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Combating Fiscal Fraud and Empowering RegulatorsBringing tax money back into the COFFERS$

Brigitte Unger, Lucia Rossel, and Joras Ferwerda

Print publication date: 2021

Print ISBN-13: 9780198854722

Published to Oxford Scholarship Online: February 2021

DOI: 10.1093/oso/9780198854722.001.0001

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Capital Taxation and International Cooperation

Capital Taxation and International Cooperation

The Causes and Consequences of Automatic Exchange of Information

Chapter:
(p.112) 7 Capital Taxation and International Cooperation
Source:
Combating Fiscal Fraud and Empowering Regulators
Author(s):

Leo Ahrens

Fabio Bothner

Lukas Hakelberg

Thomas Rixen

Publisher:
Oxford University Press
DOI:10.1093/oso/9780198854722.003.0007

Abstract and Keywords

This chapter addresses the causes and consequences of automatic cross-border exchange of taxpayer information (AEI). First, we argue that the introduction of AEI was enabled by the willingness of the United States to exert its superior economic power. Second, we find that AEI leads to shifts of international investment out of tax havens, while at the same time very sophisticated tax evaders have been able to use loopholes in the AEI regime. Third, we focus on the impact of AEI on domestic tax policies and show that AEI removes the pressure of international tax competition and enables governments to increase taxes on internationally mobile capital. International cooperation in the form of AEI increases the domestic policy space of governments under conditions of economic globalization and may enable a return to more progressive tax systems and a reversion of the trend of rising income and wealth inequality.

Keywords:   tax evasion, automatic exchange of taxpayer information, capital taxation, tax avoidance, globalization, international cooperation, financial transparency

7.1 Introduction

Internationally mobile capital is hard to tax. Wealthy individuals can evade taxes by investing in secretive tax havens and (illegally) failing to report their capital income to their home tax administrations. Multinational corporations can avoid paying taxes by (legally) shifting their (paper) profits to low tax countries. Public scandals such as the Panama Papers, Paradise Papers, and Lux Leaks, combined with significant deficits in public budgets in the aftermath of the financial crisis, have raised the political salience of these practices. Enjoying a significant boost due to increased public pressure, the OECD, coordinating the international community’s actions against international tax flight since the 1960s, (re)launched two policy processes. First, it revived the OECD Harmful Tax Competition initiative, first launched in 1998 (OECD 1998) that aims at improved financial transparency to fight international tax evasion of (mostly personal) portfolio capital. Second, it launched a new policy process against ‘base erosion and profit shifting (BEPS)’ in 2012 (OECD 2013) that aims at international tax avoidance by multinational corporations (MNC). The first policy process culminated in the adoption of automatic exchange of taxpayer information (AEI). In 2014, 51 countries adopted the so-called common reporting standard (CRS) by multilateral agreement (OECD 2014), and a further 58 have joined since, including all countries formerly notorious for their financial secrecy.1 This agreement was widely hailed as a breakthrough in the fight against international tax evasion (Christensen and Hearson 2019). According to most observers, however, the BEPS project has so (p.113) far failed to deliver substantial progress in the fight against (legal) tax avoidance (Büttner and Thiemann 2017; Lips 2019).2

These developments raise interesting questions of high policy relevance. In this contribution, we provide an overview of the questions and the answers we found in our research and in that of other international tax scholars. First, how can we explain the different outcomes of the initiatives against tax evasion and tax avoidance? Why was the international campaign against tax evasion successful, whereas the campaign against avoidance failed? We argue that the difference is explained by domestic politics in the hegemonic state (USA), enabling credible sanction threats against governments providing financial secrecy, but not against governments abetting corporate profit shifting.

Second, having investigated the causes of these policy outputs, we focus on their consequences and effectiveness. In the ecosystem metaphor of the ‘Combatting Fiscal Fraud and Empowering Regulators (COFFERS)’ project (Chapter 2), we analyse the impact of a Darwinian shock on national jurisdictions. Has AEI really made a difference for nation states? Specifically, has AEI led to changes in the pattern of international investment? Have tax evaders shifted their investments out of tax havens?3 There is a small body of literature addressing the impact of various instruments of information exchange on investment flows. We review this literature and describe our contribution to this debate. We find that AEI did indeed lead to the expected shifts in international portfolio investments. We also investigate to what extent potential loopholes in the AEI regime identified by critics, have been used by tax evaders. We find scattered evidence for their increasing relevance, suggesting that loopholes should be closed swiftly before they begin to undermine the regime (see e.g. Meinzer 2017).

