Globalization is likely over time to have a significant negative impact on countries’ ability to raise revenues through their tax systems. What steps can countries take to counter this problem?
Globalization and the consequent international integration, together with rapid technological progress, is likely to affect both the ability of countries to collect taxes and the distribution of the tax burden. Moreover, as time passes, globalization’s impact on tax revenues appears likely to increase and to become evident in countries’ revenue statistics.
The total tax burden of the member countries of the Organization for Economic Cooperation and Development (OECD) has increased substantially over the past three decades, from 26 percent of GDP on average in 1965 to 37 percent of GDP in 1997. This growth, which has slowed or even stopped in several countries in recent years, has been accompanied by some changes in the composition of tax revenue. While the share of personal income tax has fallen and that of corporate income tax has remained relatively stable, social security contributions have increased substantially. At the same time, there has been a distinct shift from specific taxes to general sales taxes. In the 1990s, the impact of globalization began to be felt more intensely as capital markets were liberalized and economies became more integrated.
Most industrial countries are collecting more tax revenue today than they did two or three decades ago. On closer inspection, however, one can detect what may be called “fiscal termites” gnawing away at the foundations of their tax systems. These termites are part of the evolving “ecosystem” of globalization, and whether they will eventually severely damage the fiscal houses remains to be seen. It is possible that, in the future, globalization will lead to new, innovative ways to use technology and knowledge to raise tax revenues. This does not diminish the need to assess ways in which current developments are likely to affect the tax system. I discuss below the impact of eight termites.
E-commerce and transactions
Electronic commerce, the first termite, has been growing at very high rates. A large share of world commerce (particularly between businesses) could soon be arranged through the Internet. According to The Economist, such e-commerce amounted to over $150 billion in 1999 but is projected to grow to more than $3 trillion by 2003. In the United States, it is estimated that some states may consequently lose as much as 4 percent of their sales tax revenues by 2003. There is, at the same time, no political impetus to tax Internet business, at least in the short term.
Several changes arising from electronic commerce will seriously challenge tax authorities. The first is a shift from paper transactions, which allow tax authorities to follow traces such as invoices, to virtual transactions, which may leave less identifiable traces. A second change is the important technological shift from the production and sale of physical products to digital ones. A number of products—such as music, photographs, medical and financial advice, and educational services—can now be downloaded directly over the Internet. This means that it will become increasingly difficult to define a “permanent establishment” for tax purposes. With a vague concept of tax jurisdiction, it becomes hard to define who should pay the tax or collect the money.
“These termites are part of the evolving ‘ecosystem’ of globalization, and whether they will eventually severely damage the fiscal houses remains to be seen.”
The second termite is that, in time, electronic money will substitute for real money in individual transactions. Chips in electronic cards will contain individuals’ money balances and be used to make payments and settle accounts, a trend that would increase difficulties for tax authorities. Such e-cash could be made available through either accounted or unaccounted systems. In the former, the e-cash issuer maintains an audit trail by keeping central records of transactions. This would not be the case with an unaccounted system, which lacks any central record of transactions. This lack of an audit trail would pose a risk to both VAT (value-added tax) and income tax collections. This problem will be compounded if it becomes possible to have payments in e-cash delivered over the Internet.
Trade within multinational corporations with operations in different countries is the third termite. This problem has recently grown in importance because of the fast growth in world trade and especially in trade within multinationals. Such trade creates problems for national tax authorities owing to the potential abuse of “transfer prices” by the multinationals, including on loans, the allocation of fixed costs, and the valuation of trademarks and patents. There is evidence that some enterprises manipulate prices to move profits from high-tax jurisdictions to those with low tax rates. Tax authorities are often at a loss on how to cope with this trend.
A recent survey of the transfer-pricing policies of more than 600 multinationals (domiciled in 19 countries) found that these corporations saw a clear connection between the desire to avoid double taxation and the use of transfer pricing (Ernst & Young, 1999). Many countries also felt pressured to resolve the complex business and transfer-pricing issues arising from globalization, particularly given the growing attention the revenue authorities in several countries are paying to the practice.
Many multinationals now realize that a global approach to designing and documenting transfer-pricing policies is desirable. An increasing number of countries are beginning to apply such arrangements, under which the criteria for applying arm’s-length principles are determined in advance. The OECD recently issued an annex to its previously released Transfer Pricing Guidelines suggesting how to conduct arrangements under the so-called mutual agreement procedure (Neighbour, 1999).
