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When Ronald Reagan and Margaret Thatcher slashed top personal income tax rates in the 1980s for the U.S. and the U.K., other nations were forced to follow suit. In the following decades, the global tax environment was transformed. Tax competition led to average top tax rates in the developed world to be cut from more than 65 percent in Reagan’s day to around 40 percent today.

This leaves to an obvious question: will the latest U.S. tax overhaul produce similar results?

A different environment

There are some reasons to question whether the recent U.S. tax reform effort will spark a new cutting frenzy, as there are notable differences between today’s tax environment and that of the 1980s and 1990s. For one, the largest U.S. reforms this time were on the corporate side, where the U.S. dropped the top rate from 35 percent to 21 percent and moved to a territorial system, though one with so-called base-erosion rules that partially undermine the change. This was a dramatic, pro-growth move, but rather than setting a new global standard, it only brings the U.S. approximately even with the OECD average corporate tax rate.

The second reason U.S. tax reform may not lead to a new global tax revolution is the emergence of an organized resistance to the forces of tax competition. With the subsequent takeover of the OECD by European tax collectors, there are powerful and entrenched interests determined and prepared to stop any more tax reform dominos from falling.
Despite these caveats, there is also evidence, in the fact that they are publicly attacking the U.S. tax reform, that high-tax nations are feeling pressured to respond.

The EU resists

Before the legislation was even finalized, much less signed into law, EU ministers were raising objections. A joint letter from finance ministers from Germany, the U.K., France, Spain, and Italy took issue with the Base Erosion Anti-Abuse Tax (BEAT) and the Global Intangible Low-Tax Income (GILTI) provisions.

There are reasons to criticize these provisions, as they exemplify an OECD-style preference for ignoring proportionality and prioritizing the punishment of tax avoidance over establishing an attractive destination for investment, but what the EU ministers really resented was that the U.S. was planning to establish its own rules rather than simply copy the work of the OECD and BEPS. It was, in other words, a threat to the relevance of the organization at the front line in their fight to preserve heavy tax takes.

Douglas S. Stransky of Sullivan & Worcester LLP perhaps said it best: “I find it laughable that the same ministers who have hammered away at U.S.-based multinationals over not paying their fair share are now crying when it looks like the attempts by the U.S. to reduce incidences of BEPS may actually have an indirect impact on these economies. These are the same ministers who have time after time accused U.S.-based multinationals of base erosion and profit shifting in their countries.”

Competition or harmonization?

The real threat to the EU from tax reform is the intensifying pressure to remain competitive. First comes the end of the uniquely uncompetitive corporate tax regime of the U.S. that left opportunity for others to target U.S.-based multinationals with large offshore cash holdings with aggressive tax grabs. That is bad enough for European tax collectors, but the prospect that it could spark a round of cuts from other nations is truly frightening.

This fear was expressed by former French finance minister and current IMF head Christine Lagarde, who fretted, “What we are beginning to see already and what is of concern is the beginning of a race to the bottom, where many other policy makers around the world are saying: ‘Well, if you’re going to cut tax and you’re going to have sweet deals with your corporates, I’m going to do the same thing.’”

The “race to the bottom” rhetoric is frequently deployed by opponents of tax competition who somehow manage to make bloated welfare states sound like paupers. The implication that governments cannot survive without high corporate income taxes, considered by many economists to be among the most destructive forms of taxation, is nonsense.

EU leaders were not quite as forthright as Ms. Lagarde. French Finance Minister Bruno Le Maire somewhat defensively claimed, “We are not criticizing the right of the American administration to reduce the level of corporate tax in the U.S.” Nevertheless, Germany’s acting finance minister promised: “We will closely assess the economic effects. We want to avoid companies moving their headquarters from Europe to the U.S. and we want to avoid investment flows being redirected.”

The key question is whether they will seek to avoid redirected investment by imposing new barriers and hindering tax competition, or by engaging in it.

Perhaps a telling sign is the fact that France and Germany are pressing forward with a plan to establish a common corporate tax, which they hope will build support for the proposed European Union common consolidated corporate tax base. Though, German Chancellor Angela Merkel did say that, “When we decide on a joint corporation tax assessment basis for France and Germany, we will also consider the realities that are unfolding in America.” Whether that could mean lower rates remains to be seen.

Others are working hard to resist the pressures to cut. A senior New Zealand tax figure warned his country against joining in corporate tax cuts. The head of the Chinese state council’s research office announced that his country was ahead of the corporate tax cut curve, but that it would not join a new international tax cut race. Canada’s current government has rejected business calls to cut rates, which Finance Minister Bill Morneau says remain competitive after the U.S. reforms.

At least for the time being, it appears a substantial resistance is holding strong.

Conclusion

While it was not as bold a move as many were hoping for, the U.S. threw down the gauntlet with last year’s tax reform. The world’s largest economy is no longer hampered by the massive handicap that was the previous version of its business tax code. How Europe chooses to respond will have major ramifications for the offshore community and the global economy.

If high-tax nations double down on tax harmonization and an anti-tax competition agenda, they will suffer the consequences of lost business and slower economic growth. The global economy will similarly suffer, but even more so the offshore community and low-tax jurisdictions that will have to deal with the fallout from a renewed push by the OECD or other international organizations to control global financial flows and the tax policies of other nations. If, on the other hand, these nations embrace competing for investment by reducing their most destructive taxes, all will benefit from increased growth under a better global tax environment.

tax competition