The History of International Business Taxation and the Effect of International Tax Competition
With the globalization of world economy, international business taxation plays a vital role in international trading.This essay introduces the history and the development of international business taxation in aspects of tax reform and the changes in corporate income tax briefly, meanwhile, analysis the negative and positive effect of international tax competition.
Key Words: history of international business taxation, international tax competition
This essay is aim to present the history of international business taxation and the tax reform in the past few decades and discuss the effect of international tax competition.In the first paragraph, we will introduce the history of international taxation from the World War I to recent years.
The tax reform in the last two decades of EU and G7 countries also be indicate in this paragraph. As the development of international economy and business taxation, countries compete with each other in order to attract foreign investment. In paragraph two, we will introduce the international tax competition and present some empirical evidences of international tax competition. However, the effect of international tax competition has been debated fierce in recent years. In paragraph three, the negative effect of international tax competition will be discussed and the positive effect will be discussed in the following paragraph.
James (1998) states that taxation is “A compulsory levy made by public authorities for which nothing is received directly in return”. It is necessary to review the international trade before we discuss the international taxation. International trade can be date back to over two thousand years which stated by Liu (1998, p.xiii) traders from Mesopotamia, Greece and Phoenicia made themselves very rich by engaging in Mediterranean trade. The international trade grows with the development of international economy. The first Bilateral Tax Agreement was signed between Belgium and France in 1843 when the international business taxation is still in an embryonic stage. Nevertheless, the international taxation system has been actually recognized since the World War I which plays a significant role in international finance, trading, and investment. At the beginning, international trade has been taxed trough indirect ways. The international business tax has been derived from customs duties when the goods and services imported from abroad. After the World War ?, the international business taxation system has been increasingly liberalized which the basic principles of international tax agreements have been laid out and spread quickly. The means of international trade taxed have been changed with a related increasing in direct sources. The whole taxation system were developed around how business profit being taxed. With the rapid growth of international economy, issues arose from the conflicts between jurisdictional rights to tax. Jurisdictions care about where the cost and revenue were generated and will be expensed. The profits and returns were taxed in forms of direct tax in the country which permanent establishment can be found or simply in forms of withholding tax. Double taxation becomes the central problem of international taxation. Tax treaties have been emerged in order to reduce the bad effects of double taxation, enable tax neutrality, to avoid double tax and facilitate the international trade and investment. It provides the possibility to visit and invest overseas without paying large amount of tax. The OECD, USA and UN have produced model treaties after the World War ?. The commentary and OECD treaty being always updated which has been treated as a starting point for negotiation. The treaties defined and allocated the rights of countries to tax. Generally speaking, the returns on overseas investment should be taxed by residence principle whereas the business profits of companies are taxed by source principle. This compromise concealed the conflicts between countries which were mainly capital-exporters and capital-importers. While the international tax agreements are useful and practical tool to resolve the jurisdictional rights between countries to tax income created by multinational companies, it is necessary to require continual renegotiation between countries as a result of countries compete with each other to attract foreign investment. Tax reform especially the corporate income tax in industry countries has been considered from the 1980s. The average statutory rates have been decreased from 48% to 35% from the beginning of the 1980s to 2001. The corporate tax rate has been declined over this period except Spain and Italy. In 1992, the EU appointed that the minimum statutory corporation tax rate has been proposed to 30% which is at the bottom of that time except the Ireland. At the end of 1990s, nearly half of the EU countries’ statutory corporation tax rates were at or below 30%. For instance, the main corporate tax rate in the UK was below 30% all the time over the past few years. According to the tax reform in the EU and G7 countries, the tax reform movements are almost universal such as lower tax rate and broaden tax base in order to attract new foreign investment.
