TAX and ESG - How tax represents one of the most tangible representations of ESG in action

It is well known that Environmental Social and Governance (ESG) factors can provide a framework for evaluating a business’ performance beyond its financial profitability by assessing its impact in each of these three broad areas. There has been plenty of discussion about a move from ‘shareholder capitalism’ to ‘stakeholder capitalism’.

In summary:

  • Environmental factors measure a business’ impact on the natural environment. This will include its use of natural resources, emissions, waste generation, and its ability to manage environmental risks (and embrace environmental opportunities).
  • Social factors measure a business’ impact on, and perception in, wider society. This will include its interaction with employees, customers, suppliers, and the external community.
  • Governance factors measure a business’ internal governance structures and practices. This will including its overall strategy, leadership, ethics, transparency and accountability, and risk management.

At its core, ESG is about sustainability; it helps identify companies that are more sustainable, and therefore better positioned for long-term success, because they manage their impact on the environment, interact positively with society, and adopt robust governance practices.

So, where does tax fit? On at least one level, tax represents one of the most tangible representation of ESG in action available.

Why tax matters

At its most fundamental, a tax is a contribution made by citizens to a nation’s government in exchange for the security, transport, health care, education (and all the other societal benefits) provided by that state to those citizens.

It is the consideration payable under a social contract; we, the people, collectively agree to surrender a proportion of our personal income and gains to the state acknowledging that our pooled contributions can provide more goods than individual payments could. A similar analogy could be run in relation to a business. The taxes a business pays on the profits they earn are the price of access to, and for operating in, a market made available to them by the state.

Of course, there is a political debate about how much government should do, and how much tax needs to be collected. There will also be debate over rates; how to delineate the tax base; and the level of acceptable administrative compliance costs: These are all component parts of identifying a taxpayer’s ‘fair share’, or ‘tax justice’. However, all sides will (normally) agree that at least some form of centralised government of state is a necessity, and very few will argue convincingly that taxation is unwarranted.

Most will agree that paying taxes owed, in accordance with the law, represents a societal good; the law is, after all (in democratic societies at least), a culmination of a nation’s collective moral and ethical decision making. It follows that meeting the challenge of climate change is, conceptually, a societal good equal to the provision of schools or hospitals or roads and railways.

By extension, the efforts of a few to illegally evade, or abusively scheme to avoid, paying tax must be socially unacceptable; it is a breach of the social contract that will create, and exacerbate, inequality.

Over the past few decades the perception that fraudulent tax evasion and abusive tax avoidance has been growing. Globalisation (that is, in this context, the breaking down of economic borders) has challenged the ability of the sovereign nation state, confined within its territorial frontiers, to continue to collect tax revenues on the economic activities that take place within those frontiers. This is because globalisation has facilitated ‘profit shifting’ by multinational enterprises, and internationally mobile individuals, that are able to operate and move between multiple jurisdictions.

The result has been that the tax base of the state has been eroded, and the extant international tax framework, put in place over a century ago, has been tested to the point of destruction. In tax technical terms, the nexus between economic activity, value creation, and the levying of taxation, has broken down.

The digitalisation of the global economy, and the growth in the importance of intangible assets (for example, intellectual property), has exacerbated this disjunction because it is increasingly difficult to identify where taxable income, profit and gains is generated. In short, the complexity of an interconnected digitalised global economy has made it increasingly difficult to clearly identify the ‘right’ place to levy tax.

The result can be either double non-taxation (i.e. profits that are either not taxed at all or, if they are, at a very low rate) or double-taxation (i.e. profits that are claimed as taxable in two, or more, jurisdictions). Neither consequence is ‘good’ and inevitably leads to increased controversy, dispute, and cost.

Over a broadly similar period, the global economy has encountered a series of serious ‘headwinds’, including the financial crisis of 2007-2009, the COVID-19 pandemic, the Russo-Ukrainian war, and a mounting climate crisis. All have required, and continue to require, substantial state intervention. Such intervention can, ultimately, only be funded through stable, sustainable, taxation.

It is, then, unsurprising that governments around the globe have attempted to ‘crack down’ on tax evasion and abusive tax avoidance. They have introduced new rules to realign economic activity and value creation with the charge to tax. They have introduced new laws that require greater transparency from taxpayers, strengthen reporting and compliance obligations, and facilitate the exchange on tax-related information across government and between states.

On the environmental side, tax policy continues to evolve as an instrument to tackle climate change and reach ‘net zero’. Some sort of pricing mechanism for carbon emissions (to disincentivise the use of fossil fuels) seems inevitable, but the expansion of tax-driven incentives that promote ‘green’ technologies and business are equally likely (see, for example, the tax credits introduced in August 2022 as part of the Inflation Reduction Act in the United States). There will be obvious tax risks and tax rewards in the climate transition.

Sustainable Tax

It is hardly surprising, then, that taxation has become a regular agenda item for Boardroom. It is an issue of both public and private reputational risk. It demands procedural rigour internally and considered presentation externally. In addition, ‘green’ taxation will present new costs, but also new opportunities, for all businesses.

The long-term sustainability of a state’s revenue will depend on sustainable taxation. That in turn will require taxpayers to ensure their tax processes are sustainable. Developments across tax in ESG will require careful tracking and agile procedures capable of quickly absorbing obligations, and taking advantage of openings, as they arise.

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