Jun 26, 2019

A Better Way for Countries to Tax Corporations

The Editors, Bloomberg News

BATH, ENGLAND - OCTOBER 13: In this photo illustration, the new £10 note is seen alongside euro notes and US dollar bills on October 13, 2017 in Bath, England. Currency experts have warned that as the uncertainty surrounding Brexit continues, the value of the British pound, which has remained depressed against the US dollar and the euro since the UK voted to leave in the EU referendum, is likely to fluctuate. (Photo Illustration by Matt Cardy/Getty Images) , Photographer: Matt Cardy/Getty Images Europe

(Bloomberg Opinion) -- At this week’s G-20 summit in Japan, all eyes will be on trade talks between U.S. President Donald Trump and Chinese President Xi Jinping. Behind the scenes, though, world leaders will have an opportunity to make progress on an issue with potentially broader and longer-lasting repercussions: how to revamp an outdated system of international corporate taxation.

For the past century, countries have taxed companies based on their location. But in an increasingly digital world, where assets tend to be more intellectual than physical, this approach makes evasion easy and often fails to levy taxes where business is actually getting done. A technology company that sells its services entirely in one country can, for example, shift profits to a lower-tax country by keeping its valuable patents or algorithms there. According to one estimate, almost 40% of multinational profits are shifted to tax havens globally each year.

Economists have long advocated a better way: Tax companies based on where they sell. Avoidance would be much more difficult, because it’s harder to play location games with customers (or metrics associated with customers) than with intangible assets. Governments would no longer have an incentive to erode their tax bases by luring companies with special preferences. And tax revenues would go to those countries whose people are actually doing the consuming.

The hard part is moving from one system to the other. The change amounts to a vast redistribution of income, from countries where goods and services are produced — or where productive assets are technically domiciled — to countries where they are sold. Also, major economies must adopt the new approach together and in a coordinated manner, lest companies find themselves grappling with a chaotic world of conflicting regimes and double taxation.

France has demonstrated how not to proceed. The country has moved to impose a tax on large digital companies of 3% of their advertising revenues, among other metrics. This would serve only to penalize a specific industry — effectively just American tech giants — while failing to further the larger goal of creating a fair and efficient international system.

This week in Japan, officials will debate more comprehensive plans that the Organization for Economic Cooperation and Development has been considering. The most promising proposal is a sort of hybrid: Instead of moving completely to a new system, it would potentially apply only to a portion of corporate profits. Known as “super-normal returns,” this is the share of profits over and above the typical return in an industry — a concept that countries already use to curb the shifting of income to lower-tax jurisdictions. Governments would then use a common formula, involving data such as marketing spending, to figure out which of them should have the power to tax those excess profits.

Though more complicated than a pure destination-based system, this “distribution-based” plan has advantages. A gradual approach is more likely to gain the buy-in the OECD is seeking from as many as 129 countries, giving them time to better understand how a new regime will affect revenues and what the unintended consequences might be. Its focus on excess profits makes sense, because this is precisely the type of income that efforts to game the current system tend to generate. The proposal also leaves much taxing power to the home countries that, after all, still provide the legal, technological and physical infrastructure needed to create goods and services. And, unlike another proposal in the mix, it mitigates the complexity by requiring all governments to use a consistent method to allocate the tax.

Granted, there’s still plenty of work to do in thinking through the costs and the effects on investment and business activity. Ultimately, though, the world must move to a better system, and the OECD is offering a step in the right direction. It’s aiming to unveil a final plan next year. The G-20 leaders should do what’s in their power to ensure this crucial effort at international cooperation succeeds.

—Editors: Alexis Leondis, Mark Whitehouse.

To contact the senior editor responsible for Bloomberg Opinion’s editorials: David Shipley at davidshipley@bloomberg.net, .

Editorials are written by the Bloomberg Opinion editorial board.