Going beyond the impact on investment flows, we improve upon existing literature by investigating an indirect effect of the Darwinian shock of AEI on national jurisdictions. We ask: Does AEI impact domestic tax policies? The hypothesis we investigate is that AEI removes the pressure of international tax competition and thus enables governments to regain ‘room to manoeuvre’, allowing them to increase taxes on internationally mobile capital. Indeed the data suggest that tax hikes on portfolio capital income have recently occurred across OECD countries. Can we attribute these domestic tax policy changes to AEI? How does AEI relate to or interact with other factors—most importantly, domestic political factors—that influence tax policy decisions? Leveraging the differential (p.114) success of cooperation against evasion and avoidance as a quasi-experiment, we find that the average tax rate on dividends in OECD countries is 4.5 percentage points higher in 2017 than it would have been absent international tax cooperation. Further, the results of a panel regression show that financial transparency, in conjunction with budget deficits, leads governments to increase taxes on dividends. These findings lend support to the notion that international tax cooperation increases the domestic policy space of governments under conditions of economic globalization.

The rest of the chapter is structured as follows: We first provide a brief primer on the international taxation of capital income and how tax evasion, avoidance and competition work (Section 7.2). In Section 7.3, we address the question of the differential success of the campaigns against evasion and avoidance. After that, we address the link between AEI and international investment (Section 7.4) and domestic tax policy (Section 7.5). Section 7.6 concludes the chapter and derives policy recommendations.

7.2 A Primer on International Capital Taxation and Its Deficiencies

According to the principles of international taxation enshrined in the OECD’s model tax convention (MTC), passive income from cross-border investment can be taxed where the investment is made (source country) and where the investor resides (residence country) (OECD 2017, Art. 10 and 11). To avoid double taxation, governments enter into bilateral tax treaties (BTTs) in which they agree on lower or zero withholding taxes applicable to investors from the partner country. Most OECD countries grant tax relief for taxes paid abroad but assert the right to tax households on their worldwide receipts of passive income (OECD 2018b, p. 24ff.). Otherwise, the government would advantage the recipients of foreign income over the recipients of domestic income, thereby violating the equal treatment and ability to pay principles underpinning most income tax systems (Scheve and Stasavage 2016, pp. 25–40).

Owing to the financial secrecy offered by tax havens, this is precisely what happened in practice. While households are legally obliged to include their worldwide capital income in their income tax statement, tax authorities traditionally had a hard time detecting underreporting. If at all, BTTs provided for information exchange upon request, which conditioned the dissemination of account data on prior evidence for tax evasion and the domestic availability of requested information (Rixen 2008, p. 75ff.). Even if a foreign tax authority provided the required evidence, tax havens could refuse to share data by referring (p.115) to domestic banking secrecy provisions. As a result, foreign account holders paid no or very little tax on unreported capital income.4

The available evidence suggests many made use of the opportunity to evade taxes. According to the most conservative estimate, 8 per cent of global household financial wealth was held unrecorded in tax havens between 2001 and 2008 (Zucman 2013, p. 1323). Further, tax evasion contributes massively to income and wealth inequality as it is mostly the very rich engaging in such activity (Alstadsæter et al. 2019). Tax evasion on this scale does not only cause immediate revenue losses and distributive concerns, but it also creates indirect losses by pressuring residence countries into tax competition. In the absence of meaningful tax cooperation, most OECD countries chose to cut taxes on capital income to prevent capital flight to tax havens (Ganghof 2006; Genschel and Schwarz 2013). Peer Steinbrück, the former German minister of finance, summarized the general logic when introducing a special tax rebate for personal capital income in 2006. From his perspective, ‘25% of X [was] still better than 42% of nothing’ (Handelsblatt 2006). With a lower premium on tax evasion, he hoped, fewer taxpayers would risk criminal charges for underreporting returns to their foreign accounts.

