By Gerri Chanel
Taxation “is the most difficult function of government, and that against which their citizens are most apt to be refractory. The general aim is, therefore, to adopt the mode most consonant with the circumstances and sentiments of the country.”
These words written two centuries ago by Thomas Jefferson, the third US president, still ring true for governments today.
What taxes will taxpayers consider palatable? At what level? How to balance that with revenue needs and the desire for economic growth? How do specific taxes and tax levels affect growth? Are there “right” tax policies for specific growth problems? How do short-term solutions affect long-term growth? The questions are almost endless — and the answers not always clear.
“A tax structure that brings certainty and stability to business is critical for business growth, for employment, for economic growth across the board.“
David Lewis, Vice President – Global Taxes & Assistant Treasurer, Eli Lilly and Company
Making the exercise even more complicated is the fact that tax policies are shaped in part by political rather than economic considerations and can be the product of negotiations among opposing views and political parties.
As European Commission President Jean-Claude Juncker once quipped about certain Eurozone economic policies: “We all know what to do, we just don’t know how to get re-elected after we’ve done it.”
However imperfect and difficult the process, developing tax policy is a fundamental function of governments, used not only to raise adequate revenue to provide services and meet other obligations, but also in the quest for the sustained economic growth that will support high employment and production and better quality of life for their citizens.
Given the low global economic growth of recent years, governments around the world have been looking hard at the effects of taxes.
Almost all taxes are considered economically distortive. However, some impede growth more than others.
In 2008, the Organisation for Economic Co-operation and Development (OECD) issued a report ranking major groups of taxes in terms of their negative impact on long-term economic growth. The report concluded that corporate/capital income taxes have the most damaging potential effect, followed by personal income taxes, consumption taxes such as value-added taxes (VAT), then recurrent real property taxes.
“Whenever an economic choice is driven by something other than pure market forces, it distorts the decision and distortions generally impede growth by making the economy less efficient,” says Michael Mundaca, National Tax Co-Director, Ernst & Young LLP, United States, based in Washington, DC and a former Assistant Secretary for Tax Policy for the US Treasury Department. In theory, the best strategy for growth is to remove the distortions.
But designing a tax system that will encourage growth is anything but simple. A nation cannot simply choose only taxes that are thought to be least distortive.
“Real property taxes and excise taxes may be the least harmful to growth, but of course you can’t run a whole government on them alone,” says Victoria Perry, Assistant Director, Fiscal Affairs Department, International Monetary Fund (IMF).
“The consensus has been that, for income taxes, low rates plus a broad base favor economic growth,” says Perry.
The right mix
Finding the right mix of taxes to balance national revenue needs and growth-friendly tax structures is not easy.
“One of the toughest problems is how to tax household income and residential property in the same way as business assets,” says Dale Jorgenson, Samuel W. Morris University Professor in Harvard University’s Department of Economics and pioneer of several aspects of modern economic analysis of tax policy.
“Without it you’re not going to gain very much from tax reform,” Jorgenson says.
Pro-growth tax strategy goes beyond national borders as well.
“Tax structures that create as few hurdles as possible for foreign direct investment support economic growth,” says Marlies de Ruiter, EY Global ITS Tax Policy Leader, based in Rotterdam, the Netherlands. “It is also important to be sure that source taxation is as low as possible so that the tax environment in domestic markets is the same for everyone who wants to invest there,” adds de Ruiter, the former Head of the OECD’s Tax Treaty, Transfer Pricing and Financial Transactions Division.
Despite the influence of tax on growth, there is no firm agreement about exactly how important it is or the potential economic growth impact of specific taxes or incentives.
“It can be difficult to isolate and quantify the effect of a tax,” says Perry. “Tax affects outputs, which can also lead back to revenues and spending, which leads back again to outputs.
Assistant Director, Fiscal Affairs Department
International Monetary Fund
State of uncertainty
If taxes are a drag on growth, so is uncertainty about those taxes, since it undermines the ability of businesses to estimate risks or project long-term returns, thereby reducing their willingness to make investments.
“A tax structure that brings certainty and stability to business is critical for business growth, for employment, for economic growth across the board,” says David Lewis, Vice President – Global Taxes & Assistant Treasurer for pharmaceutical giant Eli Lilly and Company. “Every size company needs to know that, when we make economic decisions based upon the information we have today, we can reasonably rely on the conclusion that those economic circumstances will remain in place.”
Some uncertainty today arises from OECD recommendations to address base erosion and profit shifting (BEPS).
“While the desire was to create more certainty across governments and tax policies, I think we all fear that there will be greater uncertainty,” Lewis says.
The OECD is well aware of these concerns.
“It was right to do the work on transparency and base erosion and profit shifting first because that was about fixing broken rules,” says Pascal Saint-Amans, Director of the OECD’s Centre for Tax Policy and Administration. “But we always need to get the balance right and we know it is also important to make sure that investments are not subject to hurdles from tax policies or tax administrations.”
