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Making Sense of Profit Shifting: Kevin Markle

23 min readBy: Erik Cederwall

Kevin Markle is an Assistant Professor of Accounting at the University of Iowa’s Tippie School of Business.

Previously, he was an Assistant Professor at the University of Waterloo and a Visiting Assistant Professor at the Tuck School of Business at Dartmouth College.

Professor Markle’s research focuses on business taxation, international taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. avoidance, and profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. . He has published numerous innovative and policy-relevant papers related to corporate tax avoidance—for example, on issues related to the implications for profit shifting of territorial and worldwide tax systems and on the relationship between multinationals’ use of leverage, intangible assets, and tax havens and their worldwide effective tax rates.

In 2011, Professor Markle was awarded Best Paper by a Young Scholar in Business Taxation from the Oxford University Centre for Business Taxation and received the Outstanding Tax Dissertation Award from the American Taxation Association/PricewaterhouseCoopers.

Professor Markle received his Ph.D. from the University of North Carolina at Chapel Hill.

In this interview with the Tax Foundation, Professor Markle dissects the nature, drivers, and economic effects of profit shifting. Specifically, Professor Markle highlights aspects related to the costs of profit shifting, the limitations to the current understanding of the phenomenon, why transnational cooperation in taxation could be beneficial, and how firms may be very different in their efforts or desire to engage in profit shifting. This interview is part of our 2015 Tax Foundation Forum series and has been edited for length and clarity.

Tax Foundation: What is known about profit shifting?

Kevin Markle: So like a true academic, before we can even answer that, I think we need to be somewhat clear about what we mean by profit shifting, because there are different ways of thinking about it.

I think the general consensus is that we are talking about the reporting of profit in a jurisdiction different from the one in which it would be reported if there had not been any shifting in the first place. So it’s something that the companies are intentionally doing.

Of course, we can talk about shifting across time, but in the U.S. setting that has not been too common because the rate has stayed constant. But there is shifting that happens across time, in particular when losses get involved. But for the most part, people are talking about cross-jurisdictional income shifting.

And the hardest thing about profit shifting is that other part: Where would it be reported if the firm didn’t take this action? Because we can’t observe the action, we can only observe what gets reported, so where it ends up afterward. Even a lawmaker with access to all the information available doesn’t know. We don’t know where it should have been reported.

So, with that said, what do we know about profit shifting from the academic literature? I think this:

That it happens, so it’s definitely there. It’s sensitive to tax rates, so we do see profits reported inordinately high in low-tax jurisdictions and inordinately low in high-tax jurisdictions. We know that it’s not unique to any one country – that multinationals domiciled basically in every country engage in it. We know that the level of it varies, but we don’t know really how much it varies. We also know that there are costs to it. But we don’t know what those costs are, specifically. We can label them generically, but nobody that I know of has been able to quantify what they are and talk about them in a specific way. But we do know that there are firms that engage in less profit shifting, we just don’t really know why.

TF: When you say costs, what type of costs?

Markle: So basically the way we would think about profit shifting is: “Here is an opportunity to lower your tax payments.” But that can’t come for free. There have to be costs of doing that. And the ones that most people point to are the potential costs of you stepping over a legal line, even if you don’t intend to. But you could shift to a jurisdiction and then have the jurisdiction from which it has been shifted challenge that and impose penalties and fines for the fact that you knowingly or not violated the law in that country.

And then, of course, there are legal costs, the cost of setting up the structures and maintaining the structures.

And the other one that gets some attention that’s really, really hard to get at empirically is the potential reputational cost of, “if we are perceived to be a ‘shifter.’” If there is such a thing, then is that going to be a positive or a negative? Anecdotally, from firms, we hear that all the time: “Yes, that’s a huge constraint.” We ask these questions to everybody: Why don’t you shift more than you do? Why don’t you tax plan more than you do? The most common answer is this one of reputational concern: “I don’t want to be on the cover of the Wall Street Journal.”

Another really important thing about profit shifting in general is that there’s a country A and a country B. So someone is receiving the income. We are used to thinking about it as a tax- minimizing thing from the firm’s perspective. But important, I think, in all these discussions is the fact that it’s going somewhere. So one country’s limitation or constraint on profit shifting is counter to what’s best for another jurisdiction.

The way I like to think about it is: Base erosion for one country is base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. for another country. It’s important to note that.

What are the unique factors or drivers that are underlying the profit shifting phenomenon?

Empirically, I don’t think we have really done much to validate everybody’s priors. The most obvious factors are bigger differences in tax rates, so that’s what most academic studies have shown. The bigger the difference in the tax rate, the more shifting you will see. And then the other big thing is the increasing mobility of income.

