On Credible and Empty Threats

King Lear, Act 2, scene 4:

Lear: No, you unnatural hags,
I will have such revenges on you both,
That all the world shall—I will do such things,—
What they are, yet I know not: but they shall be
The terrors of the earth.

This is very much the Trump style. I’ll cancel the Paris Agreement! Mexico will pay for the Wall!

Making credible threats is still an essential part of diplomacy. An Fengshan, spokesman for China’s policy-making Taiwan Affairs Office, said on 14 December :

Upholding the ‘one China’ principle is the political basis of developing China-US relations, and is the cornerstone of peace and stability in the Taiwan Strait. If this basis is interfered with or damaged then the healthy, stable development of China-US relations is out of the question, and peace and stability in the Taiwan Strait will be seriously impacted.

Major national interest? Check. Means to deliver on threat? Check. Careful wording allowing plenty of space for future escalation? Check. This threat is serious. Like this one.

You can also go wrong by being too specific. Theresa May, in her Brexit speech on January 17:

While I am sure a positive agreement can be reached – I am equally clear that no deal for Britain is better than a bad deal for Britain. Because we would still be able to trade with Europe. We would be free to strike trade deals across the world. And we would have the freedom to set the competitive tax rates and embrace the policies that would attract the world’s best companies and biggest investors to Britain. And – if we were excluded from accessing the Single Market – we would be free to change the basis of Britain’s economic model.

What had she been drinking?

A threat by a country of 64 million to set up as a tax haven at the expense of a neighboring trade bloc of 446 million is not credible. The larger unit simply has too many ways of hitting the mobile international companies that might be tempted. You do business here, you pay our taxes. In this case, Colbert’s dictum that taxation is “pulling the goose’s feathers with the least amount of hissing” does not apply: the governments of the 27 remaining EU countries have a political interest in making Brexit painful. It is wishful thinking to suppose that this will be swept away by an economic interest in trade. And shifting corporate taxation is a zero- or negative-sum game.

Going into the details does not help May’s case. From time to time, politicians like Sarkozy turn a momentary spotlight on the tax havens. The pressure fades – but there is now an expert tax forum at the OECD, and the menu for doing something is getting much clearer.

The simplest solution is formulary apportionment  (aka unitary taxation) of corporate profits across tax jurisdictions. The total profits of a public company are declared credibly to their stockholders. You stop giving any credit to the creative accounting by which firms shift profits to low-tax jurisdictions: it is their home turf and you can’t beat them on it. So change the rules entirely. You allocate the total declared profits across countries according to more objective indicators of real economic activity, like sales, value added, capital stock or payroll.

This scheme is already applied for state corporate taxes within the USA and Canada, so there are no killer objections of principle to extending it across borders. There would be many technical difficulties: an agreed standard for profits (GAAP or IFRS?), and the choice of objective indicators of activity. There would also be political ones, there being many losers as well as winners and an overall gain.

So far, the tax havens have survived. How do they do it? First, it’s a vital interest for Luxembourg, Switzerland, Liechtenstein, Jersey, Panama, the Cayman Islands and the rest. They field their A teams in the committees all the time. The interest of the big countries that would gain goes up and down, and is reduced by conflicts of interest – maybe outright corruption, I hope not but it’s a possibility. Second, the tax havens give ground when they must. Banking secrecy has just about gone. The flickering spotlight has shifted to “tax efficient” and opaque corporate structures.

Still, the survival of tax havens, like shipping flags of convenience, is an anomaly. If big, powerful countries and blocs really had a mind to it, they could roll over both in a week. We saw this with Swiss banking secrecy after 9/11.  A second moment of truth came with Google’s Irish tax break. The EU Commission has sent Google a bill for back tax – for €13bn. This has to be paid to the Irish government, which is fighting in a stereotypically Irish way not to be paid.

Any attempt by a post-Brexit UK to set up as a giant tax haven would arouse furious and united EU opposition. It would overcome the many hesitations and technical obstacles that have so far prevented radical European action on international corporate taxation. The EU can find ways to present Google and Microsoft with a simple choice: do business with us and pay tax, or with little Britain, and good luck to you.

[Cross-posted at The Reality-Based Community]