Economic focus: Discord over harmony

One market, one profit, 25 taxmen

MOST students of taxation know the advice that Jean-Baptiste Colbert, treasurer to Louis XIV, offered the beleaguered taxman: pluck the goose so as to get the most feathers with the least hissing. But suppose the goose is housed on one farm, eats the birdseed scattered in a second, and lays its eggs in a third. Which farmer gets the plumage?

The European Union has a single market, but 25 tax authorities, each with its own interpretation of Colbert's dictum. Multinational companies, which hop from one jurisdiction to another, expose this muddle in its worst light. The companies bemoan the burden of complying with 25 different tax codes, and argue that their profits and losses transcend national boundaries anyway. Some governments complain that the taxes a corporation pays bear little relation to the publicly provided benefits (a sound legal system, an educated workforce, passable roads) it enjoys. And the European Commission worries that competing tax codes impede the single market, keeping Europe's companies penned in behind national boundaries, deprived of continental economies of scale.

Last month, the commission said it would redouble its efforts to harmonise the corporate tax base, but not corporate tax rates. Member states will remain free to take as many feathers as they see fit, but the EU should agree collectively who gets to pluck what. Companies would calculate a single, EU-wide profit, according to one rulebook. This taxable profit would then be divvied up among governments, according to the company's weight in each member state.

The commission does not speak with one voice, however. Last week Charlie McCreevy, the commissioner for the internal market, worried about any measure that might bring about harmonisation of tax rates "through the back door". "The issue of tax rates", he insisted, "cannot be separated from the tax base."

Mr McCreevy is right in one sense. Tax rates and the tax base are linked: when rates rise, the base tends to shrink. Companies decide to make their profits elsewhere, or, more insidiously, to report them elsewhere. Under the EU's current tax regimes, the foreign subsidiary of a multinational corporation must pretend to be a stand-alone company. It must account for everything its parent gives it - parts, money, expertise - as if it were bought and sold at arm's length on the market. But the implicit "transfer prices" between different bits of a company are arbitrary and manipulable. A 2002 study by Trade Research Institute, a Miami consultancy, found American firms buying plastic buckets for $973 each and tweezers for $4,896. By overpaying or overcharging its foreign affiliates, a company can spirit losses and profits from one part of the world to another.

Expensive tweezers aside, it is not always easy to distinguish such sleights of accounting from genuine shifts in activity. In a 2003 paper*, Eric Bartelsman, of the Free University of Amsterdam, and Roel Beetsma, of the University of Amsterdam, found a novel way to do just that. They took advantage of OECD numbers on the value added by particular industries around the world and their payrolls. A company that truly departs a high-tax nation will not only report lower value-added in that country, but will also maintain a smaller scale of operations. Lower value-added should be accompanied by a lower wage bill.

Examining 16 OECD countries over two decades, the two economists found that value-added would fall in response to a tax hike, but the payroll would not, at least not to the same extent. In other words, the reported profits of companies fled, even as their operations stayed put.

Based on these numbers the two authors carried out a "back-of-the-envelope" calculation of how easily profits can be shifted on paper. If a government were to raise its corporate tax rate by one percentage point (from 37.5%, the G7 average at the start of the 1990s), more than 70% of its hoped-for revenues would fail to materialise, as reported profits disappeared overseas. This is not because the higher tax rate chokes off economic activity - Messrs Bartelsman and Beetsma hold "activity", as proxied by the payroll, constant. It is because the profits generated by that unchanged workforce are reported elsewhere.

The discipline of deception

If the commission gets its way, these accounting tricks will be much harder to pull off. Corporations would prepare a single set of figures with one, EU-wide bottom line. Thus, it would not matter which subsidiaries book a profit and which a loss. The commission claims enthusiastically that the knotty problem of transfer pricing will be solved "at a stroke".

But the Irish government fears (and some other member states hope) that harmonisation will also solve the "problem" of tax competition. Are they right? Governments could still vie with each other to attract a greater share of a harmonised tax base. A company's EU-wide profit would be divided among jurisdictions, according to some rough measure of the firm's activities in each country, such as its sales or payrolls. By setting a low tax rate, the Irish government could tempt a company to expand its sales in the emerald isle, so that a bigger fraction of the firm's EU profits fell under Ireland's purview.

But it is easier to reshuffle a firm's profits on paper than it is to restructure a firm's activities in reality. If the commission's plans were ever implemented, each member's corporate tax base would probably exhibit more inertia than it does today. The modern, mobile company is never a sitting goose for national taxmen. But if tax bases were harmonised, companies might be a little less sensitive to overzealous plucking.