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Pearl Ng’s Essay

NCH London | June 30, 2020

Should the law allow government to strike special tax deals with certain companies in order to attract foreign investment?

Pearl Ng

The UK has long been a welcoming and alluring destination for foreign investors due to its stable economy and access to the EU common market. In 2019, it was ranked most popular in Europe and 6th in the world, with 1782 foreign investment projects across the country. However, due to a weakening exchange rate and uncertainty over future trading arrangements with the EU, foreign investment into the UK has reached its lowest in six years. In the aftermath of the Brexit referendum, yet another question arises: should the government be legally permitted to negotiate lower tax deals with firms in order to incentivise foreign investment once more?

Prior to answering this question, it is important to understand what foreign investment is, and why governments seek to pursue it in the first place. Foreign investment refers to a flow of money or capital from one country to another. This could be in the form of a company setting up a new international branch, taking over an existing overseas firm (known as a merger or acquisition), building a factory in another country or simply purchasing shares to support foreign entrepreneurs.

Governments strive to increase inward foreign investment as it stimulates economic growth, contributes to GDP output and raises the standard of living. The jobs and training provided by foreign companies result in lower unemployment and a better-quality workforce. In addition, international firms entering the domestic market give consumers a greater choice of goods and services, whilst helping to lower prices by increasing competition between suppliers. Surely legalising special taxation would only multiply the benefits that foreign investment brings to a country’s government and citizens? After all, firms locate in countries with lower VAT and corporate tax where they can retain a larger proportion of their profits.

In fact, the Organisation for Economic Co-operation and Development (OECD) estimates that a 1% increase in tax rate leads to a 3.7% fall in foreign investment, showing that taxation is an extremely important factor for firms when choosing a host country to invest in. The issue is that governments are well aware of this. Desires to entice firms to set up in their economy have caused them to fiercely slash taxes and offer a host of other equally outrageous incentives.

One such example would be the bidding war in the US about which state should house Amazon’s second headquarters. This led to New Jersey and California proposing $7bn and $1bn respectively in tax breaks to the technology giant, alongside subsidies of $10,000 per job created. Schemes like these cost the government trillions of dollars that could otherwise be spent on roads, schools and other public goods.

Another key issue with legalising special tax deals is their covert and secretive nature. By allowing governments to offer undisclosed lower tax rates to prospective foreign investors, legislators undermine the transparency upon which the free market relies on. Therefore, permitting such negotiations could result in a whole host of problems from lower efficiency to information asymmetry. This rationale is reflected in EU law, which defines state aid as “the State intervening to give the benefactor a competitive advantage on a selective basis, distorting competition and affecting trade between Member States”. In other words, multinational corporations (MNCs) choose to divert their profits to the country who can offer the most favourable tax deal – often known as a tax haven – which unfairly disadvantages the economies where the goods and services were originally sold. Would it be wise to pass a law that encourages, even facilitates, tax evasion? The European Commission argues that it is surely not. Starbucks with the Netherlands, Fiat with Luxembourg, Apple’s 0.005% tax to the Irish government – these are all cases where MNCs have benefitted greatly from undercover tax agreements whilst depriving other economies, such as the UK, of their rightful revenue.

Aside from decreasing competition, a law permitting governments to strike special tax deals is susceptible to bias and abuse, as authorities could apply it arbitrarily or unjustly for political or economic gain. Allowing such behaviour would be placing a huge amount of faith in the government to act responsibly and wisely.

However, simply because there is a potential for error does not mean that it should be illegal to strike special tax deals with certain companies. After all, there are plenty of actions that the government is legally allowed to take (e.g. declare war) despite there being a risk of negative consequences. The law needs to observe a certain standard of national sovereignty, giving countries the power to make independent decisions by themselves. In fact, many governments might choose to use tax incentives strategically and in moderation to hugely benefit the economy. They could offer lower taxes to small companies in infant or emerging sectors, such as the UK’s creative industry tax relief for film, television and theatre companies. Legalising more tax deals of this nature would give the government the flexibility to target areas of the economy that require the most support, giving them the financial means to expand to their full potential. This would also help to close the wealth gap between start-up local businesses and giant multinational billionaires.

Furthermore, the government could use tax incentives to attract particularly innovative, environmentally-friendly or desirable firms. For example, UK companies who purchase energy-efficient or zero-carbon technology can claim capital allowances; similarly, lower tax rates or exemptions from levies could be implemented for non-polluting and green enterprises. This demonstrates the situations where selective advantage can be beneficial by helping governments to influence the nature and quality of incoming foreign investment.

It is true that tax incentives are by far not the only way of encouraging firms to enter an economy. Low transportation costs, access to a wide consumer base, well-developed infrastructure and a talented supply of labour are all host country perks that are attractive to foreign businesses. These advantages can potentially compensate for a lack of tax breaks; for example, Japan and Germany are economies that have strong FDI inflows despite relatively high corporate taxes. Likewise, the UK already has strong transport links, low barriers to entry and a minimal amount of paperwork for companies to complete. The online business registration process is extremely simple and accessible, allowing foreign nationals to set up a firm in as little as 14 days. However, the reality is that increasing capital mobility and decreasing trade costs are gradually rendering these non- financial benefits negligible, leaving tax reductions as the primary – if not sole – effective option to incentivise foreign investment.

In conclusion, tax incentives targeted at specific companies or sectors have the potential to cause great economic reward or harm. It is not the law’s duty to question the competency of our country’s leaders to act in the best interests of their people. Therefore, it would be wrong to disallow special tax deals simply due to a fear of their potential negative repercussions. It might, however, be reasonable to ban them should they jeopardize the competitive free market, as the law serves in part to maintain peace and harmony on an international scale. Overall, favourable tax rates to certain firms should be legalised in cases where this encourages innovation and sustainable development without reducing competition, striking the perfect balance between national sovereignty and a fair economic playing field.

 

References

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