Global justice, differentiation and the taxation of the digital economy

By Ivan Ozai

OECD’s Pillar One and the fundamental question about global justice

A final agreement on the OECD Pillar One proposal seems unlikely to happen any time soon. Still, discussions between the members of the Inclusive Framework are moving forward. They should be meeting on October 8-9 to approve the latest draft of the proposal (the “Blueprint”), which was recently made available by Professor Allison Christians on her blog. The proposal on Pillar One has been criticized on many fronts, for the most part not without reason. My purpose here is not to add to these critiques but rather to take the proposal as a point of departure for a broader discussion about the role of international taxation in addressing global inequality.

The main goal of Pillar One is to promote some reallocation of taxing rights to jurisdictions with sizeable consumer markets. The move results from the OECD’s concern about measures recently adopted or planned by these countries to tax profits from highly digitalized businesses. But reallocating taxing rights entails reforming some long-established tax rules. And Pillar One is but an illustration of a fundamental discontent of many countries with the current division of the international tax base. Underlying its political motivations, Pillar One reflects a more foundational question about distributive justice: the existing allocation of taxing rights tends to benefit certain jurisdictions over others, and the normative grounds that seemed to suffice in the past to justify that allocation are not as compelling in today’s configuration of the global economy.

Two alternative normative principles for allocating taxing rights

The normative guidance for allocating taxing rights does not deviate from the typical moral grounds for the distribution of rights and obligations in other areas of international law. Two main normative views govern such type of distribution. One view has primarily prevailed in international relations. It builds on the notion of sovereignty and the resulting requirement that a state respect other states’ autonomy and territorial integrity. According to this view, countries should be entitled to the wealth they each produce. Prevalent tax theories such as the economic allegiance theory, the benefits theory, the ability-to-pay theory, and the idea of value creation, incorporate this view. This normative stance can be called the origin-based approach because it generally entails that entitlement to tax derives from each country’s contribution to generating income.

The other normative view recognizes that countries’ economies are interconnected and interdependent and that the resulting economic ties between these countries raise duties of distributive justice (some may call this a duty of redistribution). This view requires that any international distribution of rights consider the underlying economic disparities between jurisdictions and thus become a tool for addressing global inequality. It ultimately requires rights to be distributed in a way that considers per capita income or number of inhabitants of each country. This view can be called the differential approach because it implies differentiated rights and obligations to states based on their different development needs. Some areas of international law have explicitly embraced some degree of differentiation, including international labour law, law of the sea, international trade law, international climate law, and international patent law. One prominent example of differential treatment is the principle of common but differentiated responsibilities and respective capabilities, formalized in the United Nations Framework Convention on Climate Change. The principle allocates greater environmental burdens and costs to more affluent countries than poorer ones. One central rationale derives from distributive justice considerations, premised on the idea that the distribution of burdens should be made according to countries’ ability to pay to avoid delaying poverty eradication in less developed countries.

A general survey on the political philosophy literature will show that most political theorists agree that some version of the differential approach is warranted from a normative viewpoint. Yet, traditional tax theory still mostly builds on the origin-based approach. These two views are difficult to reconcile because they produce quite different distributional consequences. Origin-based theories entail that the more a country produces, the greater its portion of the international tax base, which ultimately means that the richer the country, the richer it will become. In turn, the differential approach requires that the international allocation of taxing rights reduce rather than worsen global inequality and thus be set to the benefit of lower-income countries.

Limitation of the origin-based in pinpointing the factors that generate income

In a forthcoming paper, I argue that a policymaker concerned with global justice does not need to abandon the origin-based approach long prevalent in tax theory. She only needs to recognize its limited applicability in today’s tax policy decision-making. Origin-based theories are increasingly limited in scope because of two circumstances. First, they are infeasible to implement in practice in many cases. Origin-based approaches require pinpointing the various economic factors that have contributed to the generation of income and establishing how much each of them has contributed to generating such income. Determining these factors in a globalized, multinational scenario is complicated and often infeasible.

Pillar One provides a prominent example. Its proposed “new taxing right” adopts a formulary approach to shift part of multinationals’ residual profits to jurisdictions where consumers or users are located (to which the OECD refers as market jurisdictions). The proposal does not align satisfactorily with an origin-based rationale because there is no clear basis for allocating residual profits to market jurisdictions. Sales or user participation may be relevant contributing factors for routine profits, but it is difficult to make a direct connection between these factors and the generation of residual profits. Residual profits, by definition, are not directly attributable to any specific economic factor, which means that an origin-based approach does not satisfactorily apply. The reallocation proposed with the new taxing right seems to effect a political compromise. From a political viewpoint, this might loosely appease the current demands of market jurisdictions for greater taxing rights. But from a normative perspective, any proposal to allocate residual profits to market jurisdictions is significantly arbitrary. And from a distributive justice point of view, the proposal is problematic for benefitting specific jurisdictions, namely countries with larger consumer markets, while disfavouring lower-income countries with no clear underlying normative justification.

Limitation of the origin-based approach in consequentialist analysis

The second limitation of origin-based theories is that governments and policymakers have progressively strayed away from these theories in recent tax policy discourse. Instead, current discussions about allocating taxing rights have focused on the distributional consequences of different proposals. They have continuously relied on economic impact assessments to determine which countries will benefit or lose as a result of alternative policy choices. Pillar One is a case in point. The OECD has early demonstrated an urgent concern in disclosing the economic impacts of Pillar One on different countries. It broadly argued that “under Pillar One, low and middle-income economies are expected to gain relatively more revenue than advanced economies,” although failing to make available the data required to verify the accuracy of this claim. But the overt concern with making that argument shows cognizance that a final decision on the reconfiguration of taxing rights will require a political compromise based on its distributional impacts rather than alignment to the origin-based rationale that governed the earlier international tax order.

The differential approach as a normative alternative

The origin-based approach does not satisfactorily apply in these two circumstances, namely when it is impossible to pinpoint the factors that gave rise to a given income and when tax policy design moves away from an origin-based rationale toward one based on distributive considerations. In these two cases, the insufficiency of the origin-based approach creates a normative problem. Whenever origin-based theories fail as a normative guide for allocating taxing rights, the absence of alternative normative criteria leads to a significant degree of arbitrariness. As a consequence, the resulting allocation of rights tends to ultimately favour a few powerful countries. The differential approach offers a compelling normative alternative. By applying distributive justice principles, the differential approach also provides adequate guidance in a context where impact assessments and distributional implications assume increasing importance in international tax policy discussions.

Going back to Pillar One, its most recent Blueprint proposes a highly technical solution, the consequences of which are still unclear. The excessive technicality not only makes it difficult to assess the actual impact on different countries but, more importantly, conceals a more fundamental question about distributive justice that is implicit (although sometimes explicit) in discourse. In various passages, the Blueprint uses the term “fairness” to justify specific policy choices. It also suggests that it may be “unfair to deny market jurisdictions taxing rights over businesses that thanks to digitalisation are able to participate in the economic life of their jurisdiction remotely.” It more broadly emphasizes “the need to ensure a level playing field between all jurisdictions: large or small, developed or developing.”

If the Inclusive Framework, a group that currently counts 137 members, is to be a forum where consensus should be reached on an equal footing and aimed to ensure a level playing field between all members, the first questions that need answering are which countries should benefit from any reallocation of taxing rights and on what normative basis. And any solution to this question cannot shy away from a broader discussion about global distributive justice and a consideration of the role of taxing right allocation in either improving or impairing low-income countries’ ability to achieve sustainable development, including reducing inequality within and among countries and eradicating poverty in all its forms everywhere.

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