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Multinational corporations, stateless incomeand tax havens


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This report provides evidence toshow that the corporate incometax system is not broken and thatthe corporate income tax base isnot being eroded.

It offers a critique of the statelessincome doctrine and theinteraction between tax havens

and multinational corporations.

ACCA (the Association of Chartered CertifiedAccountants) is the global body for professionalaccountants. We aim to offer business-relevant, first-choice qualifications to people of application, abilityand ambition around the world who seek a rewardingcareer in accountancy, finance and management.

Founded in 1904, ACCA has consistently held uniquecore values: opportunity, diversity, innovation, integrityand accountability. We believe that accountants bringvalue to economies in all stages of development. Weaim to develop capacity in the profession andencourage the adoption of consistent global standards.Our values are aligned to the needs of employers in allsectors and we ensure that, through our qualifications,we prepare accountants for business. We work to openup the profession to people of all backgrounds andremove artificial barriers to entry, ensuring that ourqualifications and their delivery meet the diverse needs

of trainee professionals and their employers.

We support our 162,000 members and 428,000students in 170 countries, helping them to developsuccessful careers in accounting and business, with theskills needed by employers. We work through a networkof over 89 offices and centres and more than 8,500Approved Employers worldwide, who provide highstandards of employee learning and development.

The Association of Chartered Certified AccountantsMarch 2014

About ACCA


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Multinational corporations, statelessincome and tax havens

Sinclair Davidson

School of Economics, Finance and Marketing, RMIT University


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ABOUT THE AUTHOR

Sinclair Davidson is professor in the School of Economics, Finance and Marketing at RMIT University in Melbourne Australia,and a senior fellow at the Institute of Public Affairs. Sinclair has published in academic journals such as the European Journal ofPolitical Economy, Review of Political Economy, Journal of Economic Behavior and Organization, and the Cato Journal. Sinclair isalso a regular contributor to Australian public debate. His opinion pieces have been published in The Age, The Australian,Australian Financial Review, Sydney Morning Herald, and Wall Street Journal Asia.

The decline in corporate-tax collection in recent decades has contributed tobudget deficits. It has also aggravated income inequality: a companysshareholders ultimately pay its taxes, and with a smaller tax bill, shareholders, who

tend to be much more affluent than the average American, see their wealthincrease. Its clearly a broken system.MICHELLE HANLON, AN ACCOUNTING PROFESSOR, MIT

Corporate taxes burst into the spotlight last week, with the release of a Senatecommittee report on Apples tactics to reduce its tax payments. More quietly, butperhaps more significantly, the House Ways and Means Committee has begunwork on a potential overhaul of the tax code. Edward D. Kleinbard, a tax expertand former Democratic Congressional aide, said he had been impressed so far bythe seriousness of the committees work.DAVID LEONHARDT, WHO WILL CRACK THE CODE?, THE NEW YORK TIMES, 25 MAY 2013.

The Council of the Association of Chartered Certified Accountants consider this study to be a worthwhile contribution todiscussion but do not necessarily share the views expressed, which are those of the author alone. No responsibility for lossoccasioned to any person acting or refraining from acting as a result of any material in this publication can be accepted by theauthor or publisher.


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Contents

1. Introduction 5

2. The fiscal challenge 7

3. Corporate income tax and fiscal illusion 9

4. A critique of the stateless income doctrine 11

5. Stateless income and tax rents 13

6. Tax havens and multinational corporations 14

7. Is the corporate tax base being eroded? 17

8. Conclusion 19

References 20


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It is commonly argued that thecorporate income tax system isbroken. Twenty-five years of taxcompetition have seen corporateincome tax rates reduced. The revenueactually collected by corporate incometax, however, has not declined as much.The latest theoretical argumentsuggesting that the corporate incometax base is likely to be eroded is thestateless income doctrine. This reportis a critique of that doctrine. First, thedoctrine ignores the value ofintellectual property. Second, it is notclear that the doctrine relates to theerosion of the corporate income taxbase. Certainly there is no evidence tosupport the view that the corporateincome tax base is being eroded. At

best, the concern about the tax base isnot so much that it is being eroded, butrather that multinational corporationsdo not pay tax in every host economy.

Public outrage over the low amountsof corporate income tax paid bymultibillion dollar corporations such asApple, Google, and Starbucks hasgalvanised the UK and US governmentsinto action. T he British prime minister,David Cameron, has suggested that taxplanning has become too aggressive.The US Senate has a sub-committeeinvestigating the amount of tax thatmultinational corporations pay.

The difficulty facing both the UK and UStax authorities is that there is littleevidence of any wrongdoing by any ofthe three corporations that are regularlysingled out for abuse. It is true thatthese corporations do not pay as muchtax in the UK or the US as thosegovernments would like them to pay,but they pay as much tax as is requiredby the laws that those governments

have passed.

The argument that we hear is that thedigital economy has challenged the

fundamental assumptions underlyingcorporate income tax rules, whichoriginated when economic activity hadan unambiguous physical location andso could be taxed in that location(Australian Treasury 2013). Thoseassumptions of taxation have not beenchanged since the advent of the digitaleconomy the physical location ofeconomic activity is simply not to theliking of the UK or US governments.Much of the activity that Apple, Googleand Starbucks undertake is not sourcedwithin the UK or US and hence is nottaxable in those jurisdictions.

