The Economics of International Taxation
While little understood outside of corporate tax departments and a handful of congressional committees, the international tax laws administered by U.S. and foreign governments can dramatically affect business decision making, job creation and retention, plant location, competitiveness, and the long-term health of the U.S. economy.
The basic tenets of sound tax policy are that income should be taxed once and only once – as close to the source as possible – and that a tax system should be neutral to business decision making.1 As can be expected, most tax systems, including the U.S. corporate tax system, fall far short of these ideals.
“Worldwide Taxes” vs. “Territorial Taxes” Generally, the U.S. taxes companies on their income at the rate of 35 percent whether it’s earned here or abroad by a subsidiary. Since the foreign subsidiaries of U.S. firms pay income taxes to their host countries, the U.S. addresses the problem of double-taxation by allowing firms to take a credit against their U.S. tax for income taxes they paid to another country. Since tax rates vary greatly between countries, the U.S. foreign tax credit system is far more complicated than it first appears.
For example, suppose that Hometown Computer Company earns $100 million in U.S. profits and $100 million in profits from its Swedish subsidiary. Under a purely worldwide tax system, Hometown Computers would owe $35 million, at the 35 percent rate, on its U.S. earnings and another $35 million on its Swedish earnings. In order to avoid the double-taxation of the Swedish earnings, the U.S. system gives Hometown a $28 million foreign tax credit for the income taxes it paid to Sweden at its 28 percent corporate rate. However, under the U.S. system, Hometown still owes $7 million in U.S. tax on those residual Swedish earnings. This amount represents the difference between what the company paid to the host country and what that income would have been taxed had it been entirely generated in the U.S.
There is a limit to the foreign tax credits U.S. firms can take, and the limit is equal to the U.S. rate. Suppose that Hometown also does business in Belgium, which has a top corporate tax rate of 40.2 percent, 5.2 percentage points higher than the U.S. rate. In this case, Hometown would pay $40.2 million in Belgian tax on that $100 million in income. However, Hometown could only take a foreign tax credit equal to the U.S. rate, or $35 million. Because Hometown cannot take a full credit for the taxes it paid in Belgium, it is said to be in an “excess credit” position.2
Complicating this simple example is the fact the U.S. system does not tax profits earned abroad until companies actually return those profits to the U.S. This part of the U.S. international tax system is called “deferral” because companies can defer paying taxes on that foreign-source income as long as they reinvest that income in an active foreign subsidiary.
Further complicating things is that the U.S., like many countries, has a system of “anti-deferral” rules which tax certain kinds of foreign-source income in the year it was earned even though the U.S. parent company had not repatriated those profits. These complex rules are commonly referred to as “Subpart F,” owing to their chapter in the U.S. tax code.
The Costs of Complexity Not surprisingly, most economists and tax practitioners agree that the U.S. international tax regime is inefficient, complicated, and expensive for companies to comply with. For example, based upon a survey of the tax officers of 1,672 large firms, Slemrod and Blumenthal found that the costs these companies incur to comply with U.S. international tax laws represent about 39 percent of their overall tax compliance costs. For Fortune 500 companies the cost ratio was nearly 44 percent.
Moreover, Slemrod and Blumenthal found that the costs associated with complying with U.S. international tax laws are “disproportionately high relative to the companies’ foreign activities.”3 Indeed, while the typical Fortune 500 company dedicated 44 percent of its compliance resources to international taxes, only 27.8 percent of its assets, 30.1 percent of its sales, and 26.2 percent of its employment were generated abroad.
Taxes Matter Compliance costs are not the only burden of international tax laws. Multinational firms also commit considerable resources on tax planning in order to minimize their tax burden. Contrary to what most lawmakers believe about corporate behavior, economic studies paint a fairly conclusive picture of how sensitive multinational firms are to tax rates and tax rules, and to what extent they will alter their business arrangements to minimize their tax.
For example, using data aggregated from more than 500 multinational tax returns, Grubert and Mutti found that “average effective tax rates have a significant effect on the choice of locations and the amount of capital invested there. A lower tax rate that increases the after-tax return to capital by one percent is associated with about 3 percent more real capital invested if the country has an open trade regime.”4 Based upon these results, they predict that were taxes not a motivating factor, approximately one-fifth of U.S. capital abroad would be in a different location.
In another study of corporate tax sensitivity, economists analyzed the investments of U.S. manufacturing firms in 58 countries. They found that not only are multinationals highly sensitive to host country tax rates, but that they were twice as sensitive in 1994 as they were just a decade earlier. The study’s authors report, “These results are consistent with increasing international mobility of capital and globalization of production.” 5
Not only are U.S. firms sensitive to the different tax rates abroad, but studies also have found that foreign investors are sensitive to U.S. taxes – especially state corporate income tax rates. These studies find that state tax rates have a significant effect on the location of new plants. One such study found that high-tax states are negatively correlated with the establishment of new plants and the expansion of existing ones (meaning, the higher the rate, the lower the new investment), but these states are positively correlated with foreign purchases of domestic firms.6
Given the sensitivity of multinationals to host country taxes, it is not unexpected to find that these firms will go to great lengths to arrange their business transactions to minimize their tax burden.
