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Coronavirus and the Tax World

Posted on Apr. 6, 2020
Frans Vanistendael
Frans Vanistendael

Frans Vanistendael is professor emeritus at KU Leuven in Belgium.

In this article, the author considers the impact of the coronavirus pandemic on Europe and how tax policy may ultimately be affected.

Sitting in lockdown, this is the perfect time to reflect on the potential effect of the coronavirus crisis on national and international tax systems. Following my first Letter From Europe for the 50th anniversary of Tax Analysts,1 I had promised to write a second letter discussing the tax relationship between the United States and Europe from 1970 to today. However, at this moment of worldwide cataclysm I feel that it is more appropriate to look forward and to reflect on answers to our problems. I still pledge to keep my promise and will write the second Letter From Europe soon.

This article considers three areas:

  • the depth and duration of the health crisis itself;

  • the economic impact of the crisis; and

  • the impact on national and international tax systems.

This Letter From Europe is only the start of seeking an answer. At this time we don’t know how this will end. As with Brexit, you can expect more coronavirus Letters From Europe.

The Impact of the Health Crisis

Virology is not my field of expertise, so I will restrict myself to some general nonexpert comments. When my plane landed at Milan Linate Airport on February 12 for a week of lectures on international taxation at the University of Bergamo, I was stopped by Italian medical inspectors for a temperature check. I was lucky to be able to leave Italy safe and sound before the first case of infection was reported. Having narrowly escaped from the place in which Europe’s first COVID-19 case was reported, I feel that some comments on the development of this health crisis are in order.

The People’s Republic of China was the first country hit, and we can learn lessons from its experience. At the time of the January 30 second crisis meeting of the World Health Organization, 83 cases of COVID-19 had been reported in 18 countries, of which 76 were proven to be related to travel to China. The WHO report produced at this meeting makes it clear that China is the origin of the worldwide contagion, and that the country has been unable to prevent the virus from spreading around the world. The action taken against the disease by Chinese medical and political authorities therefore deserves some analysis.

The first case of the virus was reported in China on December 1, 2019. At that time, the exact nature of the virus was unknown. Between December 8 and December 18, seven more cases were diagnosed in Wuhan, capital of Hubei province, and on December 21 these cases were reported by Wuhan medical staff in a published report known to local and provincial political authorities. The first COVID-19 victim died in China January 9 and was officially reported on January 11. Despite the SARS precedent, Wuhan authorities were still denying the virus’s human-to-human transmissibility on January 15. As shown in the WHO report, that delay proved crucial in the failure to prevent the disease from spreading worldwide.

However, once news of the disease spread, Chinese authorities took draconian measures, starting with the January 23 quarantine (the same day as the first WHO crisis meeting) of the entire city of Wuhan.

Although it is very difficult to know precisely what happened during the crisis, one month after the lockdown of Wuhan the pandemic peaked in China with no new cases reported in Hubei province since March 18. Hopefully, the quarantine measures can soon be relaxed.

Conclusions From the Health Crisis

Are there any conclusions to be drawn so far from the development of this disease? From the point of view of fighting the disease, even a nonexpert can draw only one major conclusion: Timing in reacting to the virus is crucial. This can be seen from a comparison of the development of the disease in two other locations: Taiwan and Italy.

The lockdown in Wuhan began January 23, roughly five weeks after the illness had been publicly reported. Taiwan started systematically inspecting visitors coming from Wuhan on December 31, the same day Chinese authorities informed the WHO of the Wuhan infections. Taiwan decided to set up for a medical emergency on January 5, before any cases had been reported. The island’s first infection was reported January 21, and all schools were closed on February 2. The result is that as of March 20, there were only 135 infections and two deaths among the entire 24 million population. Although the natural position as an island (contamination arrives only via ships and aircraft) contributed to this success, the decisive factor was quick anticipatory governmental action.

In Italy, the first case was reported the night of February 20-21 in the 16,000-inhabitant city of Codogno, in the rural Po river valley. The mayor announced a total lockdown the next day. On February 23 the lockdown was extended to 11 surrounding municipalities encompassing 50,000 individuals. On March 8 the national government stepped in and ordered a partial lockdown in an area of 50,000 square kilometers, affecting 16 million people in the north of Italy. One day later that lockdown was extended to the entire country. It took Italy 18 days to shut down the whole country after the first reported case, while it took 37 days after the first medical reports for political authorities to shut down the city of Wuhan.

Only the anticipatory actions of the Taiwanese government limited the spread of COVID-19 and averted a major disaster. Even though Italian local and national authorities acted much quicker than local and national Chinese authorities, a disaster was not avoided.

