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Friday, July 28, 2023

Weekly SSRN Tax Article Review And Roundup: Elkins Reviews The Use And Abuse Of Location-Specific Rent By Kane & Kern

This week, David Elkins (Netanya; Google Scholar) reviews Mitchell Kane (NYU) & Adam Kern (NYU), The Use and Abuse of Location-Specific Rent, 76 Tax L. Rev. __ (2023).

Elkins (2018)

The authors of this week’s feature article begin with the premise that an ideal formula for allocating taxing rights among countries would be one that enables them to raise substantial amounts of revenue, allows them to do so efficiently, and assigns rights fairly. The conceptual basis for such an allocation would constitute the holy grail of international taxation. The current system, which relies upon the concepts of residence and source, fail on all three counts. Both residence and source are easily manipulable, distort locational decisions, and are flawed proxies for countries’ contributions to business profits. The proposed alternative of some sort of formulary apportionment has significant drawbacks. If apportionment factors (e.g., employees, assets, and research) are elastic, they would distort locational decisions. Apportioning by sales can be avoided by selling to an unrelated intermediary located in a low-tax jurisdiction. 

More importantly, the idea of assigning taxing rights in accordance with an agreed upon formula does not solve the problem of how to measure each country’s contribution, but merely restates the conundrum: how much does each of the various proposed factors contribute to the production of income?

Recently, scholars have claimed to have found the grail: grant to each country the exclusive right to tax the location specific rent (LSR) that originates within it. Such a tax, it is claimed, would likely raise substantial revenue, would not distort choices about where capital is deployed, and would accord with the principle of taxation in accordance with contribution. One surprising aspect of taxing LSR is that within such a framework, efficiency and equity go hand in hand. The reason that this is surprising is that much of tax policy is concerned with equity-efficiency trade-offs, precisely because taxes that promote plausible conceptions of distributive justice tend to distort choices. The key to LSR’s potential is that it combines efficiency with a particular conception of equity, namely, providing a fair return to a society’s contribution to profit.

Having presented the case for taxing LSR, the article proceeds to examine whether the promise stands up to scrutiny. Claiming that advocates of LSR have spent little time considering what LSR is and whether it can be measured, it begins by defining LSR. According to the authors, LSR has three key elements: it depends upon what the factor of production would have earned had it been deployed in other jurisdictions, it is determined by the marginal revenue and marginal costs that arise in each jurisdiction, and it is limited so that the sum of the LSR in all jurisdictions in which it operates cannot exceed the firm’s global economic rent. They go into considerable detail analyzing each of these elements.

The authors then claim that for LSR to constitute a significant concept for the allocation of taxing rights, it must both be measurable and represent the exclusive contribution of a particular country to the firm’s profit. Drawing upon their definition of LSR, they show that LSR generally does not have either of these two features. Measurability is problematic primarily because of the counterfactual nature of the definition: how much would the firm have earned had it not been able to operate in that particular jurisdiction. The problem is compounded by the fact that we do not know which is the “second best” jurisdiction, so we must consider a large number of counterfactuals. Beyond that, even if we were privy to all the relevant information (“you might imagine that God moves a firm’s activity out of X to each alternative jurisdiction, measures the firm’s profit in each of the alternatives, and then takes the difference of the firm’s profit in X and its profit in the next-best jurisdiction”), the LSR as so measured would not necessarily represent the exclusive contribution of the jurisdiction to the firm’s overall profit. A number of examples that they provide help illustrate the point. First, assume that there are a number of equally suitable jurisdictions in which the firm can operate. In other words, each country is replaceable. Under their definition, the difference between the profit that the firm in fact earns and the profit that it would have earned in the next-best jurisdiction is zero. This result, they argue, does not accord with the intuition that the country in which the firm operates does in fact contribute to its profits. Second, assume that the firm operates in a number of countries and that its operation in each of the countries is a necessary but not a sufficient condition for its profitability. In other words, it is the synergy among the countries that creates the particular profit. Were we to examine each country separately, to ask how the firm would fare were it not to operate in that country, and to consider the difference to be the LSR allocable to that country, we would conclude that each country’s LSR is equal to the firm’s entire global rent. This conclusion cannot be accurate and in fact violates the third element of their definition.

Despite these reservations, the authors do not despair of any possible role for LSR in the allocation of taxing rights. If one understands it solely in terms of efficiency, then it is a more interesting concept than if one attempts to understand it as representing the contribution of a particular country to the creating of profit. They go on to describe a number of circumstances in which LSR might be usefully employed, including what they describe as platform rent (deploying a digital platform in a particular jurisdiction) and labor rent (the hiring of employees in a country with lower labor costs).

Finally, the authors briefly discuss the question of whether allocating taxing rights in accordance with LSR is equitable. If the goal of the international tax system is to allocate taxing rights in accordance with contribution, then, subject to the provisos that they suggest, LSR might be a relevant concept. However, other conceptions of distributive justice, such as distribution in accordance with need, may not consider the question of which country or countries contribute to the production of profit to be germane. The authors do not delve into this subject, but leave it as an open question that requires further study.

The article is thorough and detailed. It provides a comprehensive intellectual history, dating back to the early nineteenth century, of the concept of rent in general and goes on to trace three distinct intellectual paths originating in the 1990s – optimal tax theory, new economic geography, and source versus residence tax entitlements – that gave rise to the concept of LSR. Their analysis of the practical and theoretical limitations, along with the albeit restricted potential of LSR is systematic and meticulous.

Reading the article, I was nevertheless left wondering to what extent the weaknesses that the authors identify in the concept of LSR were endemic to the concept itself or a function of the definition that they themselves attributed to it. As noted, the authors claim that it is difficult to consider whether LSR can live up to its promise because scholars in the field have failed to advance a rigorous definition of the term. Consequently, they propose a three-factor definition of their own. Of these three factors, the first is clearly the most significant and thematic: the difference between what the firm actually earned and the amount that it would have earned had it instead operated in the next-best jurisdiction. Many of the practical (measurement) and theoretical (synergy, replaceability) problems that they then encounter along the way seem to stem from this part of the definition, and in the end it is these problems that lead them to the conclusion that LSR, while not an entirely unviable concept, is less useful than its advocates make it out to be. However, the question remains, whether an alternative definition might raise fewer or less significant theoretical problems. As an example, consider that instead of asking the counterfactual, what would the firm have earned in the next-best jurisdiction, we instead ask the similar but distinct counterfactual, how much would the firm have been willing to pay for the right to operate in the jurisdiction (a suggestion that I have considered, e.g., here). Synergy, replaceability, and the like are ubiquitous in a market economy. They do not undermine the underlying structure or call into question the market’s capacity to allocate profit to each factor of production in accordance with its contribution, but merely affect the prices at which market actors are willing to trade property and services.

“LSR” is perhaps the latest entry to the list of acronyms (CEN, CIN, NN, CON, etc.) that have come to dominate the discourse in international taxation. The question of what exactly LSR is and the extent to which allocating taxing rights in according therewith is feasible and appropriate is a subject that will undoubtedly be debated by international tax scholars for some time to come. This article is an important contribution to that discourse.

Here’s the rest of this week’s SSRN Tax Roundup:

https://taxprof.typepad.com/taxprof_blog/2023/07/weekly-ssrn-tax-article-review-and-roundup-elkins-reviews-the-use-and-abuse-of-location-specific-ren.html

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