Recently, the Wall Street Journal(2013)explained what was going on:

The Apple units are based in Ireland,so US law does not consider them to beUS corporations subject to UScorporate tax. But since they aremanaged and controlled by Apple inthe US, Irish law doesnt consider themIrish companies and thus they are alsonot subject to the 12.5% Irish corporatetax. This isnt alchemy; itsaccountancy

None of this required a Senateinvestigation to discover becauseApple is constantly inspected by the IRSand other tax authorities. These taxcollectors are well aware of Applescorporate structure, which hasremained essentially the same since1980. An Apple executive said Tuesdaythat the companys annual US tax returnadds up to a stack of paperwork morethan two feet high.

We wonder what the Irish think of thespectacle of an American Senatorexpressing outrage that an Americancompany doesnt pay enough Irish

taxes.

It is important to note that theseactivities do not make use of bank

secrecy laws or any of the so-calledabusive practices that the OECD hasassociated with the use of tax havens inreducing corporate tax liability. Thesecorporations are fully compliant withthe tax law in the jurisdictions in whichthey operate.

SO WHY THE FUSS?

Most advanced economies have largefiscal deficits and little prospect ofreturning their budgets to surplus. It isquite clear that excessive expenditure isthe basis for these fiscal deficits. Onepossible solution to the fiscalchallenges that these economies face isto increase taxes. Increasing corporatetax is a politically desirable policy given

the fiscal illusion that surrounds thisform of taxation. First, there is awidespread perception that largecorporations pay very little corporateincome tax. Indeed the scandals thatsurround Apple, Google, and Starbuckswould appear to confirm that view.Secondly, it is not clear where theeconomic incidence of the corporateincome tax falls.

The past 25 years or so have seensubstantial tax competition betweennations this has resulted in a decline incorporate income tax rates. Thequestion is whether this has resulted inlarge declines in the revenue that hasbeen raised by this tax. Surprisingly,there is little evidence to support thenotion that tax competition hasreduced actual corporate income taxrevenues. Nonetheless, that is thepopular conception and the OECD andvarious European politicians haveadvocated tax rate harmonisationamong nations.

The latest theoretical argument tosupport the notion of tax rateharmonisation is the so-called statelessincome doctrine developed by

1. Introduction


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Professor Edward Kleinbard of theUniversity of Southern California. Underthis theory, multinational corporationsare able to generate income that isapparently untaxed. The double IrishDutch sandwich tax strategy is amechanism for generating such income.This doctrine ignores, or at leastseriously undervalues, assets such asintellectual property and trademarks.Consider, for example, the consumptionof a coffee from Starbucks. Theconsumer is not simply consuming acoffee an inexpensive, easilymanufactured, homogeneous product.Rather consumers are consuming anexperience where the coffee is only onecomponent of a branded product.Drinking a Starbucks coffee is either a

form of conspicuous consumption or areduction in information and searchcosts for consumers in a strange citywho wish to consume a product ofknown quality. The brand itself is thevalue and, unsurprisingly, a royaltypayment for the use of that brand ispaid to the owner of the brand. Againunsurprisingly, the owner of that brandlocates the brand in the legal

jurisdiction where its value ismaximised.

There is no such thing as statelessincome, rather there is income that thegovernments of the UK and the US donot tax because under their own legalsystems that income is not sourced intheir economy. When thesegovernments complain about statelessincome, the question rather should be,Why do the owners of intellectualproperty not locate their property inyour economy?.

An implicit assumption of the statelessincome doctrine is that multinationalcorporations maximise their value tosociety only when they pay tax. Ofcourse, this is not the case.Multinational corporations provideinvestment, create jobs, facilitateinnovation transfers, provide goods andservices, and also pay tax. As it is,corporations do not pay only corporateincome tax; they also pay payroll taxes,local rates, and a host of other chargesand levies. The corporate income tax isonly one among many other taxes. To

judge the merit of a multinationalcorporation only by the corporateincome tax it pays is to ignore the realeconomic value of these organisations.

The argument is that the corporateincome tax base is being eroded byaggressive tax planning by multinationalcorporations yet the evidence tosupport this argument is lacking. It isone thing to point out that multinationalcorporations do not pay tax in some

jurisdictions but that says nothing aboutthe actual corporate income tax base.To the extent that corporate income taxrevenues have fallen in recent years, thisis more likely to be a result of pooreconomic conditions than aggressivetax planning.

This report provides evidence to showthat the corporate income tax system isnot broken as some suggest. So-calledstateless income is a return onintellectual property and the idea thatthere is such a thing depends on itsproponents disregard of intellectualproperty. The amount of actual incomethat could be described as being

stateless is small and the returns on aharmonised global tax system wouldalso be small. There is no evidence tosupport the hypothesis that the UK orthe US corporate income tax base isbeing eroded.

