In his Budget on 29 October, the UK Chancellor, Philip Hammond, announced a new type of tax. This is a ‘digital services tax’, which, after consultation, he is planning to introduce in April 2020. The target of the tax is the profits made by major companies providing social media platforms (e.g. Facebook and Twitter), internet marketplaces (e.g. Amazon and eBay) or search engines (such as Alphabet’s Google).
Up to now, their profits have been very hard to tax because the companies operate in many countries and use accounting techniques, such as transfer pricing (see the blogs Disappearing tax revenues: how Luxembourg saves companies billions and Starbucks pays not a bean in corporation tax, thanks to transfer pricing), to declare most of their profits in low-tax countries, such as Luxembourg. One way of doing this is for a company’s branches in different countries to pay the head office (located in a tax haven) a ‘royalty’ for using the brand.
The proposed digital services tax is a 2% tax on the revenues earned by such companies in the UK. It would only apply to large companies, defined as those whose global revenue is at least £500m a year. It is expected to raise around £400m per year.
The EU is considering a similar tax at a rate of 3%. India, Pakistan, South Korea and several other countries are considering introducing digital taxes. Indeed, many countries are arguing for a worldwide agreement on such a tax. The OECD is studying the implications of the possible use of such a tax by its 36 members. If an international agreement on such a tax can be reached, a separate UK tax may not go ahead. As the Chancellor stated in his Budget speech:
In the meantime we will continue to work at the OECD and G20 to seek a globally agreed solution. And if one emerges, we will consider adopting it in place of the UK Digital Services Tax.
The proposed UK tax is a hybrid between direct and indirect taxes. Like corporation tax, a direct tax, its aim is to tax companies’ profits. But, unlike corporation tax, it would be harder for such companies to avoid. Like VAT, an indirect tax, it would be a tax on revenue, but, unlike VAT, it would be an ‘end-stage’ tax rather than a tax on value added at each stage of production. Also, it would not be a simple sales tax on companies as it would be confined to revenue (such as advertising revenue) earned from the use in the UK of search engines, social media platforms and online marketplaces. As the Chancellor said in his speech.
It is important that I emphasise that this is not an online-sales tax on goods ordered over the internet: such a tax would fall on consumers of those goods – and that is not our intention.
There is, however, a political problem for the UK in introducing such a tax. The main companies it would affect are American. It is likely that President Trump would see such taxes as a direct assault on the USA and could well threaten retaliation. As the Accountancy Age article states, ‘Dragging the UK into an acrimonious quarrel with one of its largest trading partners is perhaps not what the Chancellor intends.’ This will be especially so as the UK seeks to build new trading relationships with the USA after Brexit. As the BBC article states, ‘The chancellor will be hoping that an international agreement rides to his rescue before the UK tax has to be imposed.’
- How do multinational digital companies avoid profit taxes (corporation tax in the UK)?
- Explain how a digital services tax would work.
- Why is a digital services tax likely to be set at a much lower rate than a profit tax?
- Explain the difference between tax avoidance and tax evasion.
- Would it be possible for digital companies to avoid or evade such taxes?
- Is there a possibility of a prisoners’ dilemma game in terms of seeking international agreement on such taxes
- How does a digital services tax differ from a sales revenue tax
Tax avoidance has been in the news since the publication of the Panama papers, which show the use of offshore tax havens by rich individuals and companies, partly for tax avoidance, partly for money laundering and other criminal activities – some by corrupt politicians and their associates – and partly to take advantage of lower regulation of financial dealing.
There are many tax havens around the world, including Switzerland, Hong Kong, British overseas territories (such as the British Virgin Islands, the Cayman Islands and Bermuda), Jersey, Singapore and certain US states (such as Arizona, Delaware, Nevada and Wyoming).
Here we focus on tax avoidance. This is the management of tax affairs by individuals or firms so as to avoid or minimise the payment of taxes. Tax avoidance is legal, unlike tax evasion, which is the practice of not declaring taxable income.
In a statement from the White House, directly after the publication of the Panama papers, President Obama spoke about the huge international scale of tax evasion and tax avoidance:
“A lot of it is legal, but that’s exactly the problem. It’s not that [people are] breaking the laws, it’s that the laws are so poorly designed that they allow people, if they’ve got enough lawyers and enough accountants, to wiggle out of responsibilities that ordinary citizens are having to abide by.