Offshore financial centers
Offshore financial centers and tax havens, the fourth termite, have gained importance as conduits for financial investments. Their growth has been stimulated by the flow of digital information, which allows money and knowledge to be moved easily and cheaply in real time, and by the regulatory arrangements of several countries. Estimates of deposits in such legal entities as international business corporations and offshore trusts exceed $5 trillion. It is unclear how much of the income earned on these is reported to tax authorities. The United Nations has argued that these entities are often used for money laundering and tax evasion. The Group of Seven industrial countries have set up the Financial Action Task Force and have developed a regulatory framework that, if properly applied, would reduce the possibility of money laundering. But solutions are both politically and technically complex.
Derivatives and hedge funds
The growth of new financial instruments and agents for channeling savings, such as derivatives and hedge funds, is the fifth fiscal termite. Many hedge funds operate from offshore centers and are little, or not at all, regulated. Many of the same problems mentioned earlier regarding electronic commerce arise to an even greater extent with investments of hedge funds. Similarly, with respect to the earnings from derivative instruments, there are huge problems in identifying individual beneficiaries, transactions, or jurisdictions.
One of the challenges from using complex financial instruments, such as derivatives, is that they can be used in tax-avoidance schemes by exploiting uncertainties and inconsistencies in their tax treatment. Distinctions between capital income and capital gains and losses, or between dividends and interest, become highly fluid. With the widespread use of derivatives, it is no longer possible to tax income from cross-border investments by withholding taxes at the source.
Inability to tax financial capital
The sixth fiscal termite is the growing inability or, often, unwillingness of countries to tax financial capital and the incomes of persons with highly tradable skills. As the international capital market becomes more integrated and efficient, it becomes more difficult for countries to tax mobile capital or highly skilled individuals at rates much higher than those that are imposed abroad. High tax rates in one country only serve as incentives to taxpayers to move capital abroad to jurisdictions that tax it lightly or to take up residence abroad. This has become a major unsolved issue within the European Union and has forced countries either to lower marginal tax rates on individuals or to introduce dual income taxes. Consequently, global taxes with high marginal rates will be much more difficult to impose effectively in a globalizing world.
Vito Tanzi was Director of the IMF’s Fiscal Affairs Department until his retirement in January 2001. He is now a Senior Associate at the Carnegie Endowment for International Peace in Washington.
Growing foreign activities
Increased activities by highly skilled individuals outside their country of residence are the seventh termite. Such activities often permit them to underreport—or to fail altogether to report—their foreign earnings to their own tax authorities. At the same time, more and more individuals invest their savings abroad in ways that allow them to avoid paying taxes. Although the European Commission has sought to stem the problem by advocating minimum taxes on income from financial assets, this has been strongly opposed by some European countries.
The enormous increase in foreign travel in recent years, which allows travelers to shop in places where sales taxes are low, is the eighth termite. Many small countries have reduced excises and other sales taxes on luxury products to attract foreign buyers. This reduces the degree of freedom that countries have in imposing excise taxes on easily transported products. This problem is likely to intensify in the coming years as even greater numbers of people travel. Already, many people are crossing frontiers solely to buy commodities such as cigarettes and liquor, or even automobiles, in countries where taxes are lower.
Can fiscal termites be exterminated?
It is likely that, if there are no changes to neutralize the effects of these fiscal termites, or offsetting pressures to increase taxes, the ratio of tax revenue to GDP will fall in many OECD countries and, perhaps, even in some developing countries. It is too early yet to measure this decline, and some academics have argued that a decline in this ratio may be beneficial to welfare. It may, however, be possible for the world community to develop ways of mitigating, if not totally neutralizing, the impact of these fiscal termites or to introduce new taxes to counter any potential revenue losses.
For many years, tax experts recommended the taxation of global income. Many countries attempted to put such a system in place. A fundamental change may be to shift from global income taxation toward explicitly schedular taxes that tax different types of incomes (wages, rents, interest, dividends) differently. Such an approach would make it possible to lower tax rates on mobile income tax bases. This might raise questions about the fairness of the tax system, but would allow countries to minimize potential revenue losses from capital flight and emigration induced by high tax rates. Recently, Italy and some of the Nordic countries have introduced systems of dual income taxation that combine progressive taxation of (immobile) labor income and transfer incomes with a proportional tax on (mobile) income from financial capital. But this change would only partially counter the downward pressure on tax collections.