The next section will show thatadvanced economies face a fiscalchallenge. This creates the context for atax grab. Following that is anexplanation of the concept of fiscalillusion, and why corporate income taxis the ideal candidate for increasing thetax burden as a partial means ofresolving the fiscal challenge thathigh-income economies face. Therefollows a critique of the statelessincome doctrine and discussion of the

interaction between tax havens andmultinational corporations. Finally, thisreport presents evidence that thecorporate income tax base is not beingeroded.

A conclusion sums up the evidencepresented.


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The so-called advanced economies ofthe world face a fiscal crisis. Since thestart of the 21st century theseeconomies have, on average,experienced budget deficits wheregovernment expenditure has massivelyoutstripped government revenue. Thisbudgetary behaviour preceded the2008 financial crisis and the IMFforecasts that it will continue until atleast 2018 (Figure 2.1).

This fiscal challenge becomes evenmore apparent when we consider theeuro area. While the pattern of deficitsis similar to that of the advancedeconomies overall, the quantum ofexpenditure and taxation has beenmuch higher (Figure 2.2).

For all the talk of austerity the factremains that the IMF does not foreseethat government expenditure will returnto pre-2008 levels by 2018. At the sametime, however, the IMF indicates thatgovernment revenue figures havealready returned to pre-2008 levels.

2. The fiscal challenge

Figure 2.1: The fiscal challenge faced by advanced economies

Source: International Monetary Fund (2013).

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Source: International Monetary Fund (2013).

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This very simple analysis suggests that,in general, lax expenditure discipline isthe primary driver behind the fiscalchallenges that these economies face.This is unsurprising. As JamesBuchanan, the 1986 Nobel Laureate,and Richard Wagner explained in their1977 book Democracy in Deficit: ThePolitical Legacy of Lord Keynes(1977:1056):

Democratic societies will tend to resortto an excessive use of debt financewhen they have permitted Keynesianismto revise their fiscal constitutions.Thepost-Keynesian record in fiscal policy isnot difficult to understand. The removalof the balanced-budget principle orconstitutional rule generated an

asymmetry in the conduct of budgetarypolicy in competitive democracy.Deficits will be created, but to a greaterextent than justified by the Keynesianprinciples; surpluses will sometimesresult, but they will result less frequentlythan required by the strict Keynesianprescriptions.

Democratic societies have a tendencyto run budget deficits throughexcessive expenditure and this was thecase even before the 2008 financialcrisis. At the same time, however,government cannot be too brazen in itsmanagement of the budget and as suchalso engages in a political strategyknown as fiscal illusion.

Fiscal illusion occurs when governmentattempts to distort citizens fiscalconsciousness about the nature andscope of government expenditure orthe burden of taxation. The objectivehere is to obscure the real cost of publicgoods and services (Buchanan 1967:12542). The debate surroundingcorporate tax, multinational

corporations and the role of tax havensis particularly prone to issues of fiscalillusion.


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The first aspect of fiscal illusion toaddress here is the notion that taxrevenue from corporate income tax isdeclining. This perception has arisenfrom the discussion surrounding thenotion of tax competition.

Richard Teather (2005: 25) has definedtax competition as the use bygovernments of low effective tax ratesto attract capital and business activityto their country As Teather describes,in the late 1990s a number high-taxEuropean economies began to fear thattax competition would undermine theirown ability to raise tax revenue. WouterBos, former Dutch minister of finance,argued that tax competition was not

just a race to the bottom but a race

to public poverty, ... where total taxincome of the countries becomes toolow for governments to finance asustainable and sufficient level of public

3. Corporate income tax and fiscal illusion

services (Bos 2000). The particular fearis that government will be unable toraise revenue from taxing highly mobiletax bases. To the extent that this view iscorrect, one would expect to observelower revenues being raised fromcorporate income tax as corporateincome tax rates decline. In particularthis effect would have been noticeablelong before the 2008 financial crisis.What the data reveals, however, is avery different picture corporate taxrevenue has declined in the last fewyears but not in a manner consistentwith tax competition. Rather, the datasuggests that the corporate tax revenuedeclined after the 2008 financial crisis(Figure 3.1).

OECD economies raise a non-trivialamount of tax revenue from corporateincome tax. In 1965 such taxes raised2.2% of OECD GDP in revenue, while in

2010 that figure had increased to 2.9%.By 2006, however, that figure hadincreased to 3.76% the decline inrevenue from the corporate income taxsince then is the source of somedebate. It is important to recognise,however, that the trend in corporateincome tax revenue collection remainedpositive over the period 19652010.

Similarly, the proportion of total taxrevenue contributed by corporateincome tax was little changed over theperiod 19652010. In 1965 thecontribution of corporate income tax tototal taxation revenue in the OECD was8.8%, decreasing slightly to 8.6% in2010. The minimum share for corporateincome tax to total taxation revenue

was 7.2% in 1992 with the maximumshare in 2007 being 10.6%. As in thecontribution of corporate income taxrevenue to GDP, the amount of

Figure 3.1: OECD corporate income tax revenue as a percentage of GDP and total tax

Source: OECD 2013.

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corporate income tax relative to totaltaxation has declined since the 2008financial crisis, but again the pointremains that the revenue from thecorporate income tax has not declinedas the tax competition argument wouldhave us believe.