Toward that end, the OECD and the IMF published a report in March 2017 on tax certainty that had been requested by G20 leaders. The report provides recommendations for practical measures for enhancing tax certainty, including tools for both dispute prevention and resolution, according to Saint-Amans. (For prior coverage of tax certainty, see Tax Insights № 18, available at taxinsights.ey.com.)
The OECD’s ongoing work on tax certainty will remain in the spotlight for the foreseeable future.
The G7 Finance Ministers and Central Bank Governors issued a communiqué at the conclusion of their May 2017 meeting indicating that financial (including tax), economic and political uncertainties are currently significant barriers to growth. And in July 2017, the G20 leaders said they welcomed international cooperation on pro-growth tax policies and work on improving tax certainty following their meeting in Hamburg, Germany.
By all measures, the global economy has been limping along in recent years and only modest global growth is projected through 2018 because investment, trade, productivity and wage growth all remain weak, in what many have called a low-growth trap.
When growth remains slow, businesses become cautious and invest less and consumers become pessimistic and spend less, in turn increasing business restraint even more. And economic uncertainty causes banks to be less willing to lend to businesses, reducing their ability to finance investment.
A parallel problem is that, while growth remains subdued, income and wealth at the top of the economic ladder have steadily increased, causing a huge gap between rich and poor: across the OECD countries, the richest 10% of the population now earn almost 10 times more than the poorest 10%, up from 7 times in the mid-1980s.
And the middle has shrunk. The growth of median incomes has slowed and, in some OECD countries, real median incomes have not grown in decades. This further impedes economic growth, because middle classes help drive economies.
These inequalities undermine social cohesion, in turn making it even harder to implement policies that would promote growth for the most affected groups. All these trends together have led the G20 and the OECD to push hard for economic growth policies, but ones that will also promote inclusive growth.
Beyond the drawing board
Countries continue to pursue lowering their income tax rates while broadening their tax base, according to the EY report The outlook for global tax policy in 2017. Of the 50 countries surveyed for the report, eight countries reported that laws are now in place that will result in lower corporate income tax (CIT) rates in 2017. Several of the countries have begun or are about to begin significant multiyear rate reductions, including India, Japan and the UK.
Another 40 reported no anticipated or known change to their national headline CIT rate in 2017, while the change was small for the two countries reporting an increase.
At the same time, tax bases are getting broader. Transfer pricing changes were the leading causes of tax base broadening in the survey (32%), followed by less ability to deduct interest/business expenses (31%) and tax enforcement changes (21%).
Governments are also increasingly using tax policy as a tool to incentivize pro-growth behavior, such as innovation and patent boxes and incentives for both research and development and broader business investment, according to London-based Chris Sanger, EY Global Head of Tax Policy.
In the view of many economists, a key feature of a good tax system is that taxes should fall on consumers rather than producers, according to London-based Nick Catton, Assistant Director, Economic Advisory, Ernst & Young LLP, United Kingdom, and former senior economist for the UK’s HM Revenue & Customs.
“If you tax something that’s part of the production chain, you introduce a distortion both into how goods and services are produced and also into what’s consumed, whereas if a tax just falls on consumption, there’s only the one distortion,” Catton says.
It’s not surprising then that consumption taxes (such as VAT and sales taxes) were ranked low in damaging effect on growth by the OECD. Those levies have taken an increasing share of tax across the developed world in recent decades.
“We’ve seen a significant increase both in terms of rate increases and the adoption of VAT or a goods and services tax (GST),” says EY’s Sanger. “For example, China is replacing its business services tax with a VAT and India is fundamentally reforming its multi-state GST.”
The Bahamas, China, Egypt, Malaysia and Tanzania have all adopted VAT/GST in recent years, and in 2018 Member States of the Middle East’s Gulf Cooperation Council (GCC) are due to adopt a VAT.
Wait and see
Just as the OECD’s BEPS project has increased tax uncertainty for the foreseeable future, forcing businesses to wait and see how the recommendations will be implemented around the world, the use of taxes to improve economic growth will add another layer of uncertainty as policies shift.
The US is one of many nations rethinking its tax laws in the search for growth.
Any tax reform by a major trading nation would change the business and economic landscape, and many countries are modeling these potential effects and assessing how they might shape their
tax policies in response.
To a certain degree, businesses can address this uncertainty through monitoring and modeling to assess the impact of any tax reform. Organizations also need to engage with local and global leaders about possible tax policy changes and the impact on their businesses.
Those leaders are listening, since both businesses and countries have a major stake in the outcome.
“We have an extraordinary opportunity today to achieve transformational tax reform that could be a legacy to our children and grandchildren,” Lewis says with regard to US tax reform proposals. “It’s important to get it right.”
In a world searching for growth, it’s true for tax policy everywhere.
Key action points
- Monitor developments — both actual and potential — in key jurisdictions.
- Model the potential impact of tax reforms that might affect any aspect of company tax strategy.
- Communicate and engage with local and global policymakers about the potential impact of tax policy changes to ensure that they understand the business implications of any legislation.