Tax justice, capitalism and the rent-seeking multinational corporation

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I was interviewed by a UK-based academic yesterday for a piece of research that he is undertaking on the development of the tax justice movement in the UK. One of the questions he asked me was why we were so interested in the concept of unitary formula apportionment as a basis the taxing multinational companies. I explained to him that this is not just a pragmatic response to the failings of the arm's-length pricing model that the OECD requires be used for this purpose, but is in fact a conceptual response to the way in which the modern multinational company operates.

In my opinion multinational companies operate at two levels. At one level there are operating subsidiaries which accord, in varying degrees, to the model of capitalism that is sometimes taught at universities. In other words, these businesses command resources at something approximating to market prices to create goods and services that are sold to customers in something that again approximates to a competitive marketplace where some, at least, of their consumers are reasonably informed on the choices available to them and might even, on occasion, exert price pressure on the company to supply the products at prices that reflect the existence of other suppliers within that marketplace.

I stressed, however, that these are the subsidiary companies within these multinational corporations.

I also made the point that when it is said that multinational companies will relocate, very often this is not true of these subsidiaries. I do, of course, recognise that some such activities can be relocated, and indeed have been over time but this is not something companies do lightly. Because of the inherently conservative nature of all management, and because of the human cost of change which impacts those who run these subsidiaries almost as much as those who work for them, the desire to maintain a presence in a location is often quite strong. The result is that more often than not when a multinational group is tired of an activity in a place it sells it, rather than moves it.

This does, however, indicate the particular status of these productive activities within such groups. The group does not exist to run these operations: it exists to exploit them for as long as they suit its purpose to do so. In other words the group is disconnected from the subsidiaries because it is a financial engineering exercise. In the exercise of undertaking that financial engineering what it is doing is extracting rents from every part of the activity it manages. So, for example, it will extract profit from each subsidiary, but will also seek to combine them in ways that creates a supernormal profit compared to the return that they could make in isolation.

It is that supernormal profit that does, of course, make a mockery of the OECD's arms length pricing model: there is no place for that supernormal profit within that tax model, which means that the return in question all too often can go untaxed in that model. And this ability to exploit tax, both between subsidiaries, and also between states, is another rent that the group company seeks to exploit: there is a return to be made from operating in this way for taxation purposes that is unavailable to individual copies within the marketplace.

There is, of course, a third return which does equate to rent. This is the opportunity that the multinational company has to reduce its overall cost of capital by offering a composite risk to the investor rather than the specific risk that an individually focused activity can provide. The result is that the multinational company can fund its activities at a lower cost than individual entities can, providing it with another return that approximates to yield that is not so much earned as it is the consequence of exploitation, giving it the form of rent, yet again.

Add up these factors and there is a complete disconnect between the group operation and the individual subsidiary company activities. The subsidiary company activity might be represented as capitalism. The parent company activity is nothing like it: it is an exercise in exploitation, and it is the latter model that is now prevalent in the world of big business. That world of big business does, however, hide behind a veneer of what is represented to be entrepreneurial capitalism, which does in fact take place in the subsidiary companies of those multinational entities but not in the groups as a whole. The pretence that the multinational group is in fact itself capitalist in nature, is then just that i.e. a pretence or façade.

The parent company of the multinational group is, as such, an exercise in financial engineering that, like all such exercises, seeks to make its return by exploitation of artificial factors of production that are themselves inherently unproductive in the sense that they do not add to the overall net worth of human well-being. By definition, as a consequence, they extract reward, rather than add value.

This, I suggest, is part of the paradox of modern so-called ‘capitalism’. Whilst it appears to use a model based upon the creation of productive capacity to meet human need it has in fact moved on from that to instead leverage returns to a few, who include the senior management of the multinational corporation, at the expense of many with a resulting disparity of return that is so great that the income of the majority of people, including those who are managing many of the subsidiary companies of the multinational corporation, are now too low to fuel the additional demand that is required to generate the rents that multinational companies require such operations to justify their continued investment in them.

