Misrules of the Game

“There is a general rule in social and economic life. Given any system, people will find a way to exploit it… All systems will be gamed”

W Brian Arthur, Santa Fe Institute, 2014

Fairness

A fair regulatory system can foster an environment that is economically, socially and environmentally beneficial to society as a whole. Such a system is characterised by impartiality, and balances the interests and rights of all parties. But, at the best of times, the regulatory burden does not fall evenly. Regulatory costs are proportionately greater for smaller firms than larger firms, for domestic firms than international ones. Medium-sized firms are particularly penalised—too big for exemption, too small to have the economies of scale of their larger counterparts. Regulators often find it easier to pick on the soft (small) targets than sanction the bigger targets that have access to sophisticated tax expertise and political connections.

Misrules can come about due to contradictory or overly complex regulation which penalises some stakeholders more than others. The more rules are perceived as unfair, insurmountable obstacles to be circumvented, the greater the erosion of trust and the ability to enforce without coercion. This lack of fairness enables a few economic giants to game the system. Public outrage has, to date, done little to address this.

Mismatched Scales

Any regulatory system has mismatches. Each such inconsistency creates a loophole and enables the particular system to be gamed. 

• Mismatched properties: the tangible physical and the intangible digital economy cannot be compared. The abstract nature of intangibles, such as software and knowledge, means that innovations can cross borders and be freely replicated, while profits earned in one location can be shifted to another where they are taxed at lower rates. 
• Mismatched geographic scales: the digital economy operates at a supranational scale which is beyond the reach of regulators without a globalised enforcement mechanism. As the world has become more interconnected, the discrepancies between local, national, regional and global regulations have enabled global digital companies to exploit loopholes and mismatches to ‘forum shop’, picking the most advantageous legal framework. 
• Mismatched timescales: the digital economy operates at an accelerating speed, making it almost impossible to regulate using traditional formula and processes. As a result, regulation, at best, bolts the door after the horse has not only bolted, but foaled. 

Taxation

The OECD estimates that annual tax avoidance by global corporations resulted in revenue losses of 240 billion USD per annum to state coffers worldwide. This is equivalent to 10% of all global corporate income tax revenue. 

The digital economy makes this scale of tax avoidance possible. Multinational digital enterprises have been able to exploit mismatches between different tax systems, so that they can effectively transfer assets and entities across global locations to achieve ‘double non-taxation’. The location of the tax liability is moved to jurisdictions with lax tax regimes and is not aligned with the site of the economic activities and value creation. The term for this is domestic tax base erosion and profit shifting (BEPS).

More than a decade after the global financial crisis, countries have only started to collaborate to combat BEPS. There is still no international agreement regarding reform of the system to enable fair taxation. As a result, many countries are starting to implement their own unilateral tax systems, which could lead, not only to the unravelling of the global taxation system, but also to further tax avoidance.