Recognizing Equity Problems in the Taxation of Cross-Border Workers

Ruth Mason - University of Connecticut School of Law

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Suppose a Belgian resident earns all of his income in Germany. Under the Belgian-German tax treaty and Belgian law, only Germany would tax his income. But which country should grant him personal tax benefits—things like mortgage interest deductions and charitable deductions? Where a worker lives in one country but works primarily in another country, I will refer to the country where the individual lives as his “residence country” and the country where he works as his “work country.”

In tax treaties, countries usually place responsibility for providing personal tax benefits on the residence country, largely for administrative reasons: the residence country typically has more information about the taxpayer’s personal and family circumstances and about her overall, worldwide income. So in my example, although Germany has the right to tax all of the cross-border worker’s income, under the Belgian-German tax treaty, Germany has no obligation to grant him any personal tax benefits. Thus, Germany can exclude the Belgian resident from the benefits it grants to its own resident workers, while taxing him on all his income. Because the worker in my example has no taxable income in Belgium, however, any personal deductions he is entitled to there have no value. As a result, he has no effective claim to personal tax benefits anywhere in the world.

 
I.
The Double Denial Problem

The facts above come from the landmark Schumacker case decided by the European Court of Justice (ECJ).1 Schumacker was a Belgian national who earned all of his income from work in Germany. He argued that, under the nondiscrimination principles of the EC Treaty, Germany should be required to grant workers from fellow EU member states the same personal tax benefits that it grants to German-resident workers. The ECJ held that although in most cases the work country (Germany) is not required to grant nonresidents personal tax benefits, in cases like Schumacker’s—where the nonresident earns “almost all” of his income in the work country—the work country must grant him the same personal tax benefits it confers on its domestic workers, lest EU cross-border workers fail to receive personal tax benefits anywhere.

The ECJ thus solved what might be called the problem of “double denials” of personal tax benefits for EU cross-border workers. But the problem still exists for cross-border workers outside the European Union. Double denials are reminiscent of unrelieved double taxation situations in which a taxpayer gets caught between two taxing jurisdictions and, as a result, suffers higher taxation than he would in a fully domestic situation. And although thousands of tax treaties have provisions addressing the entitlement to tax cross-border income, treaties have not addressed the complementary question of the obligation to confer personal tax benefits on taxpayers with such income.

 
II.
The Importance of Personal Tax Benefits

This is no minor question. Personal tax benefits are numerous and diverse; they include everything from credits for buying hybrid fuel cars to deductions for childcare costs and home mortgage interest. As one of the most important mechanisms for delivering government benefits to individuals and rewarding them for engaging in socially desirable behavior, personal tax benefits (also called “tax expenditures”) represent a substantial fiscal commitment. For example, in the United States, tax expenditures nearly tripled in real terms over the last thirty years to $730 billion in 2004, of which approximately $650 billion represented expenditures for individual taxpayers. Amounting to 7.5% of gross domestic product (GDP), U.S. tax expenditures exceeded discretionary spending in most years of the last decade.

 
III.
Solutions to the Double Denial Problem

One question posed in my full-length Article is whether the Schumacker solution should be adopted more broadly in tax treaties. I am not the only one asking that question. The Organisation for Economic Co-operation and Development (OECD) has considered whether its influential model tax treaty2 (upon which over 3000 extant tax treaties are based) should be amended to include the Schumacker rule in order to ensure that cross-border workers will be able to claim personal tax benefits somewhere in the world.

There are many reasons countries might want to solve the double denial problem, including that double denials are unfair, inefficiently discourage cross-border labor mobility, and undermine the effectiveness of tax incentives (since a tax incentive cannot affect the behavior of a cross-border worker who is not entitled to claim it).

But the Schumacker rule is not the only possible solution to the problem. Countries could unilaterally ensure that their own residents receive tax benefits by structuring benefits as refundable credits so that the absence of tax liability at home would not bar residents from collecting benefits. The host and home countries could also split the personal tax benefit obligation. For example, U.S. states split the obligation to provide personal tax benefits to U.S. interstate workers in proportion to their right to such workers’ income. For example, if New York taxes a Connecticut resident on 40% of her overall income because she earns it in New York, New York also grants her 40% of its personal tax benefits.