In contrast to passive income, the MTC assigns the exclusive right to tax the business profits of a foreign-owned enterprise to the source country. In principle, the branch of a multinational group is thus taxable by the state in which it is permanently established (OECD 2017, Art. 7). Since the activities of MNCs are spread across related entities in many countries, the headquarter can exploit its control over the group’s integrated production and wealth chains to channel taxable income from branches across the world to related holding companies in tax havens (Seabrooke and Wigan 2017). For example, MNCs may manipulate the transfer prices for transactions between their branches. Their tax haven holding may overcharge its sister subsidiaries for the use of the group’s intellectual property (IP), thereby siphoning off their local profits through inflated royalty payments. According to the arm’s length standard (ALS), tax authorities can revalue controlled transactions if they are not priced as similar transactions between independent firms. However, since the IP of MNCs is often unique, tax examiners lack the necessary comparable for a post-hoc correction of manipulated transfer prices (Picciotto 1992, 2015).

By sticking to a representation of MNCs as networks of separate entities and prescribing an outdated procedure for the valuation of controlled transactions, (p.116) current international tax law enables corporations to avoid tax payments of between $500 and 650 billion every year (Cobham and Janský 2018; Crivelli et al. 2016). Again, direct losses are exacerbated by competitive pressure, which depresses future revenue from corporate taxation. Many OECD countries have lowered the statutory corporate tax rate, which is the decisive rate to attract paper profits (Devereux et al. 2008), to guard themselves against excessive outflows of taxable income. It was cut from an average of 46 per cent in 1983 to 22 per cent in 2017 (see Figure 7.1).

The ability of governments to engage in tax competition is due to an important feature of the international tax system—its sovereignty preserving character. The rules of international taxation merely seek to disentangle overlapping national tax systems resulting from domestic, politically salient choices. They operate only on the interfaces of national tax systems and do not interfere with them. Governments retain full formal authority over designing the main components of their tax law—namely, the tax base, tax rate, and system of taxation—independently from other governments. This allows them to use their tax policies to compete with other governments for investment and profits. While the resulting competition, as we will see, significantly constrains governments’ policy choices, i.e. their de facto sovereignty, it is based precisely on their de jure sovereignty that is left mostly untouched by the rules of international taxation (Rixen 2011).5

(p.117) Overall, this shows two things: First, the system is indeed in need of repair, as it can be gamed by international taxpayers who have ample opportunity for tax evasion and tax avoidance. Second, beyond immediate revenue losses, tax evasion and avoidance also have an indirect effect that is potentially even more important—they create tax competition among governments. Such competition does not only involve tax havens but also draws in big countries, which feel compelled to adapt to aggressive tax policies.6

Given these adverse effects, governments have tried to establish effective cooperation against tax evasion and avoidance. It is to the politics of these efforts and their outcomes that we turn next.

7.3 Fighting Evasion and Avoidance: Why the Difference?

Over the past decade, a series of scandals have raised the political salience of international tax policy. Some of these scandals, including the Panama and Paradise Papers, uncovered how rich households exploited financial secrecy offered by tax havens to hide income from the tax office. Others like the Luxembourg Leaks focused on the profit-shifting strategies of multinational firms, in some cases minimizing the tax payments of highly profitable companies to zero. Irrespective of their specific focus, both types of scandal uncovered how the most potent taxpayers shirked their fiscal responsibilities at a time of austerity. By creating widespread popular indignation, the scandals thus pushed governments in the Group of 20 (G-20) into action. The G-20 tasked the OECD to develop countermeasures to tax evasion and tax avoidance. The organization responded with a CRS for the multilateral and automatic exchange of information on bank accounts held by non-residents and a major overhaul of international corporate tax law intended to curb base erosion and profit-shifting (BEPS) (Lips 2019; Hakelberg 2020).

Despite the existence of potential workarounds, most analysts consider the introduction of the CRS a significant breakthrough (Eccleston and Gray 2014; Emmenegger 2015; Palan and Wigan 2014). At the time of writing, all traditional secrecy jurisdictions had begun to regularly report the account balances and capital income of non-residents to their respective home countries (Ahrens and Bothner 2020). To this end, the governments of countries like Austria, Luxembourg, or Switzerland had to overcome considerable domestic opposition to the dismantling of banking secrecy provisions that had provided their private banking sectors with a crucial competitive advantage and had become essential (p.118) elements of national identity (Eggenberger and Emmenegger 2015; Hakelberg 2015). Assessments of the BEPS project are less euphoric. Analysts acknowledge the underlying ambition and complexity of the task, but stress that the fundamental legal principles enabling profit-shifting remain in place (Büttner and Thiemann 2017; Picciotto 2015). Why have OECD governments not reduced the scope for corporate tax avoidance to the same extent they have for tax evasion by households with offshore accounts?

