Making Sense of Profit Shifting: Harry Grubert
June 1, 2015
Harry Grubert is a Senior Research Economist in the Office of Tax Analysis at the U.S. Department of the Treasury.
As one of the world’s foremost scholars in the field of taxation, Dr. Grubert’s research focuses on profit shifting, the economic effects of taxes on investment, trade, and firm behavior, and assessing tax policy. His research has been published widely in leading scholarly journals and is frequently cited in tax policy discussions.
Dr. Grubert received his Ph.D. in economics from the Massachusetts Institute of Technology.
In this Interview with the Tax Foundation, Dr. Grubert shares his unique insights into an economic phenomenon that he has studied closely for over three decades. Specifically, Dr. Grubert discusses the nature, trend, and drivers of profit shifting, options for fixing the U.S. international tax system, as well as tax competition and the future of the corporate tax base. 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?
Harry Grubert: There have been many studies on this topic, and the findings are fairly persuasive in that there seems to be significant income shifting. In these studies, the sources of income shifting seem to be the existence of parent-developed intangibles and in these days, to a lesser extent, the allocation of debt.
TF: Suppose you would juxtapose the realm of the known and the realm of the unknown with respect to profit shifting. Which areas of profit shifting still lie within the unknown?
Grubert: Although I have tried to make some progress on this, it’s not clear where the ultimate sources of income shifting are located. So, for example, a common question that goes back to the original papers in the field, including my own with John Mutti, is that you observe high profit rates in Ireland and low profit rates in Germany. But that doesn’t mean you’re necessarily shifting income from Germany to Ireland. It could be income that should have been paid in royalties to the U.S. So I think that’s still somewhat unclear.
What are the unique factors or drivers underlying the profit shifting phenomenon?
It’s generally the existence of some parent-created valuable intangibles, which makes goods and particularly the value of royalties and the value of the transferred intangibles difficult to assess. So I think the typical situation would be that somehow an intangible, like a patent, a trademark, or some other intellectual property, is transferred to a low-tax country or a tax haven and a royalty is created that doesn’t necessarily reflect the value of that intangible. So it’s the underpricing of the royalty that is probably the most common vehicle for income shifting.
You frequently think of income shifting as having to do with the mispricing of goods. I think that may be the case. But again, if there’s mispricing of goods, that usually would be high-tech goods or goods that embody a valuable intangible, which are difficult to evaluate.
Then, of course, another vehicle that is well-known to any tax practitioner is where you locate debt, because you want a deduction in the high-tax country and you want all the equity to be in the low-tax country. And in studies of profit shifting, there’s clear evidence of that.
And I think that it’s from “check-the-box,” which was introduced in 1997, where most of the recent publicity about some of these high-tech companies stems. Check-the-box provides companies with an opportunity to further take advantage of intangibles, and they also permit the multinational to strip out income, but through internal debt, from high-tax countries to low-tax countries, because check-the-box makes the transaction invisible from the IRS’s point of view. So companies are then not subject to the Subpart F or controlled foreign corporation (CFC) rules.
Ordinarily, before 1997, if one controlled foreign corporation paid interest to another, that would be immediately taxable under Subpart F rules, at the full tax rate.
Check-the-box has probably had a significant effect for U.S. companies, because they can inject equity into a tax haven affiliate, like in Bermuda, and then have it cross share in, for example, an R&D project with the U.S. parent. And in some way, there would be underpricing of the buy-in or of the value of the existing intangible, and the tax haven entity would then acquire this intangible after it was developed. In turn, the tax haven affiliate can on-license the intangible to various producing companies in relatively high-tax countries and strip out royalties.
Over the years, there have been a series of cost sharing regulations aimed at tightening this process. Regulations in place restrict companies’ ability to do this by mandating a higher buy-in payment, which actually reflects the value of existing intangibles. But there still seems to be significant opportunity for income shifting, despite these regulations.
