Pascal Saint-Amans, Director, OECD Centre for Tax Policy and Administration and Andreas Schleicher, Director, OECD Directorate of Education and Skills. Today’s post is also being published on the OECD Education and Skills Today blog
Investing in skills is crucial for fostering inclusive economic growth and creating strong societies. In an increasingly connected world, skills are particularly important for citizens to get the most out of new forms of capital, such as big data and robotics. More and more, policy makers are recognising that rapid change in technologies and work practices mean that people will have to continually upgrade their skills throughout their lives.
This new reality raises many questions for governments, firms and individuals, including: who is to pay for all these skills investments? In many OECD countries, student debt is rising, and in many others, public debts are persistently high. How can policy makers decide on the right financing mix for students and governments?
This is where taxes have an important role to play. In a nutshell, delivering educational services will depend on taxes, and good tax income will depend on good educational services. A new OECD Tax Policy Study, Taxation and Skills, released today, highlights the role of the tax system in ensuring that the right financial incentives are provided for investments in skills. This means making sure that governments, individuals and firms all share the costs and the benefits of better skills.
In addition to raising the revenue to finance government spending on skills, every OECD country uses the tax system to provide support for skills investments. Provisions such as tax credits, tax deductions and reduced tax rates on student income help governments support skills investments both early on and later in life. Sharing the costs in this way can make investing in skills more affordable, although these tax provisions need to be well-designed.
Besides helping share costs, the tax system divides the returns to skills between governments and students. When investments in skills yield returns, it means that individuals get higher wages, and governments get more tax revenue.
The results published today show that these returns to skills are substantial. In almost every country examined, both students and governments earn a sound return on skills investments. In some countries, however, policies could be improved to better share the returns to skills between individuals, firms and governments. Rising earnings premiums paid to skilled workers across OECD countries means that the returns to skills may grow into the future. This means better wages for individuals, more profits for firms and more sustainable public finances for governments, a win all around.
In spite of these high returns, many workers do not have the right financial incentives to make the necessary investments in their skills to succeed throughout their lives. Unlike physical assets, like property and equipment, human capital cannot be used as collateral for borrowing to finance investments. This impedes access to credit for individuals’ skills investments. Firms may also underinvest in skills because they worry that newly skilled workers may be poached by competitors. Often, individuals and firms do not have access to the right information to make informed choices about how they can invest in their skills.
Designing tax and spending policies to encourage skills investments is crucial. Useful policy approaches can include refundable tax credits for lifelong learning, income-contingent loans for tertiary education, or extra tax deductions for firms that invest in their workers’ skills.
OECD governments are increasingly looking at how policies can be designed to raise productivity, innovation and growth. We hear a lot about how tax systems can encourage investments in physical capital and innovative technologies through R&D tax credits and other measures. The report released today shows the importance of tax policies that are equally geared towards incentivising investments in human capital.
Today’s post from Ngozi Okonjo-Iweala, Co-ordinating Minister for the Economy and Minister of Finance, Nigeria, concludes a series of ‘In my view’ pieces written by prominent authors on issues covered in the Development Co-operation Report 2014: Mobilising resources for sustainable development. The Report is being launched today in London with the Overseas Development Institution, and you can watch the event by registering here.
Developing country governments would do well to strengthen their tax systems so they can mobilise the domestic resources they need to finance their own development. This is particularly true for African countries, where the recent trend of decreasing ODA shows no sign of reversing.
In developing countries in general, revenue administration is often hampered by weak organisational structures, low capacity of tax officials and a lack of modern, computerised, risk-management techniques. The value-added tax “gap” alone is estimated at around 50-60% in developing countries, compared with only 13% in developed countries. The International Monetary Fund (IMF) estimates that for many low-income countries, an increase in tax revenues of about 4% of GDP is attainable.
Since the 1990s, many African countries have made progress in improving their domestic tax capacities and receipts. Despite these improvements, however, there are still many revenue leaks that need to be plugged.
In Nigeria, we are making concerted efforts. Following the recent revision of our GDP to USD 510 billion, our tax-to-GDP ratio declined from 20% to about 12%, several points below the 15% tax-to-GDP threshold recommended by the IMF for satisfactory tax performance. Yet with our increasingly diversified economy, there is room to greatly improve our tax administration capacity and increase our tax revenues.
A recent diagnostic exercise to examine the bottlenecks in our tax collection processes revealed some interesting findings. For example, about 75% of our “registered” firms were not in the tax system! Moreover, about 65% of Nigeria’s registered taxpayers had not filed their tax returns over the past two years. With the support of external consultants, we are introducing remedial measures to improve tax performance and estimate that we can raise an additional USD 500 million in non-oil tax revenues in 2014.
The international community has an important role to play in supporting such efforts by developing countries, and evidence shows that this can yield impressive returns (see also Chapter 14). The OECD has found that every USD 1 of official development assistance (ODA) spent on building tax administrative capacity can generate as much as USD 1 650 in incremental tax revenues (Chapter 14). Yet to date, only limited funds have been targeted at improving tax institutions and tax policies.
