Hamish McRae: Power balance shifts to the private sector and away from governments

Economic View

Your tax incentive is my tax loophole. There is an obvious irony that Britain should be introducing a new corporate tax break at the very moment that we should be supporting an international effort to reduce corporate tax avoidance.

True, our tax break is to encourage fracking, which, by its very nature, takes place within our territory, while the G20 finance ministers are in Moscow this weekend discussing an Organisation for Economic Co-operation and Development (OECD) report aimed at stopping companies shuffling profits to offshore locations where they have little or no physical presence. But the basic point that countries are competing for business by creating attractive tax regimes is undeniable. Exploration for oil and gas is expensive and cut our tax rate because we want the giant companies that do this to explore and develop supplies here rather than somewhere else.

This is about power and in particular the power balance between governments and business. Governments are powerful within their own territory, though they have to operate within constitutional arrangements and comply with broadly accepted international norms. If they don't, they pay a price – revolution and/or poverty for their people. Outside their jurisdiction, however, they are not that powerful at all, and the smaller the country the less power it has.

Thus the US government has a fair degree of leverage because of the size of its market. Companies and countries want access to it. But that power has limits, and if it imposes conditions that are thought to be too onerous, then they withdraw. For example, Americans abroad are finding it harder to get wealth-management services from non-US advisers because extra-territorial regulations make them unattractive customers. China is similarly in a strong position (though less strong than the US) because companies want access to its market.

Europe is more complicated because it is not a country. Some of the power relationship applies. Europe has a fair degree of leverage over the UK because our companies want access there, but this is tempered because European companies want access here. Smaller European countries have rather more power within Europe than you might expected as they have political leverage. Ireland can give a US company access to the European market and combine that access with a very low corporation-tax rate. Luxembourg and the Netherlands have similarly "gamed" their EU membership cleverly to attract business.

Businesses are powerful because they employ people and governments are desperate for jobs. They also get things done. No government, however competent, can build an aircraft or develop an oil field. It can, as we are seeing, run a bank, but we also see how much it hates so doing.

So each need the other. But the relationship between companies and governments has changed over the years for two reasons. First, globalisation: a generation ago people mostly bought products that were made in their own country. Now you don't know where something is made.

Second, the added value of a product is not in its manufacture but rather in the intellectual capital that has gone into it: the patents, the design, the marketing, the brand.

The combination of these two features means the power balance between governments and companies has shifted – and towards companies. Their ability to shift profits around used to be limited by their physical business and by agreements on transfer pricing (the price at which companies charged other parts of the business in another country for components). You could also see what was physically transported where. But if the added value is in intellectual property then it is much harder to price – and track.

The result is that it is much harder to tax companies than it used to be, and inevitably, abuses have arisen. The purpose of these new rules is to try and curb that. The aim of the OECD plan is to stop companies avoiding tax by putting patent rights into shell companies, charging interest in one country without reporting taxable profit in another, and forcing them to disclose where they do report their income.

This makes a lot of sense. As the German finance minister, Wolfgang Schäuble, said in Moscow: "Without fair burden sharing, in the end we will destroy even a global, open economy."

But governments should not kid themselves that it will be easy to establish what is fair.

Look at the graph, which shows the proportion of GDP that company taxation raises. Germany is at the bottom of the league – it is very bad at extracting money from its corporate sector. Norway, thanks to its oil, is at the top, and other natural-resource producers such as Australia and Canada also do well. Luxembourg is successful thanks to its financial-centre business (and it is a small economy) and the UK is above the middle of the pack. Ireland and the Netherlands both have successful regimes in the sense that a lot of companies base their international operations there, but proportionately they don't extract a lot of money.

Actually we as individuals can help – simply by not buying goods and services from companies that abuse the system. But that only takes us so far: we can do without Starbucks coffee but not without a Google search.

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