There are five basic legal forms of business structures found in the United States: C corporations, S corporations, sole proprietorships, partnerships, and Limited Liability Companies (LLCs). In order to understand...
- The Tax Policy Blog
- CRS: Tax Rates Do Matter for Profit Shifting
CRS: Tax Rates Do Matter for Profit Shifting
The U.S. has the highest corporate tax rate in the developed world. The total U.S. rate of 40 percent (35 percent federal plus 5 percent state) is 15 points higher than the average rate among developed countries. One of the problems with that is corporations can move. Another problem is that profits can move, by using accounting techniques to declare revenues in one place and expenses in another. The latter problem is documented in a new report by the Congressional Research Service (CRS):
This report uses data on the operations of U.S. multinational companies (MNCs) to examine the extent to which, if any, MNCs are moving profits out of high-tax countries (or out of the U.S.) and into low-tax countries with little corresponding change in business operations, a practice known as “profit shifting.” To do this, the profits reported by American firms in two groups of countries are compared with measures of real economic activity in those locations. The first group consists of the five countries commonly identified as being “tax preferred” or “tax haven” countries, and includes Bermuda, Ireland, Luxembourg, the Netherlands, and Switzerland. The second group, which provides a baseline for comparison, consists of five more traditional economies. This group includes Australia, Canada, Germany, Mexico, and the United Kingdom.
Consistent with the findings of existing research, the analysis presented here appear to show that significant shares of profits are being reported in tax preferred countries and that these shares are disproportionate to the location of the firm’s business activity as indicated by where they hire workers and make investments. For example, American companies reported earning 43% of overseas profits in Bermuda, Ireland, Luxembourg, the Netherlands, and Switzerland in 2008, while hiring 4% of their foreign workforce and making 7% of their foreign investments in those economies. In comparison, the traditional economies of Australia, Canada, Germany, Mexico and the United Kingdom accounted for 14% of American MNCs overseas’ profits, but 40% of foreign hired labor and 34% of foreign investment. This report also shows that the discrepancy between where profits are reported and where hiring and investment occurs, as examples of business activity, has increased over time.
Additional evidence that profit shifting has increased over time is found from a comparison of business profits with economic output (gross domestic product) in the two country groups. MNC profits as a share of gross domestic product (GDP) in the traditional economies averaged from 1% to 2% between 1999 and 2008, while their profits in the tax preferred countries profits averaged 33% of GDP in 2008, up from 27% in 1999. Individual countries within the tax preferred group displayed more dramatic increases in the ratio of profits to GDP. For example, profits reported in Bermuda have increased from 260% of that country’s GDP in 1999 to over 1000% in 2008. In Luxembourg, American business profits went from 19% of that country’s GDP in 1999 to 208% of GDP in 2008.
These results are not surprising. It would be surprising to find out corporations do not respond to such huge differentials in tax rates. CRS correctly points to lowering the rate as one way to deal with the problem, although they make a number of mistakes in their analysis:
One topic that has been part of nearly every debate regarding corporate tax reform has been the 35% top statutory corporate tax rate [federal]. Reducing this rate would decrease the incentive to shift profits by reducing the tax savings such behavior would produce. Companies profit shift to take advantage of the differential between the U.S. tax rate and rates in low-tax countries. By reducing this discrepancy, the incentive to shift profits would be reduced as well. Note, however, that reducing the U.S. tax rate to within the range typically suggested, 25% to 28%, would still leave the U.S. as a high tax country relative to tax havens, implying that the incentive to profit shift would remain. A reduction in the top tax rate may also come at the cost of lost federal revenue resulting from lower tax rates being applied to corporate income. Combining a rate reduction with a broadening of the corporate tax base would help to offset any revenue loss.
First, it is true that reducing the federal rate 10 points to 25 percent would still leave us with a total rate of 30 percent, including state, and this would be higher than most countries including the “tax havens” considered here. So yes, the incentive to shift profits would still remain, but it would be much reduced. The last time the U.S. rate was 5 points above the average among developed countries was in the 1990s, a time in which profit shifting was much less of a problem, as noted by the CRS. See the chart below.
Second, CRS’s own analysis contradicts their claim that “a reduction in the top tax rate may also come at the cost of lost federal revenue.” Profit shifting works in both directions. If the rate is lowered in the U.S. we can expect an influx of profits, and as a result increased tax revenue. The frequently cited figure of $90 billion in lost U.S. tax revenue due to profit shifting may or may not be an exaggeration, but it must be treated symmetrically. By moving to a tax rate that is closer to the average among our trading partners we can expect profits shifted in to largely cancel any profits shifted out. The existing anti-abuse measures, such as transfer pricing, would suddenly be much more effective at preventing profit shifting.
Third, separate from the profit shifting issue, lowering the corporate rate lowers the cost of capital leading to more domestic investment and economic growth. This results in more profits and personal income, which in turn results in more tax revenue. By this mechanism alone, our model predicts that cutting the corporate rate 10 points would increase tax revenue. This is supported by the empirical literature relating corporate tax rates and economic growth, which finds cutting the corporate rate 10 points would add 1 to 2 points to GDP growth and likely not lose tax revenue. Alex Brill and Kevin Hassett find the (corporate tax) revenue maximizing corporate tax rate is about 26 percent. In a forthcoming study, we will use our model to show that the revenue maximizing corporate tax rate is about 14 percent, when all federal revenue sources are considered.
In sum, profit shifting is a symptom of an out of touch corporate tax system that is excessively punitive, complicated, and ineffective. The most immediate solution is a lower tax rate.
Follow William McBride on Twitter @EconoWill
Subscribe to the Tax Foundation Newsletter
Join the Tax Foundation's fight for sound tax policy Go
About the Tax Policy Blog
The Tax Policy Blog is the official blog of the Tax Foundation, a non-partisan, non-profit research organization that has monitored tax policy at the federal, state and local levels since 1937. Our economists welcome your feedback. If you would like to send an e-mail to the author of a blog post, please click on that person's name to locate his or her e-mail address or visit our staff page here.