Correction (8/25/2021): Due to a minor error in our Multinational 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. Model, several of the calculations in the original version of this post were incorrect. That error has now been corrected and this analysis has been updated accordingly.
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. by multinationals poses a major challenge in international taxation. The ability of multinational enterprises to shift the location of profits from high-tax to low-tax jurisdictions and tax havens erodes the corporate income 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. in high-tax countries. For example, a multinational with patents owned by an Irish affiliate can shift profits from high-tax countries into Ireland, where those profits face a low effective tax rate.
The Tax Cuts and Jobs Act (TCJA) of 2017 sought to address profit shifting by U.S. multinationals using three key policy changes. First, it cut the statutory corporate tax rate from 35 to 21 percent, shifting the U.S. from being one of the highest-tax countries in the world to close to the average worldwide and among developed countries.
The TCJA also pursued a stick-and-carrot approach to reduce incentives to shift profits abroad. First, it created a surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. on profits booked in controlled foreign corporations (CFCs) owned by U.S. multinationals, through the Global Intangible Low-Taxed Income (GILTI) policy. This provision created a minimum 10.5 percent tax on foreign income deemed attributable to intangible assets, defined as income in excess of a 10 percent profit from tangible assets. While intended to impose a minimum tax in the range of 10.5 to 13.125 percent, the effective tax from GILTI can exceed this intended maximum rate.
GILTI provides a penalty for booking profits abroad, but the TCJA also created a positive incentive to book profits in the U.S. with the Foreign-Derived Intangible Income (FDII) deduction, providing a 13.125 percent tax rate on this income if booked in the U.S. Combined, the lower corporate tax rate, the incentive from GILTI to not book profits abroad, and the incentive from FDII to book profits in the U.S. substantially reduced profit-shifting incentives for U.S. multinationals.
However, the Biden administration has objected to the low tax rates on intangible income from GILTI and FDII, arguing that U.S. multinationals should pay higher taxes. Accordingly, the administration’s “Made in America Tax Plan” proposes to raise taxes on U.S. multinationals by: raising the corporate tax rate to 28 percent; raising the GILTI minimum tax rate to 21 percent; repealing the tangible asset exemption in GILTI; calculating GILTI on a country-by-country basis instead of pooling all foreign income; repealing the FDII deduction; and denying deductions allocated to types of foreign income that the tax system deliberately excludes from taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. .
The administration has claimed that by raising tax rates on foreign income, these tax hikes would “substantially curtail” profit shifting by multinationals. But this claim ignores that the key incentive for profit shifting is not the tax rate on foreign income, but actually the tax rate differential between income booked abroad and income booked in the U.S. While higher taxes on foreign income reduce the incentive to shift profits abroad, raising the corporate tax rate to 28 percent and repealing the FDII deduction strengthen this incentive.
In a recent Tax Foundation analysis that accounts for these countervailing incentives, I found the Biden administration’s proposals would actually increase profit shifting by U.S. multinationals. The analysis considered four potential changes to the taxation of U.S. multinationals: the Biden administration’s proposal; a partial version of this proposal reflecting difficulties getting congressional approval for such large tax hikes; a revenue-neutral proposal that fixes unintended problems with GILTI in exchange for a higher GILTI tax rate; and restructuring GILTI to resemble the OECD/G20 Pillar 2 proposal for global minimum taxes.
The following table presents effects of profit shifting on federal 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. liabilities of U.S. multinationals. The first column presents purely static results, in which multinationals do not respond to corporate income tax changes. The second column presents the main results, assuming a consensus profit shifting semi-elasticity of 0.8—meaning that a 1 percentage point increase in the tax rate on foreign income relative to the tax rate on domestic income reduces profits shifted to that foreign jurisdiction by 0.8 percent. The third column uses semi-elasticities from recent work by economists Tim Dowd, Paul Landefeld, and Anne Moore, who estimated much larger profit shifting semi-elasticities for tax havens and smaller ones for non-haven countries.
|
Change in CIT Liabilities |
Loss to Profit Shifting |
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|---|---|---|---|---|---|---|
| Proposal | Static | SE = 0.8 | SE from DLM | SE = 0.8 | SE from DLM | |
| Biden proposal | 1394.4 | 1315.9 | 1152.6 | -78.5 | -241.8 | |
| Partial Biden | 615.6 | 579.5 | 522.3 | -36.1 | -93.3 | |
| GILTI fix | -2.5 | 0.0 | 11.4 | 2.5 | 13.9 | |
| Pillar 2 | 111.3 | 106.0 | 105.5 | -5.2 | -5.8 | |
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Note: This table presents the 10-year change in federal corporate income tax liabilities of U.S. multinationals in billions of dollars for each proposal. The first three columns present the change in these liabilities from each proposal under different profit-shifting assumptions. The static estimates use no profit-shifting response. The second column uses the moderate profit-shifting response, with a semi-elasticity of 0.8 with respect to the tax rate differential between the U.S. and each CFC. The third column uses the profit-shifting response from Dowd, Landefeld, and Moore (2018), with a semi-elasticity of 4.16 for tax havens and a semi-elasticity of 0.684 for other countries. Tax havens are identified by the Congressional Research Service. The last two columns present the revenue leakage from profit shifting, calculated by subtracting the static results. Source: Cody Kallen, “Options for Reforming the Taxation of U.S. Multinationals,” Tax Foundation, Aug. 12, 2021, https://taxfoundation.org/us-multinational-tax-reform-options-gilti/. |
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The main estimates from the paper show that profit shifting reduces the revenue from the Biden administration’s proposal by $78.5 billion over a decade. Using the semi-elasticities from Dowd, Landefeld, and Moore produces even larger effects, with the proposal losing $241.8 billion to profit shifting over a decade.
Contrary to the administration’s claim that its proposal would result in a “near-elimination” of profit shifting, their proposal exacerbates it. To understand why, let’s look at the impact on tax rates.
According to my analysis, the Biden administration’s proposal would raise the combined average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. on profits in CFCs from 16.3 percent under current law to 20.2 percent, an increase of 4.9 percentage points. However, increasing the corporate tax rate from 21 to 28 percent raises the tax rate on domestic income by 7 percentage points. Combined with FDII repeal, the administration’s proposal raises the tax rate on domestic income by approximately 9 percentage points, much larger than the 4.9 percentage-point tax hike on foreign income. On net, this substantially increases incentives to shift profits out of the U.S.
While the administration has proposed replacing the FDII deduction with an unspecified incentive for R&D, this is unlikely to change the profit-shifting outcome, as the proposal increases profit shifting even without considering FDII. Moreover, a revenue-neutral R&D subsidy to replace the FDII deduction is unlikely to function better as an incentive for booking intangible profits in the U.S.
This same pattern occurs for the partial version of the administration’s proposal, although to a lesser extent, as the tax rate hikes on both foreign and domestic income are smaller than the full Biden administration proposal.
There are many ways the U.S.’s international tax ruleInternational tax rules apply to income companies earn from their overseas operations and sales. Tax treaties between countries determine which country collects tax revenue, and anti-avoidance rules are put in place to limit gaps companies use to minimize their global tax burden. s could be changed, reformed, improved, or worsened. Reflexively jacking up taxes on U.S. multinationals does not necessarily accomplish the goal of reducing or eliminating profit shifting, and it would in fact worsen it. A well-designed international tax reform proposal should alleviate such problems, not exacerbate them.
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