Tax Minimization Strategies There are many techniques multinational firms can employ to minimize their worldwide tax burdens.7 One method some studies have identified the aggressive use of “transfer pricing” – the price a parent company charges its overseas affiliate for a product, component, or trademark. Although complicated in practice, the simple goal of this technique is to book the higher expenses in a high-tax country – thus minimizing the after-tax profits – and book the profits in the lower-tax country where they can be deferred.
Tax practitioners point out that transfer pricing is no longer the problem it once was since most revenue authorities – especially in the U.S. – have toughened up their rules in order to abate tax avoidance. However, during the 1990s, James R. Hines found “The pretax profitability of foreign affiliates is negatively correlated with host country tax rates (Hines and Rice 1994), which is suggestive of tax-motivated transfer pricing…” As Goodspeed and Witte explain, “If the subsidiary is providing the parent with an input, there is an incentive to charge a very high price for the input. Since this will result in high revenue in the low-tax country and high costs in the high-tax country, the effect will be to transfer profits from the high-tax to the low-tax country.” 8
Another method firms use to minimize their global taxes is to shift the balance of tax-deductible debt and royalty payments between high-tax and low-tax countries. For example, the tax codes of many countries, including the U.S., give a tax advantage to debt-financed expansion by allowing firms to deduct the interest costs of their loans from their taxes. However, there is no similar preference for equity-financed investments. Similarly, royalty payments are tax deductible, but dividend payments are not.
Because of these incentives, many parent firms will lend capital to their foreign subsidiaries (especially to those in high-tax nations), which allows the subsidiary to deduct the interest payments paid back to the parent, and thus lower its taxable income. For the parent, the interest payments are taxed as income, but presumably at a lower tax rate than would be the profits earned by the subsidiary in the higher-taxed country.
One study by Grubert analyzed the dividend, interest, and royalty payments by 3,467 foreign subsidiaries to their parent American companies in 1990. It found that “high corporate tax rates in countries in which American subsidiaries are located are correlated with higher interest payments and lower dividend payout rates.” 9
There is considerable evidence that multinational firms are sensitive to the taxes they pay on repatriated profits through dividends – although some studies show this sensitivity is only evident when effective tax rates fluctuate frequently as opposed to when rates are stable. A 1990 study by Hines and Hubbard found that only 16 percent of foreign subsidiaries of American firms paid dividends to the parent company in 1984, and those that did had a particular tax advantage.10 They conclude that “a one percent decrease in the repatriation tax is associated with a four percent increase in dividend payout rates.”11
Similarly, a more recent study by Desai, Foley, and Hines asserted that “One percent lower repatriation tax rates are associated with one percent higher dividends. This implies that repatriation taxes reduce aggregate dividend payouts by 12.8 percent, and, in the process, generate annual efficiency losses equal to 2.5 percent of dividends.”12 These efficiency losses have the same effect as an additional tax placed on multinational firms and their shareholders, workers, and customers.
As Gordon and Hines sum up the empirical literature, “The reported profitability of multinational firms is inversely related to local tax rates, a relationship that is at least partly the consequence of tax-motivated use of debt financing, the pricing of intrafirm transfers, royalty payments, and other methods.”13
In other words, tax rates matter. And countries with higher tax rates will always see a higher incidence of tax minimization strategies among multinationals than low-tax countries.
Footnotes 1. J.D. Foster, “Promoting Trade, Shackling Our Traders,” Tax Foundation Background Paper No. 21, November 1997. 2. Timothy J. Goodspeed and Ann Dryden Witte, “International Taxation,” Encyclopedia of Law and Economics, p. 259. www.Encyclo.findlaw.com/6080book.pdf. The credit limitation prevents firms from getting a U.S. refund on higher taxes paid to a foreign country. 3. Marsha Blumenthal and Joel Slemrod, “The Compliance Costs of Taxing Foreign-Source Income: Its Magnitude, Determinants, and Policy Implications,” International Tax and Public Finance, vol. 2, no. 1, 37-54 (1995). 4. Harry Grubert and John Mutti, “Do Taxes Influence Where U.S. Corporations Invest?” National Tax Journal, December 2000, p. 825. 5. Rosanne Altshuler, Harry Grubert, and T. Scott Newlon, “Has U.S. Investment Abroad Become More Sensitive to Tax Rates?” NBER Working Paper No. 6383, January 1998. 6. For an extensive discussion of the literature, see: Ibid., Gordon and Hines, pp. 50-51. 7. For an extensive discussion of these techniques and the literature, see: Gordon and Hines, and Goodspeed and Witte. 8. Ibid., Goodspeed and Witte, p. 6080. 9. Ibid., Harry Grubert, cited in Gordon and Hines, p. 51. 10. Cited in Gordon and Hines, Ibid., p. 55. 11. Hines and Hubbard (1990), cited in “Repatriation Taxes and Dividend Distortions,” Mihir A. Desai, C. Fritz Foley, and James R. Hines Jr., NBER Working Paper 8507, October 2001, p. 9. 12. Ibid., Desai, Foley, and Hines, p. 2. 13. Ibid., Gordon and Hines, p. 58.