Tax Avoidance in Developed Countries and Its Impact on Global Business

In 1789, Benjamin Franklin wrote a letter stating: “Nothing in this world can be said to be certain, except death and taxes”. Tax has long been seen as an unavoidable cost for business. Nowadays with the advantages of globalization however, multinational corporations (MNCs) have developed complex tax strategies to minimize this liability. Gunter & van der Hoeven briefly discussed an aspect of tax avoidance but disregarded the impact hereof on the global economy.

This research will analyze the effects of globalization on tax avoidance in developed countries and identify how MNCs participate in this occurrence. The outcome of this study will contribute to a better understanding of how MNCs avoid paying taxes in the respective countries of consumption. Moreover it could also guide as a foundation to further research how countries can adjust their tax revenue strategies and prevent this miss of income. This paper starts by defining tax avoidance and how this phenomenon has come to existence. Furthermore, it continues to analyze the impact from three different perspectives in business: government and legislation, global trade and competition, and the multinationals themselves. Lastly, the paper draws a conclusion on the issues relating to this topic.

Overview of Tax Avoidance

When discussing tax in the context of globalization, the definitions of tax avoidance and tax evasion are often mixed up. Hence, this paper will use the definitions as given by the Organization for Economic Co-operation and Development (OECD) whereby tax avoidance is “the arrangement of a taxpayer’s affairs that is intended to reduce his liability and that, although an arrangement could be strictly legal, it is usually in contradiction with the intent of the law it purports to follow”.

In contrast to this, tax evasion is defined by “illegal arrangements where liability to tax is hidden or ignored”. When analyzing the definition of tax avoidance, it quickly becomes visible that there is no clear black and white area that distinguishes right from wrong. This “gray” area often allows for creative methods to be developed in order to minimize a company’s tax liability. Although many different approaches exist, tax avoidance is mainly categorized into three groups: postponing of tax liability payments; portraying goods, services, income, or expenses at a rate which lowers or relieves the tax liability; or shifting revenue streams from high-taxed countries to low-taxed countries through various methods.

Government and Legislation

The government can best be divided into two groups with each a different interest for the country. On one side, policymakers emphasize minimizing tax avoidance gaps (more commonly referred to as anti-avoidance rules or AAR) and thereby stimulating a country of equal trade opportunities. On the other side, the group mainly exists of politicians and political scientists that compete in the international money market. The latter is hereby mostly interested in Foreign Direct Investments (FDI) as this, aside from tax revenue, also results in secondary benefits such as employment.

In addition to this, it is empirically proven by various studies that an increase in taxes shows a significant negative correlation with FDI. Assuming the perspective of the policymakers, it is noticeable that organizations such as the OECD and the European Union (EU) are currently gaining momentum in mitigating aggressive forms of tax avoidance. In the case of the EU member states, the potential missed tax revenues due to tax avoidance were estimated to be around EUR 1. 33 Trillion in 2014 according to Raczkowski. Although some people question Raczkowski’s methodology, most researchers agree that a significant revenue gap is present.

Knowing this potential gap in tax revenue, the OECD and groups such as the Tax Justice Network plead for the need of a better global governance platform that allows countries to exchange information. Although this is now becoming available upon a country’s request, the biggest problem, according to Rixen, lies in the fact that tax legislatures are mostly written within a country’s national framework, often disregarding conflicting interests with other countries.

In contrast to this, political researchers claim that creating strong global governance is too radical and for certain reasons, even undesirable. They indicate that corporate income tax rates from 1981 – 2008 clearly show a strong decrease for most developed countries. In that same timespan, however, gross tax revenue relative to a country’s GDP has remained stable. This led many political scientists to argue that corporate tax decreases have no significant impact on total tax revenue.

This claim, however, omits a valuable piece of evidence into the equation. While corporate tax rates in developed countries generally have fallen over time, the distribution of taxation has widened to a larger tax base (more new taxation forms other than corporate tax) resulting in a tax shift from MNCs to tax burdens aimed at small and medium size enterprises. An example hereof is the increase in labor taxation forms while lowering the capital gains tax in certain EU member states.