Here in the United States, there are loopholes that only wealthy individuals and powerful corporations have access to. They have access to offshore accounts, and they are gaming the system. Middle-class families are not in the same position to do this. In fact, a lot of these loopholes come at the expense of middle-class families, because that lost revenue has to be made up somewhere. Alternatively, it means that we’re not investing as much as we should in schools, in making college more affordable, in putting people back to work rebuilding our roads, our bridges, our infrastructure, creating more opportunities for our children.”
Tax avoidance, whether in tax havens, or through exploiting loopholes in the tax system may be legal. But is it fair?
Various principles of a tax system can be identified. These include:
||People in the same situation should be treated equally. For example, people earning the same level of income and with the same personal circumstances (e.g. number and type of dependants, size of mortgage, etc.) should pay the same level of income tax.
||Taxes should be ‘fairly’ apportioned between rich and poor. The rich should pay proportionately more taxes than the poor.
||Equity between recipients of government services
||Under the ‘benefit principle’, it is argued that those who receive the most benefits from government expenditure ought to pay the most in taxes. For example, it can be argued that roads should be paid for from fuel tax.
||Difficulty of evasion and possibly of avoidance
||If it is desirable to have a given tax, people should not be able to escape paying.
||Taxes alter market signals: taxes on goods and services alter market prices; taxes on income alter wages. They should not do this in an undesirable direction.
||Convenience to the taxpayer
||Taxes should be certain and clearly understood by taxpayers so that they can calculate their tax liabilities. The method of payment should be straightforward.
||Convenience to the government
||Tax rates should be simple to adjust and as cheap to collect as possible.
||Minimal disincentive effects
||Taxes may discourage people from working longer or harder, from saving, from investing or from taking initiative. It is desirable that these disincentives should be kept to a minimum.
Of course, not all these requirements can be met at the same time. One of the most serious conflicts is between vertical equity and the need to keep disincentives to a minimum. The more steeply the rich are taxed, it is argued, the more serious are the disincentive effects on them likely to be (see the blog post from 2012, The 50p income tax rate and the Laffer curve). Another is between vertical equity and equity between recipients of services. Some of the people most in need of government support are the poorest and hence pay the least taxes.
The crucial question is what is regarded as ‘fair’. What is vertically equitable? According to the second article below, people’s preferred tax rates depend on how information is presented. If information is presented on how much tax is paid by the rich, people generally feel that the rich pay too much. If, however, information is presented on how much income people are left with after paying tax, people feel that the rich still have too much and ought to pay more tax.
The majority of people in the UK feel that tax avoidance, although legal, is morally wrong. According to the results of an HMRC survey in 2015, “the majority (63%) of respondents felt that the use of tax avoidance schemes was widespread. However, the majority (61%) also responded that it was never acceptable to use a tax avoidance scheme. The most frequent reason given as to why it was unacceptable was that ‘it is unfair on others who pay their taxes’.”
In making judgements about the fairness of tax, people generally have inaccurate knowledge about the distribution of income, believing that it is more equal than it really is, and about the progressiveness of the tax system, believing that it is more progressive than it really is. Despite this, they want post-tax income distribution to be more equal.
What is more, although people generally disapprove of tax avoidance, it is the system that allows the avoidance of taxes that they want changing. As long as it is possible to avoid taxes, such as giving gifts to children to avoid inheritance tax (as long as the gift is made more than seven years before the person’s death), most people see no reason why they should not do so themselves.
The following articles look at tax avoidance and people’s attitudes towards it. They are all drawn from The Conversation, “an independent source of news and views, sourced from the academic and research community and delivered direct to the public.”.
Explainer: what are ‘tax havens’? The Conversation, Tommaso Faccio (5/4/16)
When it comes to tax, how do we decide what’s fair? The Conversation, Stian Reimers (8/4/16)
Six things a tax haven expert learned from the Panama Papers The Conversation, Ronen Palan (6/4/16)
The Panama Papers The International Consortium of Investigative Journalists
Exploring public attitudes to tax avoidance in 2015: HM Revenue and Customs Research Report 401 HMRC, Preena Shah (February 2016)
2010 to 2015 government policy: tax evasion and avoidance HMRC/HM Treasury (8/5/15)
- Distinguish between tax avoidance and tax evasion.
- Give some examples of tax avoidance.
- Look through the various principles of a tax system and identify any conflicts.
- What problems are there in having a highly progressive tax system?
- What is a ‘shell company’? How can it be used to avoid and evade taxes?
- What are bearer shares and bonds? Why were they abolished in the UK in 2015?
- What legitimate reasons may there be for a company or individual using a tax haven?
- To what extent might increased transparency in tax affairs discourage individuals and companies from engaging in aggressive tax avoidance?