If anything, the composition of the taxbase in OECD economies isinconsistent with the view that taxcompetition is reducing taxationrevenue on mobile factors ofproduction. Figure 3.2 shows that thevarious sources of taxation revenue arefairly stable. The share of taxationrevenue from personal income tax hasdeclined slightly over time and hasbeen replaced by a slight increase in

social security contributions. In otherwords one form of taxation has beensubstituted for another.

The second source of fiscal illusion toconsider is the incidence of corporateincome tax. The economic incidence ofcorporate income tax differssubstantially from the legal incidence ofthe tax. The legal incidence ofcorporate income tax is clear thecorporation is required to pay somepercentage of its taxable income to thetaxation authorities each year. Thequestion is whether corporations areable to shift the economic burden ofthe corporate income tax onto otherparties, such as customers, employees,or investors. If the burden can beshifted to whom is it shifted? The oldclich is that corporations do not paycorporate income tax, people pay thetax. So the question is, which people

pay the corporate income tax?

The fiscal illusion argument here is thatcorporations can be taxed at high rates

simply because the corporation bearsthe burden of the taxation and notindividuals and, especially, not voters.

Economists, however, have long beenof the view that the economic burden ofthe corporate income tax is not borneby corporations but is shifted. Whateconomists are unsure about is wherethat burden is shifted. KimberlyClausing (2012, 2013) has evaluated thetheoretical literature and undertakensome empirical analysis of the incidenceof the corporate income tax. It is notclear where the incidence of thecorporate income tax lies. Theimportant point here is thatpolicymakers cannot be sure who isactually bearing the costs associated

with corporate income tax and henceare making policy choices that have anunknown effect on the economy.

Figure 3.2: Tax revenue by sector as a percentage of total taxation

Source: OECD 2013.

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Edward Kleinbard, professor of law atthe University of Southern California,has developed the notion of statelessincome (Kleinbard 2011a, 2011b). Thisnotion has become particularlyinfluential in the current debatesurrounding the amount of corporateincome tax that is paid by multinationalcorporations, which will consequentlybe analysed in some depth here.

While Kleinbards (2011a) definition ofstateless income is quite convoluted,the basic idea is quite simple (2011a: 703).1

Stateless income thus can beunderstood as the movement of taxableincome within a multinational groupfrom high-tax to low-tax source

countries without shifting the locationof externally-supplied capital oractivities involving third parties.

This particular phenomenon is notunknown or unusual yet Kleinbardclaims that stateless income is notequivalent to capital mobility oraggressive transfer pricing. This is anassertion on his part and he (2011a: 707)is left having to concede that: Thephenomenon of stateless income risksappearing vague, and its analysistedious.

1. Kleinbard (2011a: 702) defines stateless incomeas follows: By stateless income, I mean income

derived by a multinational group from businessactivities in a country other than the domicile

(however defined) of the groups ultimate parentcompany, but which is subject to tax only in a

jurisdic tion that is not the location of the

customers or the factors of production throughwhich the income was derived, and is not thedomicile of the groups parent company.

He attempts to overcome this very realdifficulty by pointing to a tax strategyknown as the double Irish Dutchsandwich. This particular strategy hasmultinational corporations, such asGoogle, operating subsidiaries inIreland and the Netherlands andconsequently not paying very muchcorporate income tax in the US. Thisissue is not limited to the US; thegovernments of Australia and the UK,for example, have expressed someconcern that multinational corporations,such as Google and Starbucks, are notpaying very much corporate income taxin their jurisdictions.

The fact, however, that somemultinational corporations do not pay

(very much, if any) corporate income taxin any one particular jurisdiction isnecessary but not sufficient evidence ofwrongdoing on the part of thosecorporations. Indeed, working throughKleinbards explanation of how statelessincome is apparently generated it isdifficult to understand whether there isa problem or any wrongdoing at all.

Kleinbard views the source of statelessincome as being, an inevitable by-product of fundamental internationalincome tax norms and nationscollective failure to agree on othercritical international tax norms thatwould determine the source ofincome (Kleinbard 2011a: 704 and 706).In other words, stateless income isgenerated by the architecture of theexisting tax system and definitions ofthe corporate income tax base acrossvarious jurisdictions.

Yet notions such as separate taxpersonas, deductibility of interestpayments, freedom of contract, limitedliability, the veil of incorporation or evenexploitation of private property aretried and tested principles of commerceand taxation and it is unsurprising thatthe nations of the world would bereluctant to deviate from theseprinciples.

Kleinbard argues it is impossible tounderstand the concept of statelessincome without understanding theconsequences of stateless income taxplanning (Kleinbard 2011a). He claimsthree such consequences (2011a: 707):

When unchecked, stateless income

strips source countries (including theUnited States as the location ofsubsidiaries of foreign-controlledgroups) of the tax revenues attributableto income generated in those

jurisdictions. Its availability also distortsthe investment decisions ofmultinational firms, and under currentUS rules distorts a US multinationalfirms decision whether to repatriatethat stateless income back to the US.