To support the broader goal of mobilizing financing for the post-2015 development agenda, ODA can also be used in many other creative ways, for instance to leverage private financial resources (Chapter 11).
In my view, realising the full potential of domestic resource mobilisation in developing countries – and in Africa in particular – is central to discussions on financing the post-2015 development agenda. It will be particularly important to deploy a greater proportion of ODA in low-income countries to support their tax administration efforts. Realising this potential will require strong commitment and leadership from developing country policy makers, as well as the support of the international community.
The new OECD report on Addressing base erosion and profit shifting (BEPS) doesn’t sound like the kind of thing anybody would read for fun, but I guarantee that if you do read it, you’ll want to tell your friends (and enemies) about what you discover in its 80 or so densely written pages. Especially if you pay taxes. For instance, according to the IMF, in 2010 Barbados, Bermuda and the British Virgin Islands received more foreign direct investment (FDI) than Germany (5.11% of global FDI for the islands versus 4.77% for Germany) or Japan (3.76%). During that same year, these three small “jurisdictions” also made more foreign investments (4.54% combined) than Germany (4.28%).
So what is BEPS? “Erosion” refers to the erosion of national tax bases. “Profit shifting” is one way this happens. Companies use a number of schemes to shift profits across borders to take advantage of tax rates that are lower than in the country where they made the profit. Some multinationals end up paying as little as 5% in corporate taxes when smaller businesses are paying up to 30%. It’s all perfectly legal, and exploits the fact that tax systems are still essentially nation-based and were designed for the “old” economy in which, for example, profits from intellectual property were relatively unimportant. But even in the old economy, firms took steps to ensure that international taxation didn’t harm them. Many domestic and international rules to address double taxation of individuals and companies originated from principles developed by the League of Nations in the 1920s.
One of the most common mechanisms for exploiting flaws in the international tax system is a hybrid mismatch arrangement. As we explained in this post, the basic idea behind hybrids is to have the same money or transaction treated differently by different countries to avoid paying tax. For example, declaring the same transaction as either debt or equity depending on the tax rules of the various countries involved. Hybrids often feature dual residence, companies that are residents of two countries for tax purposes. Take Amazon for instance. Officially, they may only have a delivery service in many of the countries where they sell things. In Europe, the main business is based in Luxembourg, and the billions of euros in sales income generated elsewhere is not taxed in those countries.
The passages in the report about Luxembourg are well worth quoting. The Grand Duchy (population half a million) features in a discussion on so-called Special Purpose Entities (SPEs): “entities with no or few employees, little or no physical presence in the host economy and whose assets and liabilities represent investments in or from other countries and whose core business consists of group financing or holding activities”. Total inward stock investments into Luxembourg for 2011 were equal to $2,129 billion, with $1,987 billion being made through SPEs. Outward stock investments from Luxembourg were equal to $2,140 billion with about $1,945 billion USD being made through SPEs.
When I read the report, I thought that was a typo and checked the original data in the OECD Investment Database. But no, plucky little Luxembourg really did attract over $2 trillion in 2011. Luxembourg’s Benelux partner the Netherlands did even better. Total inward stock investments for 2011 were $3,207 billion, with $2,625 billion channelled through SPE. Outward stock investments from the Netherlands were equal to $4,002 billion with about $3,023 through SPEs.
Along with hybrid mismatches and SPEs, another favourite is transfer pricing (explained in more detail here). Around 60% of world trade actually takes place within multinational enterprises, for example the headquarters in the US paying a subsidiary in India to carry out research or manufacture components. This payment is a transfer price. Transfer prices are used to calculate how profits should be allocated among the different parts of the company in different countries, and are used to decide how much tax the MNE pays and to which tax administration.
There is no simple method for calculating a transfer price, so the final value is the result of a negotiation between the company and the tax authority. Ideally, this would be based on equal access to information, a shared objective and a “zero sum game” where an exemption in one jurisdiction is offset by tax in another. It’s not. International business consultancies have more people working on transfer pricing than any national tax authority. Prem Sikka of Essex Business School, co-author of a paper on The Dark Side of Transfer Pricing, claims that “Ernst & Young alone employs over 900 professionals to sell transfer pricing schemes. The US tax authorities employ about 500 full-time inspectors to pursue transfer pricing issues and Kenya can only afford between three and five tax investigators for the whole country.”
BEPS raises a number of questions concerning fairness and equity, including the fact that “if other taxpayers (including ordinary individuals) think that multinational corporations can legally avoid paying income tax, it will undermine voluntary compliance by all taxpayers – upon which modern tax administration depends.” There are wider economic risks too, for example employment, innovation and productivity could suffer if post-tax profit becomes the main criterion for investment.
So what should be done about BEPS? From the above, you’ll have understood that national solutions aren’t going to work. The report was commissioned by the G20 and the OECD will draw up an Action Plan, developed in co-operation with governments and the business community, to quantify the corporate taxes lost and provide concrete timelines and methodologies for solutions to reinforce the integrity of the global tax system.
