The International Crisis of Tax Legitimacy

discussed in more detail in chapter 7 below. The underlying difficulty is still that of finding an effective and legitimate way to divide nationally a profit that has been created by global activities. Although increased international administrative coordination can try to deal with the symptoms of this problem, it is unable to resolve the fundamental cause see Chapter 10.

2. The International Crisis of Tax Legitimacy

The increasing crisis of international business taxation has interacted with a growing crisis of tax legitimacy in the developed capitalist countries since the mid­1970s. Both could be said to be rooted in the recurring difficulty of establishing fairness and efficiency in the taxation of income derived from different revenue flows. 1 At the same time, underdeveloped countries have also suffered from chronic fiscal problems, due in no small part to the facilities provided by the international financial system for both foreign investors and part of the local bourgeoisie to ensure their minimal exposure to taxation. The facilities for sheltering wealth developed by the offshore tax havens and financial centres are an important factor in the capital flight which is a major contributor to the debt crisis of the underdeveloped countries Lessard and Williamson 1987. Individual income taxes account for a significantly lower proportion both of GDP and of tax revenue in underdeveloped compared to developed countries; and although revenue from corporate taxation by contrast is often proportionately much higher, this is mainly the case in countries where a few prominent companies are engaged in important oil or minerals exports Tanzi, in Newbery and Stern 1987, pp.224­6. Finally, the increased market­orientation of previously centrally­planned economies has led them to introduce or lay greater stress on income taxation. Here again crucial questions of equity and efficiency are raised, in particular, the relative burden to be placed on individual incomes and corporate profits: a sharp increase in personal taxation would be extremely unpopular, as well as restraining consumer demand, while it is feared that nascent entrepeneurship could be fettered by excessive taxation of business income Newcity 1990. 2.a The Movement for Tax Reform By the 1970s, in the industrialised countries, the postwar Keynesian compromise began to break down as inflation and other factors made the burden of taxation fall increasingly on personal income taxation of low and middle­income wage­earners. At the same time, business, especially manufacturing and mining industry, made increasingly skilful use of investment incentives and privileges obtained through 1 For a discussion of fairness, efficiency and legitimacy, see chapter 4 below. lobbying, as well as tax planning devices, to minimise its tax payments. In the US in particular, corporate taxes declined as a proportion of federal government receipts from 26.5 in 1950 to only 6.2 in 1983, while individual income taxes increased from 39.9 to 48.1. 1 In most developed countries, the share of revenue from corporate taxation remained relatively stable in the two decades 1965­85, while the burden of increased state spending fell increasingly on personal income taxation and social security contributions OECD 1987B, p.64. This laid the basis for populist campaigns to reduce personal taxation. At the same time, there was concern that corporate tax avoidance, based largely on the use of tax allowances which have a different effect on different companies and industries, was producing inefficiencies in the allocation of investments. These factors undermined the broad acceptance of the fairness of income taxes, which during the twentieth century had become the mainstay of government revenues in developed countries, especially since the second world war when their collection had been facilitated by deduction of personal income tax at source. It seemed increasingly difficult to reconcile vertical equity progressive rates on higher incomes with horizontal equity equal treatment of incomes from different sources. Although there were some calls for corporate taxation to be abolished altogether e.g. Auerbach 1983, there were also attacks on the `corporate freeloaders ¶ directed at the elimination of corporate tax shelters, especially depreciation allowances Citizens for Tax Justice, 1985. This view was not confined to anti­business circles: President Reagans Treasury Secretary, Donald Regan, recounts how he shocked the President into initiating tax reform in 1983 by revealing that General Electric and 57 other big corporations paid less taxes than his own secretary Regan 1988, 194. Major attempts to restore the legitimacy of income taxes were therefore made in a number of capitalist countries, especially the US and the UK. In several of the main capitalist countries, reductions in the top rates of personal and corporate taxes have been combined with the elimination of privileges and exemptions and attempts at more effective enforcement. It is certainly very attractive in principle to combine a broadening and simplification of the tax base, by ending tax privileges and shelters, with a reduction in top rates of tax, while at the same time making a determined attack on avoidance. However, there is little evidence yet to support the views of some right­wing economists that lower tax rates in themselves would produce increased revenues by encouraging entrepreneurship. Rather, the broadening of the tax base has been used to combine reductions of top rates with populist reductions in basic rates of personal