Why must tax treaties starve developing countries of revenue?

Hearson in Denmark. We’ll now ask his permission to use this photo.

Martin Hearson, who has just been at a parliamentary hearing in Denmark, asks a very good question about tax treaties and developing countries: why exactly is it necessary for them to insist on stiffing developing countries of tax revenue?

In more detail:

“Another point that I took from the discussion was the need to untangle the main things that tax treaties achieve, in a world where the most significant forms of double taxation are generally relieved unilaterally in the absence of an agreement:

1. Clarifying definitions, providing dispute resolution, and other technical matters that make double taxation less likely.
2. Giving tax authorities the legal basis for cooperation in enforcement matters.
3. Offering businesses the reassurance of a credible commitment to fair and ‘civilised’ (not my word) tax treatment in the future.
4. Reducing the taxing rights of the developing (ie source) country.

The case that treaties are necessary to provide items 1, 2 and perhaps 3 is strong. There is a (debatable) economic case for reducing source taxation to attract investment, made well by Clive Baxter from Maersk yesterday. But why respond to that case through bilateral treaties, which are harder to alter if the facts change, and which distort the inward investment market by treating investors from different countries differently? Why should the quid pro quo for items 1-3 be item 4? The fallacy, it seems to me, is to conflate the case for cooperation through treaties with the case for lower source taxation.

Our emphasis added. It’s a good question: why, because there may be some good reasons to sign tax treaties, does this imply that these treaties should have unfair terms? It is silly, but it’s commonly accepted in international tax.  (For a more fire-and-brimstone look at tax treaties, take a look at US tax expert Lee Sheppard’s presentation, here; see also our Tax Treaties page, explaining the basic issues.)

Another fallacy that is often overlooked in these areas is that people conflate the benefits of investment with benefits to the whole economy. In other words, if a tax break attracts investment (which often it doesn’t), then that’s the end of the story, and it’s done its job. But of course that is far from the end of the story.

If that foreign investment comes at a significant tax revenue cost, who’s to say that the overall result is good for the country as a whole?

And don’t get us started on tax-sensitive investment.