Tax cuts in major economies can reduce economic output in other parts of the world, the International Monetary Fund (IMF) has said, warning that changes to corporate tax policy can trigger significant cross-border effects.
The IMF said the globalisation of production and rapid expansion of digital technology had increased the importance of highly mobile intangible assets, including data, patents, software and trademarks. These assets now play a growing role in production and in determining the value and structure of companies.
They also allow multinational corporations to separate the countries where they report profits from those where they conduct business. Profits can be transferred to jurisdictions with lower tax rates, while governments compete to attract both those profits and investment through tax cuts and incentives.
However, the IMF said that pattern was beginning to change. As measures designed to prevent tax avoidance become more widespread, multinationals appear increasingly likely to report profits in the countries where they invest.
The finding was set out in an analytical chapter of the IMF’s latest World Economic Outlook and in an article titled Policies to Curb Tax Avoidance Are Changing How Countries Court Global Business. It was co-authored by IMF researchers Paula Beltran Saavedra, Daisuke Fujii, Gene Kindberg-Hanlon and Colombe Ladreit.
Tax competition and global spillovers
Tax competition has not disappeared, the IMF said, but its focus may be shifting from attracting reported profits to attracting the economic activity that generates them.
On average, a 1 percentage point cut in other countries’ headline corporate tax rates is associated with a 0.4 percentage point reduction at home. The response is strongest between economies at similar stages of development.
Competition over headline rates appears to have eased since the mid-2010s, a period that coincides with stronger international rules aimed at limiting tax-base erosion and profit shifting.
“Our findings suggest that reported profits have become less sensitive to differences in tax rates, while real investment has become more sensitive,” the IMF said. “This is consistent with a closer alignment of reported profits and the locations where real investment takes place.”
The pattern was particularly visible among multinationals that use less intangible capital or are headquartered in countries that have strengthened anti-avoidance rules.
The IMF said corporate tax cuts in major economies were followed by lower output elsewhere because the adverse effects of capital being redirected outweighed the positive impact of increased demand for imports.
It added that a 1 percentage point rise in a country’s corporate tax rate relative to other countries led to foreign direct investment inflows falling cumulatively by about 0.5% of GDP over three years.
Tax cuts can attract overseas investment and profits and increase domestic demand, but their effects depend on how they are financed. IMF modelling found that borrowing to fund cuts raises real interest rates and limits investment expansion across all economies in the short term. If other nations respond with similar cuts, the country that acts first sees its gains reduced.
In the longer term, governments must balance potential domestic benefits against lost revenue for public investment if they compensate through spending cuts or higher taxes elsewhere. The IMF said cross-border knowledge transfers can nevertheless create positive spillovers, particularly for emerging market and developing economies that rely heavily on corporate tax revenue for infrastructure, education, health and other growth-promoting investment.
