How the global minimum tax creates distortions.
If a recent statement by more than 100 countries agreeing on a framework for a global minimum tax is any guide, tax competition is going to be severely curtailed. But opting for cartel over competition is not the only objection to what is being proposed. Sensible tax policy may be another casualty of this deal.
After the framework was announced, many turned to see which countries had declined to sign up — at least so far. Among the dissenters, one stood out: Estonia.
Since 2014, Estonia has claimed the top rank in each edition of the Tax Foundation’s International Tax Competitiveness Index — a comprehensive ranking of the tax systems of OECD countries. The Index compares countries’ tax structures, with a particular focus on systems that are less intrusive and distortive.
Estonia’s long-standing reign at the top of this Index is a testament to the importance of simplicity and neutrality in tax policy.
While some argue that there is a race to the bottom, make no mistake: Estonia is not a low-tax country. The corporate tax rate is 20 percent as is the standard rate of value-added tax. The overall tax-to-GDP ratio was 33.1 percent in 2019, more than 8 percentage points higher than that of the United States.
Nor is Estonia an outlier when it comes to addressing tax avoidance. Like other EU countries, Estonia has adopted rules to combat cross-border profit shifting targeting business structures set up only to lower tax burdens.
The Estonian tax system is exceptional not because of how much revenue it raises, but because of the way it raises revenue. The corporate tax only applies when profits are distributed to shareholders. This means that if a company wants to use retained earnings to finance a new expansion that requires more hiring and capital investment, then the investment can be made without facing a high tax burden.
By design, this corporate tax system can result in businesses facing very low or no corporate tax liability in some years. That does not mean there will never be any corporate tax liability, but it shows the Estonian government has chosen to leave businesses to decide when the timing is right to reinvest profits or distribute them to shareholders without tax rules distorting that decision.
And that is where the principled Estonian approach has collided with a global effort to stamp out tax competition.
The proposed global minimum tax would likely apply to profits of businesses in Estonia even when Estonian rules would have left them untaxed because they had not yet been distributed to shareholders. This would upend the approach of leaving businesses’ profits alone and insert a distortion into investment decisions that the Estonian government had rightly chosen to avoid.
Tax competition has gotten a bad reputation not because of policies like those of Estonia. Leaving aside resentment over the ultra-low rates adopted in certain tax havens, much of the criticism it has attracted has been driven by the preferential and complex policies such as patent boxes, special credits, and exemptions that distort taxpayer behavior and can lead to the misallocation of investment. Making matters worse, they also tend to lead to higher enforcement and compliance costs.
Instead of countries choosing to change those policies or designing a global agreement to strictly address unprincipled, preferential, and ultimately distortionary tax rules, governments have taken a dragnet approach that captures good tax policy as well as bad.
Countries such as the United States, France, and the United Kingdom each have preferential tax policies baked into otherwise complex tax systems. They act as though they cannot reform their own rules and need a global agreement to undo the worst of their domestic tax-policy choices.
And yet, Estonia stands to the side with a well-designed tax system that raises sufficient revenue while supporting a sustainable economic model.
Whether Estonia will remain in staunch opposition to the global minimum tax or whether it will fold to the demands of countries with more convoluted tax systems remains to be seen.
What does seem to be clear is that the countries that land toward the bottom of the International Tax Competitiveness Index have put the creation of a tax cartel above encouraging sensible tax policies of the type currently in place in Estonia.