How does profit shifting alter the behavior of firms?
Apart from the revenue issue, profit shifting opportunities could alter where firms choose to locate production. As Rosanne Altshuler and I highlighted in our paper on minimum taxes in 2013, there are really two forms of income shifting: Before and after check-the-box. Before check-the-box, in order to take advantage of a valuable intangible, for example some microprocessor or drugs you developed, you had to produce in the low-tax location. You had to start this microprocessor plant or drug production facility in, for instance, Ireland because Ireland had a low tax rate. In order to shift income you had to actually have an operating business in that location. After check-the-box, this link between production and the location of income loosened, so you can just strip income to tax havens without having much business activity there.
But profit shifting does change where you might choose to produce. If opening another plant in Ireland gives you the opportunity to shift the income there, you’re more likely to locate in Ireland than in some other alternative location, which may have a higher tax.
And in a few of the operating tax havens, like Singapore and Ireland, there does seem to be a disproportionate amount of investment.
I think there’s probably as much real plant and equipment owned by U.S companies in Ireland as there is in Italy, even though Italy is around 10 times bigger in terms of population.
It used to be, before check-the-box was repealed, that we had section 936, which permitted companies to shift intangibles to Puerto Rico under very desirable tax rules. And that clearly had an effect on the extent to which U.S companies operated in Puerto Rico. At least 100,000 jobs wouldn’t have been there in the absence of all the tax benefits companies received under section 936, because Puerto Rico is a relatively high-cost place to produce.
Does profit shifting matter?
Well, it matters for revenue. I don’t want to tie myself down to any particular revenue estimate, but there are estimates by people like Kimberly Clausing and others that it costs the U.S. Treasury $50 or $60 billion a year. I don’t know, $50 or $60 billion sounds fairly significant to me.
But it can also, as I noted earlier, distort how companies do their business and promote an inefficient allocation of resources.
In relation to the directional trend of profit shifting, your paper: “Foreign Taxes and the Growing Share of U.S. Multinational Company Income Abroad: Profits, not Sales, are being Globalized” suggests that profit shifting is increasing in scale. Has profit shifting Increased over time?
In that 2012 paper, I did use fairly old data. It was data from 1996 to 2004 because I wanted to straddle the period of the introduction of check-the-box. And I did present evidence toward the end of the paper that there was an increase in the tax sensitivity of profitability in the U.S. and abroad, in response to taxes over time. So it seems to have gotten worse.
That may be the case because companies have been getting better at or more aggressive in tax planning. Maybe they found tax planning is very productive. But there does seem to have been an increasing trend in terms of the profit shifting for any given tax differential.
What is the difference between the studies using European data that suggest profit shifting is decreasing over time and the studies using U.S. data, and your 2012 study is among those, that suggest profit shifting has increased over time? Can you reconcile those two opposing indicators?
Europeans work with relatively less useful data than researchers in the U.S. because I think there’s very little micro-data for corporations. U.S. data collection gathers both corporate tax returns and information returns—what we call the “54/71”—which reports on every controlled foreign corporation. And then there’s the Bureau of Economic Analysis and Department of Commerce system, which conducts parallel data collection for multinationals.
The Bundesbank is one of the few sources that European economists use. And then there is the proprietary commercial database, Orbis or Amadeus. But as we’ve been looking at it lately, because it’s been used in the OECD’s studies of base erosion and profit shifting (BEPS), it has a great deal of gaps. I don’t know whether that’s the source of their conclusions or if it’s that tax differentials are just coming down abroad.
There really does seem to be a race to the bottom. The UK has almost become a tax haven. All of these countries that used to be high-tax countries have become much more moderate in their taxation.
For example, the UK now has a corporate tax rate in the low 20s; they’ve introduced a territorial system; and they’ve weakened their controlled foreign corporation rules. They have also implemented a 10 percent patent box. Even though the German rate is not as low as the UK’s, it has also come down substantially from what it used to be. So maybe it’s just that tax differentials are not what they used to be. Now, it could also be that countries are getting tougher on controlled foreign corporation rules, but I don’t know of any systematic study of that.
