Reforming multinational corporate income taxation in the European Union

A main reason for founding the European Union was to remove internal trade obstacles and to establish a Single Market within its borders. Along with the increasing integration of international markets, an ever-increasing diversification of firms in tandem with the development of multinational enterprises is observable. Legislative authorities of the European Union and its member states are faced with the challenge of ensuring that their corporate tax systems keep pace with this economic transformation of companies and markets. Hence, in order to meet the requirements of an integrated European market, in 2001 the European Commission proposed a switch from Separate Accounting to Formula Apportionment as the leading corporate income taxation system in the European Union. Basically, corporate income of multinational enterprises can be taxed according to these two different principles. At present Separate Accounting is applied at the international level, while some countries like the U.S., Canada, Germany and Switzerland use Formula Apportionment at the state or federal level. Under the current system of Separate Accounting each subsidiary of a multinational enterprise is treated as a separate entity subject to national tax law. For this reason multinationals have to value their intra-firm trade using internal transfer prices, which should meet an external standard of comparison, so-called arm’s length prices. Because of the very nature of internal trade with firm-specific tangibles and intangibles evaluating adequate transfer prices proved difficult. Consequently, Separate Accounting was identified as one reason for manipulations in favor of profit shifting for tax saving purposes. That is why the European Commission regards the consolidation of profits including cross-border loss offset for calculating a multinational company’s tax base as a more suitable approach in the economic union and advocates the Common Consolidated Corporate Tax Base (CCCTB). To allocate the consolidated tax base to the taxing countries a splitting mechanism is needed. Hence, the CCCTB proposal includes a system of Formula Apportionment. A formula apportions a share of the overall tax base depending on the multinational enterprise’s geographical economic activity in the respective country. The European Commission favors a common three-factor apportionment formula containing assets, labor and sales to represent the production and consumption side. The European Commission’s proposal has initiated a continuing politico-economic discussion about the efficiency and distributional consequences of the transition to Formula Apportionment in Europe. This doctoral thesis evaluates particular issues within this debate by presenting three theoretical articles to answer specific research questions. The articles are based on the methodological concept of a Nash tax competition model under perfect symmetry, where countries choose their corporate tax rates non-cooperatively. The non-cooperative behavior of one country may impose fiscal externalities on other countries and thereby renders the tax policy inefficient. This dissertation focuses on the derivation, explanation and interpretation of the resulting inefficiencies under Separate Accounting and Formula Apportionment. For this reason it contributes three papers to the theoretical literature of optimal tax policies in a non-cooperative equilibrium of tax rates. The work aims to compare and discuss the alternative policy options. The first article pertains to the public debate about the right taxation principle to apply in Europe. The article investigates the effect of fiscal equalization on the efficiency properties of corporate income tax rates chosen under the taxation principles of Separate Accounting and Formula Apportionment. Fiscal equalization ensures efficiency if the marginal transfer just reflects the fiscal and pecuniary externalities of tax rates. In contrast to previous studies, tax base equalization (Representative Tax System) does not satisfy this condition, but combining tax revenue and private income equalization does, regardless of which taxation principle is implemented. This finding implies that it does not matter whether MNEs are taxed according to Separate Accounting or Formula Apportionment if there is equalization of national income (i.e. private income plus tax revenues). Under Formula Apportionment, tax base equalization is superior to tax revenue equalization if the wage income externality is sufficiently large. Even though the European Union does not have an explicit equalization system, a part of the Unions’s budget is financed by contributions from the member states. The implied income redistribution would indeed not be enough to ensure efficiency of corporate income taxation, since the budget is not an equalization system in the sense of our analysis. But the very existence of income redistribution in Europe might indicate that reforming the member states’ contributions to the budget in a suitable way may politically be easier to achieve than replacing an implemented corporate tax system. The second article refers to the sales factor in the proposed three-factor formula under Formula Apportionment. The incorporation of a sales factor in the formula as well as the assignment of sales at the place of origin or destination are hotly debated issues. The CCCTB Working Group suggested in 2007 the inclusion of sales following the destination principle but also mentioned that “...most member states experts that would support the inclusion of sales as a factor would prefer sales measured ‘at origin’ ”. With regard to the most recent proposal by the European Commission in 2011, the European Parliament advocated that the sales weight be lowered to 10%. The Committee of the Internal Market and Consumer Protection even called for the removal of the sales factor. In contrast, from Canada and the United States, the opposite development has been observed, namely the increasing importance of the sales factor. Taking a two-country Nash tax competition model with a sales-only formula and market power, we investigate (i) whether the transition from Separate Accounting to Formula Apportionment mitigates tax competition and improves welfare and (ii) whether tax competition is weakest when sales are measured with the origin principle. The driving force is a negative consumption externality that hampers the positive formula externality present for both the origin and destination principle. The third paper investigates the Commission’s recommendation to implement a transition process to Formula Apportionment. During the change Formula Apportionment should be optional for multinational enterprises. Recent empirical literature proves that profit consolidation reduces multinational enterprises’ involuntary costs for complying with different tax laws, but increases discretionary compliance costs incurred by tax planning activities. That is why the third article considers a two-country model with multinationals that are heterogeneous with respect to their involuntary compliance costs. Additionally, multinational enterprises using the Formula Apportionment system face higher discretionary compliance costs due to restricted tax base manipulation opportunities. Hence, multinational enterprises would prefer to be taxed under Formula Apportionment if and only if under Separate Accounting the involuntary compliance costs exceed the tax advantage due to better profit shifting possibilities. We show that a non-negative threshold value of involuntary compliance costs exists such that multinationals with costs above this level choose Formula Apportionment. We prove in a symmetric setting that starting from a pure Separate Accounting system with national revenue maximization, a transition from Separate Accounting to an optional Formula Apportionment increases the non-cooperative tax rates and national revenues for both countries ending up with the results of pure Formula Apportionment. This is because with identical tax rates the multinational enterprise cannot benefit from the better profit shifting opportunities under Separate Accounting but saves involuntary compliance costs. In our analysis the optional system of tax base consolidation promises an efficiency enhancement for the member countries. Hence, we deliver an additional argument in support of an international agreement on the CCCTB proposal.

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