Why it’s time to talk about corporate tax avoidance

Government responses to the fallout from Covid-19 have been both swift and expensive. Countries around the world imposed strict restrictions on people’s movements and required most businesses to close their doors in an effort to limit contagion.

As companies saw their revenues plummet and people lost their jobs, governments introduced schemes such as furlough as part of drastic fiscal measures to cushion their economies.

These measures were unprecedented in both their scale and speed of implementation. Around the world, we saw immediate increases in government spending, tax and debt deferrals, and liquidity assistance and guarantees to companies. By mid-May, this stimulus had exceeded $10 trillion globally, which was three times larger than the rescue package during the 2008/09 financial crisis.

Budget deficits expected to swell

This decisiveness to contain the economic downturn through both increased spending and deferred tax payments, means public finances in many countries will be very much “in the red” in the coming years, with forecasts predicting record deficits. The aggregate government deficit in the EU is expected to surge from 0.6% of GDP in 2019 to 8.3% in 2020 while the US deficit is forecast to rise from 7.2% to 17.8%.

This raises the question of how governments can cover this gap in their finances. Raising taxes may be unavoidable for most administrations. Which brings us to the next question: which taxes could be raised?

This will depend on how much money governments already receive from various sources and who can bear the brunt of a higher tax bill. According to the OECD, the majority of tax revenue comes from individuals in the form of income tax and social contributions, and from taxes on goods and services, of which more than 95% is value added tax. Notably, this hasn’t changed much over the years.

Perhaps surprisingly, corporate taxes are one of the smallest sources of revenue. Taxing companies is not a straightforward tool for raising revenue. A low tax rate may mean little revenue from companies themselves but, by attracting business, it can generate more revenue from employees via income tax and indirect taxes on goods and services. This is the approach that most countries have been taking, resulting in declining corporate income tax rates worldwide.

Businesses can be taxed by other means, such as lowering tax allowances, but the overall tax impact on companies – as represented by the effective corporate income tax rate – has also been in decline in most European countries.

Corporate tax likely to come under scrutiny

At a time when households are under considerable financial strain, and with personal tax rises always deeply unpopular, taxes on business are likely to attract some attention. This is not only about what governments may do but also about what public opinion could ask for. People are very likely to expect (and demand) that companies pay their fair share, especially if they have received taxpayer-funded support during the crisis.

Strings have already been attached to Covid bailouts: companies borrowing more than £50 million from the UK government’s scheme will not be allowed to pay dividends or grant pay rises to senior management. Greater pressure for companies to pay taxes could be next.

Tax avoidance, i.e. taking advantage of the complexities in a tax system to minimise the tax bill, has already been flagged as a potential precondition for receiving support. In contrast to tax evasion, which is paying lower or no taxes through illegal means, tax avoidance is a legal activity. Still, it is often viewed with scepticism, especially where it results in profitable companies paying little tax and could be a major point of contention in the years to come.

What does this mean for asset managers?

Although some may think that minimising tax may be in shareholders’ interests, the reality is that tax avoidance could be hurtful for them as well as the public finances. The regulatory attention it attracts – through initiatives such as the OECD’s base erosion and profit shifting framework – and reputational damage leading to consumer “boycotts”, can result in loss of company value. In the long run, avoiding taxes can undermine the infrastructure on which companies rely in order to operate without disruptions; for example, road maintenance for transport of goods and state-funded education that is needed for skilled employees.

So tax avoidance is an investment risk, but there are several ways in which asset managers can manage this risk.

As owners of companies, we can actively engage with them to encourage proper tax governance and transparent tax practices. This includes reporting on issues such as tax policies or where companies operate and generate their profits and whether this involves known tax havens.

It also includes having tools in place to identify aggressive tax practices and intervene where we observe these. Today’s aggressive tax avoidance could be tomorrow’s tax evasion.

The ultimate objective is not to make companies pay more tax but rather to ensure that they pay their fair share. 

Schroders SustainEx: measuring companies’ externalities

At Schroders, we treat corporate taxes as part of companies’ societal footprint and we use our proprietary tool, SustainEx, to measure this in monetary terms. Specifically, we look into the difference between the effective tax rate that companies report and the weighted average statutory tax rate that companies face across the countries in which they operate.

Where companies do not provide enough information, we estimate their factors compared to peers and apply a penalty for non-disclosure. The majority of industry sectors in the MSCI All Country World Index have a negative tax factor, meaning they pay less than the statutory tax rate where they operate. But several of them have a positive social impact overall, such as the pharmaceuticals and renewable energy sectors. 

Companies and asset managers under scrutiny

Under the pressure of Covid bailouts, societies will increasingly look to business to do their bit for the public finances. Expectations may be amplified where taxpayer money has helped support companies in their hour of need. At the same time, society will scrutinise whether asset managers hold companies to account and what their stance is on corporate tax avoidance. Both companies and asset managers should be prepared for this scrutiny and be able to show that they are committed to working towards everyone paying their fair share.

*Based on SustainEx data for almost 9,000 listed companies in the global MSCI All Country World Investable Market Index.