The Fatal Flaw of Pillar Two

Pillar Two, the international global minimum taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. agreement, has a considerable chance of failing. Failure may not be obvious—such as countries pulling out of the agreement or retaliating against its enforcement mechanisms—and it may even preserve the appearance of a 15 percent minimum tax. But Pillar Two may ultimately allow the same problems it was designed to address.

The Pillar Two Thesis

Pillar Two’s thesis is that competition between countries constrains governments’ ability to raise net revenue from profitable businesses. The global minimum tax attempts to fix this.

A corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. is a valid part of a revenue-raiser’s toolkit, at least if it employs full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. of capital expenditures. Such a tax does not dissuade new investment at the margin under the standard model of taxes and investment behavior. Now, not all countries use full expensing, so their corporate income taxes are suboptimal, but at least some corporate taxes are effective revenue raisers.

And it’s true: corporate income taxes are constrained by competition among countries. Profitable businesses can flexibly realize their income in favorable jurisdictions. For example, a multinational enterprise (MNE) may choose to locate intangible assets not tethered to a physical location (e.g., intellectual property) in jurisdictions with low effective taxes. Since countries would prefer to attract these revenues, they have some incentive to reduce tax rates, even on corporate income taxes that are otherwise efficiently designed. At the extreme limit, the reasoning goes, corporate tax rates may fall to near zero. And if countries cannot lean on even well-structured corporate income taxes, they may fall short of needed revenues or turn to other worse-structured taxes.

Pillar Two hopes to arrest these competitive dynamics by establishing a 15 percent minimum floor through a series of minimum tax backstops. This solution, however, may fall short. Countries and companies might nominally acquiesce to the 15 percent target while circumventing the intent of that goal.

The Crack in the Foundation

Income tax rates are measured as tax divided by income. However, neither “tax” nor “income” is easy to define, and there are problems with the underlying concept of “tax rates.”

For many government policies, it is hard to decide whether they constitute reductions in tax or increases in income. Pillar Two, like all systems, draws an arbitrary line. However, a reduction in tax goes into the numerator in a tax rate calculation, while an increase in income would go into the denominator, producing very different results.

For a simple example, consider a firm that earns $100 and pays $24 in taxes before credits, but it also receives a $20 subsidy of some kind. If this subsidy is counted as an increase in income, the firm has paid $24 in taxes on $120 in income for a 20 percent tax rate. However, if this subsidy is counted as a decrease in tax instead, then its tax burden comes to just $4 on $100 of income for a 4 percent tax rate.

In both cases, the underlying economic reality is the same. There is $100 in income produced by the firm, and it is ultimately divvied up to $96 in post-tax income for the company and $4 in net income to the government. Only the method of counting is different, depending on which side of the arbitrary line the subsidy falls on.

This arbitrary line is the crack in Pillar Two’s foundation.

Goodhart’s Law: Gaming Pillar Two

The problem is that once a measure—such as the Pillar Two definition of tax rate—becomes a target of policy, it no longer becomes a good measure. (This idea is typically attributed to British central banker Charles Goodhart.) People will change their behaviors to hit the target, but not necessarily the underlying idea the target was intended to represent.

Consider a small jurisdiction whose strategy is to offer very favorable terms to businesses and attract highly mobile intangible income, skimming just a small percentage of that global intangible income for itself. Because the jurisdiction is small and global businesses are comparatively large, this strategy works well. It attracts that income through a low effective tax rate—say, 4 percent.

Initially, Pillar Two’s system of measurements works as designed. It correctly flags a situation where MNEs and low-tax jurisdictions have built a favorable arrangement at the expense of larger economies’ tax collectors.

Pillar Two then attempts to rectify the situation with a trio of minimum taxes. First, the jurisdiction is invited to comply with Pillar Two on its own, through a qualified domestic minimum top-up tax (QDMTT) at a 15 percent rate. If the jurisdiction doesn’t create one, the MNE’s home country can assess tax on the income through an income inclusion rule (IIR). Finally, if neither of these steps is taken, Pillar Two allows for an extraterritorial enforcement mechanism known as the undertaxed profits rule (UTPR), which would permit countries where the MNE is present to collect tax on the low-taxed profits. If Pillar Two works as intended, this series of backstops essentially forces a 15 percent rate on all major MNEs and all jurisdictions in the world.

However, suppose that the low-tax jurisdiction wants to continue its strategy of attracting global profits through favorable terms and skimming a small fraction. It might, for example, create a 24 percent headline tax rate, but offer subsidies amounting to roughly 20 percent of the global income located in the jurisdiction. As in the example given above, $100 in income would receive $20 in subsidies, which would be counted as income under Pillar Two rules. The $24 in tax on that $120 in income would amount to a 20 percent tax rate exceeding Pillar Two’s minimum. Therefore, through the use of Pillar Two’s accounting rules, the jurisdiction has recreated the same system it had prior to Pillar Two, while nominally coming into compliance with Pillar Two.

We can see this process in action already in Bermuda. In a consultation with the public on its tax policies for Pillar Two-eligible MNEs, Bermuda’s Ministry of Finance explains that “the Government has proposed a statutory tax rate of 15% and is developing a robust package of Qualified Refundable Tax Credits (QRTCs) to maintain Bermuda’s attractiveness.”

Importantly, the gamesmanship is not unique to small jurisdictions intending to attract on-paper global profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. . Relatively ordinary countries like Vietnam are moving to protect some of their tax incentives by routing them around Pillar Two’s rules as well.

Pillar Two’s Long-Run Outcome

All tax systems, especially those involving international income, are subject to some gamesmanship. Pillar Two is far from unique in this respect. But the Pillar Two system may be uniquely inflexible in its ability to respond to gamesmanship. In many countries, the treasury can observe unfavorable results and then occasionally adjust regulations on a variety of dimensions to curb the most popular means of profit shifting. Failing that, the legislature can change laws more broadly. This system is far from perfect; stability in tax codes is generally preferable. But it does mean that the largest holes in the tax system are eventually plugged.

One could suppose that Pillar Two would eventually develop such a system—with regulatory bodies that issue minor rule changes, new treaties for major rule changes, and a judicial system for litigating disputes. But in practice, multilateral agreements are very difficult and slow-moving. It took Pillar Two a long time to converge on its current rules. It may not sustain the momentum or the relative unity among governments needed to keep issuing new ones.

Pillar Two may be stuck with the measurement it already has—one on which it has doubled and tripled down through cascading taxes. Countries will learn to subvert that measurement.

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