Is the Race to the Bottom Over?

Economics professors like to stage a fun competition with their students to introduce them to game theory. It goes like this:

Everyone picks a number between zero and 100, and the winner is the person whose choice is closest to two-thirds of the average choice. If you think about it, the winning choice can’t be higher than 67, so no one should choose above that. But then the logic snowballs. If the class average is 67, then the winning choice will be two-thirds of 67. But if that’s the average choice, you should pick two-thirds of that number. And so on. If you assume all the other players understand the game and you’re all trying to outwit one another, you quickly spiral down to choosing zero. It’s a race to the bottom.

A race to the bottom isn’t as fun when it involves international tax rules and you’re a nation looking to collect taxes from multinational corporations. Each country wants to set its corporate tax rate lower than those of other countries; the country with the lowest rate gets a windfall of tax revenue from companies that assign it their business, or at least their reported profits. That is, until another country comes along with an even lower rate. The total tax revenue collected by all countries combined goes down with each iteration of the game. The theoretical limit is a tax rate of zero.

In reality, of course, only a few countries have corporate tax rates of zero, but competition does suppress rates and drain tax revenue. “What countries are tired of is multinational corporations trying to game the system,” says Daniel Drezner, a professor of international politics at Tufts University’s Fletcher School. “It is within the right of countries to change the laws to make sure that is less of a thing.”

And change the laws is just what they are trying to do. On Oct. 8, many of the most powerful countries in the world hammered out an agreement on a global minimum tax of 15 percent under the leadership of the Organization for Economic Cooperation and Development. The new minimum is to apply to companies with annual revenue of more than 750 million euros (that’s $868 million at the current exchange rate); if approved and fully implemented, it will generate around $150 billion in additional global tax revenue per year.

The agreement is expected to be finalized this week in Washington by finance ministers of the Group of 20, signed by national leaders at the end of this month and fully activated by 2023.

One argument against a global minimum tax is that it’s a way for rich countries to gang up on companies and extract excessive taxes to finance their costly welfare states. That’s what some conservatives contend.

Another argument against a global minimum is that it could harm poor countries with low tax rates. A poor nation that’s unattractive to multinationals might want to set its corporate tax rate very low to attract investment, and the global minimum prevents it from doing that. But Drezner says that in practice, many of the countries with very low or zero corporate taxes aren’t poor nations but comfortable tax havens, like Jersey, Guernsey, Bermuda and the British Virgin Islands.

Yet another concern is that the global minimum tax could — counterintuitively — reduce investment in rich nations like the United States. Juan Carlos Suarez Serrato, an economist at Duke University, found in a 2019 paper that eliminating U.S. multinationals’ access to tax havens raised their effective tax rates (which, of course, was kind of the point). “Firms affected by the policy responded by reducing investment and domestic employment,” he wrote.

In June, as the deal was taking shape, the Initiative on Global Markets at the University of Chicago’s Booth School of Business asked top American and European economists what they thought of it. A majority on both continents thought it would “limit the benefits to companies of shifting profits to low-tax jurisdictions” without distorting their investment choices in economically inefficient ways. Smaller majorities had confidence that it was achievable. That part remains to be seen — it’s one thing to ink a deal, but quite another to enforce it.

One of the economists surveyed, Pol Antràs of Harvard, told me by email that in an ideal world each country would set a corporate tax rate based on its “needs, preferences or constraints.” But, he wrote, “that first-best may not be attainable at all, or may be subjected to ‘gaming,’ so setting a global minimum is a way (albeit a second-best way) to limit the ‘race-to-the-bottom.’”

Sometimes the second best is the best we can hope for.

Number of the week

5.4 percent

Increase in the U.S. Consumer Price Index in September from a year earlier, in the forecast of economists at Credit Suisse. That would be tied with June and July 2021 for the highest annual inflation since 2008. The Bureau of Labor Statistics is scheduled to report the official data on Oct. 13.

Quote of the day

“As God is my witness, I’ll never be hungry again!”

— “Gone With the Wind” screenplay (1939)

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