Tax liabilities: Impacts of the trend towards lower corporate tax rates on developed and developing economies

Recent decades have seen a downward convergence in corporate tax regimes as advanced, emerging and developing economies moved to grab a bigger slice of the global investment pie. Headline corporate tax rates have fallen by 20 percentage points since the early 1980s. Alongside lower average rates, special tax incentives aimed at capturing investment have emerged, further reducing the effective rates paid by transnational corporations.

In the aftermath of the 2007-08 global financial crisis, many countries were compelled to slash spending and raise revenue in order to rein in precipitous budget deficits. Even as tax revenues as a share of GDP in many economies have reached their highest levels in decades, the trend towards lower corporate tax rates has remained largely intact.

In the face of post-crisis austerity, however, public tolerance of corporate tax avoidance has dissipated, giving rise to political momentum behind increasing transparency and limiting the scope for businesses to minimise their tax bills. The OECD has led the charge in this respect, in close cooperation with the G20 as well as partner countries and emerging markets, through the coordination of efforts to reduce base erosion and profit shifting (BEPS). Parallel efforts have been undertaken by the EU, which also continues to work towards a common consolidated corporate tax base that would have profound implications for corporate tax regimes in the region, if implemented.

DEVELOPED MARKETS: Average corporate income tax rates in advanced economies fell to 22% in 2015, down almost half from the rate in the early 1980s. In the OECD’s latest comprehensive take of changes in tax policies among its 35 members with mainly advanced economies, “Tax Policy Reforms in 2017”, the organisation pointed to a recent intensification of competition on corporate tax rates, coming after a period of relative stabilisation in the years immediately after the crisis. For example, 12 countries introduced or announced reductions in headline corporate tax rates during the 2016-17 period, with only Chile and Slovenia hiking rates. While many countries phased in these tax changes gradually, the single most dramatic change during this period was the reduction in Hungary’s corporate tax rate from 19% to 9%, effective January 2017. The OECD also highlighted rising global tax competition through new or enhanced tax incentives, with an emphasis on research and development (R&D), and intellectual property-related activities.

Despite periodic discussion around tax reform in the US, it had resisted jumping on the corporate tax-cutting bandwagon until late 2017. With a headline marginal corporate tax rate as high as 39.1% – one of the highest in the world, and more than 10 percentage points higher than the average in advanced economies – the US would appear to have been something of an outlier. When campaigning for office, US President Donald Trump called for corporate tax rates to be slashed to as low as 15%. In December 2017 the US Congress enacted a sweeping tax reform package, with the reduction in the corporate tax rate to 21% the standout feature. Additionally, a lower 15.5% amnesty rate is to be applied to historical profits, in a measure aimed at encouraging the repatriation of such funds to the US. Another key change for the US was the move towards a territorial-based corporate tax regime, which aligned the country with most other corporate tax regimes around the world. This means that US taxes will no longer be levied on the global profits of a US multinational, but only on that portion generated in the US itself. However, this move could end up encouraging offshoring.

EMERGING MARKETS: The downward convergence in corporate tax rates, and reduction in corporate tax bases, is far from being confined to the most advanced economies. In addition to Hungary, the OECD also highlighted corporate tax rate reductions recently implemented or announced in other emerging markets in Europe and MENA, notably Slovakia and Israel. The Czech Republic and Slovenia have also cut rates since 2008. Turkey, with the introduction of its so-called super tax incentive model, alongside specific incentives for R&D investment, was one of the main EMEA movers in 2016, while Hungary, Poland – and, outside the region, Mexico – signalled intentions to improve their tax incentive offerings in 2017 or subsequent years.

The knock-on impact of corporate tax reform in developed countries on emerging economies is exemplified by the pressure likely to be brought to bear on Mexico to enhance its tax offering to multinationals in light of the recent reforms in the US. Elsewhere in the region, President Mauricio Macri’s government in Argentina introduced a tax reform that would bring the corporate tax down from 35% to 25% in October 2017. According to Dante Sica, CEO of ABECEB, a regional economic consultancy, the move is in the country’s interest. “The reform is geared more towards redistributing the burden of tax than drastically reducing it, in order to prop up investment and job creation,” he told OBG.

