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Making Sense of Profit Shifting: Lars Feld

14 min readBy: Erik Cederwall

Lars Feld is the Chair for Economic Policy and Constitutional Economics at Albert Ludwigs University of Freiburg and President of the Walter Eucken Institute.

A widely cited public finance economist, Professor Feld is an expert on 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. and firm responsiveness to taxation in areas such as foreign direct investment, company structure, and mergers and acquisitions. His research focuses on economic and fiscal policies, the emerging field of New Political Economy, and the economic analysis of law.

Professor Feld is a member of the German Council of Economic Experts, the Scientific Advisory Board to the German Federal Finance Ministry, and the Leopoldina (the German National Academcy of the Sciences). He is also a permanent guest professor at the Center for European Economic Research (ZEW) in Mannheim, Germany.

Professor Feld received his Ph.D. and habilitation from the University of St. Gallen.

In this interview with the 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. Foundation, Professor Feld analyzes the nature, drivers, magnitude, and effects of profit shifting, sharing his unique insights into the German experience with the phenomenon. Moreover, Professor Feld dissects the political economy of international taxation and highlights the case for further multilateral cooperation in international taxation. This interview is part of our 2015 Tax Foundation Forum series and has been edited for clarity and length.

Tax Foundation: What is known about profit shifting?

Lars Feld: First of all, given the idiosyncrasies of the different tax systems, each country’s tax code plays a certain role in the context of profit shifting. What is most important in this distinction is that the U.S. is still using a worldwide tax systemA worldwide tax system for corporations, as opposed to a territorial tax system, includes foreign-earned income in the domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. , whereas in continental Europe you have, to a large extent, territorial systems. Great Britain, for example, switched to a territorial system a few years ago. When you take these specific particularities into account, you can identify different ways that profit shifting can occur.

The first channel [for profit shifting] that researchers looked at was the transfer pricing channel, and it later became obvious that licensing played a certain role within that channel. It also became obvious that financing within the multinational, between the parent company and its subsidiaries, became increasingly important as a way to shift profits. And so these different channels have been looked at carefully by researchers.

Through estimates of firms’ responsiveness to taxes and tax rate differentials, researchers have also been able to derive a better picture of how important the profit shifting phenomenon really is. These tax semi-elasticities, or measures of responsiveness, suggest the effects of tax rate differentials on, for example, firm’s choices regarding capital structure, financing decisions, and the extent to which they engage in profit shifting. Meanwhile, a few meta-analyses have been conducted on these topics that allow for a more holistic assessment of profit shifting. These analyses have suggested the importance and average effect of taxes on various areas related to profit shifting. Yet, researchers haven’t been able to empirically derive the extent to which profit shifting occurs.

TF: Which areas related to profit shifting do we know the least about?

Feld: One aspect we are currently discussing or debating intensively is what could be done against the ways profit shifting currently takes place. So, what would be a good reaction for governments? This is a typical tax policy question. But it's less of a research question in that sense.

What we are also discussing is the actual extent of profit shifting. I have seen estimates of profit shifting for Germany that range between €10 billion to €100 billion, which illustrates how difficult it is to estimate the extent of profit shifting. So when we start quantifying profit shifting, it's becoming more and more difficult.

Researchers can generally estimate the tax elasticities, but they cannot say what the aggregate sum of profit shifting amounts to. That’s quite interesting.

What are the unique factors and drivers underlying the profit shifting phenomenon?

One key factor is simply the incentive for firms to minimize their actual tax burden. But that is only one side of the tax competition game because on the other side you have governments legislating particular tax codes. And very often the main goal is to attract revenue.

Thus, countries try to attract additional tax revenue and seek to attract tax bases that might in the end even provide investment.

In the case of profit shifting, firms need not shift any real economic factors, moving capital and labor. But when you think about licensing, depending on how other countries react to it, this might lead to a shift of research departments to the countries that provide the particular tax treatment.

So there are two sides of the same coin. On the one side you have the incentive for firms to move or to shift profits in the tax competition game and on the other side you have incentives of governments to attract them. And both sides are necessary to come up with a full tax competition game.

How does profit shifting alter the behavior of firms?

In general, it's leading firms to take potentially distorting decisions that they would not necessarily take without the incentive to avoid taxes.