A second conclusion can be drawn from China. The timeline of the disease between the first reported case on December 1 and the presumed containing of the contagion now foreseen for the end of March is approximately four months. That provides us with an estimate of the timespan that the new virus will paralyze economic activity. It is also an indication of the economic measures necessary to reanimate the economy.

Economic Effect in the Short Run

For an economic analysis we must distinguish between the short-term effect for the duration of the crisis, and the long-term effect for post-crisis recovery. In the short term, we may experience a double economic shock: a negative supply shock and a negative demand shock combined with a liquidity crisis, all caused by decreasing economic activity as a result of successive stages of lockdown. It is important to note that these shocks are not caused by economic factors that cause variations in supply and demand, but by factors that are extrinsic to economic activity: the removal of economic agents because of health problems and a sharp drop in economic activity because of legal orders for closing businesses and general lockdowns.

A Negative Supply Shock

Factory and office closures resulting in the disruption of the supply of services and materials creates a negative supply shock. This happened in several sectors in Europe, when supplies from China of parts for assembling and manufacturing products suddenly stopped; for example, in the car manufacturing and medical supplies industries. It also happened because of lockdown measures like the closing of bars and restaurants, and major disruption to the sports and entertainment industries. As long as these supply shocks do not occur in markets for essential goods like water, food, power, healthcare, telecommunications, or basic transports, and do not affect the supply of public services like police, it is possible to ride them out provided they are limited in time. If the Chinese experience is any guide, the timespan of the supply shock — which is somewhat shorter than the timespan of the pandemic — is three to four months. If society is well motivated and disciplined, that is not insurmountable. However, it is probably the maximum timespan that this can be endured without major economic or social upheaval.

A Negative Demand Shock

Suppliers’ inability to sell their goods and services because of a sharp drop in demand is also caused by a negative demand shock. In economic theory, such shocks are mostly gradual and extend over a longer time period. In the coronavirus pandemic, we are witnessing a sharp shock because workers are dismissed, leaving them with limited income (or no income at all) to buy goods and services. Whether economic agents as suppliers or customers can survive such a sudden demand shock depends on whether there is a social system or there are private savings reserves available, or whether the government purse is capable of bridging the gap. In this respect, European countries provide for minimal social protection; however, this help is not capable of maintaining the pre-shock level of demand. If the lockdown is limited to three to four months, most households in Europe will be capable of weathering the storm, but a substantial minority may drown in the flood.

Assuming the crisis will last not longer than three or four months, the main culprit for plummeting supply and demand is limited liquidity. Because suppliers cannot sell and therefore have no revenue, they will not be able to pay their production costs, which nevertheless continue: rent, power, heating, worker wages. The end of the road is bankruptcy. It’s the same on the demand side, because with decreasing income customers will have less money to spend. In the worst case, bills of private households like utilities, rent, and mortgages will go unpaid. The result will be foreclosures, evictions, and further societal disruption.

Short-Term Remedies

This situation is totally different from the 2008 financial crisis because it is a health crisis and not a crisis of financial institutions’ creditworthiness or that of their lenders. Because it is possible to estimate its duration, there is a single priority: Prevent lasting societal disruption and other forms of irreparable damage to suppliers and customers. This can be done by avoiding bankruptcies, foreclosures, and evictions by providing quasi-unlimited liquidity to both supply and demand.

The priority is not to stimulate the general level of economic activity by increasing consumption or investment. Investments are long-term decisions, and we are targeting a period of less than one semester. The purpose is to maintain consumption roughly at its present level, and above all to permit suppliers and customers to continue to supply and demand at pre-crisis levels once the crisis is over.

The remedy is not so much manipulating the price of money (interest rates), but rather steering the volume of money available. The moves in the United States and the United Kingdom to slash the interest rate by 0.5 percent do not work in the short run, though it may be necessary for revitalizing economic activity in the long run. What is needed in the short run is plenty of cash to pay the bills. Therefore, measures by European national governments to suspend payment deadlines and extend grace periods for payments to eliminate liquidity problems, and the big bazooka of €1.11 trillion promised by European Central Bank President Christine Lagarde, are better targeted to short-term needs of suppliers and customers. The proposals by the U.S. government to pump $1.2 trillion into the economy and to spend $300 billion by quickly sending a check to every U.S. citizen are of the same nature. The check idea is very close to European schemes that provide automatic temporary unemployment benefits to workers being laid off during the crisis.

Such an explosion of cash brutally violates the orthodox economic policy of a balanced budget. EU member states’ budgetary deficits for the year will certainly exceed the 3 percent of GDP limit set in the EU Stability and Growth Pact. However, when we look back 30 years to the year 1991 — not a year of a particular crisis — all OECD countries, except Japan, had budgetary deficits and many in percentages way above the 3 percent EU norm. The highest were Greece (17.1 percent), Italy (10.2 percent), Belgium (6 percent), Canada (5.5 percent), and Finland (5 percent).2

However, even under this orthodox economic policy, borrowing to finance real investments that will directly or indirectly yield revenue in the future is allowed. The investment target in the coronavirus pandemic is preserving the market link between suppliers and customers so that after the crisis we can quickly return to business as usual (although business as usual may not be possible).