Governments might develop ways to monitor electronic commerce and electronic money or introduce new taxes such as “bit taxes,” “Tobin taxes” on foreign exchange transactions, and the like. The political mood, especially in the United States, is against imposing new taxes on Internet transactions, but there could be progress in clarifying how e-commerce transactions might be taxed within the existing framework. A number of ideas have been considered under the overriding principle of trying to maintain neutrality in the treatment of electronic commerce relative to other forms of commerce.
It is possible that offshore financial centers and tax havens will be driven out of existence by strong, punitive actions by industrial countries. The OECD has been preparing guidelines for identifying tax havens, highlighting their lack of transparency and lack of any effective exchange of information with other tax authorities. One approach has been to publish a list of tax havens as a first step toward stemming money laundering and tax evasion. Many smaller states—as well as some not so small states—have complained strongly about such an approach and about being labeled tax havens.
Through computer technology, countries might agree to an unlimited exchange of information on taxpayers. Most bilateral tax treaties include proposals for the exchange of information between tax authorities. But, owing to the sheer volume of information and language differences, this can become a frustrating exercise when an exchange extends beyond a small number of countries.
Scrutiny of, and regulations governing, hedge funds could be intensified. The Financial Stability Forum—which was established in April 1999 to promote more formal coordination on issues of international financial stability—and other forums have debated this topic in the context of the reform of the international financial architecture. So far, however, there has been little focus on the tax implications of hedge funds.
The difficulties in applying a gross withholding tax to many financial derivatives have led to calls for a more comprehensive treatment of income tax that would apply a residence-based qualification to cross-border financial transactions. This could be done through an ad hoc calculation of income where each component of a derivative is defined and treated separately before aggregating the overall tax liability. But such an approach may not prove feasible.
Several multilateral initiatives are also being undertaken to counter the negative impact of globalization on tax collections. The OECD has prepared guidelines on how to address harmful tax competition at both the national and global levels. The European Union is also discussing the impact of tax competition, including formulating a code of conduct for business taxation to help reduce distortions within the union. More distant, and possibly Utopian, possibilities are for an international revenue system to collect some taxes or for a world tax organization to develop and coordinate solutions (Tanzi, 1995 and 1999).
Faced by these termites, as well as by others that may yet appear in the future, many countries, particularly those with high tax rates, would be advised to prepare for what could be sharp declines in tax revenues. They should also begin to think about how the negative impact of globalization and new technology might be turned around to facilitate constructive changes in the way taxes are collected. Computers are becoming a big help for tax administrations.
Tax administrators and policymakers will face challenges that will change the ways in which taxes have been levied and collected. Their response to these challenges will force them to mobilize fresh resources and imaginative solutions. They will also need to rely on taxes that will be less affected by the problems described above—such as taxes on immobile factors or resources—and on the development of new tax technologies. It would be prudent not to assume the problem will simply go away. What can reasonably be assumed is that future tax systems will have different structures and probably lower tax rates than those of today. But how different the structures will be and how much lower the burdens will be remain to be seen.
This article is based on the author’s “Globalization, Technological Developments, and the Work of Fiscal Termites,” IMF Working Paper 00/181 (Washington: International Monetary Fund, 2000). This paper is to be published in a special issue of the Brooklyn Law Review published by the Brooklyn Law School (New York) to commemorate its one hundredth anniversary.
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The Economist2000 “Survey on E-Commerce: Shopping Around the Web,” February26.
Ernst & Young1999 “Transfer Pricing 1999 Global Survey: Practices, Perceptions, and Trends for 2000 and Beyond,” Tax Notes InternationalNovember15 pp. 1907–37.
John Neighbour1999 “OECD Issues Guidance on Mutual Agreement APAs,” Tax Notes InternationalNovember22 pp. 1954–57.
VitoTanzi1995Taxation in an Integrating World (Washington: Brookings Institution).
VitoTanzi1999 “Does the World Need a World Tax Organization?” in The Economics of Globalization ed. by AssafRazin and EfraimSadka (Cambridge and New York: Cambridge University Press) pp. 173–86.