Kleinbard spends a great deal of effortarguing that the norms and principles ofcommerce and taxation generatestateless income. If so, the tax base isnot being eroded per se, because it isdefined on the basis of those norms andprinciples. At best, his argument is thatthe tax base should be defineddifferently, but that is not an argumentthat the tax base is being eroded. Thesecond consequence is that the

4. A critique of the stateless income doctrine


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availability of stateless income distortsinvestment decisions from what theyotherwise would have been. Heprovides no evidence for this being so.In particular, he provides no evidencethat the existence of stateless income isa unique source of distortion over andabove the distortions introduced by theexistence of corporate taxation itself.More importantly, he provides noevidence that this distortion (if any) issomehow inappropriate.2As discussedbelow, he does provide a thoughtexperiment to support his claim thatthere is some distortion here (Kleinbard2011b). The third consequence mayconstitute a corporate governanceproblem for US corporations, but it isnot clear that this is a taxation problem.3

In sum, Kleinbards problem withstateless income is that, it destroys anypossible coherence to the concept ofthe geographic source of income, onwhich all territorial tax systems rely(Kleinbard 2011a: 714). Unfortunately,not only has he failed to make the casefor that proposition, it is also false.Stateless income tax planning does notmake geographic sources incoherent it transfers tax liability from onelocation to another. The real problemhere is that US multinationalcorporations are able to pay corporateincome tax in low-tax jurisdictionsbecause the US government has chosento define its corporate income tax basein a way that allows that to happen.

2. Kleinbard (2011a) explains that the Dutchauthorities charge a fee for the use of their tax

system in the double Irish Dutch sandwich. Thistax strategy is a source of revenue for theNetherlands.

3. See Desai and Dharmapala (2009) for theoryand evidence on this point.


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Kleinbard (2011a: 753 758) makes anargument that multinationalcorporations are able to create andcapture tax rents (especially at 2011a:754).

Stateless income tax planning offersmultinational firms, but not whollydomestic ones, the opportunity toconvert high-tax country pre-taxmarginal returns into low-tax countryinframarginal returns, by redirectingpre-tax income from the high-taxcountry to the low-tax one.

It is easy to see the problem here; forexample, in an article in the AustralianFinancial Review it was revealed that awholly Australian website, Carsales.

com, paid $27m in tax on sales of $184mwhereas Google Australia paid a mere$0.78m on sales of $1000m. (Bassanese2013).If anything, this violatesperceptions of equity within the taxsystem. For two apparently similar firmsto face very different taxation regimesis a violation of horizontal equity.

It is not clear, however, that a dif ferentialdue to differences in taxation is bestdescribed as being a rent.

The notion of rent in economicsimplies the existence of a return overand above the minimum returnnecessary to keep a factor ofproduction in employment; in otherwords what economists refer to as asuper-normal return or an economicprofit. Rents occur when supply curves

for a factor of production are inelasticor when barriers to entry exist toprevent the rents from being competedaway. Kleinbard, however, makes noargument about the existence ofinelastic supply curves or barriers toentry. Rather, he (2011a: 755) arguesthat:

Their inframarginal returns stem notfrom some unique high-value asset, butrather from their unique status asstructurally able to move pretax incomeacross national borders.

If correct, then Kleinbard has identifieda problem with the taxation system. Inall his argument, however, Kleinbardappears not to recognise intellectual

property as being an asset or havingvalue. For example, in his description ofthe double Irish Dutch sandwich heargues, there is nothing in the structurethat relies on any unique businessmodel or asset of Googles, as ifGoogles business model itself is notintellectual property. Later, whendiscussing transfer pricing, he makesthe point, following Mihir Desai andJames Hines (Desai and Hines 2003),that, the theory of the multinationalfirm can in large measure be explainedby its role as a platform from which toexploit unique global intangibles(emphasis added) (Kleinbard 2011a:735).4Yet he is unable to see that thisexploitation of unique globalintangibles plays an important role inthe generation of his so-called statelessincome.

4. Kleinbard (2011a) first acknowledges the notionthat multinational corporations exploit a core set

of intangible assets at page 710 yet he describesthe organisational structure that facilitates thisexploitation as being a fantastic notion.

In addition, the ability to move pre-taxincome across national borders is notunique to specific organisations. Thereis no barrier to entry to any organisationcreating valuable intellectual propertyand locating that property offshore. It isthe existence of valuable intellectualproperty located in a low-taxenvironment that generates Kleinbardsstateless income income that can thenhardly be described as being a taxrent. To be sure this is income that isnot available to wholly domestic firms.Similarly, wholly domestic US firms willface a higher tax burden than do USmultinational corporations but, again,there is no barrier to exit there is nopolicy to prevent US firms fromdiversifying their activities beyond US

borders. There is no basis for believingthat the differential in tax treatment ofdomestic and multinationalcorporations is a source of rent.

The point here is that multinationalfirms have a comparative advantagebased on their intellectual property thatallows them to reduce their tax burden,but that is not equivalent to having anunfair advantage.

5. Stateless income and tax rents


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This section addresses three questions.What sort of multinational corporationsestablish activities in low-tax

jurisdictions? Does investment inlow-tax jurisdictions crowd-outinvestment in high-tax jurisdictions?Finally if income shifting is occurring,how large are the quantities of potentialtax revenue involved?

