Who Wants to Win a Race to the Bottom?

15. 3. 2017

It is high time that politicians and their advisers take a more critical look at the role of “tax competition” in development processes. For decades it has been assumed that competition is universally a force for positive change, but “tax competition” has no meaningful relationship to the microeconomic competition between firms operating in a market place.

In August 2016, following a three year investigation, the European Commission (EC) determined that two tax rulings issued by the Irish tax administration relating to the tax treatment of Apple Corp’s profits booked in that country represent illegal state aid under EU law. As a consequence, Apple is now required to pay up to €13 billion of outstanding taxes plus interest. This sum is due to the Irish exchequer and to other countries in Europe, Africa, the Middle East, India, and even including the United States, which could potentially stake a claim on these profits. The secretive rulings identified by the EC as illegal state aid destroy fair market competition, and also undermine the tax sovereignty of democratic states

The EC’s ruling is remarkable in a number of ways, not least the sheer scale of the repayment order, which, despite protests from both Apple and the US Treasury, appears broadly in line with estimated revenue losses suffered by countries like Germany and the UK, and represents only a fraction of the estimated €190 billion that Apple currently holds offshore beyond the reach of any tax authority. Crucially, the EC decision highlights that Ireland is not the only country losing tax revenue from Apple’s ability to shift profits via Irish-based structures; other countries in Europe and beyond are losing significant revenues as a result of this corporate tax trickery. Even the mighty USA loses out; as US Treasury Secretary Jack Lew commented in an op-ed for the Wall Street Journal: “Our current tax code is riddled with loopholes that allow corporations to artificially lower their tax bills by shifting income from higher-tax countries to low- or no-tax jurisdictions.”

While most governments would probably jump at the chance to collect an extra €13bn in revenue, the Irish government has responded by appealing against the EC ruling, with Taoiseach Enda Kelly vowing that any funds collected from Apple will be held on escrow account pending the outcome of the appeal. The root of this extraordinary reticence about collecting taxes due on profits lies with Ireland’s leading role as a tax haven for corporate profits; for decades Ireland has—alongside other major corporate tax havens like Bermuda, Luxembourg, Netherlands, Singapore, and Switzerland—provided the means for multinational companies from the USA and elsewhere to shift profits generated in other European countries via Irish-based subsidiary companies to other subsidiaries based in ultra-low or no tax jurisdictions. In this respect the 12.5 percent corporate income tax rate in Ireland is largely irrelevant since the profits are merely being shifted via Ireland to shell companies in other tax havens: the effective tax rate on profits being booked in Ireland is typically low single figures.

For decades successive Irish governments have placed the so-called “tax competition” at the heart of their development strategy. Low corporate taxes, they argue, are vital to attracting inwards investment and helped make the Celtic Tiger the poster child for the global race to the bottom on corporate taxes. But does the evidence from the Celtic Tiger years support the claims made in favor of so-called “tax competition”? There is no question that the Irish economy boomed throughout the period from the mid-1990s to the point of collapse in 2008, but was the tax regime the core driver of this growth or were other factors at play? Chart 1 below tracks Ireland’s economic performance from the mid-50s onwards.

In 1956 the government took the first of several steps towards making Ireland a corporate tax haven, but the impact was negligible. Even the adoption of a 10 percent corporate income tax rate in 1980 did little to spur growth, and despite large infusions of European subsidies to support agriculture, infrastructure development, and social development, Ireland’s economic performance was underwhelming; right through to the mid-1990s Ireland continued to underperform relative to its European neighbors. The key to the sudden economic boom from the mid-90s lies with Ireland’s accession in 1993 to the European Single Market. This was the trigger that led to so many American companies choosing Ireland as their entry point to the buoyant markets in Europe, and even the CIT rate increase to 12.5 percent in 2003 (at the insistence of the European Union) did little to dampen investor enthusiasm.

