Manon François*
- This article was originally published in the June 2021 edition of the 5 papers…in 5 minutes.
The past decade is characterized by an increasing attention to multinational firms (MNF) behavior not paying their fair share of taxes, which led to a pressing demand to reform international corporate taxation. In 2016, the United States started a debate about whether we should maintain a tax system based on the source principle, where firms are taxed where they produce, or whether we should shift the tax system to a destination-based one, in which firms are taxed where they sell their production. If consumers are considered immobile, a destination-based system would decrease tax optimization (also called profit shifting) possibilities. However, all countries currently use a source-based system, which leads firms to shift profits to low-tax countries, triggering tax competition between States.
In this paper, Manon Francois studies the choice between a source-based and a destination-based tax system for countries facing MNF that allocate profits across tax jurisdictions to reduce their tax payments. The model introduces several levels of decisions for both firms and governments. Firms decide where they declare their profits in order to maximize their after-tax profits. Countries choose their tax rate and enforcement level, which represents how much effort governments are willing to make to prevent firms from shifting profits. Countries also choose their tax base to maximize their tax revenues. The author first investigates the impact of the choice of the tax base on tax competition between countries. With a source-based tax system, firms always shift profits to low-tax countries, which incentivizes countries to lower their tax rate to compete with their opponents and attract profits. This leads to “a race to the bottom”, where tax rates dramatically decrease, thereby potentially reducing the amounts of tax collected. When one country unilaterally moves to a destination-based tax system, it behaves as a tax haven and will thus attract profits, even if it has a high tax rate, which still generates distortions. Only if all countries use destination-based taxation can this tax competition disappear. Therefore, the model shows that, to raise as much tax revenues as possible, source-based countries devote huge efforts into preventing firms from shifting profits. On the contrary, destination-based countries will let firms shift profits without constraints.
So when should countries use source-based over destination-based taxes? Overall, the author shows that all countries should use source-based taxation if firms generate large revenues. In this case, countries set a high tax rate that does not deter firms from declaring profits because governments prevent them from shifting profits. Otherwise, all countries should use destination-based taxes. Also, there exists no sustainable situation where only one country uses a source-based system and the other uses a destination-based system. Indeed, the source-based country would face firms declaring low or negative profits because firms have an incentive to shift profits out of the source-based country and into the destination-based country.
This has important implications. First, it suggests that the current international tax system could be the outcome of a noncooperative game played by rich countries. If the objective of countries is indeed to maximize tax revenues, they should stick to their current tax system. Second, it shows that a country deciding to move to destination-based taxation could incentivize other countries to implement such a reform, implying a new worldwide equilibrium tax system immune to profit optimization. The US has already made a move toward a destination-based tax system with the Tax Cuts and Jobs Act in 2017 but has not fully moved to destination-based taxation yet. Which one is bold enough to make the first move towards a destination-based tax system?
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References
Original title of the article: Profit Shifting and Equilibrium Principles of International Taxation
Published in: PSE working paper n°2021-43
Available at: https://hal-pse.archives-ouvertes.fr/halshs-03265056
This work has been awarded the Best paper prize 2021, Workshop on Industrial and Public Economics.
* PhD Student (PSE, University Paris 1 Panthéon-Sorbonne)
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This synthesis has been published in the June edition of “5 papers… in 5 minutes!” dedicated to PhD students work.
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