Financial Transparency Coalition

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The private sector plays an important role in sustainable democratic and economic development. By creating jobs and opportunities, providing necessary goods and services, and thus improving people’s living standards, private enterprise in a market economy offers citizens the ability to prosper independently of state-provided goods and services. That, in turn, gives citizens the necessary leverage to hold their government accountable because public officials rely on citizens for support, not the other way around.

An accountable and efficient public sector is still a necessary part of development, though, and governments and private businesses must work together in this regard. Usually that entails efforts to ensure a sound business environment for the private sector to thrive, and an important part of any country’s business environment is the structure of the tax system.

Fair and efficient tax regimes are also an important part of the social contract that connects citizens to their government: citizens pay tax so that the government will provide certain public goods such as roads, ports, schools, etc. Citizens, in turn, must hold their government accountable to provide those services. Businesses are responsible for their share of taxes, too, and they benefit from those publicly-provided infrastructures as well.

At this point I would like to make the distinction between two types of tax policies: those that apply to domestically-owned and operated firms and those that apply to multinational firms. Usually these policies are the same on paper. When multinationals operate in many jurisdictions, however, countries make agreements so that multinational firms are not over-burdened with tax in every country in which they operate. These agreements, or tax treaties, guide the way multinationals operate their subsidiaries around the world.

Tax treaties come in many different forms – too many to mention here. In a recent blog post for the Task Force on Financial Integrity and Economic Development, I argued that these policies must include input from all stakeholders, including the multinationals, their subsidiaries, local businesses, and citizens.

These treaties are often very complex despite guiding models from the OECD and UN. In a recent report highlighting multinationals’ income taxes (or lack thereof) in Ghana, ActionAid alluded that tax treaties could be too dense for some developing countries to shape and structure. In order for taxes to contribute to sustainable development, however, ActionAid recommended that developing countries take more ownership in the process of negotiating tax treaties with other countries.

There is a lot at stake in designing tax treaties. Developing countries want to attract foreign investment because foreign businesses provide jobs, revenue, services, etc. Add companies’ Corporate Social Responsibility programs to the mix and poor countries have a lot to gain from foreign investment. Favorable tax rates and standardized tax treaties help attract foreign businesses.

That, however, doesn’t mean that domestic tax rates have to be low. In today’s interconnected global economy, multinational firms move their profits among subsidiaries through royalty payments, management fees, internal transfers, etc. Unfortunately, what that means for some countries is that companies won’t pay any income tax for those countries in which they do not make a profit, even if their lack of profit could be explained by extensive royalty payments to another subsidiary in another [lower-tax] jurisdiction. Hence why tax treaties are so important – they have the potential to set the rules for how multinational companies may legally conduct these transactions.

One implication of multinationals’ use of transfers is that local companies without subsidiaries could be liable for proportionately more tax than larger, and seemingly more profitable, multinational companies. Although firms operating within this system are absolutely legal, I speculate that citizens, policymakers, and public officials would change this system if they could.

But why can’t they? A lack of governance and know-how inhibits balanced negotiations. As the Ghana Revenue Authority’s (GRA) Commissioner General explained to ActionAid, “Transfer pricing [between companies’ subsidiaries] is a problem in most developing countries… Management fees is an area we know is being used widely [to avoid tax], and it’s mainly because it’s very difficult to verify the reasonableness of the management fee.” Indeed, the GRA does not have a specialist transfer pricing unit and revenue officials have limited experience and few legal frameworks to work with.

South Africa’s former finance minister Trevor Manuel also told a meeting of African tax officials that “smaller, poorer countries with tax administrations that are less sophisticated cannot be expected to develop the expertise required to unravel the complex structures that multinationals and other large companies put into place to minimize tax.”

At an event last week at the OECD on growth and tax policy, a participant raised the issue of the loopholes in international tax regimes, tax treaties, and the implications for development. While these loopholes are difficult to address without a global government, negotiating mutually beneficial tax treaties should be within the realm of all sovereign governments.

The question now is: how can developing countries build capacity to shape these treaties in order to bring them needed revenue for public services? Multinationals have teams of accountants and lawyers. What kinds of resources do developing countries have?

I asked an official at the OECD for his opinion on whether or not the OECD had plans for that kind of work. He denied that they did. He did suggest, however, that NGOs could play an important role in bringing together stakeholders, constituents, civil society groups, and expert accountants so that governments would have greater capacity to design treaties and implement tax systems to enhance their development.

Calling all accountants: the developing world wants YOU!

Originally published on the blog of the Center for International Private Enterprise