Corporate tax avoidance costs the US government an estimated $64B annually – revenue that could offset additional deficit spending or enable additional social programs moving forward – but tax avoidance rarely makes its way onto ESG issue lists, ESG rating reports, or ESG-related publications. The reasons behind tax avoidance’s omission as an ESG issue are much broader than taxation itself: it’s a tale about materiality, and about what makes an ESG issue “material.”
First, an important clarification: tax avoidance is not the same as tax evasion. Tax evasion is illegal – it is deliberately under-reporting or misrepresenting income to reduce payments. Tax avoidance is actually legal – it is simply a strategy that concerns how to use tax laws as currently constituted to avoid taxes. There are many legal mechanisms – strategically locating intellectual property, shifting location of debt, avoiding repatriating profits, inverting corporate headquarters – to avoid tax payments.
These mechanisms generally trace to one central idea: shifting profits to countries that exhibit lower corporate tax rates than others. The National Bureau of Economic Research (NBER) estimated in 2019 that 40% of multinational profits are shifted to “tax havens” (countries like the Cayman Islands, Luxembourg, and Ireland that maintain very low effective corporate tax rates). As a result, governments around the world lose about $200 billion in tax revenue annually. In the US alone, NBER researchers have estimated that the federal government loses 19% of its corporate tax revenue ($64 billion) every year.
Beyond ESG, the concept of financial materiality initially took root in investing and financial disclosures. Information is considered material if and when it can influence a reasonable investor’s decision-making. An undisclosed merger or impending lawsuit, for example, certainly could impact an investor’s thought process – but a minimal change in costs or revenue might not. The definition of materiality is still a little wonky, though. Materiality thresholds vary by audit standards, and they can be targeted frequently in shareholder lawsuits.
For ESG, “materiality” takes on a simplified meaning: if the issue at hand is bad for society and is meaningfully bad for an income statement, then it is material. If the issue at hand is good for society and is meaningfully good for an income statement, it is also material. That framework works for most issues: for instance, a fatal injury to a worker would be devastating for the worker and their family, the costs associated with the injury would be hefty for the worker’s company’s income statement, and the confluence of these two adverse effects clarifies health and safety as a clearly material ESG issue. Another example: decreasing fuel consumption is good for society (less carbon emissions) and good for a company’s income statement (less fuel expenditures), and these two realities validate fuel efficiency as a clearly material ESG issue.
The shortcoming of this rather simplified framework is its omission of a crucial set of issues: those that are bad for society, but that are good for a company’s income statement. Tax avoidance has historically fallen pretty squarely in this materiality bucket. The US federal government (not to mention state and local governments) is undoubtedly hurt by corporate tax revenue losses. But tax avoidance remains objectively very good for a company’s income statement – the practice enables additional free cash flow and higher valuations. By the traditional definition and the simplified framework, it’s simply not a material ESG issue.
The messy classification of ESG materiality is like a thorn in the side for responsible investors. There are a number of issues that create substantial positive or negative outcomes on a company’s stakeholders (e.g., carbon emissions and climate change, executive pay and income inequality, among others), but that may not be financially material. The ESG industry has attempted to reconcile this challenge by defining a separate concept: double materiality.
Double materiality, ingrained in the EU’s Non-Financial Reporting Directive and in updated definitions from the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB), segments out two forms of materiality: 1), stakeholder materiality, where an ESG issue is material in its impacts on stakeholders but not on the company’s finances; 2) financial materiality, where an ESG issue is material in its impact on both stakeholders and the company’s financial success.
But also ingrained in these updated definitions is a second concept – that materiality is dynamic. Over time, ESG issues will make the jump from materiality for stakeholders to materiality for a company’s finances. For this to happen, an ESG issue must change in two ways: 1), information on a company’s practices must become transparent for a broader audience (its investors, the government, the public, etc.); 2) that broader audience must change its decision-making based on that information (invest in the company, regulate its operations, buy its products, etc.).
Take supply chain human rights issues, for instance. 20 years ago, companies could routinely ignore poor working conditions in overseas factories to preserve profit margins. At the time, these practices had undoubtedly tremendous negative impacts on companies’ stakeholders (suppliers/laborers), but what changed to make poor working conditions a financially material ESG issue? Greater transparency and visibility, enabled by the internet, into the working practices in those companies’ factories, and consumers’ willingness to change their purchasing practices in light of that new information.
As an ESG issue, tax avoidance is starting to make that leap. Information about tax avoidance practices is increasingly available, and consumers are showing interest in using that information to make purchasing decisions. From Responsible Investor:
EU Member States have voted to adopt ‘country-by-country’ tax transparency measures, bringing an end to nearly five years of political wrangling and opening the doors for greater scrutiny on corporate tax affairs.
Yesterday, the EU Council, which represents the governments of Member States, approved requirements for companies with revenues above €750m to publish a breakdown of revenues, tax payments and other key financial data on a country-by-country basis.
Country-by-country reporting, the gold standard in tax payment transparency, will enable consumers, regulators, and investors to access to accurate information on the tax payments and tax avoidance mechanisms that companies are using globally right now. From Responsible Investor as well:
Stichting Pensioenfonds ABP, the €458bn Dutch pension fund for government and education employees, has created 10 principles on tax responsibility, raising expectations for portfolio companies in a governance area of growing importance.
The Principles for Responsible Investment (PRI) has been promoting the topic among signatories recently, taking the view that responsible tax is a material ESG issue. As the Covid-19 pandemic forces governments to inject taxpayer money into entire sectors of the economy, tax scrutiny of portfolio companies is becoming a stronger focus for responsible investors.
With a focus on government finances and the PRI to promote responsible tax practices as a material ESG consideration, pension funds like ABP are emboldened right now to make tax avoidance and responsible tax practice a meaningful part of their responsible investment programs.
At the moment, the profit potential that tax avoidance affords still outweighs any the cumulative effect of potential downsides (consumer purchasing decisions, investor scrutiny, regulatory impacts). But with better access to information and a new landscape for decision-making, the writing is on the wall: tax avoidance is making the leap from being a matter of just stakeholder materiality to being a matter of financial materiality too.