A tale of two Pillars

This article was first published on International Tax Review and is reproduced on this blog with the authorization of its authors.


Julien Pellefigue of Deloitte Société d’Avocats explains the importance of pillars one and two and the impact on transfer pricing.

After a lot of suspense, it looks like the big OECD driven tax revolution will finally become a reality in the not-too-distant future. Instead of using a magnifying glass to scrutinise the details of the two pillars, it could be interesting to take a step back, try to understand the macroeconomic foundations of that new construction and see if it is likely to achieve the objectives that have been ascribed to it.

Globalisation and the rise of multinational firms

Long story short: back in the 1950s, international trade was very limited and all the steps of the production process for most goods took place in one country (e.g. French cars were produced only in France, with few imported materials).

This organisation of industry gradually changed as the world entered the second globalisation wave. With the drop in transportation costs, the improvement in information technology and the fade out of regulatory barriers (tariffs and capital account liberalisation), firms started to realise they could reduce their cost structure significantly by splitting their production process into individual steps and locating each step in the most appropriate country (low wage countries for labour intensive steps, etc.)

This fragmentation of the production process completely changed the shape of the global economy to the point that, now, the production of pretty much any consumer good involves dozens of steps located in dozens of countries interconnected within global value chains, and intermediary products being transported over thousands of kilometres.

Another consequence of the second globalisation wave is the massive development of multinational entreprises (MNEs), which became coordinators of almost all value chains. MNEs were very small in the 70s but they have grown much faster than the economy. Today they account for a third of worldwide GDP and they control 50% of international trade.

Two other numbers are relevant for the purposes of this paper:

  • Collectively, MNEs generate a consolidated annual taxable profit of around $9 trillion, which represents a tax revenue of around $2 trillion, while most Corporate Income Tax (CIT) revenue of OECD countries actually comes from MNEs;
  • In a normal year, MNEs make foreign direct investment (FDI) of around $1.5 trillion. For developing economies, this can represent up to 40% of their total gross capital formation.

From national tax monopoly to international tax competition

For a long time, states enjoyed a fiscal monopoly. Whatever innovative new tax they enacted, taxpayers – including firms – had no (legal) choice other than paying. With globalisa- tion, the balance of power has been turned upside down and MNE have become so large that they can have states compete to attract them to their jurisdictions.

Yet, in a world where direct state interventions are generally prohibited, the most obvious tool to attract the MNEs is the tax lever, specifically reducing the corporate tax rate they would have to pay.

Using a pastry metaphor for international tax competition, MNEs represent two big pies: one taxable profit pie and one investment pie. States are competing, under the current rules of the tax game, to have the bigger share.

The intensity of tax competition has increased over the past 30 years, so much so that one could even talk about a tax war. Ireland is a good example of a winner of that war. Decreasing its statutory CIT rate from 50% to 12.5% enormously increased the flows of inward FDI, from $100 million in the 1990s to $1.2 billion at the end of the 2010s. Maybe more surprisingly, that move also multiplied its CIT revenue by almost three, from 1.8% to 5% of its GDP.

This rather counterintuitive result can be explained by a base effect offsetting the rate effect: the decrease in the tax rate led MNEs to allocate significantly more profit to their Irish subsidiaries, which more than compensated for the lower rate. All in all, the Irish GDP per capita compared to the UK GDP per capita rose from 60% in the 90s to almost 200% now. The same story could be more or less told for other investment hubs, like Luxembourg (the only large country in Europe where GDP per capita is higher than Ireland).

Things get political, finally

The tax war also had severe consequences for the losers, particularly in Europe, the US and some developing states. Rich countries lost inward FDIs and a taxable base, but in addition, they had to reduce their CIT rate to limit the erosion effect. As public spending continued to rise in the same period, states had to find new sources of revenues and they generally chose to increase the tax on consumption, which was a less mobile base.

As a result, the worldwide average CIT rate dropped from 40% in 1981 to 23% in 2020, while VAT rates increased from 18% to 20% over the same period. As capital tax is mostly borne by the richest households whereas VAT is paid by everyone, the tax mix in OECD countries generally became more regressive as a result of the international tax war.

The turning point of the story took place in the aftermath of the 2008 financial crisis. A famous 2012 article (which won the Pulitzer Prize) in the New York Times took the topic of international tax out of the muffled atmosphere of academia and international organisations and brought it into the wider public domain.

The notion that large multinationals were evading tax resonated very strongly with the middle class in a number of rich countries. And this is easily understandable as the members of that class have been the big losers of globalisation – their net revenue stagnated in real terms between the 1980s and now, while they have suffered from the politics of fiscal austerity that were put in place, and from the more regressive nature of the tax mix they were facing.

Politicians finally realised that they could use public resentment against MNEs and globalisation as a trumpeted cause in their campaigns, and the topic of tax reform left the administrative realm to become political. It is probably this political drive that explains the success of the two pillars proposal, whereas all previous attempts at reform, which lacked such support, failed – like the original CCCTB directive in Europe.