But which country ought to provide personal tax expenditures for cross-border workers? This question goes beyond double denials and falls into a gap between two otherwise robust literatures. One is the literature on domestic tax expenditures, wherein scholars have argued that structuring tax expenditures as deductions and nonrefundable credits is unfair and inefficient because they confer smaller (or zero) benefits on low income taxpayers. But no one has noted that those arguments also apply to cross-border workers, even when those cross-border workers earn high incomes. The second body of literature deals with immigration and discusses whether documented and undocumented immigrants should be entitled to the same direct spending (i.e., non-tax) benefits as citizens. Scholars have analyzed the direct spending question from moral, political, and labor market efficiency perspectives, but they generally skip over the tax spending question.

The bulk of my full-length Article uses the classic tax policy criteria of equity, efficiency, and administrability to analyze the question of which country should confer personal tax benefits on cross-border workers. I ultimately conclude that each of these criteria supports retention of the status quo. In other words, although it may lead to double denial situations, the current tax treaty rule that discharges the host country from conferring personal tax benefits on cross-border workers is fairer, more efficient, and simpler than the alternatives.

 
IV.
The Problem of Asymmetrical Labor Migration

In at least one situation, however, the arguments for imposing some of the burden for personal tax benefits on the work country seem compelling: when bilateral labor migration is asymmetrical. Labor migration is asymmetrical between two countries when more residents of the first country work in the second country than vice versa. By disassociating the entitlement to collect taxes from the obligation to provide tax benefits, the current allocation may require a country to extend benefits to a resident from whom it has collected little or no tax. Because bilateral tax treaties impose reciprocal entitlements and obligations on the contracting states, if cross-border labor mobility between the two countries is symmetrical, then any method they choose for allocating tax entitlements and personal tax benefit obligations should be revenue neutral. The easiest way to explain this is with an example. Assume that, consistently with international tax norms, France confers full personal tax benefits on French residents, even when they earn a majority of their income (and pay a majority of their taxes) in Germany. France loses revenue because it extends tax benefits to French residents from whom it collects little or no tax.

But consider the reverse situation, in which German residents earn income in France. France collects taxes from the German workers without incurring any obligation to grant them personal tax benefits. The outbound and inbound scenarios balance: What France loses in a residence-country capacity, it gains in a work-country capacity. As long as the income earned by French residents in Germany is roughly equal to the income earned by German residents in France, any method they choose for allocating tax revenue and personal tax benefits should be close to revenue neutral. If all reciprocal methods for allocating personal tax benefits are revenue neutral under conditions of symmetrical labor migration, then there is no inter-nation equity argument for choosing among them, and other criteria should guide the allocation decision.

In contrast, asymmetrical bilateral labor migration produces net revenue gains and losses from the provision of personal tax benefits. Specifically, under the current rule that allocates personal tax benefits to the residence country, net labor exporters—countries that send more workers abroad than they receive from other countries—lose revenue because they cede to the work country primary taxing authority over their residents’ foreign labor income, but they retain full personal tax benefit obligations with respect to those residents. Likewise, net labor importers gain revenue because they tax foreign workers’ income but do not need to provide them personal tax benefits.

 
V.
The Equity Impact of Asymmetrical Labor Migration

Developing countries tend to be net labor exporters because they tend to have lower wages and labor surpluses, while developed countries tend to be net labor importers due to their higher wages and labor shortages. Ironically, the personal tax benefit allocation rule in the OECD model tax treaty therefore tends to shift tax revenue from poor countries to rich countries.

Although I ultimately conclude in my Article that the revenue shift from poor to rich countries just described does not justify altering the default personal tax benefit allocation rule in tax treaties, it is nevertheless important to recognize it. Highlighting the revenue losses suffered by developing countries when they relinquish the entitlement to tax their residents’ foreign-source income while retaining the obligation to grant them personal tax benefits may help developing countries negotiate more favorable terms in their tax treaties with developed countries.

More broadly, my aim is to analyze what is at stake in tax treaty personal tax benefit provisions. So far, countries considering what to do about Schumacker situations have focused exclusively on tax revenue and administrability concerns, almost to the complete exclusion of equity and efficiency. My Article seeks to change that.

 

Acknowledgments:

Copyright © 2010 New York University Law School.

Ruth Mason is an Associate Professor of Law & the Trachsel Corporate Law Scholar at University of Connecticut School of Law.

This Legal Workshop Editorial is based on the following Law Review Article: Ruth Mason, Tax Expenditures and Global Labor Mobility, 84 N.Y.U. L. REV. 1540 (2009).

  1. Case C-279/93, Finanzamt Köln-Altstadt v. Schumacker, 1995 E.C.R. I-225.
  2. MODEL TAX CONVENTION ON INCOME AND ON CAPITAL (OECD Comm. On Fiscal Affairs 2008), available at http://www.oecd.org/dataoecd/14/32/41147804.pdf.

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