The International Monetary Fund (IMF) has published on its website a working paper (No. 15/118) entitled “Base Erosion, Profit Shifting and Developing Countries”. Although the working paper does not necessarily represent the views of the IMF it has been published with a view to inviting comments on this subject that can promote further debate on the issues raised.

Although the subject of base erosion and profit shifting (BEPS) is receiving international attention most of the statistical evidence on the subject relates to developed countries. There is however evidence that a single international tax case can involve significant revenue from the point of view of a developing country. Another important factor is that developing countries are more reliant on corporate income taxation as a share of tax revenue than is the case for developed countries. Developing countries have fewer realistic alternative sources of revenue so they are more vulnerable to erosion of the corporate tax base.

Analysis of Spillovers

The paper aims to provide empirical evidence of profit shifting and to quantify the effects. The study therefore looks at the spillovers from one tax system to another and tries to quantify the effect by analyzing statistics. Put simply this is a measure of the interaction of tax policy changes (tax base or tax rate) in one country on the tax policy of another country.

Cross-border spillovers are divided for the purpose of the analysis into two categories. The base spillover is the impact of one country’s tax policy on the policy of other countries. This could be the impact on real activities or on profit shifting of paper profits. The paper aims to disentangle the effects of these two activities.

The strategic rate spillover is the impact on policy choices of a country of tax rate changes abroad. The study aims to measure the tax rate-setting responses to the tax rates set elsewhere. This therefore aims to arrive at an estimate of the impact of tax competition on tax policy.

Although there have been plenty of studies involving advanced economies there have not been many studies of the effect of these spillovers on developing countries.

Assumptions and Problems

As with all approaches to the issue the paper contains some simplifications and assumptions. One problem is that cross-border investment decisions are driven by the average effective tax rate (AETR) rather than the statutory corporate income tax rate. In other words, investors look at the effective tax rate after taking into account deductions for items such as depreciation or investment.

Also, the effects of operating through tax havens are over-simplified because companies are attracted to low tax jurisdictions by more than just the low tax rate – there are other special regimes and arrangements including favorable regulatory procedures. The identification of effects arising from tax havens depends on plausible but untestable assumptions of a correlation between the movement in statutory rates and special regimes.

Resource rich countries were excluded from the data as these will have distinct drivers of activity.

Findings

The study finds that long-run base spillover effects are significant, amounting to between 0.56% and 1.11% of GDP. These effects are large when viewed as a percentage of the total tax revenue. Both the spillover effect on real investment and the effect on profit shifting seem to be significant and there is a definite “tax haven effect”. The spillover effect is delayed for some time after a change in policy – 50% of the effect comes through in the first 2.4 years.

The results appear to indicate that tax base spillover effects are much larger for non-OECD countries than for OECD countries. This issue therefore matters at least as much for developing countries as for developed countries. Although this result is subject to the problems of measurement of base spillover with respect to tax havens and other problems of measurement it does suggest that BEPS issues are more urgent for developing countries than for developed countries.

Revenue cost of BEPS

Quantification of the amount of tax revenue at stake from base erosion and profit shifting has always been elusive. The study suggest that the long run revenue loss could be much larger for developing countries – around 2% for developing countries as opposed to around 0.6% for developed countries.

Strategic rate spillovers

In the collection and analysis of statistics in respect of strategic rate spillovers the foreign tax rates were analyzed in four ways – weighted according to GDP, unweighted across all countries, adjusted for tax haven weights, and weighted by inverse distance. The tax haven weighting gave a slightly larger response than others, and the GDP weighted average rate abroad gave the most significant result.

Conclusion for BEPS and tax policy

The results of the study suggest that base erosion and profit shifting and international tax competition are important issues for developing countries, and are at least as important as for advanced economies. As mentioned above the base spillovers are two or three times larger than for developed countries and these have an effect on real investment decisions and on profit shifting in equal measure. The loss of tax revenue through tax avoidance activity involving tax havens also appears to be larger outside the OECD, amounting to an estimated 1% to 2% of GDP. The strategic rate spillover effects are also more significant in developing countries.