What is the future of the corporate tax base? Could it still exist in 20 years?
Well, I think the long-term viability of the corporate tax base is a serious issue. On the other hand, most people point to the stability of corporate revenues relative to GDP. But I think that’s probably because corporate profits have become more important as a share of GDP. I have seen the decompositions, and there is probably some impact of income shifting on what is happening to corporate revenues in the OECD countries.
As your question indicates, there may be some question about the viability of the corporate tax. I think the growing importance of intangibles and intellectual property has probably been a very important driving force. And that’s one thing that the BEPS project is aiming to address, whether it’s successful or not. I think people have started to get a bit concerned about this issue, and there are various attempted cures—for example, a lot of countries have introduced thin capitalization rules.
In your 2005 paper with Rosanne Altshuler, “The Three Parties and the Race to the Bottom: Home Governments, Host Governments, and Multinational Companies” you explore the dynamics of tax competition. What is your thinking on the race to the bottom in corporate tax rates at this point? Are we heading towards the bottom at an increasing rate?
I’m not sure. It may be flattening out, possibly because of the need for revenue. One point we did make in that paper is that host countries could well be cooperating in this race to the bottom. I think that’s what we wanted to really point out. Potential host countries could be permitting measures such as income stripping from their tax bases as a way to attract mobile capital.
What is the best estimate of profit shifting out of the U.S.?
Estimating the revenue effects of profit shifting is something that’s conceptually difficult to analyze or project. Then, of course, there’s a difference between static and dynamic estimates.
In the 2012 paper I referenced earlier, I concluded that, if average effective tax rates in the U.S. and abroad were the same and there existed no tax differentials, 12 percent of the worldwide profits of U.S. multinationals would be in the U.S. rather than abroad. But I didn’t try to translate that into any revenue number [because] you would have to start considering what all the responses would be of the companies and so on.
What is missing for a better understanding of profit shifting?
I think profit shifting is pretty well known. Maybe the data could be better, but the rough significance of profit shifting is fairly well known.
Better data sets could enhance our understanding of profit shifting. Even though I think that the data we have here at the Treasury are probably better than any other country—and certainly if you complement those data with the data that the BEA collects—there are still limitations.
For example, with the Treasury data, we don’t really know how much R&D is performed by the subsidiaries abroad, although in the BEA benchmark that is known. But it’s not part of our micro database. We have an advantage at the Treasury since our data are in terms of taxes paid, but there are still gaps. Our database is based on the country of incorporation of the subsidiary, but that may not be where the income is actually taxed. The country of incorporation may not be the same as the tax residence, which has recently come up a lot in all the publicity about multinational tech companies.
So the data can always be improved and refined. And then there’s a gap in that it’s very difficult of knowing which tax regimes companies are actually under. There are all sorts of special regimes. Multinationals have special deals in various countries, including well-known major European countries. So, in our data, we can only judge the taxes multinationals actually paid.
What are potential solutions to address profit shifting?
I have only been involved peripherally in the BEPS discussions, mainly in measuring BEPS, but I think it remains to be seen what comes out of the BEPS process and how much will change in our national law and how much other countries will change in their national laws. For example, changes in the rules for how multinationals allocate debt around the world based on assets or income to prevent income shifting could occur. But at this point, whatever will happen remains very unclear.
My view is that the U.S. has to make some policy decision on its own.
What are potential solutions to address profit shifting for the U.S.?
In the President’s budget, a minimum tax was proposed, so that’s one possibility. That presumably will take a lot of the juice out of income shifting and will normalize effective tax rates so that they don’t become extremely beneficial abroad. That’s one solution. And that’s not dissimilar from what the Camp bill proposed. The Camp bill could be interpreted as a per-country minimum tax.
