The Basement on the Race to the Bottom
Poole professors take a closer look at the global minimum tax rate.
On October 7, 2021, 136 countries agreed to implement a global minimum tax rate of 15% to go into effect by the year 2023. This landmark agreement marks the end of “the Race to the Bottom,” where countries were continuously undercutting one another by offering incremental tax-perks to corporations to entice them to set up operations in their jurisdiction.
Countries are permitted to set whatever tax laws they wish to enforce in their jurisdiction and for their constituents. However, some countries offer lower tax rates and better insulation from higher taxation in other countries than others. These countries often have been referred to as “tax havens.” Through these tax havens, companies have lowered their tax liabilities through aggressive tax planning practices like corporate inversions and tax-motivated income shifting. These practices are controversial because governments lose significant tax revenues, which often leaves their own citizens footing the bill for important expenses.
Meanwhile, the countries offering tax incentives and very low tax rates do not gain nearly as much as what is lost from the originating countries. As the incentives stack up, other countries hoping to get their hands on a piece of the pie in turn offer corporations even better tax incentives, hence leading to the race to the bottom.
As the 136 countries have identified, it is simply unsustainable to continue competing with one another by continuing to lower corporate tax rates. The agreement for a 15% global minimum corporate tax rate diminishes the benefits to countries for offering exceedingly low tax rates and therefore puts an end to this undercutting process. While the details of the agreement are not yet ironed out, it will allow countries where corporations are domiciled or have substantial operations to levy additional taxes against corporations that are using cross-border income shifting strategies to pay tax at less than the 15% minimum tax rate. The minimum tax only applies to companies with revenues of greater than 750 million Euro. Additionally, the minimum tax will be calculated after considering reasonable expenditures for physical investment and payroll costs.
In terms of benefits, these changes have the potential to dramatically increase U.S. income tax collections. The rules will inherently decrease incentives to lower taxable income through income-shifting tax planning activities, thereby better-aligning tax payments with economic activity. In addition, these changes could also have other indirect benefits for corporate stakeholders.
Research by Lewellen shows that firms with substantial tax haven operations are associated with manager misconduct and higher costs of raising capital. If corporations are less inclined to operate in tax havens as a result of this agreement, shareholders and other corporate stakeholders may reap the benefits from reduced negative consequences of tax haven operations.
However, an unintended negative consequence of this agreement could be that it actually provides greater incentives for firms to shift operations abroad. More specifically, as we incentivize a match of corporations’ economic activity to where they physically operate, firms become incrementally incentivized to locate their operations in these overseas jurisdictions that have a lower corporate income tax rate than the U.S. (currently 21%).
Consistent with this, research by Goldman suggests that higher foreign employment helps enhance the economic substance of foreign transactions, and therefore firms can continue to reduce their U.S. tax burdens by locating more employees abroad. This point is even more important given the numerous proposals to increase the corporate income tax rate.
Finally, while the details of the agreement have yet to be laid out, the proposed changes and calculations required for determining the global minimum tax rates appear rather complicated. Therefore, these new requirements may be burdensome to taxpayers in terms of compliance costs, as well as to tax authorities due to the difficulty of implementing and enforcing the new regulations.
What Happens Next?
While the agreement among the 136 countries is a landmark day for international taxation, the hard part begins now. Each of these countries must now individually pass the legislation. After all, in the U.S., it is Congress, rather than President Joe Biden or U.S. Secretary of the Treasury Janet Yellen – or even the IRS, for that matter – who creates tax laws. While all countries who agreed to this deal likely do not need to eventually pass it in their own country for this agreement to be effective, there will likely be varying levels of difficulty when formally implementing this landmark agreement worldwide.