If you’ve any experience of how these international efforts work, your reaction may be that there will now be years of discussion followed by a vague declaration that something must be done. So here’s a nice surprise for you: “It is proposed that an initial comprehensive action plan be developed within the next six months so that the Committee on Fiscal Affairs can agree it at its next meeting in June 2013. Such an action plan should (i) identify actions needed to address BEPS; (ii) set deadlines to implement these actions; and (iii) identify the resources needed and the methodology to implement these actions.”
By the way, did you know that one of the Virgin Islands was the inspiration for Stevenson’s Treasure Island? You couldn’t make it up.
UPDATE July 19 2013 The Action Plan against BEPS
Queen Elizabeth sent her first email long before you did. I got that from one of those sites giving details of this day in history, according to which she sent it on March 26th 1976 from the Royal Signals and Radar Establishment. (The Ministry of War used real names in those days, whereas now RSRE is part of something that calls itself QinetiQ.) Anyway, I was looking to find some great OECD-related anniversary that I could write about (the first lip reading tournament held in America?) to justify not reporting on the Annual International Meeting on Transfer Pricing under the auspices of the Tax Treaty and Transfer Pricing Global Forum being held here today and tomorrow.
Transfer pricing is important and interesting, it’s just that, as Brian Atwood, chair of the OECD Development Assistance Committee noted in this post the other day, it’s one of those subjects that’s “founded on concepts that are both technically demanding and arduous to understand and implement”. In fact, delegates to the meeting will be working on how to simplify and streamline the process, since even the experts admit that the rules are complex.
So what is transfer pricing and why does it matter?
Around 60% of world trade actually takes place within multinational enterprises, for example the headquarters in the US paying a subsidiary in India to carry out research or manufacture components. This payment is a transfer price. Transfer prices are used to calculate how profits should be allocated among the different parts of the company in different countries, and are used to decide how much tax the MNE pays and to which tax administration.
They’re also useful to the company itself first, because they can avoid being taxed twice if the various countries they are active in have signed agreements with each other on how to tax MNEs. In most cases, these are based on the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
In many cases, they’re calculated using a technique with the deceptively simple name of “the arm’s-length principle”, although some countries, notably Brazil, use other methods. The ALP states that operations should be priced by comparing them with similar operations carried out on a commercial basis at market prices, as if both parties were independent entities – at arm’s length from one another.
In practice, this can be extremely difficult, particularly in developing countries. For instance, the developing country subsidiary may be the only firm in its particular line of business, so there’s nobody to compare with. Likewise, transactions involving high value-added services or intangible assets like intellectual property may be unique. And in many countries, publicly available information that the tax authorities can use is limited.
Given that there is no simple method for calculating a transfer price, the final value is the result of a negotiation between the company and the tax authority. In an ideal world, this would be based on equal access to information, a shared objective and a “zero sum game” where being taxed in one jurisdiction is offset by an exemption in another.
Of course it doesn’t work like that. Companies want to pay as little tax as possible and governments need tax revenue. There’s a whole international business whose goal is to help companies “manage the level of taxes paid on a global basis at a competitive level” as PwC put it in their prospectus. These international consultancies have more people working on transfer pricing than any national tax authority. Writing in The Guardian, Prem Sikka of Essex Business School, co-author of a paper on The Dark Side of Transfer Pricing, claims that “Ernst & Young alone employs over 900 professionals to sell transfer pricing schemes. The US tax authorities employ about 500 full-time inspectors to pursue transfer pricing issues and Kenya can only afford between three and five tax investigators for the whole country.”
The meeting at the OECD coincides with an initiative from The International Tax Review to ask tax practitioners to vote for who they think are the leading forces in global transfer pricing development. Apart from PwC, there are NGOs like ActionAid, MNEs like GlaxoSmithKline, and multilateral agencies and international organisations, including the OECD. You can vote here.
The OECD Observer has good articles explaining transfer pricing in more detail:
How much you pay in tax depends on personal allowances, tax rates and brackets, social security contributions and benefits; the numbers can start to get confusing.
One way to cut through the muddle is to think in terms of the tax wedge. In basic terms, this is the difference between the net earnings that a worker takes home at the end of the year and what it costs to employ that worker. On the employer’s side, this cost includes the worker’s salary as well as employer contributions for social security (e.g. healthcare, pensions); on the worker’s side, the negatives are income tax and employee social security payments, while the positives include the salary and, possibly, cash benefits, for instance.
The tax wedge ranges from just over 15% in Mexico for a single worker on an average wage, to just over 55% in Belgium.
Most OECD countries have seen huge rises in public debt during the crisis. That’s going to have to be repaid eventually, which is going to mean higher taxes or lower spending or – more likely – both. So, government spending priorities are set to be a hot topic over the next few years. To get a sense of current priorities, take a look at this interactive graphic on the OECD Factblog.