Possible Spillovers from International Tax Reforms1
Recent international tax reforms, in particular the major reform undertaken in the United States in 2018, are likely to have spillovers on other economies, including Hong Kong SAR. While Hong Kong SAR’s corporate income tax system remains competitive in absolute terms, tax cuts elsewhere may make it relatively less attractive as a place for investing and reporting profits. The resulting medium-term revenue loss is estimated at roughly 5 percent of corporate income tax revenues at the current rate of 16.5 percent. If the corporate income tax rate were to be reduced, revenue losses would be higher.
A. The 2018 U.S. Tax Reform and Other Recent Reforms
1. The recent U.S. tax reform reduced the corporate income tax (CIT) rate by 14 percentage points. As a result, the combined (state and federal) CIT fell from around 40—one of the highest rates globally—to 26 percent, which is close to the OECD average of 24 percent. This cut follows a period of three decades of a global downward trend in corporate tax rates, during which the United States had kept its rate roughly constant.
2. Apart from the tax rate cut, the recent U.S. reform also included a host of additional measures with sometimes counteracting effects. Further tax-reducing measures include: expensing of investment; a shift to a territorial system, which exempts foreign profits of U.S. multinationals (except to the extent covered by ‘Global Intangible Low-Tax Income’ (GILTI), see below); and ‘Foreign Derived Intangible Income’ (FDII), which effectively provides a preferential CIT rate for the export share of profits that exceed 10 percent of tangible assets. Other measures that aim at reducing profit-shifting out of the United States are likely to increase tax liabilities of U.S. firms: GILTI creates a minimum U.S. tax on foreign active income without deferral, but with a foreign tax credit; and the ‘Base Erosion Anti-Abuse Tax’ (BEAT) functions as an alternative minimum tax, which disallows deduction of most foreign related-party service costs.2
Regional CIT Rate Comparison (in percent)
Source: FAD TP Rates Database.
3. Various other economies have also recently changed their tax treatment of corporate income. In the region, in 2017 Vietnam reduced its statutory CIT rate from 22 to 20 percent. In Mainland China the rate remains unchanged, but a tax deferral concession for the reinvested earnings of foreign investors was introduced. Overall, Asia’s average headline CIT rate has remained stable at around 21 percent within the last three years, however, and Hong Kong SAR’s 16.5 percent rate is comparatively low. Among the G7 economies, Italy reduced its CIT rate from 31.4 to 24 percent in 2017 and the United Kingdom from 20 to 19 percent in 2017. France announced a reduction in the headline CIT rate to 25 percent by 2022.
B. Impact on Hong Kong SAR from U.S. Tax Rate Cut
4. As a global financial center, Hong Kong SAR is particularly susceptible to changes in the international tax landscape, and its economy has strong links to the United States. At the end of 2017, while only 2.1 percent of Hong Kong SAR’s inward foreign direct investment (FDI) stock is directly financed from the United States, this figure likely conceals indirect investment going through offshore centers, which account for 45 percent of total FDI in Hong Kong SAR.3 Other data confirm strong economic ties between the United States and Hong Kong SAR: For instance, 13 percent of local offices are established by U.S. corporations (Census and Statistics Department HKSARG).
5. Under constant policies, corporate tax revenue in Hong Kong SAR might decrease by 5 percent due to changes in firms’ incentives of where to report profits and undertake real investment. Beer, Klemm, and Matheson (2018) estimate revenue spillovers from a one percentage point decrease in the U.S. CIT rate as follows:
where εK denotes the semi-elasticity of capital with respect to the tax differential, α is the capital intensity of production, εS is the semi-elasticity of reported profits with respect to the tax differential, and ωHKG is a country-specific weight, and Δtus is the change in the U.S. statutory tax rate (14 percentage points). The first three parameters are taken from the ample empirical literature on the topic;4 the weight is set at 14 percent as explained in the following paragraph. Combining the parameter estimates with this country-specific weight suggests that long-term revenue losses as a result of the combination of changes in where profits are reported and where real investment is undertaken, could be as high as 5 percent of CIT revenue (Equation 1). In the short run, revenue losses can be counteracted by any positive spillovers from a booming economy in the United States.
6. The calculation of revenue spillovers for Hong Kong SAR requires choosing the economy-specific weight that reflects the importance of the U.S. market for the corporate tax base in Hong Kong SAR. For instance, a weight of 1 would reflect a tax base that consisted entirely of MNCs with close ties to the United States; in contrast, a value of zero would reflect a tax base with no ties to the United States at all. Beer, Klemm, and Matheson (2018) use two types of weights: FDI weights and weights based on the number of links of multinationals to the United States. For Hong Kong SAR, using direct FDI weights does not appear appropriate given the likely underestimation of U.S. links as a result of FDI structured through offshore centers. Data on the number of ownership links are not available—which is unfortunate, as this measure would appropriately allow inclusion of all multinationals, not only U.S.-owned groups. As an approximation of the FDI link, this calculation uses the direct U.S. FDI of 2.5 percent and adds a share of the FDI coming from offshore centers. Specifically, it applies the global share of U.S. outward FDI stocks in total outward FDI stocks of 24.4 percent (UNCTAD, 2016) to the 47 percent of offshore center investment, yielding an estimated ratio of 14 percent.
