Mobilising measures for healthy tax competition

While advanced EAP economies such as Australia, Japan, Hong Kong, China, and New Zealand offer few tax incentives, developing EAP economies offer a broad range, including blunt instruments such as tax holidays and reduced rates, with costly revenue implications. EAP, Sub-Saharan Africa, Latin America, and the Caribbean regions have the highest frequency of countries offering tax holidays.

illustration photo/ Source: freepik.com

The quest to entice more FDI is understandable, but research consistently shows that firms do not rank tax incentives as the primary reason for choosing where to invest. Instead, political and macroeconomic stability, the legal environment, and labour skills are the key determinants of FDI, according to the World Bank Global Investment Competitiveness Report 2020.

In EAP, competition for FDI triumphs over efforts to rationalise tax incentives, leading to sizable revenue losses. For example, in Laos, the World Bank’s forthcoming public expenditure review report will indicate that the corporate income tax (CIT) gap – the difference between taxes legally owed and those collected – was over 80 per cent in 2020. In practice, competition leads to a race to the bottom, with large investors able to play one country off another to reach favourable deals that involve long tax holidays.

This has led to increased tax incentives in a number of EAP countries. Notably, Cambodia, Indonesia, Fiji, Laos, Myanmar, and Papua New Guinea have all ramped up their incentive offerings. As a result, CIT productivity in the region, defined as the ratio between actual CIT collection as a share of GDP and the standard statutory rate, is low.

As a high-level, composite indicator, CIT productivity reflects the efficiency of the overall CIT system and is, among other things, highly sensitive to blunt profit-based incentives such as tax holidays and rate cuts.

In 2019, CIT productivity hovered around 10 per cent or less in Laos, Myanmar, the Philippines, and Papua New Guinea – significantly lower than averages observed in EAP overall (14.6 per cent) or in Europe and Central Asia (18.6 per cent).

Excessive tax incentives undermine the fairness and efficiency of the system and reduce the government’s capacity to finance growth-enhancing investment in infrastructure and human capital. This is particularly acute in developing East Asia where the average tax to GDP ratio is 13.1 per cent, significantly less than their aspirational high-income peers who average around 17.6 per cent.

This situation could change next year when the global minimum tax (GMT) comes into effect. In October 2021, the G20 introduced the global agreement on CIT that aims to achieve a global minimum effective rate of 15 per cent for multinational enterprises (MNEs) with a global turnover above $810 million. Although ambitious, the agreement is set to be implemented next year.

The GMT does not directly obligate countries to adopt a minimum CIT rate of 15 per cent. However, the plan incentivises countries to raise their effective CIT rate to the 15 per cent minimum.

Two sets of rules are applied. The first allows countries where the parent company of an MNE is taxable to impose a top-up tax on the profits of any foreign subsidiaries, paying an effective rate of less than 15 per cent. If the home country of the parent company chooses to impose a CIT rate of less than 15 per cent, then the second rule allows the host country where the MNE subsidiary carries out its business activities to charge top-up taxes on the subsidiary.

Effectively, while countries are free to offer tax holidays and CIT rates below 15 per cent, as GMT rules are coming into effect, they are giving away their taxing rights to the FDI exporting countries, or countries where MNE subsidiaries operate. At the same time, MNEs will no longer benefit from tax holidays and reduced rates because there will always be one or several countries that will bring their effective rate to 15 per cent.

Countries that do not act upon the GMT, especially developing countries with a wide range of incentives, could lose out when other countries introduce domestic tax rules to top up under-taxed profits. Several EAP countries, including Australia, Japan, South Korea, Malaysia, and New Zealand, are advancing implementation.

At a minimum, countries should evaluate the effective rate applicable to businesses operating in their jurisdictions that are subsidiaries of the MNEs that will be subject to the GMT. If there are cases where the effective CIT rate is below 15 per cent, countries should consider introducing domestic top-up taxes to expand their tax base.

In addition, countries should consider reforming their incentives to align with the GMT. Countries could go further by overhauling their CIT policy framework to be compatible with the GMT while making their CIT regime more attractive to investment, stimulating economic growth.

The GMT provides an opportunity for developing EAP countries to raise much-needed domestic revenue as part of a coordinated global agreement to set a minimum corporate tax rate. EAP countries should embrace this opportunity and use the GMT global coordination as a springboard to overcome harmful regional competition by committing to stronger regional coordination on related matters.

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