tax. Certainly, the British reforms of corporation tax in 1984, involving the abolition of stock relief and reduction in capital allowances, as well as 1 US Congress 1984; note however that state corporate income taxes have grown at a faster rate than other state taxes: Musgrave in McLure 1984, p.229, and Chapter 9 below. measures to tax the retained earnings of Controlled Foreign Corporations in tax havens, contributed to the inflows of revenue which financed the cuts in top rates, and significant cuts in the basic rates of both personal and company tax Devereux 1987. Not only did the reductions in top rates lead to political criticisms of handouts to the rich, they also focussed attention on the regressive nature of other important taxes, such as national insurance contributions, and the ill­fated Poll Tax. At the same time, many argued that the attack on tax shelters was not being vigorously pursued. Although the US Tax Reform Act of 1986 was a comprehensive package, it was criticized as replacing one set of distortions by another. Although the attractions of a radical reform enabled a sharp break away from the trend of annual tax bills handing out benefits to favoured constituencies, the pressures of the political process inevitably meant that reform was bought at the price of a myriad of exclusions and concessions Birnbaum Murray 1987. The Act certainly produced a thicker tax Code and a vast increase of workload for tax consultants. Such reforms have aimed to maintain or restore the contributions of direct taxes to national revenues. At the same time, the increasing pressures on direct taxes on incomes have led both to their supplementation by a wider range of taxes especially turnover taxes and to a reconsideration of the role and basis of income tax. Many economists have advocated a shift to expenditure or consumption rather than income as the tax base. By measuring spending rather than disposable income, it would encourage savings and investment Kaldor 1980, but although an expenditure tax has been tried in India and Sri Lanka it was repealed in both countries; such a change would create significant problems of international coordination if carried out unilaterally Meade 1978. Some economists have also advocated a radical switch to a consumption basis for the corporate income tax, by exempting interest and dividend income and allowing full deduction of all business purchases but not allowing deduction of interest payments as an expense; this might reduce inequity, by bringing the effective tax rate on domestic capital to the rate de facto applied to international investment, but even its advocates accept that a unilateral move in this direction would be impossible Bird 1988, 296. Some governments have attempted to reduce the burden of personal income taxation by increasing indirect taxes, such as turnover taxes or value­added taxes. In some countries, notably France, indirect taxes and social security contributions have historically made a proportionately much greater contribution to national revenues than direct taxes on income. However, while such taxes are efficient to collect and can take some of the pressure off income­tax, they are regressive and can be politically difficult to implement or increase beyond a certain point. Popular resistance created continuing political crises over the attempts to introduce VAT in Japan; the US still has no national sales tax, and there is strong resistance in Britain to further increases in the scope of VAT in line with European norms. Canada followed New Zealand in introducing a broad­based value­added tax on sales from 1991, but although it was praised by tax experts it aroused considerable political opposition. For developing countries, the World Bank has advocated the increased use of user charges to bolster state revenue and investment in infrastructure services IBRD 1988, p.81, but argues that tax reform must consider the interaction of a range of commodity and income taxes ibid. p.86. In general, although consumption­based taxes have been making an important contribution to state revenues, their regressive nature makes it unlikely that they could replace taxes on income. Although these attempts to restore the legitimacy and effectiveness of taxation have been carried out by national governments responding essentially to domestic fiscal and political pressures, they have taken place as part of a world­wide debate. Changes in taxation, especially major changes by the dominant states in the system, inevitably exert a pull on other states, because of the high mobility of capital. They also have significant implications for the international coordination of taxation. Above all, a determined attack on avoidance, if it is to take place, must be internationally coordinated, since the opportunities for international avoidance form such a serious obstacle to effective national tax enforcement. Certainly, the attempts to re­legitimise income taxation in Britain and the USA included new measures aimed at ensuring taxation of a `fair ¶share of the income of global businesses. Although the US Tax Reform Act did not change the basic approach to international taxation, it included many provisions drawing back income into the US tax net. These included: i the `super­royalty ¶ concept, allowing re­valuation of intangibles transferred internationally to reflect the income earned by the transferee see Chapter 8 below; ii the `separate basket ¶modification to the foreign tax credit see Chapter 1 above which, although it did not replace the overall tax credit with a per­country limitation as had been threatened at one point, required increased