As an example stemming from discussions about the financing channel of profit shifting, firms acquire other firms in low-tax countries, say in Ireland or in an Asian country, and they mainly do that in order to avoid taxes, in order to shift the financing function to that new subsidiary. Without the possibility to avoid taxes, they would not necessarily acquire.

How about the firm's capital structure more broadly. Is that altered as a result of profit shifting?

The firm’s capital structure is definitely altered as well. What we observe from multinationals is that they, for example, have incentives to finance their investments to a larger extent with debt than with equity. And then use the profit shifting possibilities that accompany these financing decisions in order to avoid taxes.

And what we also have to keep in mind is that the whole area of mergers and acquisitions— and to what extent the differential tax treatment of mergers and acquisitions in countries around the world affects the location of these mergers and acquisitions—is very important. And this is an area that is not researched to a large extent. We don't have many papers on that.

Does profit shifting matter?

Yes, it does, in the sense that it provides distortive incentive to firms and governments and both follow these incentives. So firms shift profit and act in ways they would otherwise not do without these possibilities, so there is a distortion induced by the international tax system. And governments engage to a much larger extent in drafting changes in the tax code than trying to improve other factors that might influence investment in their jurisdiction. So, in that sense, it matters.

For a detailed discussion of how taxes affect foreign direct investment, see Professor Feld’s paper, “FDI and Taxation: A Meta-Study.”

So for whom does profit shifting matter the most? High-tax countries?

Well, negatively it matters for high-tax countries to a large extent. But positively it also matters for tax havens and low-tax countries. And drawing on our knowledge of asymmetric tax competition we could say that, in this game, the small jurisdictions that are very often tax havens feel the advantage of acting strategically to attract tax revenue to a much larger extent because their economies and government budgets are smaller.

Let’s talk about the evolution of profit shifting. Has profit shifting increased over time?

Yes, I think so. It has increased over time because of the variation in ways to shift profit and because new possibilities to shift profit have opened up, for example, through licensing.

Licensing has become more and more prominent and important over time. But some other channels that were previously used more extensively, for example, the financing channel, have become less prominent. But I think the extent to which the licensing channel is used today, the additional profit shifting that could be conducted via this channel, is larger than the reductions in profit shifting that occurred due to measures fighting profit shifting via, for example, the financing channel. But what this also means is that the way profit shifting has been conducted has also evolved over time.

Since the late 1980s and the early 1990s when the academic study of profit shifting really started, global GDP has increased significantly. Is the dramatic rise in economic activity the key explanation as to why profit shifting has increased, or are there other important reasons as well?

I think it's not so much the income increase across time. Otherwise the increase in GDP between the mid-1950s until the end of the 1970s should have been accompanied by similar increases in profit shifting. But it was much less prominent then as compared to these days. I think the difference between the 25 years I just mentioned and the time afterwards is that globalization has increased to a considerable extent. Firms are much more internationalized. For example, German multinationals, which have many subsidiaries in other countries, today, use these subsidiaries in their value chains to an extent that was not known in the 1970s. And this increases the possibilities for optimization of tax payment.

What is missing for a better understanding of profit shifting?

Data. We have gathered much better micro-data on multinational firms in different countries, and this has improved our knowledge considerably. Nonetheless, when you then trace a particular behavior of multinationals—the numbers of observations that exist are not enough. And therefore, it is necessary to have much broader data sets to assess particular behavior resulting from tax rate differentials and tax code differentials. With the additional data, we would be quick to develop new and better models.

The tax literature has to find broader data sets in order to employ methods that have been employed in other areas of economics.

What are possible solutions to address profit shifting?

International coordination, multilaterally at the OECD level, might help. One area in which multilateral cooperation and OECD guidance could be helpful is in establishing minimum standards for the implementation of patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. regimes. In connection with several European countries considering implementing patent boxes, Germany for example, argued with the UK and Dutch governments that there should, to some extent, exist minimum standards for the level of actual research and development that must take place in the countries that enact patent boxes.

A corporate tax rate reduction is another measure that can reduce profit shifting. Germany has had several corporate tax reforms. In 2001 and 2008, the tax rate on corporate profits was reduced substantially. The reaction from firms to these measure was a reduced incentive to avoid taxation in Germany.

Thin capitalization rules are also a part of the story in addressing profit shifting. These rules have been adopted in many countries, and Germany has also introduced one a few years ago. This type of tax barrier is trying to fight the particular form of profit shifting occurring via the financing channel, which is related to capital structure choices. These thin capitalization rules are often complemented with controlled foreign corporation (CFC) rules for increased efficacy.