This is not a new phenomenon. IMF research has identified evidence of a “partial race to the bottom” in corporate tax regimes in 50 emerging and developing economies in the decade running up to the global financial crisis, as countries have been under pressure to reduce tax rates in order to attract investment. While the IMF found that headline tax rate reductions in emerging and developing economies were on a par with those seen in advanced countries over the same period, tax competition served to reduce the tax base even where the headline corporate tax rate was unchanged. Evidence of a race to the bottom in such special regimes, whereby parallel tax systems are essentially established, was found to be particularly strong in African countries, where effective corporate tax rates had essentially fallen to zero in many instances. Large declines in effective corporate tax rates were also found to have taken place in Egypt, Ghana, Kenya and Morocco in the decade before the global financial crisis. As part of the same research, the IMF’s quantitative analysis demonstrated that higher tax rates adversely affect both domestic and foreign investment.

TRICKLE DOWN: Long-term trends towards lighter taxation of corporate profits in advanced and emerging economies have had a knock-on impact on developing and least developed countries. In some cases profits on activities carried out in developing countries are diverted to friendlier corporate tax regimes in advanced economies. According to Oxfam, for example, corporate tax avoidance schemes give rise to $100bn in lost tax revenues for developing countries. There are also situations where developing countries may lose out on even greater revenues by following suit and introducing their own corporate tax avoidance schemes or incentive regimes. Action Aid, a South Africa-based NGO has estimated that annual tax revenue lost by developing countries as a result of tax incentives offered to large businesses amounts to $138bn.

IMPLICATIONS: One of the most important implications of downward corporate tax convergence is the reinforcement of inequality, both within and between countries. When investment is diverted from emerging and developing markets, where returns should be higher, to advanced economies purely for tax reasons, the result is likely to be relatively slower cross-country convergence in living standards.

In advanced, emerging and developing economies alike, reduced taxation on corporate profits means, on the one hand, that wealth remains more concentrated in the hands of shareholders; while on the other hand, a combination of increases in other taxes or reduced spending is necessary to maintain healthy public finances. In sub-Saharan Africa, for example, countries rely on indirect taxes for around two-thirds of their tax revenues compared to less than one-third in advanced economies. At the same time, overall tax revenues in less developed economies are generally much lower than in advanced economies, meaning that there are less resources available for either public investment or social spending – both of which tend to benefit those on the lowest incomes and improve an economy’s productive capacity for the future.

As the IMF concluded in July 2017, “The trouble is that by competing with one another and eroding each other’s revenues, countries end up having to rely on other — typically more distortive — sources of financing or reduce much-needed public spending, or both. This has serious implications for developing countries because they are especially reliant on the corporate income tax for revenues.” The IMF also notes that while efforts such as the OECD-G20 BEPS initiative may reduce tax avoidance, such measures could lead to more intense tax competition in other realms.

Even the economic rationale for reduced corporate taxation rings hollow. In theory, relatively lower taxes on corporate profits across the board should encourage productive investment. However, in the decade since the global financial crisis there has seen a slowdown in investment. Rather than reinvesting earnings to further expand their businesses, large corporates the world over have, in aggregate, been either hoarding cash or returning it to shareholders in the form of dividends or share buy-backs at historically high rates.

The big potential game-changer in global corporate tax regimes early 2018 remains the tax reform under way in the US. While downward convergence in corporate tax rates had slowed in the aftermath of the global financial crisis, such a significant reduction in the world’s largest economy would seem to confirm recent trends. A large number of countries have already announced, or begun, phased multi-year rate reductions, with those moving in the opposite direction now very much the outliers. The medium-term outlook for corporate tax rates is therefore clear: globally coordinated efforts to improve transparency and curb the aggressiveness of legal tax avoidance schemes are changing the tax landscape somewhat, but do not appear to have slowed the emergence of new or redesigned incentives in advanced, emerging or developing economies. Going forward, this appears to be the more intense arena for tax competition among countries, albeit, perhaps, now with clearer rules of the game.