Each of these questions addressesissues raised in the previous section.For example, if those multinationalcorporations with high levels ofintellectual property or unique businessmodels establish operations in low-taxenvironments, then Kleinbards notionof stateless income, which ignores orundervalues intellectual property, is

seriously incomplete. Similarly thestateless income doctrine contains animplicit assumption that multinationalcorporations provide any benefit to thehost economy only through payingcorporate income tax. If multinationalcorporations provide other benefits forthe host economy then reducedcorporate income tax receipts may be avaluable price to pay for these otherbenefits. Finally, the question of howmuch money is at stake is alwaysimportant.

Daniel Mitchell (2006) defines a taxhaven as any jurisdiction, anywhere inthe world, that has preferential rules forforeign investors. Tax havens and taxcompetition are intimately related toeach other. It is important to dispelstereotypical views about whatconstitutes a tax haven. That view mayrelate to some tropical island paradisewith poor banking practices that allowsmoney laundering and related criminalbehaviour. To be sure, such places doexist, but they are not usually tax

havens. Switzerland the worlds mostfamous tax haven has none of thosefeatures. Dhammika Dharmapala and

James Hines (2009: 1058) haveinvestigated the features of tax havensand report that they are usually well-runeconomies.

Some of the characteristics of taxhavens are well documented in theliterature: tax havens are smallcountries, commonly below one millionin population, and are generally moreaffluent than other countries. What hasnot been previously noted in theliterature, but is apparent in the data, isthat tax havens score very well on cross country indices of governance qualitythat include measures of voice andaccountability, political stability,government effectiveness, rule of law,and the control of corruption. Indeed,

there are almost no poorly governedtax havens.

This is an important finding it is notjust low rates of corporate income taxthat are important in establishing a taxhaven. These economies must also bewell governed, so as to reduce the risksof expropriation of property.

On the flip-side, what sort ofmultinational corporations establishtheir operations in tax havens? MihirDesai, Fritz Foley and James Hines Jr.(2006) consider the location andinvestment decisions of a sample of USmultinational firms over the period 1982 1999. They report (2006: 529):

Large firms with high shares ofinternational activity are the most likelyto have haven affiliates, and firms inindustries characterized by high R&Dintensities and significant volumes ofintrafirm trade similarly exhibit thegreatest demand for tax havenoperations.

This latter result is consistent with thestateless income doctrine in that large

multinational corporations with intrafirmtrade are likely to be located in taxhavens. The two results set out here,however, are also consistent with thecritique set out in the previous section.R&D-intensive firms are very likely tohave operations in well-governedeconomies that also have low rates ofcorporate income tax. Kleinbard eitherignores or undervalues this aspect ofmultinational corporation behaviour.

Desai et al. (2006b) also report that taxhaven activity increases economicactivity in nearby non-tax haveneconomies. Owing to the higherafter-tax returns that multinationalcorporations are able to enjoy as aconsequence of tax havens, they are

able to maintain higher levels of foreigninvestment than they otherwise wouldhave been able to maintain. In otherwords, far from having a negativeimpact on their neighbours, tax havenshave a positive impact on economicactivity. In particular, a one per centgreater likelihood of establishing a taxhaven affiliate is associated with 0.5% to0.7% greater sales and investmentgrowth outside of tax havens within thesame region (Desai et al. 2006b: 223). Inother words, the use of tax havens bymultinational corporations allowshigh-tax regimes to attract foreigninvestment that might otherwise notoccur. This increases the economicwelfare in those economies while alsoproviding investors with greater returnsthan they would otherwise have earned.

Desai et al. (2009) also investigate theimpact of US multinational corporationsoffshore behaviour within the US. Theyreport that those multinationalcorporations that expand their offshoreactivities also tend to expand their

onshore activities. Foreign investment iscomplementary to domestic investmentand not a substitute.

6. Tax havens and multinational corporations


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Dhammika Dharmapala and NadineRiedel (2013) investigate the amount ofprofit shifting that actually occurs using5400 European multinational affiliatesover the period 19952005. In the firstinstance they report that profit shiftingdoes occur. The magnitude of the profitbeing shifted, however, is only 2% ofparent corporation profits. While theyindicate that this amount is substantialit is lower than many other (indirect)estimates of the amount being shifted.This result is consistent with estimatesin the literature of the gains to be madefrom tax harmonisation.

There is a small academic literature thatattempts to provide internationalevidence of the relative costs and

benefits of tax competition andcoordination. Ian Parry (2003) hasestimated that the welfare costs fromtax externalities are generally less that5% of capital tax revenue. Hisconclusion is that his results cast somedoubt on the economic case forharmonizing capital taxes across a blocof regions such as the Economic Union.Peter Srensen (2004) presents a farmore comprehensive analysis of taxcompetition and coordination. He hasdeveloped a plausible and realisticgeneral equilibrium model providing asynthesis of existing and has thenestimated (by calibration) themagnitude of gains from coordination.Using an egalitarian welfare function, hehas evaluated welfare under thealternative tax regimes. The best-casescenario is shown in Table 6.1.

