Taxing times: a new era of political economy

Next year is expected to see an unprecedented fiscal event: the introduction of harmonised corporate tax rules across more than 140 countries. The two key aspects of this harmonisation will be a minimum 15% tax rate and agreement on the basis on which tax is calculated, focusing on the location of a company’s customers rather than the jurisdiction in which the company concerned would prefer to pay tax.

Outside the countries of the European Union, this is an extraordinary step – and even inside the EU, every piece of tax harmonisation has had to be fought for. Fixed exchange-rate systems and currency unions have required synchronisation of monetary policy, but fiscal policy has long been jealously guarded as the ultimate national economic prerogative.

Unlike monetary policy, the question of what to tax, by how much and how to spend the revenue was seen as more than a mere technical matter. On the contrary, it told us everything about a nation’s priorities.

As of 2023, this hitherto-untrammelled area of operations is set to be curtailed – with major implications for large corporations around the world. But why this measure, and why now? To some extent, it was inevitable in the wake of the abolition of exchange controls in the 1980s, with Britain having led the way in 1979. Money, including corporate revenues, could now legally be moved to any jurisdiction willing to receive it. That did not, of course, necessarily mean that the company’s domestic tax authorities would accept that it should be subject to much smaller levies in a low-tax jurisdiction, but ways were found to show that revenues properly belonged in such jurisdictions.

Fundamental reform needed

One way was to vest ownership of corporate assets, such as materials, licences and intellectual property (IP), in a subsidiary in the low-tax jurisdiction, then have the subsidiary charge high fees for their use to fellow subsidiaries in the group.

In this manner, “profit shifting” occurs. In many cases, tax authorities reserved the right to object to excessive fees, and a game of cat and mouse frequently ensued.

In parallel with this, jurisdictions increasingly set out to make themselves attractive to foreign capital; a process of tax competition that was initially associated with current and former European dependent territories, mainly in the tropics, but more recently spread to models of EU respectability Ireland and Luxembourg, the so-called on-shore offshore centres. According to critics, the net result was “fiscal erosion”; the weakening of revenue streams that ought to be available for public services.

From 2013 onwards, work on addressing this issue was led by the Organisation for Economic Co-operation and Development (OECD), the 38-member club of advanced economies. By 2018, it was agreed that a fundamental reform of the tax system was needed and in 2019 the OECD released proposals for two key changes, or “pillars”.

Impact on corporate stocks

One pillar would allocate more taxation rights to those countries where the company’s customers are based. The second would allow countries to levy further tax on profits in cases where they believed the low-tax jurisdiction had taxed companies insufficiently.

At this stage, it seemed unlikely that consensus could be reached across so many jurisdictions with so many conflicting priorities. But momentum was building even before the inauguration of US President Joe Biden in January 2021, a change of occupant in the White House that was to have major implications for the reforms. On 21 March, Mr Biden declared that the US would support a global minimum tax rate. In due time, this minimum rate became the second pillar, set at 15%.

In October last year, the OECD published details of the plan. Only the largest multinational companies, those with sales of more than €10 billion, would be affected by the first pillar (the one relating to taxation focused on where the customers and markets are located), while the 15% tax rate would apply to all large multinational firms with sales of more than €750 million.

Reforms on this scale cannot but have implications for the companies and the jurisdictions concerned, so we set out to identify them. We used high-frequency asset-price analysis to measure the impact on corporate stocks and on countries’ credit default risk within minutes of the reform announcements (the narrow window allows us to filter out any other events that may explain price movements).

Excess returns

A key finding is that the share prices of those companies with high foreign earnings or high levels of intangible assets or both (ie, those that stood to gain the most from the status quo) fell significantly within minutes of announcements or actions related to the tax reforms. Among these were Apple and Alphabet, Google’s owner.

By contrast, those companies, however large, that generate most of their income in their domestic market and have little reliance on IP exhibited no significant share-price movements. Walmart is one such: while Apple’s share price fell immediately, Walmart’s remained stable.

Nor are these immediate share-price reactions the whole story. The downward effects of the regulatory announcement not only persist, but grow in magnitude over a longer period. For example, the price fall is four times larger taken for the whole day, and shares continue to drift for about two weeks before flattening – and remaining flat.

In terms of quantifying the significance of the price response there is no substitute for gauging real-life market reaction, so we put together long-short portfolios in which we shorted stocks with high levels of international exposure and reliance on intangible assets, and bought those with low levels in these two areas.

These portfolios were assembled immediately after each tax event and held for two weeks. We found that this strategy yielded a daily excess return or “alpha” of 17 basis points, or more than 3% a month. Of course, not every official announcement with regard to this process will have the same effect on the same companies. To take one example, on 8 October 2021 the OECD declared that only the largest multinational companies, those with sales of more than €10 billion, would be affected by the new rules on taxation based on the location of firms’ customers.

We used this to refine our research and found that the stock prices of those companies that found themselves above the new thresholds fell by about 31 to 34 basis points compared with the shares of those below the limit.

Implications for business

Global tax reform has implications for a number of industries. We found that high-tech sectors and businesses making intensive use of IP, such as those in chemicals, computer chips and electronic engineering and laboratory equipment, generally suffered negative share-price reactions. It would seem that investors assume such companies take advantage of international tax planning under the existing rules and can expect bigger tax bills after the reform.

By contrast, companies in those sectors where businesses provide tangible goods and services, such as construction, steel, hospitality and retail, were almost unaffected; perhaps not surprisingly given that such companies will generate the largest part of their revenues domestically and pay tax likewise.

Then there are the jurisdictions that have benefited until now from tax competition. We used credit-default swaps (CDS) to gauge investor sentiment as to the likely impact on the public finances of such countries. A CDS is essentially a type of insurance policy that transfers the risk of default from the investor to the CDS provider. CDS “spreads” represent the amount the investor must pay the CDS provider annually. The higher the spreads, the more negative is investors’ view of a country’s public finances.

We found that countries that have attracted a disproportionately high amount of corporate tax revenue under the existing system experienced a significant increase in CDS spreads after the reform actions or announcements, and that these effects persisted over time.

Emerging countries to benefit

This suggests that investors believe jurisdictions such as Ireland that have been at the forefront of tax competition will see a decline in corporate-tax revenues. By contrast, markets appear to believe that emerging countries such as Brazil, China and India will benefit from higher tax revenues under the reforms.

Two final points arise from our research. First, investors seem to believe that companies will not be able to use clever planning to skirt the new rules. Second, the impact of the changes is so profound that it will affect the political economy of corporate tax design.

Marcel Olbert is Assistant Professor of Accounting at London Business School. Roberto Gomez Cram is Assistant Professor of Finance at London Business School