In contrast to previous accounts, emphasizing distinctive balances of power in international negotiations over countermeasures to tax evasion and avoidance (Grinberg 2015; Lips 2019), our research shows that the US government dominated negotiations over the CRS and the BEPS project’s final recommendations. Owing to the country’s unique combination of internal market size and centralized regulatory authority, the Obama administration could credibly link market access to compliance with its tax policy demands. Instead of the power balance between states, differences in the discursive and structural power of affected interest groups in the United States provide the decisive explanation for progress in the fight against tax evasion and stasis in the fight against tax avoidance (Hakelberg 2020). Discursive power refers to an interest group’s ability to shape the interests and perceptions of policy-makers and the general public by linking its demands to established norms and ideas (Fuchs and Lederer 2007). Structural power is based on an interest group’s ability to make credible threats of disinvestment (Hacker and Pierson 2002).

When entering office, the Obama administration was committed to fighting tax evasion by households with offshore accounts and tax avoidance by multinationals artificially shifting profits to tax havens (Office of the Press Secretary 2009). In the wake of the UBS scandal, which revealed how the bank and its US clients had circumvented preexisting reporting requirements, the administration’s proposals for the removal of corresponding loopholes faced little political opposition. Households break the law when they underreport foreign capital income in their tax return. Hence, they face the difficult task of raising political support for crime when trying to prevent countermeasures. Moreover, they play a negligible direct role in job creation, and their wealth and income usually result from their embeddedness in a network of social ties that make relocation difficult (Young 2017).

Against this background, congress adopted the centrepiece of the Obama administration’s anti-evasion efforts in March 2010. The Foreign Account Tax Compliance Act (FATCA) obliges foreign banks to automatically report US taxpayers’ foreign income to the Internal Revenue Service (IRS) (Hakelberg 2015, 2016). The act draws its force from a built-in threat of sanctions that makes foreign banks, which do not comply with reporting requirements, subject to a 30 per cent withholding tax on payments from US sources. Because of the dominant role of the American financial market, no international bank could (p.119) afford this penalty. Instead, they lobbied their home governments to repeal secrecy legislation that prevented their compliance with FATCA (Grinberg 2012; Emmenegger 2017). The exchange relations were codified in bilateral intergovernmental agreements (FATCA IGAs) with foreign jurisdictions. Virtually all important tax havens entered into such agreements (Eccleston and Gray 2014).

By forcing tax havens to abolish secrecy provisions, the US government enabled the EU and OECD to request equivalent cooperation from these countries and multilateralize the AEI (Hakelberg 2015). In the EU, large member states and the Commission invoked a most-favoured-nation clause contained the Directive on Administrative Cooperation to break Austrian and Luxembourgish opposition to an automatic information exchange of bank account data in the union (Hakelberg 2015). Likewise, the OECD developed its automatic information exchange policy with the support of the G-20. In 2014, the common reporting standard (CRS) was adopted on a multilateral basis (OECD 2014). However, it contained a significant exception. Since the US financial industry, which musters considerable discursive and structural power over the political process, opposed additional reporting requirements for US banks, the IRS still does not reciprocate the AEI, providing wealth managers in secretive US states such as Nevada or South Dakota with a comparative advantage in the attraction of hidden wealth (Hakelberg and Schaub 2018).

Similarly, the Obama administration’s efforts to curb profit-shifting by multinational cooperation faced fierce opposition from affected industries. In response to its initiatives, multinationals invoked the legality of tax planning, blaming legislators for the drafting of incoherent tax codes. Besides, they claimed to serve the public good by stressing their obligation to maximize profits on behalf of shareholders, and by linking a lower tax burden to more investment and jobs (Elbra and Mikler 2017). With these arguments, multinational corporations convinced enough members of Congress to block proposals from the Obama administration that would have forced them to repatriate foreign profits they had hitherto hoarded in tax havens to avoid tax payments in the United States. As a result, the Obama administration lacked a national regulatory model when Germany and the United Kingdom put corporate tax avoidance on the G-20’s agenda (Hakelberg 2020).

