Profit shifting by multinational enterprises across jurisdictions is driven by tax rate differentials. The U.S. reduced profit shifting from the U.S. by reducing its 35% federal corporate income tax (CIT) rate to 21%, and other 2017 tax changes. However, while the global average CIT rate has been declining, tax rate differentials across countries have been increasing (see blog April 3, 2017).
One important effect of proposals to address the tax challenges from digitalisation of the global economy currently being considered by the Organization for Economic Cooperation and Development (OECD) is the potential reduction in cross-border tax rate differentials. Both the potential Pillar 1 nexus and reallocation rules and the Pillar 2 global minimum tax proposals reduce tax rate differentials, and thus would reduce profit shifting. The extent to which they reduce BEPS and the associated revenue losses from BEPS will depend on their design. This note examines the extent to which tax rate differentials are reduced by a 10% global minimum tax.
Based on reporting by 94 jurisdictions in the OECD Corporate Tax Statistics Database (35 OECD countries and 49 non-OECD countries ranging from small tax havens to China and India), tax rate differentials can be calculated with 2018 tax rates and with a global minimum tax.
Bottom-line: a global minimum tax on a jurisdiction-basis would reduce general CIT rate differentials by 9% and would reduce preferential CIT rate differentials by 20%. Since intangible income is more likely to be subject to profit shifting and subject to preferential rates, the overall effect of a global minimum tax at 10% could be as much as 15% (roughly the average of the general and preferential rate differences).
In addition, recent research by JCT economists (Dowd, Landefeld and Moore, 2017) finds that profit shifting is greater when tax rate differentials are large. A global minimum tax reduces the average tax rate differentials with zero rate havens from 23.5% to 13.9%, a 41% reduction. Thus, the reduction in profit shifting from a global minimum tax is likely to have a greater positive effect than a uniform reduction in tax rate differentials.
Background on the calculations
The 2018 corporate tax rates come from the OECD’s Corporate Tax Statistics Database; the GDP and inbound foreign direct investment (FDI) statistics from the IMF’s World Development Indicators; and the summary of preferential tax regimes from the OECD’s Centre for Tax Policy and Administration. The table below shows the descriptive statistics:
Simple average CIT rates suggest non-OECD countries have lower average rates than OECD countries, but that is because tax havens, such as the Cayman Islands, are given the same weight as China and India. When using GDP-weighted averages, the non-OECD countries have similar average rates as OECD countries, but the variation in general tax rates across countries as shown by the standard deviation is significantly higher for non-OECD countries.
Average tax rate differentials across the 94 countries are calculated using a 94x94 matrix, calculating the tax rate differential for each country with the other 93 countries. Tax rate differentials are weighted by the amount of inbound FDI in each country. Tax rate differentials are calculated where the home country’s tax rate is higher than the tax rates of countries receiving inbound FDI.
As shown in the graph above, the average general tax rate differential for the 94 countries is 6.1% in 2018, but would decline to 5.4% with a 10% minimum tax on a per country basis. The average preferential tax rate differential is 6.0% in 2018, but would decline to 4.8% with a 10% minimum tax. Assuming profit shifting is half from general rate differentials and half from preferential rate differentials, the overall decline in profit shifting would be roughly 15% with a global 10% minimum tax.
This reduction would increase tax bases of low, middle and high-income countries that have rates above 10%. Countries with general CIT rates below 10% account for less than 2% of global GDP and 7% of inbound FDI. Countries with preferential tax rates below 10% account for 4.5% of global GDP and almost 20% of inbound FDI.
Pillar 2 proposals would have a static revenue gain from a global minimum tax, but also a revenue gain from reduced profit shifting due to smaller tax rate differentials. Similarly, Pillar 1 proposals for revised profit allocation rules would reduce tax rate differentials between tax havens and other countries, resulting in less profit shifting and increased tax revenues, beyond the reallocation of taxable income.
Smaller cross-border tax rate differentials also reduce tax-induced economic distortions across a number of different economic margins. Future analyses of the economic and revenue effects from specific proposals arising out of the OECD tax digitalisation initiative will be helpful to policymakers in designing a new consensus-based international tax system for the 21st century.