What Does Research on Profit Shifting Tell Us?

February 24, 2016

Today, the Ways and Means Committee held a hearing on international tax reform. One issue that came up was profit shifting. Most people agree that profit shifting happens and reduces that amount of corporate tax revenue the government collects, but academic research suggests there is significant uncertainty about the magnitude of the problem. Even so, lawmakers may still want to address it. If they do, what should be done about it? Fortunately, some research tells how we could reduce it. And the solution is actually really simple.

So what is profit shifting and why do some lawmakers care?

In the world of multinational corporations, profit shifting is the act of allocating revenues and expenses in different countries in a way that minimizes one’s tax bill.

The theory of why a company would shift profits makes sense. A company that operates across multiple countries will need to account for its profits in different countries. The allocation of revenues and expenses can be complex, making it difficult for companies to perfectly define where profits should really be taxed. The sometimes subjective nature of cross-board accounting can lead to firms choosing to place some profits where they are taxed less.

This is a big deal for the U.S. The U.S. corporate income tax rate is the highest in the developed world at 35 percent. The average among major nations is about 24 percent and is as low as 12.5 percent in Ireland. If a U.S. company that operates in multiple countries can shift a dollar of profit from the U.S. to a country with a corporate tax rate closer to the average, the company could save, on average, 11 cents in tax.

Lawmakers are concerned about profit shifting because it has an impact on the amount of revenue that the corporate income tax ultimately collects.

While the theory makes sense, researchers have had a tough time measuring the extent to which it actually occurs. When we interviewed several academics about the topic, there was no clear consensus on the magnitude of profit shifting, or whether it has been increasing over time. This is mainly due to a lack of reliable data.

Even so, lawmakers may still be concerned about it. So what could they do?

The solution to profit shifting is actually pretty simple and some research holds the key:

A recent paper by Professor Kimberly Clausing of Reed College estimated that $111 billion in federal corporate tax revenue was lost due to profit shifting in 2012. This is due to $371 billion of corporate profits being shifted outside of the United States. She comes to this conclusion by looking at the difference between the effective tax rate in the United States and the effective tax rates in foreign countries and how that difference in tax rates influences the amount of profits being realized in these countries.

Although the estimates are on the high side, Clausing’s research shows us that the underlying driver of profit shifting out of the United States is the difference between the U.S. corporate tax rate and corporate tax rates overseas.

Thus, the most straightforward solution to profit shifting is to reduce the difference between the U.S. corporate tax rate and rates throughout the world by cutting the corporate tax rate. With a lower corporate tax rate, the incentive to place a dollar of profit in a foreign country would be much smaller than it is under current law.

Another implication of Clausing’s research is that the budgetary cost of a corporate rate cut is smaller than we think. This is because after a corporate rate cut, companies would shift less profit abroad, increasing the base, or the amount of taxable profit. Take for example a cut to the U.S. corporate tax rate of 25 percent. This would lower corporate tax revenue by about 29 percent from around $242 billion per year to $173 billion per year (2012 dollars). However, the lower corporate rate would encourage less profit shifting. As a result, companies realize $67 billion more in profit in the United States and pay $17 billion in tax. In total, the cut to a 25 percent rate would cost a quarter less.

Estimated Annual Revenue Impact of a Corporate Tax Cut with Income Shifting, in Billions of Dollars

Corporate Income Tax Rate

Baseline Corporate Revenue

Income Shifted Due to Lower Rate

Additional Corporate Revenue Due to Income Shifting

Total Corporate Tax Revenue

35%

$242

$0

$0

$242

30%

$208

$35

$10

$218

25%

$173

$67

$17

$190

20%

$138

$89

$18

$156

Note: Tax rates are statutory corporate tax rates. Tax revenue and income estimates are in billions of 2012 dollars.

Source: http://taxfoundation.org/article/corporate-income-tax-rates-and-base-broadening-income-shifting

 

While there is uncertainty about its magnitude, there is no doubt that profit shifting is a real thing. However, the solution to it isn’t a maze of rules and regulations to prevent it. Research actually suggests that the easiest way to reduce profit shifting is to simply reduce the incentive to shift by having a lower corporate tax rate.

Read more on profit shifting here.

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