Although the US Treasury hoped at the beginning that the BEPS project would exert additional pressure on US multinationals, concern over the redistributive consequences of countermeasures proposed by European governments soon became the central issue. Contentious proposals included greater leeway for tax examiners in the recharacterization of controlled transactions between branches of the same group, an extension of the permanent establishment definition, determining when a government has the right to tax a company operating on its territory, and the reporting of information on profits, payroll, and intra-firm payments on a country-by-country basis. From the US perspective, all of these (p.120) proposals threatened to redistribute taxing rights away from a company’s country of residence and towards source countries where it produces or sells its goods and services. Ultimately, the Obama administration preferred a low foreign tax burden of US multinationals to the taxation of their foreign profits by EU countries. Its negotiators significantly pared back each of the contentious proposals, thereby essentially defending the international tax system’s status quo (Hakelberg 2020).

7.4 Information Exchange and Investment

Tax evasion is facilitated by the financial secrecy that tax havens offer to foreign customers. The previous section made clear that credible sanction threats from the US government led to significant progress in the fight against tax evasion. However, how effective is the automatic exchange of information relative to previous attempts at information exchange? This section embeds our corresponding findings in the relevant literature.

In the 2000s, countries negotiated a large number of information-on-request (IOR) treaties. They allow treaty partners to request information about capital holdings of individuals in partner jurisdictions. However, IOR treaties suffer from several vital shortcomings. Firstly, information requests require reasonable suspicion, which is difficult to come by considering the secrecy tax havens offer to their customers. Secondly, international investment networks were covered insufficiently by IOR treaties so that tax evaders could move their assets to non-compliant jurisdictions. IOR treaties, therefore, proved to be ineffective overall. Johannesen and Zucman (2014) find that they caused a modest reduction of assets in tax havens, but funds were merely relocated to non-compliant havens, ‘leaving roughly unchanged the funds globally held in tax havens’ (p. 75). Further analyses show that they also reduced inbound investments, i.e. by tax havens in non-haven jurisdictions (Hanlon et al. 2015; Menkhoff and Miethe 2019). However, Menkhoff and Miethe (2019) find that the effects of IOR treaties on both inbound and outbound investments dissipated over time. Overall, IOR treaties were thus ineffective in the fight against tax evasion.

Verdicts on another key policy initiative, the EU’s Savings Tax Directive (STD), are similar. The STD implemented a system under which information about foreign accounts was transmitted on an automatic basis, which implies that no reasonable suspicion is required. It covered 27 EU countries as well as several third countries and dependent territories. However, policy-makers were not able to resolve the pitfalls of previous efforts. Firstly, the STD allowed participating countries to levy withholding taxes on the capital incomes of foreign investors instead of disclosing their identity under automatic information exchange, effectively preserving banking secrecy. Most tax havens opted for this model (see Rixen and Schwarz 2012, p. 156). Secondly, the STD had an incomplete coverage of (p.121) capital forms, allowing evaders to shift their holdings from debt to equity portfolios to evade reporting. Lastly, not all jurisdictions offering financial secrecy participated, allowing evaders to shift funds to non-compliant havens. Empirical assessments show that the STD did affect cross-border investments, but it did not lead to a reduction of tax evasion overall (Caruana-Galizia and Caruana-Galizia 2016; Johannesen 2014; Rixen and Schwarz 2012).

The failure of past efforts led experts to call for international cooperation of unprecedented scale (Palan et al. 2010). To increase effectiveness, information should not be exchanged upon request but automatically. The FATCA and CRS have a comprehensive coverage of jurisdictions and capital forms and require financial institutions in participating countries to identify beneficial owners of financial assets. There seems to be limited opportunity to dodge information exchange like in the past. To assess whether the treaties are truly effective, Ahrens and Bothner (2020) analyse the Bank for International Settlements’ (BIS) Locational Banking Statistics (LBS), which cover information on foreign bank deposits and debentures held in 47 countries. A difference-in-difference analysis, which under plausible assumptions identifies the causal effect of the FATCA and CRS, shows that the treaties were successful overall. Investments in tax havens are estimated to be 67 per cent below where they would have been without the treaties. However, this estimate pertains solely to assets not successfully hidden behind corporate identities or trusts. Replication analyses using data from the International Monetary Fund’s Coordinated Portfolio Investment Survey (CPIS) corroborate the results.

Supplemental analyses show that unlike in past international cooperation, there is little evidence for treaty circumvention by deposit shifting or the use of shell corporations. Evaders do not seem to have moved funds to non-compliant jurisdictions, including both traditional tax havens and the US, which does not reciprocate information sharing. Furthermore, assets attributed to jurisdictions that traditionally host shell corporations did not increase. Although these results are cursory, the FATCA and CRS seem to be more effective than previous IOR treaties and the STD. For the time being, they have led to a reduction of cross-border tax evasion. However, it is crucial that policy-makers stay on their toes because significant loopholes remain, and new secrecy jurisdictions may emerge.