itemization; iii a new tax on the profits of US branches of foreign corporations see Chapter 5 section 2b below; and iv ending the deductibility of interest on acquisition expenses of dual­resident corporations against the income of related US corporations. These measures entailed unilateral reallocations by the US of global income into the US tax net. This unilateralism involved the overriding of existing treaty obligations, which led to protests by the USAs treaty partners see chapter 11 below. The continued attack by the IRS on tax havens also led to complaints against US unilateralism. Thus, in the absence of adequate international criteria for the allocation of income between states, national attempts to re­establish fairness in income taxation have increased international conflicts. The international coordination of indirect taxes should be simpler, in technical terms at least. The system introduced in France in the mid­1950s of a Value­Added Tax on turnover based on the destination principle provided the basis for the adoption of the VAT as the fiscal base of the EEC Easson 1980. Although the abolition of EC frontier controls and the completion of the internal market was thought to require a switch from the destination to the origin principle, criticisms of the theoretical solution of moving to an origin basis led to arguments for the more practical solution of moving tax borders to account books Cnossen 1983. Administrators have also preferred the view that a common internal market does not require harmonization of consumption taxes but only abolition of border controls, so that the problem is rendered technical instead of political. 1 Certainly, the difficulties of obtaining political approval for the greater degree of harmonization needed to move to the origin principle obliged the Commission to retreat from the blueprint proposed in 1987, and it is being treated, at least in a transitional period up to the end of 1996, as a problem of collection, to be solved by a clearing­house mechanism. However, the result is `a patchwork of provisions ¶Terra and Kajus 1990, p.318 which appear to rely greatly on improved administrative cooperation, and still leave important issues unresolved, notably the criteria for treatment as a single taxable person of undertakings within a linked group ibid. p.319. There are significant parallels with direct taxation, where the difficulties of harmonization have also led to greater reliance on coordination and administrative cooperation. Harmonization, rather than coordination, would require a closer alignment of VAT rates which, although a relatively easy matter technically, has run into greater political opposition, since taxes on spending become deeply rooted in socio­political patterns which are locally and nationally based. 2.b European Community Harmonization The major impetus for a more fundamental attempt at tax harmonization results from the programme for completion of the EC Internal Market by 1992. This has enabled the revival of initiatives by the Commission that had been allowed to become virtually dormant, including those for the coordination and harmonization of direct taxes on business. The Commission had been quite active in the 1960s in making proposals for harmonization of taxes on business and income from capital, but the initiatives flagged in the 1970s Easson 1980; and although a directive was approved in 1977 for mutual assistance in tax matters even this received only lukewarm support in practice from national tax administrators see Chapter 10 below. However, fresh work was begun after 1979, when the Parliament deferred a decision on the 1975 Commission proposal for a system of company taxation based on partial imputation and banded tax rates European Commission 1975, and invited the Commission to 1 Peter Jefferson Smith of the UK Customs and Excise, in Gammie Robinson 1989, p.33. work on harmonization of the business tax base. This renewed activity led to a proposed directive on the carry­over of the losses of undertakings COM 84404; see Andel in Cnossen 1987. The Commission became more ambitious once the target of 1992 was set by the adoption of the White Paper on the Completion of the Internal Market, and the Single European Act accelerated the political processes, although tax matters still require unanimity in the Council of Ministers. 1 Compared to the harmonization of VAT, which was already causing considerable conflict, business tax harmonization would be even more far­reaching; but a strong economic case could be made out for a considerable degree of coordination, if not full harmonization, of corporate taxation Devereux and Pearson 1989, Gammie and Robinson 1989. The Commission produced proposals for the alignment of the rates of corporation or business taxes, as well as draft principles for harmonization of the business tax base circulated and quite widely publicized in 1988. Harmonization of the definition of taxable profits would entail acceptance that member states could no longer provide for investment incentives via the tax base ­ although grants and credits could be given by other means, to the extent permitted under the procedure for approval of state aids Articles 92­3 of the Rome Treaty. Other important aspects of the proposal included allowing a 5­year period for the writing­off of goodwill, which would have a significant effect on company acquisitions especially in the service sector. An important role in the implementation and development of the process of harmonization of the tax base of business was envisaged for an Advisory Committee made up of national representatives and