How do corporate tax burdens vary with firm size? and why that matters?

Corporate income tax is an important source of government revenue, especially in low and middle-income countries. However, effective tax rates are often far below statutory rates due to generous tax incentives provided to attract investments. These incentives include tax credits, income exemptions, and reduced rates.

The OECD/G20's proposal to establish a global 15 per cent minimum tax on large multinationals could profoundly impact the effectiveness of tax incentives meant to attract investments and call into question their rationale.  Yet, the distribution of effective tax rates and the take-up of tax incentives are not well documented in developing countries.

In a recent paper, we constructed firm-level effective tax rates using administrative data and a consistent methodology across 13 countries at various income levels in Africa (Ethiopia, Eswatini, Rwanda, Senegal, and Uganda), Latin America (Costa Rica, Dominican Republic, Ecuador, Guatemala, Honduras, and Mexico), and Eastern Europe (Albania and Montenegro).

Within sample countries, we found tax burdens unequally shared across firms, following an inverted U-shape. Smaller firms often benefit from reduced rates and are more likely to declare losses, yielding zero tax liabilities.

While effective tax rates initially increase with firm sizes, they flatten at the 90th percentile and decrease at the top: the largest 1 per cent of firms face an effective tax rate (ETR) that is on average 2.5 percentage points lower than the ETR for other top decile firms. This pattern is consistent across countries: effective tax rates rise in all 13 countries for small and medium firms, and drop in 9 of 13 at the top.

We analysed the types of tax incentives firms claim to better understand the low tax burden for the top 1 per cent. We controlled for whether a firm claims for different types of tax expenditures: exempt income, special deductions, re-timing (loss carryback or carryforward), and tax credits, as well as for characteristics of the firm (sector, location, age).

The tax differential for the top 1 per cent is mostly due to tax credits claimed by large firms and income exempted from tax. Geography also plays a role, by partially proxying for preferential tax regimes such as special economic zones.

Policy implications: The wide scope of a 15 per cent minimum tax

A global corporate minimum tax could have a wide scope and generate significant revenue since tax incentives substantially decrease the tax burdens of large firms, many of which belong to multinational groups. 

As currently designed, pillar II of the OECD/G20 Inclusive Framework allows headquarters countries of multinationals (MNEs) to claim a top-up tax if profits reported by MNE subsidiaries in other countries are taxed at an effective rate below 15 per cent. Few MNEs are headquartered in developing countries, thus these countries are unlikely to directly benefit from claims to under-taxed profits.

Yet, a global minimum tax would encourage countries to ensure that large firms pay at least 15 per cent of their profits in tax in each country they operate in and limit the rationale for tax incentives since source countries hosting MNE affiliates could raise their ETRs without changing the overall tax burden for the MNEs and deter investment.

Changes to the global corporate architecture could present an opportunity for low and middle-income countries to put an end to the competition for lower corporate taxation by reducing tax incentives and increasing revenue. To actually achieve these revenue gains, countries will need to make difficult adjustments to their tax codes.

One approach is to restrict the generosity of tax incentives offered to MNEs and eliminate the incentives that do not have clear societal benefits. Another promising path, followed for example by Colombia, is to cap the value of tax incentives as a percentage of firms' tax liability, ensuring that effective tax rates do not fall too low.

A third alternative could be to impose a minimum tax on the revenue of MNEs, such as the one Honduras had in place before 2018. Countries will face crucial policy decisions in the coming years, highlighting the importance of generating thorough evidence on the design of these various policy options.

Pierre Bachas is an economist at the World Bank. Anne Brockmeyer is a senior economist. Roel Dom is an economist. Camille Semelet is a consultant.