The habit of taxing Multinational Enterprises (MNEs)’ profits is the legacy of a time when “GM had to make cars in Detroit and Hollywood had to make movies in L.A.”, but is now inefficient and detrimental to global welfare, a new study by Nicolai Foss, Rodolfo Debenedetti Chair of Entrepreneurship at Bocconi University, and colleagues asserts. The optimal solution would be zeroing corporate tax and replacing it with a hike in taxes on dividends and sales.
The trouble with profits as a tax target is that, ideally, governments should tax MNEs for their consumption of local public goods, and profits are a poor proxy of this. Furthermore, profits are extremely mobile and MNEs can easily shift them from high corporate tax locations to lower ones, through the mechanism of transfer prices. Finally, profit taxes lower MNEs’ incentives to invest, depriving local markets of positive spillovers (such as employment) and externalities (the web of buyers, suppliers and specialized support firms that the presence of a MNE entails).
The inefficiency costs of corporate taxes, the authors note, include the enormous expenditures of governments on policing and monitoring legitimate business activity, as well as the countervailing expenses MNEs incur in order to generate “a veil of secrecy” around their activities.
Taxing corporate profits made sense when trans-border transaction costs were high and MNEs had to move entire value chains to a national market. However, nowadays such transaction costs have dramatically fallen and MNEs can fine-slice their value chains, fully realizing the benefits of specialized local resources.
As “locations and firms need one another in the manner of flowers and bees”, the authors state, the establishment of an MNE branch is preceded by a short-listing process that pits locations one against another in a race whose weapons are tax cuts and subsidies.
In principle, MNEs should choose location based on the fit of local resources with any single ring of their value chains and this behavior would ensure both the best results for the company and the highest possible global welfare in the long term. In the real world, though, managers often choose the short-term benefits of lower taxes over long-term value creation, ultimately hurting also their shareholders.
In presence of such a tax race, the only equilibrium, the scholars show, is the reduction of corporate income tax rates to zero. They propose, then, to tax the real beneficiaries of MNEs’ activities, shareholders and consumers, through a hike of taxes on dividends and sales. “Finding a proper mix of taxes that make our proposal financially sustainable is far from impossible”, the authors write, using the UK case as an example.
Dividends and sales taxes, the authors argue, are much easier to harmonize than corporate taxes and, making earnings management useless, such policies have the salutary side effect of allowing the MNEs to focus on their core activities.