- What light does/can behavioural economics shed on people’s perceptions of fairness?
- How might the use of absolute amounts or percentages influence people’s thinking about the fairness of a tax system? What implications does this have for politicians in framing tax policy?
- In the principal–agent problem, where the principals are the tax authorities and the agents are taxpayers, why does asymmetric information arise and why is it a problem? How do the tax authorities seek to reduce this problem?
Some of the largest companies around the world operate in multiple locations. This allows them to take advantage of wider markets, cheaper transport and of course, lower taxes. In many cases, we see companies selling in one country, but locating their Headquarters in another, where tax rates are cheaper and hence their tax bills are lower. Much criticism has been levelled at such companies, who are accused of not paying their fair share in tax. There has been a crackdown on these companies and the UK is playing a leading role in this tightening of tax laws. Google is the latest company to face a large payment in backdated taxes.
This is a company with a complex structure, which has involved Bermuda as a key location, with its zero rate of corporation tax and a Irish European base. Though locating its business in different countries is legal, it has now agreed to pay HMRC £130 million in back taxes from 2005, following a 6 year investigation. Google will also change its accounting system such that it pays more tax in Britain for sales in this country.
Google may be the first in a line of companies making such changes to its accounting practices following a global drive to tackle the low levels of taxes paid by these large companies. This change in tax rules may bring welcome relief to government coffers, though criticisms remain about the ‘real’ figure that Google owes. As an example of this: in 2013, Google’s UK revenues were $5.6bn. Yet it only paid £20.5m in tax on its UK profits. The Head of Google Europe, Matt Brittin said:
“The rules are changing internationally and the UK government is taking the lead in applying those rules so we’ll be changing what we are doing here. We want to ensure that we pay the right amount of tax.”
Mr Brittin was clear in saying that these back dated taxes are not evidence that they had been paying too little tax in previous years. He confirmed that they were abiding by tax laws at the time and that tax laws are now changing and hence so will the amount of tax they pay. He continued:
“I think there was concern that international companies were paying only in respect of profits that they make and those were the rules and the pressure was to see us pay in respect of the sales we make to UK customers – and the same for other companies…So, we are making a change because we want to continue to comply with the rules and the rules are changing.”
As the push to tighten tax laws changes, with firms paying more tax on sales as well as profits, we may observe more companies changing their accounting structures. The OECD has taken a big step in simplifying international tax laws and the coming years will tell us just how big an impact this will have and whether companies such as Google will face tax bills in other European countries as well. The following articles consider this taxing matter.
Google agrees £130m UK tax deal with HMRC BBC News, Kamal Ahmed (23/01/16)
Google strikes £130m back tax deal Financial Times, John Gapper (22/01/16)
Google strikes deal with UK tax authority Wall Street Journal, Sam Schechner and Stephen Fidler (23/01/16)
Google agrees to pay HMRC £130m in back taxes The Guardian, Kevin Rawlinson (23/01/16)
Google tax labelled ‘derisory’ by Labour’s John McDonnell BBC News (23/01/16)
Google to pay £130 million UK back taxes, critics want more Reuters, Tom Bergin (23/01/16)
Google to pay UK £130m in back taxes The Telegraph (22/01/16)
Google says it will pay £130m in back taxes Independent, Adam Barnett (23/01/16)
Google ‘agrees’ to pay £130m in extra UK tax after outrage when it coughed up just £20m on UK sales of nearly £4bn Mail Online, Imogen Calderwood (22/01/16)
Google agrees to pay $185 million in UK tax settlement Bloomberg, Brian Womack (23/01/16)
- What is the difference between a tax on sales and a tax on profits?
- How can companies legally avoid tax? Do you think they have a moral duty to pay tax?
- If firms face higher rates of taxation, how will this affect their costs and profits?
- Why are the larger multinationals, such as Google more able to engage in tax avoidance schemes?
- Do you think the problem of tax avoidance is one of the negative consequences of globalisation?
- Is the criticism about the ‘low’ amount of taxes paid to HMRC justified?
- The OECD has taken a leading role in tightening international tax policy. Do you think this will negatively impact the competitiveness of the global market place?
- What are the costs and benefits to a country of having a low rate of corporation tax?
