LOUIS XIV’S FINANCE minister, Jean-Baptiste Colbert, famously declared that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.” When it comes to taxing companies, a modern finance minister might rephrase this as “the largest possible amount of revenue with the smallest possible amount of economic and political damage.”

Studies have shown that high corporate-tax rates discourage business investment and entrepreneurship, and countries that try to squeeze their firms too hard often have larger black (or informal) economies. In a globalised world, high taxes may simply lead businesses to move to places that offer more competitive rates or tax breaks to companies that set up operations within their borders.

Yet if the public suspects that companies are not paying their fair share of taxes, governments come under pressure to take action. Multinationals have plenty of scope to reduce their tax bill because different governments offer a choice of rates and ways of taxing businesses, including tax breaks for activities such as research and development. “If you stick to the rules, you can lower your tax rate very substantially,” says Martin Sorrell of WPP, the advertising and marketing group. “But if you’re too aggressive, it can cause issues with your stakeholders.”

In recent years the public has increasingly come to believe that big businesses can get away with paying little or nothing in the way of profits tax. Many people now think that corporate taxes in their present form are no longer fit for purpose. “The corporate-tax system is completely broken,” says one technology executive. Executives from Amazon, Google and Starbucks were brought before a parliamentary committee in Britain in late 2012 and berated for paying very little tax there. The coffee company was so embarrassed that it promised a £20m ($32m) voluntary payment to the British tax authorities. Yet defenders of corporate-tax tactics point out that executives have a fiduciary obligation to shareholders to maximise profits and dividends, and there is no reason for them to pay any more tax than is legally required. If the tax rules have left loopholes, then the best remedy would be to change the rules.

The G20 group of leading economies recently asked the OECD, a mainly rich-country think-tank, to take a look at corporate-tax avoidance. In its report on “base erosion and profit-shifting”, released last year, the OECD expressed concern that “due to gaps in the interaction of different tax systems, and in some cases because of the application of bilateral tax treaties, income from cross-border activities may go untaxed anywhere, or be only unduly lowly taxed.”

Sharing out the feathers

It is widely but wrongly believed that the only tax paid by businesses is the one levied on their profits (known in America as the corporate income tax). In fact, a study by PwC, an accountancy firm, shows that, on average, companies pay more tax on labour, such as employers’ social-security contributions, than on profits (see chart 2). In addition there are property taxes, sales taxes, environmental taxes and so on. The average global company pays some 43.1% of its commercial profits in tax, of which 16.3 percentage points is labour-related, 16.1 profit-related and 10.7 others.

Since America levies a federal tax of 35% on corporate profits (among the world’s highest), this source accounts for a large proportion of its corporate-tax revenue. But European firms pay a lot of labour taxes, so the total tax take from companies is almost identical on the two sides of the Atlantic, at 40-45% of profits. According to the PwC survey, the total tax take from the corporate sector in the developed world has remained at much the same level since 2004.

The big question is whether it makes sense to tax corporate profits at all. A company is a legal entity; if it is taxed, it must pass the levy on

Tax revenue from profits has declined since the economic crisis. OECD figures show that the average country now raises the equivalent of about 2.7% of GDP in the form of profits taxes, compared with 3.5% in 2007. But that probably just reflects lower profits since the crisis, not a structural shift. In the longer term the share seems to have held fairly steady.

As the PwC report points out, “our current tax regimes were developed in economies largely concerned with the exchange of physical products made and sold in physical locations.” Moreover, the system was devised at a time when companies were more national in character and global trade had a smaller share of GDP. The modern economy depends heavily on services and intangible goods that flow across borders. Individual American states, too, have found it difficult to impose sales taxes on goods traded over the internet.

There are three approaches to taxing profits, known as residence, source and destination. The residence is where the company’s owners are based; the source is where the goods or services are produced; and the destination is where the goods are consumed. So for, say, an American-owned company that produces medicines in an Irish subsidiary which are sold in France, America is the residence, Ireland the source and France the destination. All three countries can claim a share of tax revenues.

A sales tax or value-added tax would focus on the destination, France. A profits-based system would concentrate on the source, Ireland. And a system based on personal taxes would raise the money in the residence, America, when shareholders receive dividends or make capital gains. In practice, elements of all three systems are used.