Most importantly, some jurisdictions have begun to offer tax residence and citizenship to foreign investors wishing to circumvent the reporting of their assets to their home countries. By obtaining a so-called golden passport or residence permit, a tax evader can document residence in a secrecy jurisdiction vis-à-vis the bank managing her accounts. As a result, the bank will no longer send information on her capital income to her former home country but to the tax haven that provided the submitted documents. Although the tax evader may spend most of her time in her country of origin, information on her foreign accounts may thus never reach the tax office at her place of primary residence. Our research shows (p.122) that portfolio investment from jurisdictions with golden passport schemes into the Eurozone increased relative to investment from jurisdictions without such schemes after the adoption of the CRS. However, there is no comparable effect on portfolio investment into the United States and the United Kingdom, and no effect whatsoever on internationally held deposits (Ahrens et al. 2020b).

The reason for this discrepancy might be the legal recognition of the Anglo-Saxon trust in common law countries. Here, trust arrangements enable wealthy households to obtain considerable legal tax benefits. In contrast, civil law countries do not recognize trusts, taxing the beneficial owners currently on the return to the portfolio held in trust (Harrington 2016). Therefore, golden passport schemes may be more attractive to wealthy European households seeking to benefit from similar reductions in wealth and income tax. At least, our secondary finding points in this direction. Similar to the primary result, we find that portfolio investment from jurisdictions with opaque or non-existent trust and company registers into the Eurozone also increased while there is no corresponding effect on portfolio investment in the United Kingdom and United States or deposits in general (Ahrens et al. 2020b). Next to a golden passport scheme, opaque trusts and shell companies may thus be a vital selling point for wealth managers in secrecy jurisdictions. Overall, however, there is only scattered evidence for AEI circumvention via golden visa or passport schemes and lax beneficial ownership registration.

7.5 Automatic Information Exchange and Domestic Tax Policy

The previous section has shown that AEI did have the expected effects on international portfolio flows: tax evaders shift their portfolios out of tax havens. But does international cooperation in the form of AEI also curb the pressures of tax competition? If residence countries receive full and high-quality information on their taxpayers’ foreign funds, the threat of capital flight, which led them to lower their tax rates in the past, disappears. Will this effect reverse the trend of ever-lower (portfolio) capital tax rates, which has marked the era of neoliberalism over the last 35 years (Swank 2006)? Researching the effects of AEI on domestic tax policy has not previously been undertaken. Our research on this issue charters into new territory.

Our theoretical argument is the following: once governments are freed from competitive pressure through AEI, they should be free to raise taxes in accordance with domestic political demands again. For example, left governments are generally in favour of higher taxes on capital (e.g. Basinger and Hallerberg 2004) and could seize the opportunity offered by financial transparency. Similarly, heavy budget deficits (e.g. Lierse and Seelkopf 2016) or voter demand for compensatory (p.123) fairness (Limberg 2019; Scheve and Stasavage 2016) could lead governments to increase taxes on portfolio capital. Figure 7.1 illustrates our argument.

Capital Taxation and International CooperationThe Causes and Consequences of Automatic Exchange of Information

Figure 7.1 Determinants of capital tax rates.

To submit this argument to an empirical test, we pursue two different strategies. In a first step, we leverage the differential success of the fight against tax evasion and avoidance described in Section 7.3 in a quasi-experiment. While there is adequate cooperation against portfolio capital tax evasion, avoidance of corporate profits taxes by MNCs mostly continues unhinged. Since the relevant domestic political determinants of tax rates are identical for business profits and portfolio capital, the difference in the effectiveness of cooperation should lead to a divergence in the respective tax rates.

Indeed, comparing the development of average tax rates in OECD countries on dividends at the shareholder level, an appropriate indicator for taxes on portfolio capital, with the statutory tax rate on retained corporate profits provides initial evidence for this theory (see Figure 7.2). Whereas dividend taxes increase after 2009, the year the G-20 countries credibly committed that ‘the era of banking secrecy is over’ (G-20 2009), corporate profits taxes continue to decrease. In a comprehensive difference-in-difference analysis, we estimate the average tax rate on dividends in OECD countries to be 4.5 percentage points higher in 2017 than it would have been absent international tax cooperation (Hakelberg and Rixen 2020).7

Capital Taxation and International CooperationThe Causes and Consequences of Automatic Exchange of Information

Figure 7.2 Average tax rates imposed on dividends and corporate profits in OECD countries (%, taxable income).