In conclusion, it seems that both politicians and economists are each measuring a country’s performance in their own way making it hard to compare the (dis)advantages of each. Nonetheless, one thing is sure, countries are actively competing to attract as many companies to their country, often neglecting that this drives at the expense of the local SMEs.

Global Trade and Competition

Although governments rest with indecisive conclusions on which tax strategy is best for the country, this part of the study focuses on how taxes impact trade and competition equality for profit-driven organizations. Looking at the grown global economy, it is evident that globalization has increased the amount of multinationals. Whereas in 1960, about 6, 000 multinational organizations were registered, the list has grown to almost 80, 000 in 2006.

This growing increase shows that globalization has, among other factors, positively impacted merger and acquisition (M&A) activity as many companies nowadays split their production into different processes in different countries. Although research about competitive advantages between multinationals and Small and Medium-sized Enterprises (SMEs) is ample, many case studies have explored how MNCs such as Starbucks, Amazon, Google and Fiat structure their legal entities and pursue aggressive tax avoidance strategies. In a particular case with Starbucks, Reuters investigated their earnings in the United Kingdom.

While the company has been active in the British market since 1998 and totaled a gross sales of around 3 billion pounds in those respective years, the company has only paid 8. 6 million pounds in corporate taxes. This in other words means that the company has so far paid a tax rate of less than 0. 3% while competing organizations in those same years were taxed around 24%.

In summary, what these multinationals above clearly indicate is that most MNCs operate with a combination of tax minimization strategies. One could therefore say that as long as all profit driven organizations can use the same tax minimization strategies, the competition could still be deemed fair. However, as often forgotten, SMEs cannot operate under these strategies as they require a certain minimum size of business in order to be financially viable. This leaves small coffee shops trying to compete with a chain such as Starbucks at a strong disadvantage.

Multinational Corporations

As shown in the previous chapters that certain governments let MNCs operate under privileged circumstances. This chapter discusses how multinational companies think about the tax avoidance strategies and what comes to mind in the decision making process of choosing these certain strategies. According to Evertsson, companies like Ikea simply make use of the situation given at hand. She indicated in her case study that countries often cut deals in order to become more attractive for investment opportunities.

Opportunistic organizations might hereby be inclined to make use of these incentives. Looking more specifically at tax incentives and the decision making process for MNCs, Rixen argues that the most sensitive form of taxation is the corporate tax rate of a country. Additionally, empirical evidence shows that other tax sensitive topics are items such as: ease of profit shifting and other discrete investment decisions, whereas issues such as the minimum required investment size play a less important role.

A third aspect often overestimated is reputational risk. Research revealed that while executives state to bear reputational risks in mind when determining their tax strategies, empirical evidence shows that there are no significant reputational costs after a MNCs aggressive tax avoidance policies are revealed. Most often, shortly after such an exposure, the company’s stock price declines but this is almost always recovered within the following 30 days.

In conclusion, tax avoidance is a phenomenon driven by the global market. Multinationals hereby indicate that shareholders generally see taxes as a cost that should be reduced as much as possible. MNCs operate in accordance with the law. They hereby believe that companies should not be held liable for tax avoidance activities as it is the country’s themselves who initially approved these gaps in the law.

Conclusion

In the media, multinationals are often seen as the offender pursuing illegal activities. The population hereby tends to confuse tax avoidance for tax evasion. This research indicates that tax avoidance is a completely legal method of minimizing a company’s tax liability within the framework of the law. The study reveals that globalization has given MNCs competitive advantages with regard to taxation laws. Countries are nowadays actively competing to attract foreign investors by incentivizing MNCs with favorable tax rulings. Opportunistic organizations can hereby cherry-pick the best deals of each country.

Politicians argue that these favorable rulings are necessary to stay competitive and that the lack in revenue is offset by the employment offerings that MNCs provide for the country. The missed revenue from taxation is often recovered by increasing tax burdens on SMEs leaving them at a disadvantage. Organizations such as the EU have started tracking aggressive forms of tax avoidance. Multinationals hereby respond that they should not be held accountable for their tax strategies. It is the countries’ legislatures that facilitated these possibilities in the first place.