Ireland’s key attractions to US investors included its English language speaking business community, its longstanding cultural and economic ties, the relatively low-cost labor force, and its membership of the European Union and the Single Market. This is not to discount the tax offering, which was clearly attractive to many multinational companies wanting access to Europe’s markets, but it does call into question the claims made about “tax competition” as the basis for a sustainable development strategy, since—as the EC ruling makes clear—the losses not only accrue to the Irish exchequer but also to other countries in Europe and beyond. Even if we ignore the harmful impacts on other countries: if Ireland can only attract investors by showering them with subsidies and secret tax treatments, while potentially losing tax revenues from investments that would have been made regardless, the overall cost was arguably far too high.

It is high time that politicians and their advisers take a more critical look at the role of “tax competition” in development processes. For decades it has been assumed that competition is universally a force for positive change, but “tax competition” has no meaningful relationship to the microeconomic competition between firms operating in a market place. The term “tax competition” is a complete misnomer, typically used in an obfuscatory way to suggest that the underlying process is benign for all players, which it is not. A more accurate term is “tax wars,” which captures the sense that this is an unproductive and ideologically driven race to the bottom between nation states vying to lure the world’s most mobile forms of capital. Politicians, journalists, and even economists who routinely use the term “tax competition” in an uncritical sense reveal a profound failure to comprehend the politic economic processes at work.

At operational level, “tax competition” is the process where countries offer fiscal incentives to attract or retain investment or capital, triggering other countries to engage in the race. The incentives may involve lowering tax rates, special tax treatments, tax holidays, export processing zones, even outright subsidies. In many cases these treatments are applied selectively, creating an uneven playing field within markets, typically to the disadvantage of domestically located small and medium enterprises. These market distortions lie at the heart of the EC’s ruling on Apple, since the benefits of these special treatments largely accrue to big and powerfully connected businesses which are consequently able to outcompete their rivals and freeride on publicly-funded services. Ironically, as economist Mariana Mazzucato points out, Apple was itself a major beneficiary of the huge state-led investment in the revolutionary technologies that underpinned the iPhone and iPad, including the internet, GPS, touchscreen displays, and an array of communication technologies.

At the theoretical level, the arguments date back to an academic paper by economist Charles Tiebout, who equated competition between nation states with market competition between firms. The comparison is, of course, nonsensical, since the majority of citizens are unable to migrate freely across borders to pick and choose between differing mixes of taxes and state expenditure. Moreover, the nonsense is a dangerous one: whereas a failing company is likely to be replaced by the forces of creative destruction within a dynamic capitalist economy, a country that cannot compete on tax will be unable to deliver security or public services to its citizens, and may ultimately succumb to being a failed state.

“Tax competition” is most acute when countries vie to attract mobile portfolio capital. The goal is to gain taxing rights over this capital, which does not necessarily require genuine underlying economic activities to be located within the taxing jurisdiction. For obvious reasons, “tax competition” is not targeted at less mobile factors of production like land and labor, with the outcome being that while nominal and effective tax rates on capital have fallen significantly in most countries over the past three decades, tax rates on labor and consumption have risen to compensate, which has contributed to lower rates of job creation and rising wealth and income inequality.

Corporate tax cuts subsidize business at the expense of costs elsewhere in the economy; either higher taxes for others, or increased debt, or cutbacks to public services, none of which contribute to making a country more competitive. Indeed the evidence from the past decade, in the UK for example, suggests that cutting CIT rates does not stimulate investment but merely encourages companies to hold large uninvested cash reserves on their balance sheets. Taxing those reserves to invest in infrastructure, public housing, education, and training would probably yield more sustainable jobs and stable societies in the long run.

The EC’s ruling against Apple’s special treatment by the Irish tax authorities is a welcome and long overdue signal that political action is both possible and necessary to counteract the political power of Capital to play one nation off against another in a constant process of securing direct and indirect subsidy. Far from being an inevitable outcome of capital market liberalization, tax competition is a self-harming reaction from politicians fooled by fallacious arguments based on nonsensical assumptions. Instead of joining this mindless race to the bottom, which incidentally can only lead to negative tax rates for big businesses, politicians should focus on attracting productive investment by improving infrastructure, training a more productive workforce, and creating a tax regime that does not favor capital over labor and consumers. After all, the race to the bottom leads us all to a place—the bottom—where no sane person would want to go.

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