Enter the two pillars (of wisdom?)

The story is ultimately rather simple: rich countries realised that they were losing too much revenue, investments and public goodwill from tax competition. Tax competition was made possible by the current international tax regime, so they decided to change that tax regime.

Two things particularly needed revision: (i) the ability of states to attract MNEs with low tax rates should be curbed, and (ii) the rules should be updated to better allocate the profit generated by the ‘digital economy’ (that’s to say, allocate more profit to rich countries that have a large consumption base).

The two pillars can be seen as ways to implement that programme. Pillar two aims to limit the intensity of tax competition by imposing a de facto minimum CIT rate of 15% worldwide. Pillar one aims to allocate more taxable profit to ‘market economies’ by modifying the transfer pricing (TP) rules.

While pillar one was originally designed to tackle the specificities of the digital economy, as the US strongly objected to a tax specifically targeting ‘digital’ companies, its scope was extended, from digital MNEs to the largest and most profitable MNEs from many sectors. 

As of today, two questions remain: (i) will the two pillars globally be turned into positive law? And (ii) will they ulti- mately achieve the objective that was ascribed to them? A number of academic studies have been produced recently on that topic, which helped us propose the following analysis:

Despite the recent opposition of some European countries, it is now almost certain that pillar two will be turned into a directive in Europe and incorporated into the positive law of a large number of countries by 2024. As to its efficiency, that depends on whether one looks at taxable base or investments.

It is very likely that most states with low CIT rates will raise them to 15% in the next few years. As a matter of fact, that process has already started. In effect, it looks like pillar two will indeed create a 15% CIT rate floor worldwide.

It does not mean that it will reduce all incentives to structure operations so as to allocate more taxable base to states with a 15% CIT rate (15% is still significantly less than the average tax rate in OECD countries) but it will stop the race to the bottom and it will presumably reduce the total amount of profit allocated in low tax jurisdiction. The most serious estimates however show a limited macroeconomic effect of the measure (eg 3% of CIT increase in France, according to a study by Parenti and Toubal).

For the competition to attract investments on the other hand, it is likely that the effects of pillar two will be completely marginal. In the current state of the world, it would be somewhat naïve to imagine that countries will stop trying their best to attract the investments of MNEs because of pillar two. They will simply stop using CIT rates and switch to other instruments.

This has already started as certain states that have increased their CIT rate to 15% publicly mentioned that they didn’t need the money and were willing to give it back to firms as subsidies. Other strategies exist: CIT is a small portion of the total taxes paid by firms, decreasing the production taxes or SSC would also be a very attractive measure that could be used by states to attract investments. Pillar one is a completely different animal. We don’t have yet the final version of the proposal, but the complexity of the rules is such that it is still uncertain whether it will be fully enacted. Even if it is, it concerns so few firms (with the current size threshold) that its impact on the allocation of the tax base should be very limited, save for the US according to a study by Devereux.

Despite all the talk about a revolution, it seems that, even if the two pillars will put a stop to the CIT race to the bottom, they will only marginally change the international allocation of the tax base. And these results will be obtained at an extremely high cost for firms, as the complexity of the new rules is extraordinary, even from tax practitioners’ standards.

Based on this conclusion, one could be tempted to downplay the importance of the reform. That would however be very wrong, because the new tax framework is likely to have an incredibly important impact outside of the tax world. As mentioned at the beginning of this article, the current global industrial organisation is based on fragmented processes where the production of any good involves many international transactions of intermediary product moving from one step of the value chain to the next.

Such an organisation requires a total absence of tax friction on international transactions: in particular no customs duty and no double taxation of the profit. There are so many steps in a given value chain, that if each step were to be taxed, the total taxes would quickly exceed the overall profit and it would make international value chains no longer economical.

After the failure of the BEPS project (a failure for TP, it was a success in many other areas), there was a serious risk that the global consensus on international taxation, based on the arm’s-length principle, would collapse.

States would have then started to make unilateral decisions on international taxation (DSTs are a good example of that), and the multiple taxations that would have arisen would have quite simply broken the international production system, with potentially unfathomable economic consequences.

So, it could be argued that what was really at stake with the tax reform was the creation of a new international consensus on taxation, that would avoid multiple taxation, so that the international production infrastructure could be maintained. In other words, a tax revolution had to be made so that the globalised production infrastructure remains the same, hence the title of this chapter (an excerpt from The Leopard by Lampedusa).

Whatever one thinks of the current globalised economy, and its impact on the environment, the work of the OECD concerning the two pillars is probably the most important piece of international policy that has been put together in the recent past.


Julien Pellefigue

Julien Pellefigue, Partner, is an Economist in the Transfer Pricing department of Deloitte Société d’Avocats. He has more than 13 years of consulting experience both in economic consulting (transfer pricing […]