As we reported last week, the EU badly wants its own tax on corporate income:
The EU has borrowed quite a bit of money in recent years, and the government of the European Union is now in the very same situation as the U.S. government: its cheap debt is maturing just as interest rates are high and rising.
When cheap debt is replaced with expensive debt, the EU desperately needs more tax revenue to fill the budget gap.
Foremost among the sought-after revenue sources is a tax on corporate income, or “profits” as the legal and political minds in Brussels prefer to call it. The idea is to impose a tax rate of 1.5% and to have the member states collect the tax on behalf of Brussels.
There are a number of reasons why this tax is a bad idea. I mentioned two of them last week:
- The European economy is in poor shape; the last thing it needs is a new tax; and
- The tax would be distortionary in that it would hit member states differently depending on how important corporate income is to their economy.
Here is another reason to stop the EU’s profit-tax grab: it is impossible to lock in the tax base. Either the tax becomes a power tool that the EU can use against recalcitrant member states, or it becomes the most unpredictable cost item in any corporation’s finances.
The idea of an EU-specific profits tax originates in a very long campaign by the Organization for Economic Cooperation and Development, OECD, against what they call “harmful” tax practices by multinational corporations. For more than 20 years, the OECD has worked to stymie—and eventually eliminate—the opportunities for businesses, and by extension individuals, to move to a tax residence of their liking.
In plain English, the OECD has been trying to remove the ability for countries and territories to compete for financial and human capital with low taxes. This phenomenon is known as international tax competition, and it is beneficial to everyone—except high-tax governments. The idea that a country can cut taxes to become more competitive is attractive both from an economic viewpoint and from the perspective of national sovereignty. Yet as explained in detail by Dan Mitchell, president of the Center for Freedom and Prosperity and the world’s leading expert on tax competition, there are formidable forces at work to end the right of nations to exercise fiscal sovereignty.
What the OECD is doing is nothing short of creating a global tax cartel, with governments banding together against their very own taxpayers. The European Union has been more than willing to join this cartel, for reasons that are never spelled out explicitly, but dwell not-so-subtly just under the rhetorical surface. It is strongly implied in the anti-tax competition campaign that their goal is to protect governments with high taxes and expansive, expensive welfare states.
The call for a global minimum corporate income tax was a first foray by the high-tax cartel into policy making. The attempt by the EU to create its own corporate tax is part of the next step, namely to solidify the enforcement of higher taxes. The fact that the EU also needs more revenue to bankroll its own bad fiscal habits is, cynically speaking, a fringe benefit for the tax collectors in Brussels.
So far, the tax-cartel enforcement aspect of this new EU profit tax has gone unnoticed. That is unfortunate; the EU has already shown its willingness to try to bully member states that do not bow to its wishes. Other governments do the same.
The bullying mechanism is not visible from the surface of the tax proposal. It is buried in its technical details, underneath the flat-rate idea that the current debate is focused on. It has understandably attracted attention, since the idea is that member states add it onto their own corporate income taxes. As I pointed out in last week’s analysis, this has caused controversy based on the very different burdens that this tax would impose on individual EU member states.
Beyond the apparent macroeconomic distortions, this tax has the potential to be both complicated and unpredictable. Most of all, though, it has the potential of working as an enforcement tool against tax competition. Given the specific tax base that the EU wants to use, it is fairly easy for the tax-o-crats in Brussels to construct the tax so that it will neutralize any efforts by individual member states to break away from the EU’s desired tax uniformity.
Here is how it would work. When the EU defines the tax, it pinpoints the base for tax collection as a corporation’s “residual profit.” There is no EU-sourced document that defines what this type of profit is; the same term is used by the OECD, again without providing any definition of the term. To get some analytical clarity, we have to turn to the Bulletin of International Taxation, BIT, a publication of the International Bureau of Fiscal Documentation. In an article for BIT from 2021, Stephen Shay, professor of tax law with Boston College, concisely explains the term “residual profit” in its proper context.
A residual profit is the money that a corporation makes on top of what is technically referred to as ‘risk-free’ and ‘risk-based’ income. These three categories of income add up to the money earned by the corporate owner, i.e., the shareholder. He is, of course, also the legal owner of corporate income, which means that for practical purposes, we can think of the income discussed here as, simply, corporate income.
Let us relate the three categories of income to each other (using strictly hypothetical numbers):
- Suppose a corporation makes a ‘profit’ of €1,000;
- Of this, €200 is risk-free income;
- Risk-based income is €500; and
- Residual income is €300.
