Tax, market power and global value chains

By Clair Quentin

Everybody knows that the least profitable thing to do in business is actually physically produce stuff. Most of the ‘value added’ – that is, most of the profitability and most of the salaries – comes from the product development and the design and the data and the algorithms and the branding and the marketing and so on.

And this phenomenon, as is likewise widely recognised, has a geography. In many sectors, the profitability arising from sales made into the deep-pocketed consumer markets of the Global North/economic core is underpinned, on a material level at least, by physical production performed by generally extremely low-paid workers in the Global South/economic periphery.

The ‘global value chains’ connecting the extremely low-paid workers to the deep-pocketed consumers are dominated by ‘lead firms’. These are multinational enterprises (generally taking the form of groups of companies) which hold the intangible assets – intellectual property and so forth – which are instrumentalised in various ways so as to capture the lion’s share of the value added arising in the chain.

These lead firms are one of the reasons why those physical production nodes generate so little value added. The lead firms’ intangible assets enable them to act as ‘choke points’, and as such they exercise disproportionate market power, able to force down the prices they pay and/or force up the prices they charge, as contrasted with other actors in the chain. A classic illustration might be the power that brand-owners hold over access to market for manufactured goods.

The use of intangible assets in this way by lead firms is a major element of the story of international corporate tax avoidance over the last few decades. Intangible assets can easily be parked offshore, or more easily than a factory and a bunch of workers, so that the revenues associated with them can accrue offshore and thereby escape tax.

It is for this reason that there has been shift in international corporate tax policy, taking effect from about ten years ago, towards allocating profitability for tax purposes towards the country where the work behind those assets is performed, rather than to the tax haven where it accrues to a shell company as a matter of legal form.

But there are hard constraints upon which countries stand to benefit from that reallocation.

 

Not all countries will gain from reallocating taxing rights

It is generally possible for a country where the work of developing and maintaining intangible assets is being performed to stake a tax claim to the revenue. This is because the lead firm will have a taxable presence there in the form of the corporate group member employing the workers in question.

And it is currently being proposed that countries where sales are being made can stake a claim too, even if the lead firm doesn’t have a taxable presence there.

Applying a similar logic, it should also be possible for the Global South/economic periphery counties where the physical production is taking place to claim taxing rights over some of that revenue. But in fact they can’t, for two interconnected reasons.

First, owing to the downwards pressure which lead firms exert on value added in production nodes, it would be hard for the countries in question to argue that those entities are being inadequately rewarded for their role in the chain. The lead firm would just point to low open-market wholesale prices and say: “I’m sorry but that is all that those outputs are worth – the profit you are already taxing is fully representative of the value creation taking place in your jurisdiction”.

But secondly (and this is the hard constraint) it is often not the case that the company doing the low-margin, low-wage production in the Global South/economic periphery country is owned in-group as a subsidiary of the lead firm.

The typical global value chain relationship is one where a lead firm exercises control otherwise than through direct ownership in a corporate group, but nonetheless gets what it wants for a low price, for example because suppliers have to compete intensely in order to supply to it or face not having a buyer at all.

(Just as, in turn, the supplier’s workers also generally face the choice between a labour market heavily skewed in favour of buyers or no income at all).

And accordingly – and this is the key point – the lead firm would not normally even have a taxable presence in the country where production takes place. Its control is exercised through market power rather than ownership.

This is not a dynamic that is widely recognised or understood. For example it is widely believed, even among senior policymakers, that the current rules genuinely reward countries for fostering value creation.

This is to suggest that the huge gulf between, say, the UK’s tax revenue from multinational enterprises and, say, Kenya’s, is referable to the UK’s vastly superior fostering of value creation as compared to Kenya’s. But of course it is not. It is referable to the myriad mechanisms by which the world’s rich countries keep poor countries poor and cheap labour cheap.

Indeed if the current rules reward states for anything in particular, it is for fostering the means by which world-spanning companies extract value from exploited workers in far-flung places, as opposed to actually producing anything of value themselves. And I guess, to be fair, that is something the UK has historically been egregiously good at.

 

The problem with formulary apportionment

So what is to be done? A crucial point to emphasise is that the current progressive policy ask in this area, known as ‘unitary taxation by formulary apportionment’ (‘UTFA’), would not help either, and for precisely the same reason that the existing norms do not help.

UTFA would treat multinational firms as single global entities and allocate their profitability for tax purposes to different countries based on a formula (such as the location of their assets, sales and labour).

But UFTA only envisages the reallocation of profitability upstream in global value chains to production nodes in circumstances where the lead firm controls production through ownership, as opposed to market power. In other words it would replicate the precise same problem.

But even if reallocation upstream based on market power were formally within the scope of prevailing international corporate tax norms, the actual revenue is not there, upstream, available to be taxed.

And so such norms could only be operationalised if they were in practice accompanied by colossal unconditional fiscal transfers from where the profits accrue (i.e. wealthy countries) to countries of the Global South/economic periphery. Sadly this is not a realistic prospect.

Clair Quentin is a law lecturer at the University of Kent in the UK.