And finally, regarding transfer pricing regulations, these rules are of course aiming to adapt to the new possibilities for profit shifting that emerge through firms’ innovative search for tax avoidance strategies. But for transfer pricing regulations, there is always the ”hare and hedgehog” problem, where the government is always one step behind firms in implementing transfer pricing regulations, just like the hare in the fable of the hare and hedgehog. So I'm not so confident anymore that these rules do much, but at least they help somewhat.

Is it possible to effectively address profit shifting without multilateral cooperation? Can countries unilaterally solve this?

Some of the measures we have discussed—tax rate reduction, thin capitalization rules, CFC regulations, and transfer pricing rules—are all actions that governments can take to address profit shifting. And so there is the possibility to unilaterally do something against profit shifting.

My problem with unilateral measures is that they are often inefficient, in the sense that they do not specifically address the problem that occurs.

For example, the thin capitalization rule in Germany allows firms to deduct interest payments on debt up to a certain amount, and then they must shift the losses that might occur due to these interest payments to future years. But it might simply be that a firm actually is as highly indebted as the high interest payments indicate. So with such rules it’s not easy to distinguish between a justified extent of interest payments and an unjustified extent of interest payments that simply occurs because of profit shifting. This is my main problem with unilateral actions. They are not smart enough. In a multilateral treatment, it’s possible to find smarter solutions.

In the next couple of years, I think we will see a combination of both unilateral and multilateral initiatives. There will be further international and multilateral coordination, and there will also be unilateral actions by different countries.

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

I'm hoping for better data, and as a result, I believe we will see researchers digging even further into the different possibilities for profit shifting that international taxation is offering firms, beyond the areas we already know about such as licensing and financing decisions. This is something that is going to occur. And I think we have already started to analyze M&A and international taxation, and this is somewhat related to other channels that might be used for profit shifting. I think these interactions will be addressed as well to a larger extent.

I also think that we will be better equipped to solve the puzzle regarding the amount of profit shifting that occurs.

Perhaps this is less of a research question, but I'm curious to see how long the U.S. will stick to its worldwide taxation system. And what the U.S. will do next: Try to make adjustments within the current system or abolish the worldwide system and try to address the disadvantages that the U.S. currently faces with its tax code.

In the arena of government policy actions, there will be a combination of further initiatives along the lines of the BEPS initiative. We will see reactions from different countries on the basis of the BEPS agreement. So whatever the final outcome of the BEPS project, tax havens and countries with particular provisions for firms to avoid taxation will try to identify what will be possible on this basis. They will try to innovate with new developments in their tax codes to facilitate tax avoidance. And in turn, high-tax countries will try to react to that until the next round of multinational negotiations takes place. This is a mechanism that will occur for a couple of years.

How do you envision the future of the corporate 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. ?

Within corporate taxation, we have already seen a movement away from the idea of the ability to pay principle to a type of benefit taxation. And I think this will continue in the future. So what this means is that firms are paying for infrastructure and other benefits they receive from the different countries they operate in through corporate taxation or local business taxes. I think this is a result of the internationalization that we will continue to observe.

And the other side is the increase in the importance of intangibles in connection with internationalization. This will provide many new challenges to properly defining the tax base, which will in turn become increasingly complicated. And I don't actually know what that means for corporate income taxation. It reinforces what I noted previously regarding a continued movement toward the benefit principle of taxation. But perhaps there will be an even greater extent of base erosion despite that.

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

I would recommend a meta-analysis paper that was published as a discussion paper in 2013 by two German researchers, Jost Heckemeyer and Michael Overesch: ”Multinationals' Profit Response to Tax Differentials: Effect Size and Shifting Channels.” This is a paper that provides a broad overview of the empirical literature on profit shifting. I would say it is my favorite paper because it gives a very good overview of the topic as well as provides extensive insights into the quantitative dimensions of profit shifting.

How about some of your own papers?

Two of my papers related to profit shifting, ”Capital Structure Choice and Company Taxation: A Meta-Study,” a meta-analysis published in 2013 together with Heckemeyer and Overesch, and “Effects of Territorial and Worldwide Corporation Tax Systems on Outbound M&As,” which analyzes the interplay between different tax systems and mergers and acquisitions, could be of interest.