Commission officials. There was some scepticism that rapid progress could be made on such ambitious proposals, even with the political impetus given by the 1992 target. To maintain the momentum, Mme Scrivener, the Commissioner responsible for taxation, in December 1990 appointed a working group under Dutch former Finance Minister Onno Ruding, to report on the degree to which corporate taxation distorts the internal market, and whether Community action should focus on harmonization of the tax base or of tax rates. Both politicians and academic economists differ in their evaluations of the degree of direct­tax harmonization necessary to liberalise the movement of capital. This is important not 1 The primary aim of the Treaty of Rome was to establish the Common Market and the free movement of goods, so in addition to the removal of tariffs it included specific provisions for taxes on products Articles 95­99 Rome Treaty; however, the removal of exchange controls and other direct restrictions on the free movement of capital was not reinforced by any specific Community competence in relation to direct taxation. Instead, Article 220 of the Rome Treaty urges that the abolition of double taxation w LWKLQWKHRPPXQLW\EHWDNHQXSCVRIDUDVLVQHFHVVDU\¶E\QHJRWLDWLRQEHWZHHQWKH0HPEHU6WDWHV which restricts the role of EC institutions in this field. It was for this reason that the arbitration of double taxation claims resulting from transfer price adjustments was dealt with by a Convention between the Member States and not a Directive, as originally proposed by the Commission, thus removing its enforcement from the purview of Community institutions see below, and Chapter 10 section 3.a.iii. only in relation to direct corporate taxation, but also corporate­personal tax integration, i.e. the tax treatment of dividends. 1 In the meantime, significant progress was being made on establishing a European tax regime for groups of related companies. In mid­1990 agreement was reached on three long­standing proposals, which entailed benefits for cross­European groups of companies, and might pave the way for similar provisions applying beyond Europe. Agreement in the form of a treaty established an arbitration procedure for double taxation claims resulting from adjustments of transfer prices EC 1990C; see Chapter 10 below; a Directive for a common system of taxation for mergers or acquisitions between different member states prohibited member states from taxing gains or preventing carry­over of losses EC Council 1990A; and a further Directive on dividend payments from subsidiaries to parent companies within the Community required member states to exempt from withholding tax dividend payments made directly by a subsidiary to a parent company, if both companies are resident in a member state and the parent owns at least 25 of the capital of the subsidiary, while requiring the state of the parent to exempt such distributed profits from tax or allow a credit for the related corporation tax paid at source EC Council 1990B. Following this success, two further proposals for Directives were issued at the end of 1990: first, to extend the exemption from withholding tax also to interest and royalties paid directly by a subsidiary to a parent, defined in the same way as in relation to dividend withholding taxes EC Commission 1991A. A second, more far­reaching proposal, would permit the offsetting of profits and losses between members of a corporate group within the Community, in this case where 75 of the capital and a majority of the voting rights is owned by the parent EC Commission 1991B. Mme Scrivener also referred to the Ruding group the more radical possibility of consolidation of tax accounts of groups of companies within the Community. Perhaps significantly, the progress made towards liberalization has not been matched by agreement on measures to prevent avoidance and evasion. This was illustrated by the controversy over a relatively limited proposal, linked to the liberalization of capital movements within the Community, which was put forward in 1989 European Commission 1989, for a minimum 15 withholding tax on income from bank deposits, shares and bonds held by Community residents in other EC states. Motivated by pressure, especially from the French government, to prevent tax evasion which might ensue from the lifting of exchange controls, it was nevertheless opposed by the financial centres, Luxembourg and the UK. The Commission saw this as a minimalist proposal to extend taxation of bank and bond interest at source to all European Community residents, which would entail little administrative burden, since there was already some provision for source taxation of interest in all member 1 Compare for example the respective contributions of Musgrave and Bird in Cnossen 1987. See also Devereux and Pearson 1989. states except Luxembourg, Germany and Greece. Germany had attempted to come into line by introducing a withholding tax on all interest payments from January 1989, but this lasted only until July, and was cancelled by the new government coalition, following an outflow of capital estimated at DM60 billion, mainly to Luxembourg. In principle, this failure should strengthen the case for a harmonised EC withholding tax which Luxembourg would also be obliged to apply. However, since the Commissions proposal did not apply to Eurobonds, it raised the threat of capital flight to non­EC financial centres, while the idea that the withholding tax could be extended world­wide was described as `little more than a pious hope ¶UK House of Lords 1989, p.10. Since deduction at source is applied by most countries to employment income and dividends, and often also to interest payments to residents, it would seem both logical and equitable to extend it to interest payments to non­ residents. 