January 2014 newsletter- Tax regimes in a global environment

A recent study by KPMG reported a favourable shift toward the UK’s regime of corporate taxation even though lower tax rates can be found elsewhere. In this article, Gareth Myles1 explains why this might be, and how national tax systems function in a global environment.

When does corporate tax efficiency become tax avoidance? 
HMRC recognises four types of tax compliance behaviour. ‘Tax planning’ is when a taxpayer responds as Parliament intended to a tax incentive. An example would be placing savings in an ISA to benefit from tax-free interest payments. ‘Tax avoidance’ is when tax liabilities are reduced using tax laws to obtain an advantage that Parliament never intended. Whether Amazon assigning its sales to an affiliate in Luxembourg qualifies as avoidance has to be tested against this definition and the relevant EU rules. This has to be distinguished from ‘abusive tax avoidance’ which occurs whenever activities are undertaken solely for the purpose of reducing the tax bill. The recent General Anti-Abuse Rule (GAAR) uses a double-reasonableness test to define abusive avoidance as arrangements ‘the entering into or carrying out of which cannot reasonably be regarded as a reasonable course of action, having regard to all the circumstances’. Arrangements that might be regarded as abusive include the formation of ‘hybrid entities’ which are affiliate companies that exist only to exploit differences in tax rules between countries or the use of financial engineering to create positions that only deliver benefits through tax reductions. The fourth type of behaviour is ‘tax evasion’ which is the false statement of tax liabilities. In short, tax planning becomes avoidance when less tax is paid than Parliament intended, and becomes abusive when unnecessary activities are undertaken to reduce the tax bill. The headline cases that have been reported in the media are all examples of tax avoidance but not of abusive tax avoidance.

Have companies have always worked so hard to minimise their tax liabilities or is this is a new phenomenon? 
Corporations now work so hard to reduce tax liabilities because of the increase in opportunities to do so and the gains that can be made. In an older, simpler world the possibilities did not exist so there was little point in making effort. What has caused the change is the increase in globalisation, the growth of the multinational, evolution in the nature of products, and new ways in which products are traded. Most cases of tax avoidance arise from multinationals making the most of international differences in tax rates and regulations. If the tax rate is lower in one country than another, it makes sense for transactions to be recorded in the low-tax country. The evolving nature of products and new forms of trading assist with this. Intellectual property (IP) has become a more significant component of products and it is very hard to place a fair price on IP. 
When a coffee company in the UK states that it has to pay a licence fee to an affiliate in the netherlands for the IP in a brand of coffee it is very hard for HMRC to determine what this licence fee should be. The company can effectively choose its own licence fee to minimise tax liability. Similarly, the growth of sales over the internet has created a divide between the location of the purchaser and the place to which the sale of the product is assigned. Sellers can select the location to gain a tax advantage without altering the experience of the purchaser. Finally, financial instruments are now available that were unimaginable 30 years ago. This permits complex financial engineering to exploit tax differentials to the full. Companies now work hard to minimise tax liabilities because the potential gains are so significant.

Does the UK need to have a tax system that is favourable to companies to attract businesses and commerce. or does globalisation mean companies can operate in one country but choose to pay their taxes elsewhere? 
The consequence of globalisation and the internet is that the identification of where companies operate is becoming ever more difficult. It is known where they are located and registered since this relates to a legal requirement. Identifying the location of a specific transaction is much more difficult. Even if the purchaser believes the purchase is made in the UK it could easily prove to be with, for example, an Irish affiliate. To a considerable degree companies can choose where to pay taxes by suitable locational choices. If the UK wishes to collect corporation tax as it currently operates it does need to ensure that there is an incentive for corporations to declare profit in the UK. Setting the UK corporation tax significantly above competitor countries will see profits relocated elsewhere. The difficulty with this argument is that if all countries follow this advice then tax rates will be driven down as each seeks to gain advantage. This is the ‘race-to-the-bottom’ that EU rules against harmful tax competition are designed to avoid.

And what exactly makes a tax regime attractive to companies? Last month it was widely reported that the UK had become more attractive to multinationals over the previous year, even though its corporate tax rates were by no means the lowest. What else are they looking for?
The location decision of a corporation will involve consideration of a wide range of factors and expectations of the future environment. The level of tax rates will be one factor but need not be decisive. We can think of a corporation weighing the level of profit against the risk to profit when making a location decision. For example, location in a low-tax jurisdiction may increase profit in the short term but this could be threatened in the long-term by political instability leading to the seizure or destruction of assets. The level of risk is reduced if the legal system is fair and transparent, corruption is limited, and the political system democratic and inclusive. These are all attractive features of a potential location. Corporations might have historical attachment to a particular location, or benefit from economies of agglomeration. If sufficiently important these factors will offset the cost of higher taxes.

Could corporate tax ‘avoidance’ have a knock-on effect on individual taxpayers’ morale and ethics (ie, ‘why should I pay tax in full when companies don't bother’)? 
There is no formal evidence on this issue. The concept of tax morale has been found to be important in empirical studies and the social norms of tax compliance provide a convincing explanation of observed behaviour. The link that is missing is how the reporting of corporate behaviour affects tax morale. It is clear, though, that countries can become trapped in a position where the prevalent ethic is the non-payment of taxation. Corporate failure to pay the ‘fair’ amount of tax cannot but push an economy in this direction.