Long-Term Prospects

The initial expectation in Europe is that the period after the coronavirus pandemic will not be business as usual. The pandemic has demonstrated that world-spanning supply chains are extremely vulnerable to disruption. Customers in the EU were surprised to find out how many materials, spare parts, and even final products were imported from China and suddenly not available. A case in point was the scarcity of face masks for patients and medical staff in Belgium.

Early in the crisis, hospitals in Belgium found they were running through their stocks of face masks. China was the main supplier of these masks, and by the time the coronavirus hit Belgium, all masks in China were of course destined for fighting the crisis at home. Eventually a direct telephone call from King Philippe of Belgium to Jack Ma, the former CEO of the online store Alibaba, arranged a delivery of 5 million masks, which arrived in time. However, this unorthodox way of making a deal is certainly not the model for a reliable supply chain.

Rearranging the Supply Chain

It is dawning on European political and economic leaders that relying on non-EU suppliers for strategically important products may make the EU vulnerable to political and economic pressure. This is already clearly the case for oil and gas, of which Europe has insufficient reserves. However, this is even more so the case with the competition to roll out 5G mobile networks. The concerted effort by Chinese 5G operators, fully supported by the Chinese government, to secure a dominant position in the world market raises the question of what would happen if U.S. and European customers embrace policies opposed by the Chinese government. Thanks to the coronavirus, U.S. President Trump may get some support in the EU for his opposition to the Nord Stream gas pipeline from Russia to Germany and the 5G network sold by the Chinese company Huawei.

The wave of climate demonstrations has made it clear that while world-spanning supply chains may provide products at the cheapest price, there are many indirect costs not reflected in that price, costs the market does not take into account. The OECD’s base erosion and profit-shifting program has demonstrated that the intangible building blocks of the world-spanning supply chain can easily be located in tax havens through what the Court of Justice of the European Union has labeled “wholly artificial arrangements.” Offering proposals to build more robust and less vulnerable supply chains does not mean the sudden resurrection of national customs borders. But it may result in more reliable supply chains being limited to large regional areas in which countries are willing to engage in economic cooperation and are unlikely to enter into conflict with each other. Regional examples include countries that comprise the EU, the United States-Mexico-Canada Agreement, Mercosur, and regional groupings in Asia and Africa.

Tolling the Bell for Profit Supremacy?

A second reason why business as usual will not resume is that the coronavirus pandemic may mark the end of profit-making as the absolute supreme guiding principle of human activity in the market. In several EU lockdown countries, spontaneous demonstrations have been held to show solidarity with COVID-19 victims and uplift depressed spirits. People in cities across Europe opened their windows and started singing, making music, and hand-clapping in appreciation for medical staff, police officers, garbage collectors, bus drivers, and workers in daycare facilities and grocery stores who kept essential businesses open. Suddenly there has been a tidal wave of appreciation for people active in the public sector, like police, schools, and healthcare, areas that for years have been the object of painful budgetary cuts. Nowadays these activities are characterized as essential to the survival of society. If this large social consensus is consolidated after the crisis into political power, a fundamental societal change will have taken place. Today it is too early to tell what will happen in Europe after the crisis, but we will know by the end of the year. In the United States, that will be the time of national elections.

It is also too early to tell whether and how the economic reconstruction will take place when the pandemic is over. If traditional economic rules are still valid, we should see a substantial increase of inflation and nominal interest rates, though effective interest rates may remain negative. As inflation goes up, nominal interest rates will also go up, but will remain below the inflation rate. However, after the 2008 financial crisis, traditional economic wisdom no longer counts. Following the massive public cash injection used to combat the 2008 financial crisis, inflation has remained quite low and has not increased substantially. If the major consequences of the coronavirus crisis turn out to be as described above, the traditional economic rules of liberal capitalism that ruled the globe since the time of former U.S. President Ronald Reagan and former U.K. Prime Minister Margaret Thatcher will no longer apply.

The Tax World

What about the BEPS value chain?

If the two long-term economic changes described above materialize, they will affect tax systems nationally and internationally. The reorganization of supply chains will affect the value chain, the object of the BEPS program. If the length of the supply chain is shortened and the complexity simplified, functions and risks of economic activity will be territorially reallocated and regrouped. In a way, free trade will be regionalized in clusters of countries that can agree on common business standards including not only tariffs, but also quality standards for allowing access to products — that is, the WTO may be regionalized.

