Spurred on by the threat that the digital economy will deprive governments of the revenues to fund function (as well as distorting the economy away from traditional ways of selling), the international community is at long last recognising that something is wrong. But the flaws in the current framework of multinational taxation — based on so-called transfer pricing — have long been known.
Transfer pricing relies on the well-accepted principle that taxes should reflect where an economic activity occurs. But how is that determined? In a globalised economy, products move repeatedly across borders, typically in an unfinished state: A shirt without buttons, a car without a transmission, a wafer without a chip. The transfer price system assumes that we can establish arms-length values for each stage of production, and thereby assess the value added within a country. But we can’t.
The growing role of intellectual property and intangibles makes matters even worse, because ownership claims can easily be moved around the world. That’s why the United States long ago abandoned using the transfer price system within the US, in favour of a formula that attributes companies’ total profits to each state in proportion to the share of sales, employment, and capital there. We need to move toward such a system at the global level.
How that is actually done, however, makes a great deal of difference. If the formula is based largely on final sales, which occur disproportionately in developed countries, developing countries will be deprived of needed revenues, which will be increasingly missed as fiscal constraints diminish aid flows. Final sales may be appropriate for taxation of digital transactions, but not for manufacturing or other sectors, where it is vital to include employment as well.
Some worry that including employment might exacerbate tax competition, as governments seek to encourage multinationals to create jobs in their jurisdictions. The appropriate response to this concern is to impose a global minimum corporate-income tax. The US and the European Union could — and should — do this on their own. If they did, others would follow, preventing a race in which only the multinationals win.
Since its inception, the OECD/G20 Base Erosion and Profit Shifting Project has made an important contribution to rethinking the taxation of multinationals by advancing understanding of some of the fundamental issues. For example, if there is true value in multinationals, the whole is greater than the sum of the parts. Standard tax principles of simplicity, efficiency, and equity should guide our thinking in allocating the “residual value,” as the Independent Commission for the Reform of International Corporate Taxation (of which I am a member) advocates. But these principles are inconsistent either with retaining the transfer price system or with basing taxes primarily on sales.
Politics matters: The multinationals’ objective is to gain support for reforms that continue the race to the bottom and maintain opportunities for tax avoidance. Governments in some advanced countries where these companies have significant political influence will support these efforts — even if doing so disadvantages the rest of the country. Other advanced countries, focusing on their own budgets, will simply see this as another opportunity to benefit at the expense of developing countries.
The OECD/G20 initiative refers to its efforts as providing an “Inclusive Framework.” Such a framework must be guided by principles, not just politics. If the goal is genuine inclusiveness, the top priority must be the wellbeing of the more than six billion people living in developing countries and emerging markets.
The writer is the winner of the 2001 Nobel Memorial Prize in Economic Sciences. His most recent book is Globalization and its Discontents Revisited: Anti-Globalization in the Era of Trump.
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