No winners in the race to the bottom | by Roman Grynberg

by Jun 5, 2012All Articles

zero-percentZero corporate tax rates and expensive incentives are not worth the investments they attract, writes Roman Grynberg.
The freeing up of international trade and the increased mobility of investment have resulted in what tax analysts frequently call a “race to the bottom” in terms of company taxes.  Although capital is now extremely mobile, the global community, through the International Monetary Fund (IMF), the World Bank and the Organisation for Economic Co-operation and Development, is still pressing countries to eliminate their remaining restrictions on capital flows.
But because capital is both mobile and scarce, countries desperate for investment that will create jobs often compete by lowering their taxes, using special incentive schemes to make countries that are otherwise un­attractive look fairly good.
For the Europeans and the Americans, this is a real issue that undermines their revenues and social model.
In 1983 the average statutory corporate tax rate of 13 Western European countries was 49.2%. By 2008 the average tax rate of these countries had dropped to 27.2%.
Legal tax incentives
But many large European countries, such as the United Kingdom, have also applied other legal tax incentives and provisions that have permitted companies to avoid paying local taxes. As a result, corporate tax revenues on both sides of the North Atlantic have not been growing in proportion to corporate profits.
So, with tax revenues not rising as needed, governments simply cut back on expenditure or shift the tax burden to other, more in­equitable taxes such as value-added tax, which fall on consumers who are not mobile and cannot easily move to another location where they could earn higher wages and pay less taxes.
In the 2000s, in response to the squeeze on taxation revenues caused by this competition, the OECD found an appropriate and easy target – the many small developing states that tried to copy Switzerland’s prosperity by establishing tax secrecy laws and tax havens – and introduced the “harmful tax” initiative.
Predator boom
The tax competition faced by rich countries came from several sources. First, members of the organisation increasingly bought into the “supply side” economics of United States president Ronald Reagan, which said that if you lower taxes on companies and the rich you will stimulate investment. It started an unavoidable trend of lowering tax rates.
The pressure on tax revenues in developed countries also came from countries such as Ireland, which sought to transform itself from a butter-exporting backwater in the 1970s into the industrial powerhouse it became. Ireland was so effective in its industrial and tax policy of poaching investment from its older and richer European Union neighbours that, just before its collapse during the international economic crisis in 2008, it was the second-richest country in the EU after the real culprit, Luxembourg.
Ireland followed a predatory policy, lowering its effective tax rate – what companies actually paid – to about 5.5% in the 1990s. What Ireland learned in the 1980s and 1990s, the new East European member states of the EU have simply copied since they acceded to the union and have continued poaching investors from the old industrial powers.
Rich irony
But the real long-term culprits were superrich countries such as Luxembourg and Switzerland, which, depending on the oil price, normally rank among the two richest countries.
They prospered greatly by providing honest, hard-working, but tax-avoiding (and often tax-evading) EU citizens – and many international criminals – safe places to hide their ill-gotten gains. By 2005, Switzerland reportedly had €3-­trillion of bank deposits from EU citizens alone. Luxembourg remains the tax haven of choice of companies operating in Europe.
Countries such as the UK could shut off the tax havens with appropriate anti-tax avoidance legislation, but London has preferred to complain of others while using this as a source of advantage to get ­corporate headquarters, such as AON Insurance recently, to relocate to the City.
Luxembourg and Switzerland are members of the OECD and hence its secretariat has had a difficult time picking on them and American tax havens such as the state of Delaware.
So, when in doubt, pick on the small, weak and poor. Although the  organisation’s harmful tax initiative has been successful in bringing poor but largely irrelevant tax havens in the Caribbean and Pacific into line, the policies of Luxemburg and Switzerland continue to put downward pressure on effective tax rates in the developed world.
Hitting bottom
In Africa, countries also bought into the argument that lower taxes would bring in new investments and, by the 1990s, had started to use special incentive schemes. All the evidence suggests they were right to try – but not if their houses were not in order and investors regarded a country as profoundly uncompetitive. In those cases, the incentives did almost nothing.
According to a recent IMF working paper, Africa has finally won the race to the bottom and effective zero tax rates. The authors, SM Ali Abbas and Alexander Klemm, conclude: “A race to the bottom is evident among special regimes, most notably in the case of Africa, creating effectively a parallel tax system, where rates have fallen to almost zero.”
South Africa has maintained something above a zero effective corporate tax rate because it is the economic epicentre of Southern Africa. But in neighbouring countries, such as  Namibia, rates under tax incentives are, in effect, zero.
Over the past decade the effective rates for Egypt, Mozambique and Uganda have all been pretty close to zero. Others such as Tanzania, Mauritius and Nigeria have had negative effective tax rates at times.
As African economies start to recover from the civil wars and liberation struggles of the 1990s, they will increasingly compete with South Africa for investment and then even Pretoria will have to rush to the bottom to maintain its position.
Paying the price
One classic example exemplifies how damaging these incentives are. At the beginning of the past decade, a Malaysian company called Ramatex proposed to build a huge textile plant in Southern Africa that would employ 10000 workers to process African cotton for export to the US market.
Ramatex had four countries – South Africa, Botswana, Namibia and Madagascar – competing for it. Unfortunately for Namibia, it won after providing the company with subsidies worth more than R60-million to build the plant and excempting it from paying taxes.
But there could not have been a worse time to build a textile plant – it followed the phasing out of the Multifibre Agreement (2005) – and, after several years, the company shut down, leaving Namibia to deal with the mess and the unemployed.
Apart from this, Namibia has received precious few investments despite a zero-tax regime in its export processing zones.
As the recent euro crisis has illustrated, even rich developed countries jealously protect their sovereign right to tax.
Small African developing countries desperate for investment will not abandon these rights easily and so this race to the bottom will continue, even “below ground”,  and, as Ramatex shows, will get even worse as desperate countries become willing to offer large subsidies to attract investments.
The real danger is that African countries may conclude that state ownership is a cheaper option.
These are the views of Professor Roman Grynberg and not necessarily those of the Botswana Institute for Development Policy Analysis where he is employed
Source : Mail & Guardian  1/6/12
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