You need two things to be able to benefit from profit shifting. You need the incentive to do it, so there has to be returns to it. So that’s the tax rate side. But then you also need the opportunity, and I think that the increasing mobility of income, meaning… more income is being generated by “assets” that are intangible and therefore more mobile. They don’t need to be in a specific place in order to produce the widgets that are being sold, and so I think those two are the biggest factors.

How does profit shifting alter the behavior of firms? So how do firms change their behavior because there is an opportunity to shift profits?

This is the really important question. This is an area where I don’t know of existing empirical research, and I think it’s an area that there is great opportunity, because I think the flat out answer is “We don’t know.” But anecdotally, what firms, I think, have been doing for a long time is figuring out, “How much do we have to do in the real world in order to be able to justify or be compliant with the law and have our profits in another location?” And there are numerous anecdotes of companies that have literally moved employees to different jurisdictions and/or moved plants to different jurisdictions. And so that’s sort of the, “What do I have to do to accomplish the profit shifting?” I don’t know that, at least to my knowledge, there are many empirical studies of that.

Does profit shifting matter?

From the academic’s point of view, we always have to kind of preface an answer to a question like this, on that depends a lot on your perspective. So the way an economist would think about this is called global welfare. So, basically, does the pie get bigger in general? From a global welfare point of view you would say that it really doesn’t matter because all that’s happening is that the pie is staying essentially the same size but it is being divided up differently. From a global point of view, that’s fine, as long as the dollars are not leaving. Obviously, there is an element of profit shifting that’s, “Let’s get it off the grid entirely.” But those are the extremes and those are almost always on the wrong side of the legal-non-legal line. But if you think from a global welfare perspective about a question like this, you say, “No, it doesn’t matter at all.”

But I don’t think that’s how most people think about it. Most people come with a national welfare perspective, which is essentially, “From our point of view, does it matter to us that dollars are shifted out of the reach of our taxing authority?” In that case, yes, it’s a huge problem. Now, it’s not as simple as those dollars are gone and therefore we are poorer.

But, without the sort of trickle effects, just ignoring those for a second, if you have a smaller tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , then, yes, you have less revenue. And you either spend less or you find other sources for it. It’s not rocket science. From our perspective, it‘s definitely an issue that’s contributing to the fiscal difficulties of multiple countries.

Has profit shifting increased over time?

The empirical results that we have would say that the answer to that is yes. Klassen and Laplante in their 2012 paper do a comparison of U.S. firms only. They compare two five-year periods: 1998 to 2002 and 2005 to 2009. And they say that, “yes, $10 billion more per year is leaving the U.S. in the later period than was in the earlier period.” And Kim Clausing has two studies. In her 2011 paper in Tax Notes, she compares year 2004 to year 2008, I think. And the number has gone up, significantly actually.

So the other side of that, though, is that Dhammika Dharmapala has this paper where he has really done a great job of surveying the whole literature. And one thing that comes out of that is that the estimates have been decreasing over time—basically, the semi-elasticity to tax rates. And I think that's being slightly incorrectly interpreted, because really I think the point coming out of Dhammika Dharmapala's paper is that as our techniques for studying these things change, and the availability of data has increased, our numbers are coming down.

That's very interesting in and of itself. But it’s not, I don't think, a conclusion of that paper that it's actually decreasing over time. I think the conclusion is that it's smaller than we had thought it was all along. That paper is somewhat silent on whether it's increasing over time. I could be wrong about that. But I believe the answer to that’s yes. And there's other anecdotal stuff. For example, when you look at the amount of trapped cash that has skyrocketed.

We saw an estimate recently that it's now past $2 trillion. And understanding of course that that’s not all shifted profit. Those are foreign profits and a decision not to bring them back to the U.S. I get that entirely. But I think that there's got to be some sort of correlation there with the fact that the number of foreign profits being left overseas has gone up so much that you would expect that some of those profits maybe had their natural home in the U.S. at one point before actions were taken.

Let's take U.S. multinationals as a sample. Are they homogeneous with respect to profit shifting?

Firms are not homogeneous on any dimension. And so one of the fascinating things to us as academics that we're always trying to figure out is: Why doesn't everybody do the same thing? What is it that constrains people who don't? What is it that motivates or enables the people who do?

One of the leading researchers in our field, Ed Outslay at Michigan State, at every chance he gets he reminds people of that to accomplish profit shifting you need two things: You need incentive, so that can come from rate differences, but then you also need the opportunity. You need to have a profit margin that enables this to happen.

So firms are not homogeneous on those dimensions. And also they're not homogeneous on the dimension of the mobility of their income. And I think the big one is the foreign market for what they sell.

When we do these empirical studies, we do our best to control for these things. So it’s basically to say, what we're doing when we give you our estimate of what firms are shifting is that we are holding those things constant.