In the model, tax competition had noimpact on labour income taxes.Furthermore, the largest impact of taxcompetition was not under-provision ofpublic goods, but rather too littleincome and wealth redistribution. Inparticular, relative to full-blown taxcompetition, tax coordination wouldlead to higher taxes on capital, andhigher redistribution; but lowerinfrastructure spending, lower capitalstocks, lower profits, lower real wages,lower GDP, and higher real interestrates. All these changes would result isan increase in social welfare of less than1% of GDP, but only if taxpayers haveegalitarian objectives. What happens inthe model is that GDP falls butinequality falls by a greater amount withthe net effect being an increase in themedian voters level of satisfaction. It isnot clear that taxpayers would have

egalitarian welfare functions as isassumed in the model. In short, thisassumption supposes that taxpayerswould be happier because they wouldall be equally poorer.

Enrique Mendoza and Linda Tesar(2005) provide evidence that taxcompetition can lead to welfareimprovements. They examine taxcompetition in a two-country dynamic,neo-classical general equilibrium modelwith perfect international capitalmobility. Using data from Europeaneconomies they then calibrate themodel and examine the consequencesof tax competition and harmonisation.The results are quite stark; the gainsfrom coordination are very low evenwhen tax competition does cause arace to the bottom. They (2005: 202)explain their results as follows:

Table 6.1: Best-case scenario of tax competition and coordination.

Competition Coordination

Policy variables

Capital tax rates 12.7 42.3

Labour tax rates 44.4 44.4Transfers 100.0 177.0

Infrastructure spending 100.0 95.0

Other variables

Capital stock 100.0 88.0

Employment 100.0 99.0

Profits 100.0 95.0

GDP 100.0 95.0

Average real wage rate 100.0 96.0

Real interest rate 100.0 109.0

Welfare gain %GDP 0.94

Source: Adapted from Peter Srensen, 2004, Table 1.


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In the case in which the fiscal solvencyexternality triggers adjustments inconsumption taxes, Nash competitionin capital income taxes produces astaggering race to the bottom incapital tax rates. However, contrary tothe conventional wisdom that thisreduction in capital taxes is harmful tosociety, we find that European countriescould make welfare gains of about 0.7per cent in lifetime consumptioncompared to the pre-tax competitionequilibrium. The race to the bottom isharmful in the formal sense that thecooperative equilibrium dominates theNash outcome, but we find thatquantitatively in this game of capital for consumption taxes the gains fromtax coordination are negligible at less

than 0.04 per cent.

They conclude that the structure ofEuropean taxation already reflects theoutcome of a competitive process andany gains from coordination are likely tobe very small.

This literature is important tounderstanding Kleinbards statelessincome doctrine, as Kleinbard hasadvocated tax harmonisation with aglobal corporate income tax rate of 25%(Carswell 2013). The primary difficultywith Kleinbards position is illustrated inTable 6.1. All the economic indicatorsare more favourable under taxcompetition than under taxharmonisation.


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The notion that corporate income tax isunsustainable has been debated forsome time. Indeed, some argue that thesurvival of such tax is something of apuzzle. It is certainly true that capital ishighly mobile and tax competitionamong states often quite fierce.Corporate income tax rates havereduced quite substantially over time yet corporate income tax revenue has not.

Figure 7.1 shows the 30-year history ofcorporate income tax revenue as apercentage of GDP for OECDeconomies and the (weighted) averageof OECD corporate income tax rates.The average OECD corporate incometax rate has declined from a high of50.5% in 1983 to 29.6% in 2010. By

contrast, the revenue to GDP that hasbeen collected from the corporateincome tax has increased from 7.6% in1981 to 8.6% in 2010. Corporate incometax revenue reached an all-time high in2007 of 10.6%.

Looking at Figure 7.1 it is somewhatdifficult to accept the argument thatcorporate income tax is unsustainable.Clearly, high corporate income tax ratesare not, but the corporate income taxitself does raise a significant amount ofrevenue and continues to do so evensince the 2008 financial crisis.

7. Is the corporate tax base being eroded?

Figure 7.1: OECD corporate tax revenue and corporate tax rate

Source: OECD (2013) and Jane Gravelle (2012: Table A-1).

60

50

40

30

20

10

0

OECD corporate income taxrevenue as a percentage of GDP

Average OECD corporate tax rate

%

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The key to understanding what ishappening is that as corporate incometax rates have declined, so thecorporate income tax base hasincreased. What the stateless incomedoctrine suggests is that the tax base isnow being eroded. That proposition,however, is an empirical question.

Peter Srensen (2007: 1778) hasprovided a test where the ratio ofcorporate income tax revenue to GDP isdecomposed into its component parts:

Where R = corporate tax revenue, Y isGDP, C is total corporate profit and P istotal profit earned in the economy. R/Cis a proxy for the average effectivecorporate income tax rate, C/P is the

share of corporate profits and P/Y is theprofit share of the economy. Thisdecomposition allows us to determinewhether any changes in the corporate

tax revenue to GDP ratio are due tochanges in the effective corporate taxrate or in the corporate tax base(defined as the interaction of the shareof corporate profits and the profit shareof the economy).

