Pillar Two’s Unintended Consequences

The OECD’s Pillar Two aims to establish a global minimum taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
rate of 15 percent to curb what European officials have referred to as a “race to the bottom.” On the surface, imposing a worldwide flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets.
rate might appear like a simple way to end tax competition below the 15 percent threshold and curb profit-shifting to low-tax jurisdictions, but in reality, Pillar Two will have complex effects on different jurisdictions’ models of governance. Ultimately, it may not eliminate competition for investment and income; it may just change the way countries compete for investment to less transparent, less efficient methods.

How Pillar Two Affects Different Kinds of Countries

Pillar Two’s effects on countries’ tax regimes will depend on their level of development and previous tax strategies. For example, low-tax regimes can be important tools for developing nations to attract foreign direct investment and stimulate economic growth, which may not be possible otherwise. Thus, finding ways around Pillar Two’s restrictions is essential for their economic development and competitiveness with more developed nations. And that’s exactly what some are doing.

The Indonesian Minister of Investment argues that Pillar Two fails to treat developed and developing countries equitably and that the “former must leave room for the latter to attract investment.” The OECD itself acknowledges that less advanced economies benefit from attractive tax regimes, which help offset other disadvantages like poor geographic location and lack of natural resources.

Additionally, while many high-tax jurisdictions’ treasuries stand to benefit if Pillar Two curbs profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens.
, they may inadvertently harm their own economies in the process. The tax rates of low-tax countries can facilitate reinvestment in high-tax countries, driving growth by reducing the cost of capital—essentially, because profit shifting insulates investments from the high headline tax rates in those countries. The global minimum tax could erode this dynamic, affecting the very nations that champion the policy. Additionally, the global minimum tax won’t necessarily benefit all high-tax country treasuries; for example, the US may see reduced tax revenues from higher foreign tax credits.

Given the different needs of different countries, it may be better to respect individual countries’ fiscal sovereignty and existing tax policies. Allowing countries to set their own tax policies can allow for experimentation and, hopefully, more efficient economic results.

Emerging Subsidy War

Pillar Two shifts the competition from a “race to the bottom” for the lowest tax rates to a “race to the top” for the highest subsidies.

To maintain a competitive edge, countries will likely offer substantial financial incentives to attract and retain multinational corporations, making the system less equitable and transparent. Indeed, not every country can afford to hand out incentives.

Refundable tax credits—which can reduce a taxpayer’s liability below zero, resulting in a refund—are becoming one of the most popular forms of incentives. Due to a quirk in Pillar Two rules, they are not counted as a reduction in tax. Vietnam and Bermuda, for example, have set their corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.
rates to 15 percent to comply with Pillar Two, but are also developing refundable tax creditA refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words, a refundable tax credit creates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit (EITC).
packages to remain competitive in the global market.

Substance-based carve-outs allow companies to exclude a portion of their income from the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.
if it is tied to substantial business activities in the jurisdiction, such as payroll and tangible assets. These are considered less mobile and therefore less likely to be subject to profit shifting, but there is still some tax competition over tangible assets.

While this provision is intended to protect real economic activity, it can be exploited by countries to remain competitive. For example, Singapore’s corporate tax rate is 17 percent, but using substance-based carve-outs will reduce the effective rate to below 15 percent. Such a system is more complex and opaque than a simple flat rate.

A subsidy war will significantly impact countries that cannot afford to participate in cash handouts to companies to remain competitive. Unlike more advanced economies, many low-income developing countries argue they cannot provide such incentives due to liquidity issues. This inequity will exacerbate unfair tax competition and only allow wealthier countries to remain competitive under Pillar Two.

Evaluating Pillar Two’s Effectiveness and Unintended Consequences

Even as it adds complexity, Pillar Two faces diminishing returns, as it comes on top of many other measures designed to do the same job. Before enacting more policies directed at curbing tax evasion, it is important to analyze the effectiveness of existing policies. For example, there has been a 20 to 25 percent decrease in profit shifting to tax havens since the Base Erosion and Profit Shifting (BEPS) project in 2013.

The increasing complexity of regulations creates challenges for both countries and companies and can hinder economic growth. Decluttering the tax code to weed out ineffective policies and move towards a simpler international environment will benefit all parties.

Pillar Two risks creating a more complex and unfair international tax system. It is inadvertently fostering new, opaque, and complex forms of competition, and policymakers should consider alternative approaches to creating a fairer international tax environment.

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