Now we're also somewhat holding our noses when we make statements like that, because we know that our techniques for controlling for things are blunt. There are tons of assumptions that go into what we do. But at the end of the day, we're forced to accept them. So we do our best to say, “Our way of estimating things gets rid of firm heterogeneity.”

What is the best estimate of profit shifting out of the U.S.?

This is one of those places where the range of passing the smell test is so broad, because we just don't know. Now most of the stories that we hear about: Starbucks, Apple, and Google, those are not really talking, specifically anyway, about what's being shifted out of the U.S. But we kind of infer that if they're doing it in Europe, then they must be doing similar things here.

But as far as I know, we don't know those things directly. But what those stories do is enlighten us to the incredible ingenuity and aggressiveness of what firms can do. But those are not the average firms.

Scott Dyreng and I have an estimate in our paper, and our sample of the U.S. economy is from 1998 to 2011. We end up with a portion of U.S. multinationals, and we estimate that those firms are shifting out $11.6 billion per year in total. So not each firm, but in total, that's the amount that we would say is leaving.

But we would absolutely have to make clear that it’s not in any way an estimate of what's actually leaving the U.S. It's what those firms in the sample shift. The only economy-wide estimate that I'm aware of is Kim Clausing's estimate. I think in 2008 her estimate comes out to like $256 billion.

So do I think that that’s a realistic number? Yes, I do. I don't think there's anything wrong with what she's doing as long as you understand what she's doing. And really what she's doing is basically saying, “If nobody ever made a location decision based on tax rates, then that's our baseline for where dollars would be reported. And so anything that’s driven by tax rates or associated with tax rates, we are going to call profit shifting.” That's difficult, because there are reasons to be in Ireland that are not all tax rates. And we're going to attribute every dollar that goes to Ireland as being there because of tax rates. So that's my only hesitation with that estimate.

Klassen and Laplante, like I noted earlier, they estimated about $10 billion more is being shifted, comparing the 1998 to 2002 and 2005 to 2009 time period.

What is missing for a better understanding of profit shifting?

The biggest one by far is the data. These are not things that firms would want to tell us or tell the world. And the interesting question is: Do they even know how much they're shifting out? If we could give them truth serum and say, “Hey, how much are you shifting out each year?” I don't think they would have an easy time coming up with that number.

Because, again, where should the profits have been in the first place? “Why did we go into that particular country—was that all tax?” And I think every answer I've heard is that it's never all tax.

It's the data, because we're forced to use public disclosures. Some people in the academic world have access to better data from the Bureau of Economic Analysis (BEA). But most of us are left with public disclosures, and that's after all the dust has settled.

The other thing, too, that I would mention is some sort of consensus on where the profits should be reported, absent shifting. Because every model, whether they like it or not, is assuming something about that. And so that’s a huge limitation of us being able to say, “Here is a number for profit shifting, and here is a scale.“

What solutions are there to address profit shifting?

I gave a presentation last summer in which I talked about the research that we do broadly. One thing that I fixated on for a while is that with profit shifting, there's always a winner and a loser. It's not a lose-lose situation. The example that I used was that I put up the Chancellor of the Exchequer in the U.K., proudly and loudly saying, “The U.K. is open for business. We are going to be a very business-friendly country.”

And you can take that statement that he made and basically say, “We want dollars that are being taxed elsewhere right now to be taxed in Britain.” One country's base erosion is another country's base broadening. So I think that the number one tool that has to come to bear is basically cooperation. If you don't have multilateral cooperation, then you're essentially in what you can call a race to the bottom or fight to the death.

There isn't an equilibrium that I see coming out of that, other than an equilibrium where one country has everything and everybody else has nothing. So in terms of an equilibrium outcome, where everybody can sort of live with it, I think you have to have multilateral cooperation. And the difficult thing with that is we are not starting from a baseline of nothing and designing a system. We're starting from a baseline where some countries, some firms, have a lot. So to get to what anybody would call any sort of theoretical equilibrium, people have to give stuff up. And countries, companies, and people are not good at doing that.

I've heard a lot of pessimism about the BEPS project, simply based on this. Based on the fact that it’s unavoidable, that what’s going to be asked is for people to give up what they have. But this is the human existence, isn't it? I don't think there is a solution that doesn't involve multinational cooperation. I think that's the key piece.

If we assume multilateral cooperation is not practically feasible—for the time being— what would you suggest be the path forward, at least for the U.S.?

Well, it's a very hard question. But I think what the U.S. needs is a simpler territorial system with the proper targeted constraints on profit shifting.