An investigation by the International Consortium of Investigative Journalists has revealed how more than 1000 businesses from 340 major companies from around the world have used Luxembourg as a base for avoiding huge amounts of tax. Many of the companies are household names, such as Ikea, FedEx, Apple, Pepsi, Coca Cola, Dyson, Amazon, Fiat, Google, Accenture, Burberry, Procter & Gamble, Heinz, JP Morgan, Caterpillar, Deutsche Bank and Starbucks. Through complicated systems of ‘advanced tax agreements’ (ATAs), negotiated with the Luxembourg authorities via accountants PricewaterhouseCoopers (PwC), companies have used various methods of avoiding tax.
Although such measures are legal, they have denied other countries vast amounts of tax revenues on sales generated in their own countries. Instead, the much reduced tax bills have been paid to Luxembourg. The result is that this tiny country, with a population of just 550,000, has, according to the IMF, the highest (nominal) GDP per head in the world (estimated to be $116,752 in 2014).
So what methods do Luxembourg and these multinational companies use to reduce the companies’ tax bills? There are three main methods. All involve having a subsidiary based in Luxembourg: often little more than a small office with one employee, a telephone and a bank account. All involve varieties of transfer pricing: setting prices that the company charges itself in transactions between a subsidiary in Luxembourg and divisions in other countrries.
The first method is the use of internal loans. Companies lend money to themselves, say in the UK, from Luxembourg at high interest rates. The loan interest can be offset against profit in the UK, reducing tax liability to the UK tax authorities. But the interest earned by the Luxembourg subsidiary incurs very low taxes. Profits are thus effectively transferred from the UK to Luxembourg and a much lower tax bill is incurred.
The second involves royalty payments for the use of the company’s brands. These are owned by the Luxembourg subsidiary and the overseas divisions pay the Luxembourg subsidiary large sums for using the logos, designs and brand names. Thus, again, profits are transferred to Luxembourg, where there is a generous tax exemption.
The third involves generous allowances in Luxembourg for losses in the value of investments, even without the company having first to sell the investments. These losses can be offset against future profits, again reducing tax liability. By transferring losses made elsewhere to Luxembourg, again usually by some form of transfer pricing, these can be used to reduce the already small tax bill in Luxembourg even further.
Tax loopholes offered by tax havens, such as Luxembourg, the Cayman Islands and the Channel Islands, are denying exchequers around the world vast sums. Not surprisingly, countries, especially those with large deficits, are concerned to address the issue of tax avoidance by multinationals. This is one item on the agenda of the G20 meeting in Brisbane from the 12 to 16 November 2014.
The problem, however, is that, with countries seeking to attract multinational investment and to gain tax revenues from them, there is an incentive to reduce corporate tax rates. Getting any binding agreement on tax harmonisation, and creating an essentially global single market, is likely, therefore, to prove virtually impossible.
Webcasts and videos
Luxembourg Leaks: Tricks of the Trade ICIJ in partnership with the Pulitzer Center (5/11/14)
Luxembourg ‘abetted’ companies in avoiding taxes France 24, Siobhán Silke (6/11/14)
Tax deals with Luxembourg save companies billions, says report Deutsche Welle, Dagmar Zindel (6/11/14)
Luxembourg: the tax haven and the $870m loan company above a stamp shop The Guardian, John Domokos, Rupert Neate and Simon Bowers (5/11/14)
Luxembourg leaks: nation under spotlight over tax avoidance claims euronews (6/11/14)
Northern and Shell used west Dublin address to cut Luxembourg tax bill on €1bn The Irish Times, Colm Keena (6/11/14)
The ATO’s global tax avoidance investigation ABC News, Phillip Lasker (9/11/14)
Pepsi, IKEA Secret Luxembourg Tax Deals Exposed TheLipTV, Elliot Hill (9/11/14)
Leaked Docs Expose More Than 340 Companies’ Tax Schemes In Luxembourg Huffington Post, Leslie Wayne, Kelly Carr, Marina Walker Guevara, Mar Cabra and Michael Hudson (5/11/14)
Luxembourg tax files: how tiny state rubber-stamped tax avoidance on an industrial scale The Guardian, Simon Bowers (5/11/14)
Fact and fiction blur in tales of tax avoidance The Guardian (9/11/14)
companies engaged in tax avoidance The Guardian, Michael Safi (6/11/14)
The Guardian view on tax avoidance: Europe must take Luxembourg to task The Guardian, Editorial (6/11/14)
G20 leaders in the mood to act on tax avoidance after Luxembourg leaks Sydney Morning Herald, Tom Allard (6/11/14)
Scale of Luxembourg tax avoidance revealed economia, Oliver Griffin (6/11/14)
EU to press Luxembourg over tax breaks amid fresh allegations BBC News (6/11/14)
Luxembourg leaks: G20 alone can’t stamp out tax avoidance The Conversation, Charles Sampford (7/11/14)
‘Lux leaks’ scandal shows why tax avoidance is a bad idea European Voice, Paige Morrow (8/11/14)
EU to Probe Luxembourg’s ‘Sweetheart Tax Deal’ with Amazon International Business Times, Jerin Mathew (7/10/14)
Luxembourg Leaks: Global Companies’ Secrets Exposed The International Consortium of Investigative Journalists (5/11/14)
- Distinguish between tax avoidance and tax evasion. Which of the two is being practised by companies in their arrangements with Luxembourg?