7. Hong Kong SAR has no present plans to reduce its headline corporate income tax rate. Modeling a typical competitive reaction by rate cutting, however, indicates that a reduction in Hong Kong SAR’s CIT rate would aggravate—not forestall—the tax revenue losses estimated in the previous paragraph. Empirical evidence suggests that countries tend to reduce their CIT rates in response to other countries’ tax rate cuts. The U.S. tax reform could thus trigger a new round of CIT rate cuts globally. To capture the combined revenue implications, including tax policy design reactions in other countries, Beer, Klemm, and Matheson (2018) augment equation (1) to add a policy response:
Hong Kong SAR’s tax rate is a policy choice that cannot be predicted by a model, but based on a review of the literature of fiscal reaction functions, one can estimate the likely tax cut, if all economies, including Hong Kong SAR, react just as they did on average in the past.5 Here, μ represents the change in Hong Kong SAR’s CIT rate, t that would on past evidence typically occur in response to a one percentage point reduction in the weighted tax rate ωHKGtUS Then, including both Hong Kong SAR’s hypothetical direct reaction to the U.S. cut, and indirect reactions to other countries’ expected policy responses, the value of μ is calibrated at 1.6. This would suggest in the model that Hong Kong SAR might reduce its CIT rate by 3 percentage points over the long run. This hypothetical direct reduction in the tax rate would translate into revenue losses of 18 percent, while changed profit-shifting and investment incentives would in this scenario reduce revenue by 4 percent rather than the 5 percent estimated initially. So, while the policy response mitigates revenue losses from MNC’s reaction somewhat—from 5 to 4 percent of CIT revenue—the lower tax rate, which applies to both MNCs and domestic firms, would by far outweigh these marginal revenue savings.
C. Impact from Other Reforms
8. The impact from the other measures in the U.S. tax reform is harder to quantify, but also likely to be important. Beyond the tax rate cut, which raises the relative attractiveness of the United States, the following effects can be expected:
- Reported profits: On one hand, FDII strengthens incentives to report in the United States and GILTI and BEAT make it harder to report profits outside the United States. On the other hand, territoriality reduces the cost of reporting profits outside the United States (when the other provisions are not binding).
- Real investment: On one hand, investing in the United States becomes more attractive because of expensing and, for some firms, FDII. On the other hand, territoriality makes investment outside the United States more attractive. GILTI (by exempting 10 percent return on capital) and BEAT (by allowing deductions for imported goods but not services) can, counterintuitively, also increase incentives for real investment outside the United States.
- Competition between other countries: Territoriality may also make U.S. multinationals more sensitive to foreign tax rates, so that the relative tax rate of Hong Kong SAR compared to other economies rises in importance. This is somewhat counteracted by GILTI.
9. Tax cuts in other countries can be expected to intensify the impact, especially in the case of regional competitors. As noted above, the average tax rate in the regions has not changed, but if this were to happen it would lead to further—likely negative—spillovers.
10. Hong Kong SAR has a competitive tax system and revenue losses resulting from spillovers from international tax reform are expected to be manageable. In a policy response scenario—in which Hong Kong SAR and other economies are modelled to reduce their tax rates following the same reaction functions as on average in the past—revenue losses would be much greater. These can be avoided by maintaining the rate at the current level in response to the U.S. rate cut. In case of widespread regional tax cuts, the situation should be reassessed.
Beer, S.,A.Klemm, andT.Matheson,2018, “Tax Spillovers from U.S. Corporate Income Tax Reform,” IMF Working Paper, No. 18/166.
Chalk, N.,M.Keen, andV.Perry,2018, “The Tax Cuts and Jobs Act: An Appraisal,” IMF Working Paper, No. 18/185.
Leibrecht, M. andC.Hochgatterer,2012, “Tax Competition as a Cause of Falling Corporate Income Tax Rates: A Survey of Empirical Literature,” Journal of Economic Surveys26 (4), 616–648.
Prepared by Sebastian Beer and Alexander Klemm (both FAD).
For a more detailed description and assessment of the U.S. tax reform, see Chalk, Keen, and Perry (2018).
All data from Census and Statistics Department HKSARG. For the purposes of this calculation the British Virgin Islands, Cayman Islands, and Bermuda are counted as offshore centers. Investment coming from the Netherlands and Singapore is also likely to include investment originating elsewhere. Including those two countries, the ratio of FDI with unclear origin rises to 53 percent.