So this has existed for a while in Germany. Europe has been in this state for a while. So anybody that says, “As soon as we go territorial there will never be another dollar taxed in the U.S. ever again.” That has just not been the case. Nobody adopts the territorial regime without also bringing in base erosion prevention measures. And so I think it's in the CFC rules.

So some type of targeted legal frictions?

Yes, there has to be. This is ultimately no different than parenting or being a teacher. You want the good kids to be free to do great things, and you want to somehow constrain the bad kids from harming themselves and harming others. And so it's really not that different.

What you don't want is a system that completely constrains the good kids from flourishing, and I think that the more you try to write a broad policy that applies to everybody, you're going to tend toward the constraining of good.

What about other possible measures?

The other thing that's talked about is rate reduction. I think that's a very interesting one, because the U.S. did get left behind on that.

I would be fascinated as an academic, and I would also be fascinated as a participant in the system, to know whether a rate reduction, if you went from 35 percent to 25 percent, how much it would matter in a world where there are single digit rates available. So does the incentive get dulled enough and are the costs big enough that we would see a reduction in what happens?

The other one that has to be put on the table if you're going to allow everything into the conversation is the elimination of the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. . This is a theoretically quite sound argument that no one even believes will ever happen. But if it did, most of this would go away.

Theoretically, that's a great solution to this problem, to have no corporate income tax. It's a hugely burdensome system when you think about what you get from it. But it's just not something that would ever fly in the real world.

So taking away the corporate tax or finding some sort of global solution in terms of multilateral cooperation are perhaps best case scenarios in your mind?

Yes, I think so. The reason I think that, just to be clear why I think cooperation has to be, is because what we see in the studies that we do is that firms do respond to tax rates. But what we infer, and what we know from talking to them, is that they exploit differences and inconsistencies in laws across countries. So these hybrid entities are a huge part of the story, and those types of things should be eliminated when you have a multilateral cooperation.

What major developments do you expect in the next 1-2 years?

Whatever comes out of the BEPS initiative will be a development, whether it's nothing or it's sweeping. And they seem to be very committed to finishing their work in a timely manner. So that's going to be a big development, whatever comes out of that.

In terms of academically or empirically, if we can get some sort of measure at the firm-level for the U.S., that would be great. If we can get people being able to look at a greater proportion of private companies, that would be a good thing. I don't know if I expect it to happen, though.

The other major development I think we should get to is we should start to develop a better understanding of the costs of income shifting. Nobody has really ever looked at this. So in the popular press, there is never really a mention of the cost. Everything that we hear about are these so-called success-stories where they're getting away with murder.

But we know that there must be firms out there who tried and failed, and firms who are out there and got into it and realized the cost, even if the benefits are slightly outweighing it for now, the costs are higher than they thought they were. We know very little about that. And I think that's somewhere we should be looking at a little bit more to be able to quantify that, because that also answers the question of: Why doesn't everybody do it?

See this 2013 paper by Markle and Scott Dyreng for a discussion related to frictions or costs associated with income shifting.

What are some of your own favorite papers or resources related to profit shifting?

So the best paper by far for anybody to start with is Dhammika Dharmapala's paper that he just published in Fiscal Studies last year. He worked very hard to go through a very dense literature, and the paper is written really nicely and accessibly. I would argue not just to academics. The high-level stuff is presented in a way I think people can understand. And it really does nicely survey the literature and gives us an idea of what we know. And what I really like about it is that it lays out the chronology of what we knew and what we know. And that's really helpful because it reminds us that ten years from now someone is going to write another paper that says, “Back in 2014, here's what we knew, and we thought we knew a lot. It turns out we didn't know it as accurately as we thought we did.” It keeps us going and keeps us humble. His paper for sure is a great paper.

I also do like Kim Clausing's studies a lot, because I think they are simple enough and they answer important questions clearly.

And then the other paper that—it's a non-American paper so it may not get as much attention—I think was very innovative is a Huizinga and Laeven paper in the Journal of Public Economics in 2008. The reason I think it's an important and good paper is that it's the first, as far as I know, that looks at this whole phenomenon of profit shifting more at the portfolio-level rather than simply countries independently.

Most of the studies that we have, when we look at sensitivities to tax rates, we are assuming that that's the only country, for that particular data point, that that firm is in. And we know that in the real world that's not true. If I'm in ten different countries, and I'm thinking about how I'm going to optimally report my profits, I'm going to think about multiple countries, not just the one with the lowest tax rate or the highest tax rate.

So I think that was a very important paper in getting us all thinking. They basically took the original idea behind the Hines and Rice model, which is at the country-level, and brought it down to the firm-level and introduced this new way of thinking about the incentive to shift income as not simply being the statutory rate of a given country. And I think that was a huge innovation that the rest of us hopefully can build on as we look at this problem going forward.