Note: Data is from OECD (2019b). Specifically, we obtain data on corporation taxes from the OECD tax database’s table II.1, where we use the indicator ‘combined corporate income tax rate,’ which compiles member states’ ‘combined central and sub-central (statutory) corporate income tax rate given by the central government rate (less deductions for sub-national taxes) plus the sub-central rate.’ Data on dividend taxes comes from the database’s table II.4, where we use the item ‘net personal tax,’ which ‘shows the net top statutory rate to be paid at the shareholder level, taking account of all types of reliefs and gross-up provisions at the shareholder level’. We excluded Norway and Finland in the empirical analysis. Due to the peculiarities of the dual income tax their tax policies during the 2000s included very extreme policy shifts. Nevertheless, our results hold if both countries are included. See Hakelberg and Rixen (2019) for details.

There is, however, substantial variation around this trend. Belgium, for instance, raised the tax rate on dividend payments from 15 per cent in 2008 to 30 per cent in 2018, Hungary lowered it from 35 per cent to 15 per cent and Sweden kept it constant at 30 per cent. This cannot be explained by financial secrecy alone. Furthermore, the binary approach of the diff-in-diff analysis disregards that some countries were subjected to a more significant increase in financial transparency than others. The US, for example, does not reciprocate information sharing, which implies that jurisdictions for whom financial services provided by the US are pivotal saw a lesser increase in transparency.

Therefore, our second empirical strategy aimed at investigating the variation across countries in more detail. In Ahrens et al. (2020a), and in line with the general theoretical model presented above, we argue that the variation in countries’ reactions to increased transparency depends on domestic factors. Transparency alone is not sufficient to motivate governments to increase tax rates. Transparency instead is an enabler because it complicates tax evasion by households, effectively giving governments leeway to increase tax rates as they see fit. However, governments may or may not use this leeway depending on domestic factors such as the ideological colour of governments, absence or presence of compensatory fairness arguments among voters as well as budget constraints. (p.124) (p.125) Such domestic factors are the drivers of tax policy decisions. Our main argument is that primarily those governments who experience domestic pressure to increase rates use the room to manoeuvre introduced by financial transparency.

The most critical domestic factor that drives tax increases is the budgetary situation of a government (Lierse and Seelkopf 2016). Financial transparency makes it more likely that higher taxes on capital income actually lead to higher tax revenue because evasion is less likely. Governments facing budget constraints should thus have an incentive to increase taxes on capital income when their investment environments become more transparent. Ahrens et al. (2020a) therefore expect an effect of budget constraints, on dividend tax rates, that depends on the level of financial transparency. In the same vein, we expect conditional effects of government partisanship, compensatory fairness demands (Limberg 2019; Plümper et al. 2009) and the mismatch between the taxation of labour and capital (Ganghof 2006).

To test the argument, Ahrens et al. (2020a) first develop a novel financial transparency indicator, which measures financial transparency in the investment networks of 35 OECD countries between 2001 and 2018. The resulting Investment Network Transparency Score (INTS) reveals a strong upward trend in transparency, reflecting the gradual replacement of banking secrecy with increasingly effective methods of information exchange. We use this indicator in multiple regression analyses to determine its conditional impact on tax rate reforms.

The results show that financial transparency does not have an independent effect on the taxation of dividends. As expected, the effect of transparency is conditional on a domestic factor, namely the budget balance. There is a significant interaction between financial transparency and budget balance. Negative budget balance in combination with high transparency motivates cabinets to increase taxes on dividends, which confirms the expectations. For the other domestic factors, there are no significant independent or interaction effects. The absence of an interaction between transparency and fairness concerns comes as a theoretically interesting surprise. However, the main results fit with our theoretical arguments. No government raises dividend tax rates just because of an increase in financial transparency. It seems that high financial transparency gives national governments the room to raise taxes on portfolio capital if they need revenue because of budget constraints.

7.6 Conclusion and Policy Implications

Unlike efforts to curb tax avoidance by corporations, international cooperation against tax evasion proved to be successful. As a result, governments regained manoeuvring room to democratically set domestic tax policies that had previously (p.126) been lost to the constraints of tax competition. However, pressing challenges remain.