The risk-free part is defined as the money that the corporate owner could have made if he had chosen to invest in a risk-free asset instead of corporate shares. As Shay points out in his article, sovereign debt—treasury securities—is the go-to definition of an investment without risk. Normally, that definition of risk-free assets is limited to debt issued by governments with a perfect credit score. Shay is kind enough to include the U.S. government in the risk-free category, despite its recent downgrade and less-than-perfect credit score.
When the EU defines its corporate tax, it excludes the risk-free part of the income from the tax base for one simple reason. If that income is burdened with an extra tax, investors will quickly move away from the stock market and put their money in treasury securities instead. After all, if you can make €200 from owning government debt, why own shares in a corporation and have to lose some of that income to taxes?
To be clear, the risk-free part of corporate income is not free from taxes altogether. Current taxes apply; risk-free income would be shielded from this tax only.
In addition to the risk-free category of income, a corporation earns money to compensate for investor risk related to the purchase of a specific asset. Together, the risk-free and risk-compensating income categories are referred to as ‘normal’ income. In the words of Shay, this is “the return necessary to compensate the investor for the risk of the investment.”
In other words, this is the money the corporation needs to make in order to secure the continued satisfaction of its shareholders.
If the corporation earns less than normal income, it loses investors. If, on the other hand, it earns more than normal income, it earns ‘residual’ income. It is this part of the corporate earnings that the EU wants to tax.
This is the point where the EU’s proposed tax becomes financially unpredictable, but also a political tool for member-state tax compliance.
The major problem with the intended tax base is in the method for defining the income to which the tax applies. In short, to isolate the amount that is ‘residual income.’ The metrics used to identify it will be dependent not on the performance of the corporation per se, but on how investment alternatives perform.
It is easy to construct a scenario where the income on risk-free assets falls. All that is needed is a repetition of the episode a few years ago when yields on sovereign debt vanished. Zero interest rates eradicated earnings on treasury securities. Accordingly, in the example above, suppose that the risk-free income falls to €100.
Since the risk-based income is the same, i.e., €500, this means that the residual income increases from €300 to €400. All of a sudden, without doing anything at all, the corporation is forced to pay a third more in corporate income tax to the EU.
The tax burden can, of course, decline if the risk-free income rises, but that only adds to the absurd volatility of the bill for this tax.
The EU would (hopefully) never pass a tax that has this ridiculous property; the three categories of income would not be defined in real time, but rather based on some technocratic scale included in the tax code. Therefore, a more likely scenario is that the EU simply adopts a tax rate, sets a bureaucratically determined threshold for it, and calls the income above that threshold ‘residual income.’ While this makes the tax burden more predictable for the taxpayer, it forfeits one of the stated purposes of targeting just the residual part of corporate income, namely to avoid causing so-called efficiency losses in the economy.
An efficiency loss occurs when economic decision-makers, i.e., households/workers, investors, and employers/entrepreneurs, choose a less-perfect alternative when buying, selling, producing, and consuming, than they otherwise would have done. In the context of the EU tax, the less-perfect alternative is chosen because taxes make the perfect choice economically undesirable. This is why the EU wants to leave normal, i.e., risk-free and risk-compensating, income out of its tax base.
It sounds good to say that a tax is designed to avoid efficiency losses in the economy. In practice, though, that avoidance is merely a theoretical concept; neither corporate executives nor shareholders know on a regular basis how to separate their earnings into the normal and residual categories. Therefore, the tax that the EU is proposing is nothing more than an added burden on top of European corporations that are already burdened enough by taxes, regulations, and expectations of political correctness.
But wait—there’s more. As mentioned, this tax can be used to neutralize attempts at tax competition between EU member states. The method that the EU could apply is based on the income categories we just reviewed. All the EU has to do is determine that a cut in the corporate income tax in, say, Hungary would be tantamount to an increase in the residual income earned by corporations in Hungary. This would therefore expand the tax base for the EU tax, which, as a consequence, would then go up.
If the tax is designed with this purpose in mind, it will automatically neutralize any tax cut by an individual country. While the current proposal does not appear to come with this mechanism, it could easily be added later; the idea with the current proposal for a corporate income tax is to establish the tax itself. Once it is in place, it can be tweaked and tuned for whatever extra functions the EU would like to add—in addition to collecting revenue, of course.