How about a territorial system? Can that be beneficial for the U.S.?
Everyone agrees that the repatriation tax is a bad idea. The question is what comes along with a territorial system or what I prefer to call a “dividend exemption system.”
The concern about introducing a territorial system is that it will increase income shifting. Now, a dollar abroad isn’t worth a dollar in the U.S. because it costs to either avoid the repatriation tax, to borrow against that dollar, or to bring the dollar back. A dollar abroad in a low-tax country is therefore going to be worth a lot more or visibly more. So it increases the incentives for income shifting. So I think in a way some minimum tax or a measure that addresses that base erosion possibility has to be implemented.
That’s why Chairman Camp proposed a tax on excess intangible income, which is very close to the minimum tax idea.
Are U.S. multinationals at a competitive disadvantage because of the current international tax system? Is there a competitiveness issue?
Well, there may be. Though, companies seem pretty successful at shifting income and exploiting the opportunities for income shifting to lower their worldwide tax rate. But with respect to the repatriation tax, as I noted previously, everyone agrees that’s a bad policy. So U.S. multinationals may be disadvantaged by that to some extent. And that may have some visible impact on multinationals’ cost of capital.
Are U.S. multinationals, or multinationals in general, a homogenous group with respect to profit shifting?
Presumably, it’s the high-tech companies or the companies that have valuable intangibles—whether they’re marketing intangibles, industrial intangibles, or other types of intellectual property—that probably have the greatest opportunity for income shifting. And they appear to take advantage of these opportunities for income shifting. So it’s not a homogenous group. It depends very much on what intellectual property they have, broadly speaking.
It could also just be superior management abilities. And there does seem to be some variation among how aggressive companies are, since all of them don’t have very low effective foreign tax rates. Some actually seem to pay substantial amounts abroad.
What major developments do you expect in the next 1-2 years?
In a global perspective, there may be some cooperation on areas such as CFC rules and thin capitalization rules, but I’m not sure how much further beyond that multilateral cooperation will go. CFC rules actually provide quite an opportunity to address profit shifting. I think one of the options in the BEPS discussion is really to have something similar to a worldwide minimum tax in the form of CFC rules. But I’m not sure whether countries will adopt that.
Some have suggested that we have a worldwide deal on formulary apportionment, but I don’t think that’s in the cards. Others are of the view that we should have a destination-based income tax—that it’s the place where you consume that should be taxing the profits because consumers are much less mobile than income. I have a paper that’s coming out in the Tax Law Review, which looks at that. I’m rather skeptical that it will work, although there are still some people who are proponents of that. For example, they believe in sales-based formula apportionment. But I think those types of proposed solutions have a great deal of problems.
Together with Rosanne Altshuler, I am planning to look at how to shift the burden of taxation from the corporate level to the personal level. Because, presumably, the ultimate shareholder is relatively less mobile and has less opportunity for income shifting, it would be advantageous to have a substantial cut in the corporate tax and shift the burden of taxation on corporate income or on capital to the ultimate shareholder and the personal level. That would be a major shift and change in the opportunity for income shifting at the corporate level. The question is how to do it.
What are some of your own favorite papers or resources related to profit shifting?
I think many of them have been discussed here today. I would recommend my early paper together with John Mutti, “Taxes, Tariffs and Transfer Pricing in Multinational Corporate Decision Making,” which really goes back 25 years. There’s the paper from 2012 in the National Tax Journal that we discussed. And there’s my 2003 paper in the National Tax Journal, where I looked at the impact of parent intangibles and debt. Parent intangibles and debt explained basically 100 percent of the income shifting or the disparities in profitability between high-tax and low-tax countries.
In September of last year, I reviewed Daniel Shaviro’s book on international taxation, and that could also be a good resource.
These comments represent the views of the interviewee only and do not represent those of the U.S. Department of the Treasury.
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