And that is why that investment in what might be called capitalist activity is no longer taking place: it is now a widely acknowledged fact that most large companies are now seriously cutting back on their investment spending.

This is also why multinational companies are so dedicated to re-engineering their businesses to create debt as a consequence of their trading wherever it is possible. So, telephone companies wish to sell phones on contracts that disguise implicit high rates of interest. And retailers seek to provide credit cards whilst care manufacturers make most of their money from extending credit to their customers, and not by making the car. That's because the excess rates of return on capital that the implicit interest rates in these transactions implies provides the rent that multinational companies are now seeking rather than from making the product itself.

And, now that tax avoidance activities are under challenge, those multinational corporations realise that another opportunity for rent seeking behaviour may be closing. No wonder they are fighting back in opposing unitary formula apportionment taxation that seeks to charge a company to tax where its identifiable fundamental economic activity takes place.

The three things that allocate taxable profit to a jurisdiction in this process are usually third-party sales, which means there must be a genuine customer in a location, or where people are actually located, which means there must be real activity in a jurisdiction, or where tangible physical assets are i.e. productive capacity exists. What about formula does, by definition, ignore is where the rental returns within that multinational corporation arise. It is those rental returns that have been reallocated to tax havens, aided and abetted, admittedly, by transfer mispricing into those places of the genuine profit arising from real productive activity, and unitary taxation seeks to reverse this process so that the rents implicit in that process will be subject to tax in the locations where they can be best seen to have arisen. It so happens that this is also most likely to mean that tax rates will be higher than the multinational corporation wishes because real activity usually takes place in major centres of population and they are associated with higher corporate tax rates.

Unitary taxation can then be seen as a pragmatic solution to a tax problem

but that would be to ignore its wider indications. As I have often argued, tax justice is one of the most pro-business lobbies that exists in current economic policy debate. We are firmly in favour of supplying the information that is needed to ensure that the effective allocation of capital to productive activity takes place to deliver appropriate rates of return on capital. The fact is, however, the modern financial markets are not interested in that process: what they are about is maximising the rental rate of return, which is something fundamentally different, and which can only be achieved in conditions of opacity, whether that capacity be supplied by tax havens, or by the very marked lack of transparency that is one of the key identifying qualities of modern consolidated financial statements published by multinational corporations.

Tax justice is then a direct challenge to rent seeking behaviour and the financial markets that promote it, including much of the financial services industry. But it is not a challenge, at all, to the genuine application of private capital to the productive process in transparent markets dedicated to meeting the needs of consumers, wherever they might be.

There is much discussion at present about the need for a new vision of politics, whether it comes from the bishops of the Church of England or from the Greek finance minister. I am not suggesting that the tax justice movement has the answers to all questions: that would be absurd. What I am saying is that if we are to genuinely understand the necessary relationship which must exist in the modern state between effective government supplied services and the essential role of the market then we also have to be able to differentiate the role of the rent seeker, and take action to limit their opportunity to exploit at cost to the many for the benefit of the few, or we cannot address the problems that they create. Those problems are implicit in the current structure of markets, and the way in which financial reporting is designed to meet their needs and not the need of genuine capital driven investment for social benefit through effective markets. And likewise, taxation is at present designed to meet the needs of the rent seekers, and not to meet the need of business, with appropriate incentives being provided to those real businesses who are seeking to serve real consumer focused markets.

Any vision for change does not need in that case to eliminate productive privately owned capital from markets, where I have always believed it has a role, not least because it is an essential part of a mixed economy. That process of change has instead to focus upon how we can control and regulate through taxation, and otherwise, rent seeking behaviour so that the enormous amount of effort that has been diverted to this activity can instead be released for productive use within the economy as a whole.

If tax justice can help draw attention to this issue then it serves a wider purpose, and I am convinced that it does. But that also explains why reform of taxation is essential. We have to strip away the facade of the current multinational company that makes a mockery of entrepreneurial capitalism and put in place systems that encourage effective marketplaces focused upon meeting need. Effective taxation systems are one key element in that process, and unitary taxation is an essential part of that.