10 May 2018

Lower taxes, better business?

Thomas writes:*

The Netherlands recently suffered from a mild political shake-up caused by the government covering up a memo describing the effects of the proposed change of the dividend tax (henceforth: memogate). Currently, companies pay a 15% tax on the dividend they return to shareholders, which shareholders can partially get back when finalizing their tax returns. The proposal is to simplify the process by collecting the tax directly from the shareholders (either through income or corporate tax). This sounds like a minor administrative change that has no substantial consequences, which is entirely the case for Dutch companies with Dutch shareholders. However, as of now foreign shareholders lose out on their 15% without being able to reclaim it through their tax returns, a disadvantage that the proposal is to overturn. Proponents designate the status quo as protectionism and emphasise the need for a better business climate, whereas opponents refer to the proposal as a subsidy for foreign shareholders. So what would be the concrete consequences of the plan?

The first place to look is in the memo (part one [pdf] and part two [pdf]) that sparked memogate. It mentions three main issues at hand: firstly, the administrative benefit for Dutch companies; secondly, the budgetary consequences for the Dutch state; and lastly, the benefits for the Dutch business climate. The first two are relatively straightforward. Experts argue that there is a substantial gain for Dutch companies for not having to go through the administrative work that the dividend tax entails while paying the same in taxes in the end through their corporate taxes. This brings us to the second issue, namely the costs for the Dutch state, which have been estimated to be €1.4 billion. Sacrificing €1.4 billion for the sole benefit of saving administration seems rather wasteful.

Here the argument of the favourable business climate comes in, the basic intuition of which is that the measure will entice companies to settle in the Netherlands, bringing with them jobs and tax revenues. Whether it really works that way is quite contentious. The prime objection against this argument is that companies might settle in the Netherlands, but only in the form of letterbox companies, which have no benefits in terms of productivity. The infamous memo itself states that 87% of the letterbox companies in the Netherlands has no employees at all. It is estimated that all 15,000 letterbox firms employ 13,000 FTEs in the Netherlands, which is remarkably little for their €3.5 trillion worth. When taking this view, it seems that there is relatively little benefit to the proposal, except for helping a small part of the financial services sector (which is also mentioned to consist of highly skilled employees that should have no difficulty finding other employment).

The proponents of the idea bring forth two responses. Firstly, they say that the government is also taking action to address the issue of letterbox firms, which it seems to be in the process of doing. Secondly, they argue that the combination of these two measures should attract the real headquarters of companies, with employees, boards, and valuable investments like R&D departments. Unilever and Shell are extensively mentioned in this regard (possibly because their dividend taxes make up almost half of the total gains on the entire tax).

After Unilever had decided to move its HQ to Rotterdam however, the CEO stated that it where other factors drawing Unilever to the Netherlands, like the legal means to prevent hostile take-overs that Dutch law provides. If it were the dividend tax that mattered, the CEO stated, we would have stayed in the UK, which already does not have one. This was also reflected by the memo, where significant doubt was cast on the relation between dividend taxes and the location of headquarters. Additionally, it turned out that just a handful of jobs was actually moved to the Netherlands as a consequence of the move.

Proponents may have been too enthusiastic about their plan. Attracting companies seems to be about more than tax rates, but, as was alluded to, hinges on a multitude of factors, which will hopefully discourage governments from engaging in a race to the bottom with their corporate and dividend taxes (a race which the Netherlands is currently winning). In fact, they may do a better job in the long term by investing in the quality of their institutions and the skills of their constituency, for the sake of both their citizens and the companies.

Bottom line: Those who claim that lower corporate tax rates are good for attracting business may need to question their conclusions: the benefits seem minimal, and society may be better off by usefully investing the yields of a higher tax rate.

* Please help my growth and development economics students by commenting on unclear analysis, other perspectives, data sources, etc. (Or you can just say something nice :)