Getting corporates to cough up tax money

Using loopholes in tax laws, large corporations shift profits out of the country of operation to tax havens or Off-shore Financial Centres (OFCs) where very little of their profits were generated. These activities, collectively termed Base Erosion and Profit Shifting (BEPS), deprive countries $100-400 billion worth of corporate income tax revenues annually and affect rich and poor countries alike. This forces countries to lower their corporate tax rates in order to ensure compliance. Apart from lowering revenues to fund social sector schemes, this strategy also makes the tax structure regressive. But as long as there are OFCs and different countries have vastly different systems of taxation, MNCs will continue to use tax avoidance strategies. Countries are, therefore, trapped in an inferior equilibrium. In this equilibrium, the best response for any country is to lower its tax rates as much as possible, and we end up in a proverbial ‘race to the bottom’.

Countries would do better if they instead came together to negotiate a multilateral treaty that sets certain taxation standards, accounting principles and minimum threshold tax rates to minimise the possibility of tax avoidance. Of course, the OFCs would still exist. But if large economies ratify this treaty, then MNCs will find it difficult to avoid taxes in these countries. They also cannot shift their operations out of these countries as this is where the market is. The G20 is an ideal grouping for such a treaty. This group makes up 85 per cent of the Gross World Product (GWP).

There has indeed been a move in this direction. The OECD/G20 Action Plan on BEPS is a multilateral convention that seeks to close loopholes in tax treaties worldwide. India recently signed this convention.

However, this convention is not enough. Any signatory can decide to violate the convention by moving away from the standards enlisted in the Action Plan to attract MNCs or foreign capital into its economy. There is no penal provision for such a violation. What is needed is a stronger treaty with a ‘punishment’ clause. Thus, if any country violates the treaty, then all countries withdraw from the treaty and all of them are back to square one. In Game Theory parlance, this strategy is called Grim Trigger. The action by one country of violating the treaty triggers a set of actions that puts all of them back to the initial grim scenario. 

This strategy is commonly used by unstable cartels to sustain their collusive practices.

Why should such a strategy work? As explained in the beginning itself, a world without any treaty traps all countries in an inferior equilibrium with falling revenues and regressive tax structures. A treaty improves on this outcome collectively by lowering the possibilities of tax avoidance by MNCs. Yet, a country can individually benefit by violating the terms of the treaty, given that all other countries abide by it. (Visualise the WTO treaty. Free trade benefits countries collectively. But EU benefits individually by preventing free trade in agriculture, which protects its farmers).

The author is a research scholar at Delhi School of Economics