1 However, the existence of international capital markets, and especially of offshore financial centres and tax havens, makes it difficult to apply source taxation of interest payments to non­residents without a comprehensive international arrangement for enforcement see Frank in Council of Europe 1981, 100­101. Indeed, Britain and the US introduced exemption from withholding tax for payments to non­residents of quoted Eurobonds in 1984 in order to compete with the offshore financial centres see Chapter 7 section 3ii below. Hence it was not surprising that the ECs withholding tax proposal was shelved, although a related proposal to improve information exchange did obtain support. 2 In taxation, as in other areas, the impetus and processes for seeking harmonization within the European Community are a significant force in the world system, since European harmonization can act as a catalyst for broader global agreement. Conversely, some matters such as the imposition of a tax at source on interest payments to non­residents, discussed above cannot be dealt with purely within the European framework. Europe also provides a barometer for the storms that harmonization proposals are likely to provoke. Issues which cannot be resolved within the framework of relatively common culture and interests, as well as the supranational structures, of the EC are unlikely to make much progress on the world stage. In this perspective, it is significant that fundamental issues of business tax harmonization have finally come onto the European agenda; but equally notable that so far the targets are minimalist, and may remain so. The British government in 1 This point was made by the ECs Economic and Social Committee in its comments on the withholding tax proposal: EC Economic and Social Committee 1989. 2 7KLVSURYLGHGWKDWZKHUHWKHWD[DXWKRULWLHVRIDPHPEHUVWDWHVKRZWKDWDCVLJQLILFDQW¶WUDQVIHURI funds has taken place without an appropriate tax declaration, the requested state would be required to obtain and provide information about the funds, even if its own administrative procedures do not allow such information to be obtained for its own tax enforcement purposes : COM8960 Final; Official Journal 1989C141 p.7. Despite the public support it obtained, this proposal had still not been approved by the end of 1990. Chapter 10 below deals in more detail with administrative assistance in tax enforcement. particular has taken the view that market forces are more effective in producing regulatory convergence than coordinated state action; 1 but market forces tend to result in competition to reduce regulation or offer exemptions, which would reduce tax revenues and not necessarily end distortions. A survey of British companies showed a near­unanimous view in favour of the creation of a uniform tax base and a band of tax rates in the EC Devereux and Pearson 1989, p.72. The move towards abolition of withholding taxes on intra­group payments should pave the way towards taxation of corporate groups on their EC operations based on consolidated accounts; but the EC member states would still be faced with choosing between negotiating concessions of sovereignty and tax rights between residence and source jurisdictions, or taking the leap to either European unitary taxation based on formula apportionment or a single European corporation tax. 2 The measures for completion of the internal market, especially the liberalization of capital movements, will also have significant implications for the tax treaties of EC members with other countries. For example, limitation of benefits provisions in recent US treaties such as the US­German treaty signed in 1989 in certain circumstances deny treaty benefits to third­country shareholders, such as partners in a German joint­venture company see Chapter 7.3.a below. The logical trend should be towards the increasing alignment of the terms of EC member states tax treaties with third countries, coordination of treaty negotiation and of their interpretation and application by the competent authorities, and eventually the joint negotiation of tax treaties by the EC states. Since taxation is one of the most jealously guarded of sovereign powers, this evolution may be a slow one. Conclusion. To summarize, it seems that taxation of corporate or business profits will remain a significant element of state finance in most developed capitalist countries, in developing countries and, increasingly, in the former state socialist countries. The search for an adequate, globally­oriented system to coordinate business taxation is therefore unavoidable. Yet the debate on fundamental issues has just begun, and the political processes for publicizing the debate and considering solutions are virtually non­existent. 1 This view was expressed in relation to taxation by J.Isaac, Deputy Chairman of the Board of Inland Revenue: Gammie and Robinson 1989, p.28. 2 Devereux and Pearson 1989 canvass the options ch.4; although they see the strong advantages of the single European company tax, they exclude it as involving too much surrender of sovereignty; the advantages of the unitary approach would be outweighed by administrative costs so long as tax systems differed, but there would be pressure to harmonise them due to the absence of capital­export neutrality. McLure 1989 argues that increased economic integration will make it harder to attribute geographical source to income and force states to grasp the nettle of a unitary approach.

4. I