Bold new framework for tax

ZHONG JINYE/FOR CHINA DAILY

At a meeting in London on June 5, finance ministers of the G7 nations agreed to speed up reform of the international tax system to meet the challenges brought by globalization and economic digitization. Their consensus includes supporting current tax reform under the Organization for Economic Cooperation and Development/G20 Inclusive Framework and establishing a global minimum tax rate of 15 percent for large multinational companies.

The reform is expected to be conducive to a global tax agreement extending to the G20 and other countries and jurisdictions, which will profoundly benefit the development of the world economy in the digital economy era.

Today's international tax system evolved in the 1920s, which avoids double taxation of enterprises by multiple tax jurisdictions. In the 21st century, the digital economy has grown to be a new engine of economic globalization that is posing challenges to the existing tax system.

First, it results in the allocation imbalance of tax benefits among economies. Under international tax rules, multinational companies avoid double taxation by paying taxes according to where their headquarters are based. However, due to the business models of the digital economy, some enterprises can make profits relying on the internet instead of setting up operational entities. That leads to a mismatch of earnings and taxes, triggering the allocation imbalance of tax benefits among economies, since a company's profits can be reallocated across borders and companies can make money in places where they have no headquarters.

Second, the existing system results in tax erosion and twisted investment incentives. To deepen economic globalization, economies have announced various policies to attract investment from multinational companies. This has triggered a race to the bottom on international tax rates, causing a rapid decline in global corporate income tax rates. The worldwide average statutory corporate tax rate has consistently decreased in the past two decades, dropping by 16 percentage points to 22.6 percent.

This race between economies has provided multinational companies with room for tax arbitrage. Also, it has led to tax-base erosion and profit shifting (BEPS), which means losses in tax revenue for governments. According to the OECD, governments lose up to $100 billion to $240 billion in tax revenue a year due to BEPS, accounting for 4 percent to 10 percent of the total global corporate income tax. Apart from increasing the financial pressures on many countries, this also causes distortions in tax incentives for investment and loss of investment efficiency.

In 2013, the OECD and the G20 began reshaping international tax governance. The G20 based its new tax rules on the OECD's BEPS initiative in order to address problems such as multiple non-taxation and tax evasion. In October 2020, the OECD released the blueprint of a two-pillar solution.

The aim of pillar one is to introduce a new profit allocation mechanism and nexus rules to expand the taxing authority of market jurisdictions. Under pillar two, the problem of multinational companies allocating their capital globally in order to avoid taxes and maximize profits will be solved by proposing a global minimum tax rate. The two-pillar package is stated in the OECD/G20 Inclusive Framework on BEPS.

The consensus within the G7 has led to the OCED's two-pillar package being approved by major developed economies. On July 1, the OECD announced that 130 countries and jurisdictions, including the G20, have joined the two-pillar plan to reform international taxation rules, which represents a significant progress in the reform of the international tax system.

Through the system, governments of most countries, except some tax havens, can increase their fiscal revenue. Pillar two will ensure that global taxes increase by nearly $150 billion each year. Pillar one allows the tax-raising power of over $100-billion profits to be reallocated annually, showcasing the equitability of taxes.

With the agreement, countries can promote unification of tax systems and stop escalating tax wars for more international investment and fix problems caused by BEPS.The reform of the international tax system can ensure a fair environment for the competition between economies and between domestic companies and multinational enterprises. At the same time, social welfare will be improved thanks to an optimized global resource allocation and income distribution system.

Tax is an important factor affecting international capital flow. But the latter can be driven by more variables. Since it initiated reform and opening-up in 1978, China has introduced favorable policies to facilitate two-way investment. Its comprehensive advantages during opening-up, such as its institutional strength, thriving market and excellent human resources, have helped increase investment.

Moreover, China's progress because of reform and opening-up in the past four decades was based on the flow of goods and factors of production. To develop new systems for a higher-standard open economy, the country should enhance its openness in a more active way. Besides the flows of goods and factors of production, it needs to give greater emphasis to opening-up based on rules and related institutions to develop an institutional system and supervision model that are in line with prevailing international rules.

Hence, participating in the reform of the international tax system should be regarded as an important part of China's opening-up and global economic governance reform and the opening-up. In the long run, it will be of great significance and far-reaching influence on high-quality inbound and outbound investment.

The author is a professor and the head of the School of Economics and Finance with the International Relations University. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.