Following Srensen, Figure 7.1 capturesthe data for this decomposition fromthe OECD and employs corporateoperating surplus as a proxy for totalcorporate profit and total operatingsurplus as a proxy for total profit.Srensen provides the decompositionfor several OECD economies over theperiod 19812003. The analysis belowreplicates the decomposition for theperiod 20002010 for the UK and theUS. The governments in these two

countries have been particularly criticalof multinational corporations and thecorporate income tax that they pay.

The data does not support the view thatthe corporate income tax base in eitherof these two economies is beingeroded. It is the case that the averageeffective corporate income tax rateappears somewhat volatile but thatcan the attributed to the 2008 financialcrisis, regular business cycle effects,accumulated tax losses and the like.The stateless income doctrine does notpredict declines in the corporateincome tax rate; it predicts erosion ofthe tax base. Tax competition betweennations leads to a reduction in thecorporate income tax rate. Statelessincome should lead to the erosion ofthe corporate income tax base thedata for the UK and the US does notsupport that doctrine.

Figure 7.1: Corporate tax decomposition for the UK and the US

Source: OECD 2013.

70

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30

20

10

0R/Y

R/C

P/Y

C/P

%

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The corporate income tax system is notbroken. It is true that somemultinational corporations do not payas much tax in their host economies astheir consumers and voters in thoseeconomies might expect. Yet this doesnot necessarily imply any wrongdoingon the part of those corporations. AsKleinbard makes clear, multinationalcorporations are fully compliant withthe law of the land in those economieswhere they operate and the governmentsof those economies have been unwillingto change the international income taxnorms and tax architecture.

It is in this environment that fiscalillusion can be deployed to increase thetax burden on corporations. Yet there is

no evidence to support the view thatthe revenue already collected bycorporate income tax has declined inrecent decades. There is no evidence tosupport the view that the corporateincome tax base has been eroded inrecent years. There is no evidence tosupport the view that a decline incorporate tax revenue has contributedto current budget deficits. If anything itis clear that expenditure decisions, notdecreased revenue, has contributed tothese deficits.

Nonetheless, the stateless incomedoctrine may be used as a catalyst forre-writing the corporate income taxsystem. In the same way that an old taxis a good tax, so an old tax system islikely to be a good tax system. If onewere to accept Kleinbards argument atface value, then governments wouldneed to modify substantially howcorporate income tax works and variousnorms underpinning internationaldouble taxation agreements in order toredefine stateless income as being

sourced in either the UK or the US (orindeed in any other economy).

The question that needs to beanswered is this: What would be theconsequences of expanding thedefinition of source for corporateincome tax purposes? At presentstateless income is not stateless at all,it is simply not UK- or US-sourceincome. Stateless income is not someform of economic rent, as Kleinbardwould have us believe. Rent can betaxed with impunity. To the extent thatstateless income is really a return on thedevelopment and ownership ofintellectual property, then increasingtaxation will have allocative efficiencyconsequences. At the same time itwould also adversely affect the Irish andDutch tax bases.

It is known, however, that multinationalcorporations add value to both theirhome economies and their hosteconomies. Tax havens add value byallowing multinationals to reduce theirtax liabilities while increasing theirinvestments in high-tax economies. Anincrease in their tax burdens wouldreduce those levels of investment,leading to reduced employmentopportunities, reduced consumptionand reduced innovation.

It is not clear that tampering with thetried and tested norms of corporateincome tax to (possibly) generate morecorporate income tax revenue whilereducing the corporate income taxcollected in foreign economies, andpossibly reducing investment at home,employment at home and consumptionat home, is good policy.

8. Conclusion


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Australian Treasury (2013), Implicationsof the Modern Global Economy for theTaxation of Multinational Enterprises[Issues Paper] , accessed 14 December 2013.

Bassanese, D. (2013), GapingLegislative Loopholes Mean HugeLosses in Tax Revenue, The AustralianFinancial Review, 20 June , accessed14 December 2013.

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Value, The Review of Economics andStatistics, 91 (3): 53746.

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Dharmapala, D. and Riedel, N. (2013),Earnings Shocks and Tax-motivatedIncome-shifting: Evidence fromEuropean Multinationals, Journal ofPublic Economics, 97: 95107.

Gravelle, Jane. (2012), InternationalCorporate Tax Rate Comparisons andPolicy Implications, CongressionalResearch Service , accessed 14December 2013.

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Kleinbard, E. (2011b), The Lessons ofStateless Income, Tax Law Review, 65:9171.

Leonhardt, D. (2013), Who Will Crack theCode?, The New York Times, 25 May.

Mendoza, E. and Tesar, L. (2005), WhyHasnt Tax Competition Triggered aRace to the Bottom? Some QuantitativeLessons from the EU, Journal ofMonetary Economics, 52: 163204.

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Parry, I. (2003), How Large are theWelfare Costs of Tax Competition?,Journal of Urban Economics, 54: 3960.

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Srensen, P. (2007), Can Capital IncomeTaxes Survive? And Should They?,CESifo Economic Studies, 53 (2):172228.

Teather, R. (2005), The Benefits of TaxCompetition (London: The Institute ofEconomic Affairs).

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References


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