ally had a hard time detecting underreporting. If at all, BTTs provided for information exchange upon request, which conditioned the dissemination of account data on prior evidence for tax evasion and the domestic availability of requested information (Rixen 2008, p. 75ff.). Even if a foreign tax authority provided the required evidence, tax havens could refuse to share data by referring

to domestic banking secrecy provisions. As a result, foreign account holders paid no or very little tax on unreported capital income.⁴

The available evidence suggests many made use of the opportunity to evade taxes.

According to the most conservative estimate, 8 per cent of global household financial wealth was held unrecorded in tax havens between 2001 and 2008 (Zucman 2013, p. 1323). Further, tax evasion contributes massively to income and wealth inequality as it is mostly the very rich engaging in such activity (Alstadsæter et al. 2019). Tax evasion on this scale does not only cause immediate revenue losses and distributive concerns, but it also creates indirect losses by pressuring residence countries into tax competition. In the absence of meaningful tax cooperation, most OECD countries chose to cut taxes on capital income to prevent capitalflight to tax havens (Ganghof 2006; Genschel and Schwarz 2013).

Peer Steinbrück, the former German minister offinance, summarized the general logic when introducing a special tax rebate for personal capital income in 2006.

From his perspective,‘25% of X [was] still better than 42% of nothing’(Handelsblatt 2006). With a lower premium on tax evasion, he hoped, fewer taxpayers would risk criminal charges for underreporting returns to their foreign accounts.

In contrast to passive income, the MTC assigns the exclusive right to tax the business profits of a foreign-owned enterprise to the source country. In principle, the branch of a multinational group is thus taxable by the state in which it is permanently established (OECD 2017, Art. 7). Since the activities of MNCs are spread across related entities in many countries, the headquarter can exploit its control over the group’s integrated production and wealth chains to channel taxable income from branches across the world to related holding companies in tax havens (Seabrooke and Wigan 2017). For example, MNCs may manipulate the transfer prices for transactions between their branches. Their tax haven holding may overcharge its sister subsidiaries for the use of the group’s intellectual property (IP), thereby siphoning off their local profits through inflated royalty payments. According to the arm’s length standard (ALS), tax authorities can revalue controlled transactions if they are not priced as similar transactions between independentfirms. However, since the IP of MNCs is often unique, tax examiners lack the necessary comparable for a post-hoc correction of manipulated transfer prices (Picciotto 1992, 2015).

By sticking to a representation of MNCs as networks of separate entities and prescribing an outdated procedure for the valuation of controlled transactions,

⁴ They only paid tax, if they invested in countries with which their tax haven of choice had not negotiated a waiver of withholding taxes. In turn, low or zero treaty withholding rates provided committed tax evaders with an opportunity for round-tripping. By investing through a tax haven, which had struck a generous BTT with their home country, they could also strip the return on their domestic investment from its tax burden (Hanlon et al. 2015).

current international tax law enables corporations to avoid tax payments of between

$500 and 650 billion every year (Cobham and Janský 2018; Crivelli et al. 2016).

Again, direct losses are exacerbated by competitive pressure, which depresses future revenue from corporate taxation. Many OECD countries have lowered the statutory corporate tax rate, which is the decisive rate to attract paper profits (Devereux et al.

2008), to guard themselves against excessive outflows of taxable income. It was cut from an average of 46 per cent in 1983 to 22 per cent in 2017 (see Figure 7.1).

The ability of governments to engage in tax competition is due to an important feature of the international tax system—its sovereignty preserving character. The rules of international taxation merely seek to disentangle overlapping national tax systems resulting from domestic, politically salient choices. They operate only on the interfaces of national tax systems and do not interfere with them. Governments retain full formal authority over designing the main components of their tax law—

namely, the tax base, tax rate, and system of taxation—independently from other governments. This allows them to use their tax policies to compete with other governments for investment and profits. While the resulting competition, as we will see, significantly constrains governments’policy choices, i.e. their de facto sover-eignty, it is based precisely on their de jure sovereignty that is left mostly untouched by the rules of international taxation (Rixen 2011).⁵

International Constraint:

Tax Competition

Domestic Output:

Capital Taxes Domestic Driving Factors:

- Left Governing Party - Budget Deficit

- Compensatory Fairness Demands

International Enabling Factor:

Cooperation (Transparency) –

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Figure 7.1 Determinants of capital tax rates.

⁵ Tax competition in the real world is different from the basic Tiebout model, which expects shifts of tangible factors of production in response to tax differentials (Tiebout 1956). While real competition for foreign direct investment and taxpayer residences exists, virtual competition forfinancial wealth and reported (‘paper’) profits is more intense (Genschel and Schwarz 2011, pp. 349–51). That is, nation-states do not primarily compete for production sites and blue-collar jobs. They compete for the deposits and portfolios of wealthy individuals, who evade taxation at their primary residence, and for the profits of MNCs, which avoid taxation where they develop, manufacture and sell their products.

Overall, this shows two things: First, the system is indeed in need of repair, as it can be gamed by international taxpayers who have ample opportunity for tax evasion and tax avoidance. Second, beyond immediate revenue losses, tax evasion and avoidance also have an indirect effect that is potentially even more important—they create tax competition among governments. Such competition does not only involve tax havens but also draws in big countries, which feel compelled to adapt to aggressive tax policies.⁶

Given these adverse effects, governments have tried to establish effective cooperation against tax evasion and avoidance. It is to the politics of these efforts and their outcomes that we turn next.