• The communique released by finance ministers of the G7 group of advanced nations is an attempt to reach a “grand bargain” around tax. According to the initiative, revenue from US technology firms would be taxed in the country in which activity is taking place, in exchange for all countries abandoning Digital Services Taxes (DST) and imposing a minimum corporate tax rate of 15%.

• A combination of resistance from countries whose corporation tax is less than 15%, carveouts for important industries and difficulties in ratification by the US Congress are likely to limit progress towards this goal in Europe.

• The status quo on the suspended tariffs is likely to continue, as no action will take place before the G20 summit in October, and the US is unlikely to implement the tariffs before the US Congress acts (if ever).

• Even if the proposal is implemented, the revenue-raising implications are modest. Nonetheless, this is likely to set the framework for future discussions on tax harmonisation at the EU and international level.

A communique, released by the finance ministers of the G7 group of advanced nations on June 5th, aims to inject momentum into finding a common approach to the long-running problem of corporate tax optimisation. Some countries have been pursuing diverse strategies to limit the flight of multinational tax dollars or to try to lure them in with the promise of ultra-low tax rates. This issue has divided the US and Europe, and created divisions within Europe. The EU has sought to receive revenue from the activities of (mostly American) tech companies within its borders, while American regulators have tried to limit the attractiveness of global tax havens for ostensibly American multinationals.

An EU-US grand bargain?

The announcement during the meeting of the finance ministers represents a grand bargain of sorts between the US and EU to address the issue of tax havens and the flight of corporate tax ownership to the lowest-revenue jurisdictions. The US administration is concerned about the siphoning of multinationals’ revenue to low-tax jurisdictions, many of which are in the EU, and about the DST implemented by several European countries. The dispute with Europe over the DST came to a head on June 2nd, when the US implemented and immediately suspended a series of retaliatory tariffs targeted at European countries that had implemented DSTs. EU member states are similarly concerned that US tech companies, particularly those such as Google or Facebook that have a very light physical footprint, are taking a disproportionate share of European commerce without contributing to EU coffers.

The bargain would address these concerns by requiring companies, particularly tech companies, to be charged sales tax in countries in which they have activities (so-called pillar one). This would remove the need for DSTs and set the stage for their repeal. In return, all countries, especially low-tax countries, would agree to implement a minimum 15% global tax (so-called pillar two) on corporations in their home jurisdictions.

Resistance across the board

The proposal by the G7 faces a long and rocky road to enactment, not least within the EU, and it may not be adopted at all. Cyprus has already threatened to block the proposal at the EU level, and low-tax jurisdictions such as Hungary and Ireland may also oppose it, as their economic growth models are based on attracting multinational corporations, in part by offering low business tax rates. This strategy of attracting inward foreign direct investment (FDI) through low tax rates is a successful tool of economic development, and small countries such as these are protective of their sovereign right to tax multinationals as they see fit.

Outside the EU, the UK chancellor of the exchequer, Rishi Sunak, has suggested that financial services firms in the city of London be exempted from the first pillar. Preliminary proposals by the OECD in the autumn included carveouts for several sectors, and the final proposal sets a profitability threshold of a 10% margin, but the full list of exemptions is not yet finalised (and has the potential to become long). Meanwhile, governments that have implemented DSTs have indicated that they are unlikely to repeal them until the US Congress passes a law allowing for pillar one to take effect, which may need to take the form of an international treaty and requires two-thirds support in Congress—a high bar given the polarised political climate in the US.

The economic implications of this on the US’s suspended tariffs on Europe are uncertain, but the status quo is likely to prevail for at least the next year. The administration of Joe Biden, the US president, cited progress on the taxation issue as a justification for the suspension of the tariffs, and as a result is unlikely to repeal them if the delay comes from the US Congress itself. Additionally, the G7 proposal will have to be agreed by a much wider group of actors to truly take effect, most prominently at the summit of the more globally diverse G20 group of countries, which is set to take place in October. As a result, there is unlikely to be much external pressure to push recalcitrant EU countries into line on this issue in the near future.

Little change ahead

In addition to the diplomatic headaches associated with negotiating and ratifying the deal, its capacity for raising tax revenue is dubious. There are specific problems associated with the two pillars set out by the deal.

The first pillar, stating that 20% of firms’ corporate taxes will be based on the origin of sale rather than its operational origin, remains only narrowly defined. The new rules apply only to firms that have profit margins in excess of 10%. By this definition, only highly profitable companies with large investments of intangible capital (such as pharmaceutical or tech firms) are likely to be affected by the agreement, meaning that not all US tech giants will be covered by this proposal. For instance, Amazon, which has massive global operations but very low profit margins, will be largely unaffected by this new rule.

The second pillar—the 15% minimum tax rate—also remains insufficient as a tool to raise revenue. The deal in principle reduces the incentive for firms to declare profits in foreign (less taxed) jurisdictions, as the firm’s country of origin could place surcharges to bring effective tax rates up to the floor of 15%. However, in practice OECD data indicate that only three EU countries (Ireland, Hungary and Cyprus) have corporate tax rates that are lower than the agreed 15%, limiting the pillar’s efficacy. Moreover, it remains to be seen how much room countries will have to avoid this pillar by artificially reducing their corporate tax rate through national exemptions for investment or other activities.

Moreover, in most large economies, corporate tax rates do not play a large role in raising revenue, limiting the gains for G7 countries in striking the deal. OECD data indicate that, across the group, corporation tax rarely accounted for more than 10% of government revenue in 1965-2017, despite the various changes in the rate and classification of corporate taxation. This share is fairly modest compared with social security contributions (25%), personal income tax (23%) and value-added tax (VAT; 20%). Even if the new rules generated a substantial change in the declaration of new taxes, this would be unlikely to substantially bolster the fiscal position of major economies.

A long road ahead

Despite the agreement’s relatively modest objectives and outcomes, it represents progress in international tax co-operation. The number of firms that will be directly affected by the agreement is small, but the position of intangible capital (such as intellectual property rights on consumer data) will only become larger in the coming years, and, similarly, the problem of how to tax this capital’s returns effectively will grow in importance. Moreover, in many European countries, the demographic profile is set to worsen, diminishing the scale of government revenue that can be raised from taxation on labour (social security and personal income tax). This will require a pivot towards other sources of revenue, such as corporate taxation. We expect the G7 agreement to provide a framework for future discussion on a European level as international discussions progress, but there is little prospect of meaningful agreement for some years.

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