Is there confusion about tax and what it goes towards? A recent example was a car driver who knocked a cyclist off his bike, afterwards stating that ‘he doesn't pay road tax, I do’ — whereas there is no such thing as road tax. 
There are many misunderstandings about tax in all parts of society. The recent press coverage of major corporations has reported the very high sales revenues of firms and the surprisingly small tax payments. Where this is mistaken is that corporations pay tax on profits not on sales, and a high value of sales does not necessarily imply profitability. Amazon, for example, made losses for many years before moving into profit. Going further back in time, a large media fuss was made over a hedge fund manager who ‘paid less tax than his cleaner’. The issue in this case was that the hedge fund manager paid a marginal tax rate of ten per cent whereas the cleaner paid a marginal rate of 25 per cent. This does not imply the manager paid less tax: for example, ten per cent of £2 million is forty times 25 per cent of £20,000. This confusion between the average rate, the marginal rate, and the amount of tax paid is commonplace and hinders discussion. The idea that the road tax (or car tax as it is now called) is collected to pay for roads reveals the time it can take for incorrect beliefs to be revised. The revenue from the tax was hypothecated to pay for roads between 1925 and 1936, but still surfaces 77 years later.

Has any research gone into whether there is a theoretical threshold of where tax levels are likely to become unsustainable (i.e., would trigger widespread tax refusal)? 
The response to a tax can take several forms. Take, for example, an increase in the income tax. People can respond to this by working less hard, or moving to a less demanding occupation where pay is lower. or they can engage in tax planning to reduce the tax liability. At the extreme, they can become non-compliant. The observed response to the tax increase will be the sum of all three. The most recent evidence in this area is the issue of whether the marginal income tax rate should remain at 50 per cent or be reduced. The work of HMRC, in agreement with the findings of the ESRC-financed Mirrlees Review, (see Newsletter no. 160 Jan 2013) concluded that tax revenues would be higher if the top marginal rate of tax was less than 50 per cent. This shows that ‘refusal’ need not necessarily take the form of evasion, but can occur through other legally-permissible responses. Another example is the experience of the Community Charge, or ‘poll tax’, of the late 1980s. This tax was met with widespread refusal due to the perceived inequity, which was supported through a well publicised campaign of civil disobedience.

How are some countries able to keep tax levels which would be seen as a no-go in the UK? What does this say about the culture and values of a country such as Denmark where very high taxes are acceptable because they fund very good health, education and welfare systems? 
It is becoming increasingly apparent that individual attitudes toward tax compliance have a significant social element. In the academic literature this idea is captured by the concepts of tax morale, social custom, social norm, and network effects. All of these capture the idea that there is a socially-constructed and supported idea of what is acceptable and what is not. In this context, ‘acceptable’ relates to both sides of the social contract between the taxpayer and the state: what is paid in tax, and what is received from the state. When the behaviour of individuals is influenced by social factors there can be multiple potential equilibria supported by distinct sets of social beliefs. This permits societies that are a priori identical to settle into different equilibria where the social beliefs are self-sustaining and coherent with the tax rates and state provision. For a given society to move from one equilibrium (perhaps with low taxes and low provision) to another (with high tax and high provision) may simply not be possible without some external shock to social beliefs. If one looks at the level of public expenditure in the UK before and after the First World War there is clear evidence of a step increase. This has been attributed to an ‘inspection effect’ where many of the privations of pre-war living were exposed by the experience of war, and led to a change in social beliefs about the appropriate level of provision.

Would the UK population welcome much higher taxes if the level of public-funded benefits were far greater? 
A common finding in opinion polls is that a majority of the population are willing to pay a higher rate of tax if the revenue is used to fund the health service. The experience of elections is that a party that offers this option is not elected. Two explanations can be offered for these contradictory findings. It is possible that the answer to the poll is given because of social pressure to appear generous and kind-hearted to the pollster. Alternatively, the opinion poll may be eliciting the truth but the political promises on the use of revenue may not be believed. In economics the issue of credibility is an important one. The promises of political parties are unlikely to be judged credible, particularly on the uses of tax revenue. Behavioural economics has also shown that people can hold beliefs that are at variance to the facts. So it is possible that all people can believe that it is everyone except them that will benefit from increased government spending. These observations show why it would be difficult for such a change to receive support even without entering into the debate on whether public or private provision is best.

Does HMRC spend a disproportionate amount of resources on investigating small-scale tax avoidance (such as the landlord who doesn't declare rental income) rather than large-scale tax frauds by individuals or companies? 
HMRC is charged with the objective of maximising revenue. This objective can only be achieved if HMRC makes a careful selection of who to audit with the intention of making the best use of audit resources. The actual strategy they employ is not public information. However, the economic theory tells us that the effort expended on an audit should be proportional to the additional revenue that is expected to be recovered. This implies that small-scale avoidance is worth pursuing if the audit can be conducted quickly and easily, while large-scale avoidance will be pursued even if considerable, but not excessive, effort is required. The best strategy will involve auditing at all levels of evasion provided the chance of successful conclusion is sufficiently great.

1. Gareth Myles is Professor of Economics at the University of Exeter and Director of the ESRC/HMRC/HMT Tax Administration Research Centre (TARC). This conversation is based on an article previously published in the ESRC's Society Now magazine. We are grateful to the ESRC for permission to draw on the earlier version.