If strategic sustainability becomes a priority, this type of production chain reorganization is likely to arise for physical products like foodstuffs, face masks, automobile parts, and 5G hardware out of a combination of business self-interest and newly imposed government rules. The question is whether the shorter and simpler production lines will also be applied to services in general, and digital and financial services in particular.

Although business interest in shorter and simpler supply lines for these economic activities is less evident, court decisions like Indofood3 and the more recent Danish tax cases4 indicate that judges are losing patience with long and tortuous financial supply chains. Patience with artificial financial supply chains may be wearing even thinner when physical supply chains become more compact. Flows of royalties, interest, and dividends may be presumed to flow within the same territorial areas as the physical supply chains of the goods they produce or support.

What About State Aid?

Another potential area of change is state aid. When I look at the present rescue programs for airlines in Europe, there is only one possible conclusion, which I described in my February 10 Letter from Europe.5 According to article 107 of the Treaty on the Functioning of the European Union, this is prohibited state aid. Despite this reality, the European Commission has indicated that because of the COVID-19 pandemic it is “all hands on deck,” and state aid rules will not be enforced. In fact, state aid rules were never designed for an economic crisis caused by a worldwide health emergency. During the pandemic, EU member states will be allowed to do whatever it takes to save their major economic operators. If I understand the conditions for extended credit facilities, the rescue operation may run until the end of next year and even beyond. In some cases, nationalization of major businesses may be the only remedy.

In the long run, state aid may never be the same. After a regrouping of the supply lines, it may become acceptable state aid policy to support regional economic champions in world markets. Even under orthodox state aid rules, it has always been difficult to enforce fair competition rules — for instance, in the aircraft industry. Alitalia is a case in point.6 When supply lines are being reordered, it may be tempting for the EU to relax state aid rules and support EU champions losing ground in the 5G and online business sectors. If we follow this policy, it becomes important to protect the free entrance of newcomers into the market, and most of the few EU companies in this market are in fact newcomers. Newcomer protection was the U.S. Federal Trade Commission’s focus of attention when the coronavirus struck.

A Fundamental Shift in Burden Distribution

I also expect some change in national tax systems’ burden distribution. The growing inequality in income distribution and wealth following the post-communism spread of market globalization has been well documented. In the United States and EU, the financial crisis has exacerbated that inequality. The COVID-19 pandemic has demonstrated that income and wealth are concentrated in sectors that, in these exceptional times, are not essential for the survival of society. There are many social needs that are not being fulfilled by the global market economy. This will affect the political consensus about who should contribute more to the public cause. I expect rearrangements in taxes on profits and capital gains taxes compared with taxes on labor. How this will be done in practice depends on the national tax system structure.

Finally, in Europe these days many people are asking what is really important in life and are prepared to rearrange their priorities. In particular, people are questioning whether continued economic growth and higher consumption should be the ultimate goals of life, particularly given that the majority of middle-income Europeans already enjoy quite a comfortable lifestyle. Much will depend on what the top earners in European society will do: the leading entertainers, athletes, businesspeople, and politicians, whose wealth and earnings are much higher than that of average middle-class Europeans. They are the role models in European society. If, after this crisis, they return to business as usual and give the signal that the sky’s the limit, I foresee huge social upheaval in Europe, compared to which the social upheaval caused by Brexit and the policies and conduct of Trump will be peanuts.

If on the other hand, as leaders of society they have the wisdom to temper their urge for boundless consumption and rewards, it will be possible to reallocate, without great upheaval, the burdens of less fortunate citizens at the bottom of society. This was necessary but did not happen after the 2008 financial crisis. I can only hope that the outcome of this health crisis will be different.

FOOTNOTES

1 Frans Vanistendael, “A Golden Anniversary?Tax Notes Int’l, Mar. 16, 2020, p. 1185.

2 See Table 6.2: General Government Financial Balances, 1986-1993, in Ken Messere, Tax Policy in OECD Countries 122 (1993).

3 Indofood International Finance Ltd. v. JPMorgan Chase Bank NA, London Branch[2006] EWCA Civ 158.

4 N Luxembourg 1 and Others v. Skatteministeriet (N Luxembourg 1), joined cases C-115/16, C-118/16, C-119/16, and C-299/16 (CJEU 2019); and Denmark v. T Danmark, joined cases C-116/16 and C-117/16 (CJEU 2019). For discussion, see Vanistendael, “Tax Abuse in Europe: The CJEU’s N Luxembourg 1 and T Danmark Judgments,” Tax Notes Int’l, Feb. 10, 2020, p. 629.

5 See Vanistendael, supra note 4.

6 See Alitalia v. Commission, T-296/97 (GCEU 2000).

END FOOTNOTES

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