- Explain what is meant by transfer pricing.
- Do a search of companies to find out what parts of their operations as based in Luxembourg.
- In what sense can the setting of corporate taxes be seen as a prisoner’s dilemma game between countries?
- Discuss the merits of changing corporate taxes so that they are based on revenues earned in a country rather than on profits.
- What type of agreement on tax havens is likely to be achieved by the international community?
- Is it desirable for companies to be able to offset losses against future profits?
The UK Shadow Chancellor, Ed Balls, has announced that, if Labour is returned to power in the next election, it will bring back the 50% top rate of income tax (see also). This will apply to incomes over £150,000.
But will this raise more tax revenue? The question here concerns incentive effects. Will the higher rate of income tax discourage work by those earning £150,000 or encourage tax avoidance or tax evasion, so that the total tax take is reduced? The Conservatives say the answer is yes. The Labour party says no, claiming that there will still be an increase in tax revenue.
The possible effects are summed up in the Laffer curve (see The 50p income tax rate and the Laffer curve). As the previous post stated:
These arguments were put forward in the 1980s by Art Laffer, an adviser to President Reagan. His famous ‘Laffer curve’ (see Economics (8th edition) Box 10.3) illustrated that tax revenues are maximised at a particular tax rate. The idea behind the Laffer curve is very simple. At a tax rate of 0%, tax revenue will be zero – but so too at a rate of 100%, since no-one would work if they had to pay all their income in taxes. As the tax rate rises from 0%, so tax revenue would rise. And so too, as the tax rate falls from 100%, the tax rate would rise. It follows that there will be some tax rate between 0% and 100% that maximises tax revenue.
As Labour is claiming that re-introducing the 50% top rate of income tax will increase tax revenue, the implication is that the economy is to the left of the top of the Laffer curve: that, at current level of income, the curve is still rising.
Work by HMRC, and published in the document The Exchequer effect of the 50 per cent additional rate of income tax, suggested that the previous cut in the top rate from 50% to 45% would cut revenue by around £3.5 billion if there were no incentive effect, but with the extra work that would be generated, the cut would be a mere £100 million. This implies, other things being equal, that a rise in the rate from 45% to 50% would raise only a tiny bit of extra taxes.
However, the HMRC analysis has been criticised and especially its assumptions about the incentive effects on work. Then there is the question of whether a rise in the rate from 45% to 50% would have exactly the reverse effect of a cut from 50% to 45%. And then there is the question of how much HMRC could reduce tax evasion and avoidance.
The following article from the Institute for Fiscal Studies examines the effects. However, the authors conclude that:
… at the moment, the best evidence we have still suggests that raising the top rate of tax would raise little revenue and make, at best, a marginal contribution to reducing the budget deficit an incoming government would face after the next election.
But there is also the question of equity. Putting aside the question of how much revenue would be raised, is it fair to raise the top rate of tax for those on high incomes? Would it make an important contribution to reducing inequality? This normative question lies at the heart of the different views of the world between left and right and is not a question that can be answered by economic analysis.
50p tax – strolling across the summit of the Laffer curve? Institute for Fiscal Studies, Paul Johnson and David Phillips (Jan 2014)
- Distinguish between tax evasion and tax avoidance.
- How would it be possible for a rise in tax rates to generated less tax revenue?
- Could policies shift the Laffer curve as opposed to merely resulting in a move along the curve?
- What is meant by ‘taxable income elasticity (TIE)’? What are its determinants?
- Is the taxable income elasticity at the top of the Laffer curve equal to, above or below zero? Explain.
- Why did the Office for Budget Responsibility chairman, Robert Chote, conclude that, whatever the precise answer, we were ‘strolling across the summit of the Laffer curve’?
- Explain why ‘there is little additional evidence to suggest that a 50p rate would raise more than was estimated by HMRC back in 2012’.
- What contribution can economists make to the debate on the desirability of reducing inequality?