The trickiest issues arise when it comes to deciding where profits are generated. The subsidiaries of multinational companies trade with each other all the time. The big concern is that they will distort the market through “transfer pricing” so that subsidiaries in low-tax countries overcharge subsidiaries in high-tax countries to maximise the profits generated in the low-tax jurisdiction. To get around this problem, the tax authorities ask for intra-company transactions to be made on an “arm’s-length” basis, meaning that the prices are similar to those a company might pay if dealing with an unrelated business.

This principle is easy to apply to standardised goods such as commodities, but much harder when it comes to more specialised products. If a multinational retailer uses a franchise system, the individual franchises clearly depend on the parent’s brand and need to pay a fee for the privilege. The “intellectual property” of the company can be held in a subsidiary in a low-tax country. “Historically there has been little to stop a company transferring its intellectual property to any jurisdiction in the world and then charging the high-tax jurisdiction for the rights,” says Ben Jones of Eversheds, a law firm. This is a perfectly legal way of reducing the tax burden.

Another approach is to load up subsidiaries in high-tax companies with lots of debt, perhaps borrowed from subsidiaries in low-tax regimes. Since interest payments are tax-deductible, the effect is to lower the group’s overall tax bill.

All this has led to a series of cat-and-mouse games as governments try to crack down on such strategies and companies devise ever new approaches to exploit the rules to the full. Most experts now believe that the corporate-tax system is in urgent need of reform. In Britain the Mirrlees review in 2010, led by Sir James Mirrlees, a Nobel economics laureate, concluded that the current system resulted in both “very high compliance costs for international companies, and very high administration costs for tax authorities”.

In their 2005 book, “Reforming the US Corporate Tax”, Gary Hufbauer and Paul Grieco of the Peterson Institute for International Economics in Washington, DC, argued that “the corporate income tax badly serves the United States. It hobbles the country in global competition; it does little or nothing to promote equality, its original and still commonly recited justification; it is rife with distortions that erode efficiency; and it promises to get much worse in the future.”

The big question is whether it makes sense to tax corporate profits at all. A company is merely a legal entity; if it is taxed, it must pass the levy on to its shareholders (in the form of lower dividends), to its workers (in the form of lower wages) or to its customers (in the form of higher prices). If governments want to tax shareholders, workers or consumers, it may be better to do so directly.

America’s companies have not been sitting on their hands. The biggest change in the country’s corporate governance has been the rise of business structures such as partnerships that act as “pass-through vehicles”. Provided that all profits are remitted to investors each year, such structures avoid corporate income tax. America now has more such partnerships than it has traditional corporations.

But this leads to a three-tier tax system. Partnerships escape the tax on profits. Multinationals can reduce their tax bills by shifting production and profits to lower-tax regimes. The losers are smaller companies, which have less room for manoeuvre.

Worse, as governments try to crack down on the multinationals’ tax strategies, the tax code gets more and more complex, increasing the administrative burden for small companies. According to the National Federation of Independent Business, an American lobby group, five of the ten biggest worries of small businesses are tax-related.

Time may help reduce the problem. With many businesses already escaping the profits tax, and with some governments lowering their rates to attract multinationals, the world may very slowly be moving away from it. Perhaps in 50 or 100 years’ time it may have disappeared altogether. Many economists think that would be a sensible reform.

But abandoning the profits tax in isolation might invite new forms of tax avoidance. “If you abolished corporate tax, that would let people shelter money in companies and might undermine personal income tax,” says Bill Gale of the Brookings Institution, an American think-tank. A profits levy acts as a withholding tax, says Pascal Saint-Amans of the OECD; if it were abolished, the loss of revenue might be substantial. Many shareholders, including pension funds, have tax-exempt status, or they are based overseas, often in low-tax centres; they might make no contribution at all.

Pending a drastic overhaul, the OECD report suggests some possible rule changes to crack down on tax avoidance. But they will require international co-operation; if a few countries decided to opt out, they might become the tax domicile of choice, and revenues in the rest of the world would decline. Some commentators are pessimistic about the prospects. Mr Hufbauer points out that in America a commission has spent 50 years trying to come up with a formula to divide tax revenues among the individual states, so far without success. The reason he cites is the same that may make an international deal impossible: “When the crunch comes between attracting jobs and upholding the uniform tax code, the jobs will be more important.”