First, there are remaining loopholes that plague the AEI regime. As our research shows, one problem is golden passport schemes that allow tax evaders to become citizens of countries that they never lived in. The OECD already put such schemes on its agenda and compiled a blacklist of jurisdictions providing golden passports (OECD 2018a). Governments must continue to apply pressure on countries offering golden passports to abstain from this practice. The second problem is that while the coverage of the AEI regime is high, several jurisdictions are still reluctant to join threatening its future success. Most importantly, the United States do not share information with foreign jurisdictions. This is especially worrisome because the US is the largest financial centre in the world. It has both an incentive and the possibility to develop tax haven operations in the future. States such as Delaware, Nevada, and South Dakota already allow foreign investors to establish shell corporations that do not require identity verification. The EU should pressure the US into participating in reciprocal AEI in the future. While the US is the most important financial centre of the world, the European market is certainly big enough to leverage economic power. However, in order to make its sanction threats credible, the EU would need to speak with one voice. This requires overcoming internal dissent. Abandoning the unanimity principle in EU tax policy in favour of simple or qualified majority voting would be a step in the right direction.

Second, a return to a truly progressive tax system hinges on effective cooperation in the area of business taxation. However, to date, no comparable breakthrough to AEI has been achieved. Political pressure to move forward on this front should be upheld. Replacing separate entity accounting and the ALS with unitary taxation, as currently proposed by the European Commission in its proposal for a common consolidated corporate tax base (CCCTB), seems to be the most ambitious but also the most promising way forward.

Third, and more generally, our findings bear on current debates about the role of international cooperation in the fight against growing income inequality and populism. While discussions of income inequality and taxation are often limited to national institutions and policies only (but see Piketty 2014), we show that the creation of enabling international institutions and policies are a necessary precondition for progress. If policy-makers aim to end the neoliberal and regressive tax policies that have characterized recent decades, they need to strengthen international cooperation. In contrast to assertions by nationalists, international cooperation does not constrain national policy choices. Instead, it expands the domestic policy space. Rather than being pressured by tax competition to lower taxes on portfolio capital, under AEI governments have real discretion over the applicable rate. In other words, while tax cooperation requires governments to give up some of their de jure sovereignty, they regain (p.127) de facto sovereignty, i.e. actual democratic control over their tax policy. International tax cooperation is an essential and necessary element of the normative vision of ‘sensible globalization’ that could end the current trajectory of unregulated ‘hyper globalization’, which is unsustainable because it puts all states into a ‘golden straitjacket’ that makes it impossible to compensate the losers of globalization at the national level (Rodrik 2011). In the face of rising nationalist and protectionist tendencies, it is high time for internationalists and international institutions to act on this insight and push for more effective tax cooperation.

7.7 References

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Notes:

(1) OECD (2019a).

(2) Recognizing the shortcomings of the BEPS project, the OECD has initiated a further policy process, often referred to as BEPS 2.0. Proposals include far-reaching reforms of the international tax system. At the time of writing this chapter, it is too early to tell whether BEPS 2.0 will bring significant reform or not.

(3) Chapter 14 sees this shock through an agent based model.

(4) They only paid tax, if they invested in countries with which their tax haven of choice had not negotiated a waiver of withholding taxes. In turn, low or zero treaty withholding rates provided committed tax evaders with an opportunity for round-tripping. By investing through a tax haven, which had struck a generous BTT with their home country, they could also strip the return on their domestic investment from its tax burden (Hanlon et al. 2015).

(5) Tax competition in the real world is different from the basic Tiebout model, which expects shifts of tangible factors of production in response to tax differentials (Tiebout 1956). While real competition for foreign direct investment and taxpayer residences exists, virtual competition for financial wealth and reported (‘paper’) profits is more intense (Genschel and Schwarz 2011, pp. 349–51). That is, nation-states do not primarily compete for production sites and blue-collar jobs. They compete for the deposits and portfolios of wealthy individuals, who evade taxation at their primary residence, and for the profits of MNCs, which avoid taxation where they develop, manufacture and sell their products.

(6) In this respect, international tax policy follows the maxim voiced by Margaret Thatcher on the occasion of the establishment of International Banking Facilities in London: ‘If you can’t beat them, join them’ (Eden 1998, p. 659).

(7) We control for important potential confounders—like the occurrence of a financial crisis that may affect tax rates on dividends differently from tax rates on profits, and the top rate on personal income that may be linked to dividend taxes but not corporate taxes.