To some extent, the universal tax reform movement of reduce the tax rate may indicates the signal of a process of international tax competition. In this tax competition world, the tax rates are not set absolutely freedom as it is necessary for countries to pay attention to what their rivals have been doing. Different tax jurisdictions use their tax system to compete with each other thereby attracting foreign investments. There are two kinds of foreign investments in broadly; they are portfolio investment and foreign direct investments respectively. The portfolio investments do not involve running a business which including bank deposits, company shares holdings, government securities holdings, bond holdings and so on. On the other hand, the foreign direct investment involves found the business such as subsidiaries and branches in another countries. In this essay, we focus on the tax competition based on the foreign direct investment. There are a number of forms of tax competition which the most common one is the lower tax rate. In addition, the tax-free zones, tax holidays, reduction or elimination of withholding taxes, particular investment allowance, and accelerated depreciation deductions for foreign investors are common forms of tax competition as well.There are some empirical evidences of tax competition of the last two decades. The figures 1 demonstrate there is a steady decrease of corporate tax rates in the EU from 1995 to 2006 and the figure 2 indicates the evolution of corporate tax rates for OECD and EU from 1995 to 2007. If we confirm the international tax competition accompany with the corporate rates reduction, the evolution of the EU tax systems in the last two decades is a perfect instance of international tax competition between each tax jurisdictions. Tax rates have significantly decreased as a consequence of international tax competition. Specifically, the figure 2 shows the average tax rates have decreased by nearly 10% for EU15 from 1993 to 2007 and declined to less than 20% in 2007 for EU 10. The entry of new members of the EU in 2005 may take more pressure on the international tax competition of the old EU.
Figure 1: Statutory corporate tax rates in the EU from 1995 to 2006
Figure 2: The evolution of corporate tax rates in OECD and EU, 1995-2006
It is obvious that as the accelerating of the process of globalization, countries expand the tax competition for mobility of tax base and attract investment. But the issue arose from how does international tax competition works. On the one hand, from the literature review, there is no controversy about the harmful of international tax competition in the world. W. Oates (1972) states that “The result of tax competition may well be a tendency toward less than efficient levels of output of local services. In an attempt to keep taxes low to attract business investment, local officials may hold spending below those levels for which marginal benefits equal marginal costs, particularly for those programs that do not offer direct benefits to local business.” Consequently, the negative effect may obtain from the international tax competition on suboptimal level of public expenditure. Local governments may found themselves involved in a tax rate war which similar to the market price war so as to attract tax bases. There will be a loss of tax revenue and the earnings will be gone to multinational companies instead thus the government would be more difficult to supply public goods and service. Furthermore, the international tax competition might lead to an unfair tax system. In order to balance the financial resources, the shortfall in corporate tax as a result of tax rate reduction caused by international tax competition will be passed on to the property tax, consumption tax, income tax and other tax base with relatively weak mobility. In addition, the international tax competition provides the possibility for the transfer pricing and international tax avoidance. For instance, subsidiary A within a multinational company located in low tax regime supply goods and services to subsidiary B within a multinational company located in high tax regime for “high” price thus the profit of subsidiary A is higher and the opposite of subsidiary B. Therefore, the net profit after tax within the group will be increased as a result of transfer pricing. In economic literature, competition to some degree seems to be a special value and meaning. Competition is the key variable of the market mechanism which can lead to improve the efficient allocation in public sector. However, it is opposite in tax domain, an inefficient allocation might occur when there is an international tax competition between countries. Different tax jurisdictions tend to attract tax bases through the mobility of consumers and corporate. Tax bases will be reallocated among countries as a result of this mobility. Multinational companies will endeavor to exploit the possible tax arbitrage by transfer into the more beneficial regions. The gain of the tax base by one jurisdiction comes from the loss of another. Hence, tax externality between countries would be caused by the mobility.
On the other hand, there is another voice for support the tax competition. Other things being equal, the country who takes part in international tax competition will attract more cash flows thereby promoting the development of the country’s economy. The case of Ireland provides an excellent instance of benefit from international tax competition even if this particular regime expired at the end of 2005. There are a number of benefits can be obtained by shareholders through the using of Irish financial service centre companies such as 200% deduction for rental expenditure, 100% reduction for equipment or refurbishment in relation to buildings, 10% tax rate and exemption from stamp duty. Ireland has been highly successful in tax competition and attracts a large number of financial service companies to run business in Dublin which has overtaken Luxembourg as the EU’s leading jurisdiction for cross-border life assurance. Furthermore, the value of investment fund assets has been grown faster than other countries especially in hedge funds which facilitate the stock market to manage the funds established outside the EU. Ireland has become a significant cross-border services financial market.
Besides, in general, high tax rates, unfair taxation and non-standard tax system will affect the taxpayer’s decision-making behavior and resulting in unnecessary loss, damage the tax neutrality. However, international tax competition will lead countries to reduce their tax rates and broaden the tax base, thereby reducing the distorting effects of tax in economy and conducive to implementing the principle of tax neutrality.
Since the World War I the international taxation system has been recognized and afterwards the tax competition has been emerge with the development of international economy and tax system. Countries compete with each other to attract foreign investment. Even though the limit harmful of international tax competition is undisputed, we cannot neglect its positive effect.
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