Making Sense of Profit Shifting: Mihir Desai
May 12, 2015
Mihir Desai is the Mizuho Financial Group Professor of Finance at Harvard Business School and a Professor of Law at Harvard Law School.
An authority on tax policy, international finance, and corporate taxation, Professor Desai has on multiple occasions testified before the U.S. Congress on matters pertaining to corporate and international taxation. Professor Desai’s research on tax policy in a globalized economy and on the intersection of taxation, corporate governance, and multinational firm’s internal capital markets has been published in leading scholarly journals, and his commentary is frequently cited in widely known publications.
Professor Desai received his Ph.D. in political economy from Harvard University, an MBA as a Baker Scholar from Harvard Business School, and a bachelor's degree in history and economics from Brown University. He is a Research Associate in the National Bureau of Economic Research's Public Economics and Corporate Finance Programs and served as the co-director of the NBER's India program.
In this interview with the Tax Foundation, Professor Desai analyzes the nature, drivers, and economic effects of profit shifting, with a specific emphasis on the real economic distortions that profit shifting may cause. Moreover, professor Desai highlights aspects related to firm uniqueness with respect to profit shifting and offers a set of possible solutions to address profit shifting. 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?
Mihir Desai: Most people think about profit shifting as the artificial reallocation of profits in response to tax rate differences. And the key word there is of course artificial. So it’s some notion that profits are being reallocated around the world in a way that does not correspond to some underlying economic logic.
So that's the way we tend to define it and what do we know about it? Well, we know that it happens, and we know that it happens with some regularity, and we are concerned about it or people are concerned about it for really two reasons.
One is that there are obviously revenue consequences to it, which might be of interest to governments. But maybe more interestingly, there are a set of real distortions that will be associated with it, which is a way of saying that not only do governments potentially lose revenues, but firms are undertaking decisions that they wouldn't have undertaken otherwise in order to achieve those profit reallocations. So that’s why we care about it.
I think we have a pretty good understanding of that it has increased over time, and I'm speaking particularly for U.S. firms. If we looked at the longer sweep of history, I think measured elasticities have grown somewhat. And so I think what we know about it is that it's a very important phenomenon. We know that it’s associated with revenue considerations but also real activity, and we know that it’s an activity that has grown in prominence.
TF: Is the unknown with respect to profit shifting significant in proportion to what is known about profit shifting?
Desai: I think we know less than we should know about the real consequences of profit shifting.
Just to be clear, tax rate differences will give rise to differences in real activity, that is, lower tax rates can encourage real activity, and they will give rise to profit shifting. But they may also give rise to an interaction between the two. Which is, as you are doing profit shifting, you also may choose to do real decision-making in a different way.
So I think the big area of the unknown is: Do profit shifting activities lead to very significant real decisions that are also distorting? Just to make it concrete… if you are a firm and you want to, for example, shift profits to a low-tax jurisdiction out of the U.S., will you also, in order to justify that, undertake very significant real activity to ensure that that happens? So, that’s like saying that you have to have some real activity that's a complement to the profit shifting in order to justify it. And I think that's one area which is really rich.
What are the unique factors or drivers underlying the profit shifting phenomenon?
I think that there are really three primary drivers that we have seen grow over time, and they are all growing at a fairly secular way or they have grown in a fairly secular way.
The first is obviously globalization of production and production chains around the world. So the globalization of firms means that firms are located all around the world and then that comes along with associated profit shifting opportunities. And it certainly enables certain kinds of profit shifting opportunities. That's the first major trend in the last thirty years that has accelerated profit shifting.
The second major trend is the increasing importance of intangible assets and intellectual property. The economy has become more and more knowledge-intensive and more and more reliant on intellectual property. And the consequence of that is, of course, that transfer pricing is not merely about, ”I'm going to sell a widget from my American subsidiary to my Irish subsidiary.” That widget we can all roughly agree on the price of. There might be some disagreements, but they will be well bounded. But, if instead I transfer a patent or I have a royalty stream, it becomes much more complicated to apply standards like an arm’s length standard or some notion of what that true value is. And moreover, the firm has a high degree of asymmetric information about the value of those intangible assets relative to the value of a widget. So the growing reliance on intellectual property is the second major driver of profit shifting activities.
And then the third is the differences in statutory rates between the U.S. and the rest of the world. So clearly one big driver of the incentive to shift profits is tax rate differences. And so the fact that there’s a large tax rate difference, that has grown over time between the U.S. and much of the world, creates greater transfer pricing incentives. And on top of that, the unique aspects of deferral might accelerate that even more such that firms want to transfer price profits out of other countries and into low-tax jurisdictions that they keep offshore because of the worldwide incentives in the U.S. system.
So broadly speaking I think it's globalization of production, it’s growing levels of intangibles in the economy, and it’s the increasing distinctiveness of the U.S. tax system relative to what the rest of the world does.
How does profit shifting alter the behavior of firms?
In one kind of simple case, the only real changes might be the allocation of talent towards profit shifting activity.
In the simple story where we just take a dollar out of the U.S. and we put it into a low-tax jurisdiction, or a dollar out of Germany and put it into another jurisdiction, all that’s really involved is the reallocation of talent towards activities not entirely productive. So, that's unfortunate, but it isn't also terribly concerning in that real investments are not being distorted.
The more worrisome case is if I undertake some profit shifting and as a consequence of that, I will undertake real investment decisions. For example… I may reallocate a plant towards a jurisdiction where it’s sub-optimal simply because I'm trying to justify some profit shifting activity. I may change the structure of my internal contracts. I may change the structure of my organization in order to justify some tax savings. In the limit when we think about the distortions, clearly the recent inversions and the recent M&A activity that we see is a large magnification of potential real distortions.
By that I mean, if firms are willing to undertake very large mergers as we have seen in the life sciences industry in the last year, it’s worrying because a major motivation for some of those transactions is clearly tax savings. And by that I mean the ability to expatriate or invert via a merger.
So now it’s no longer just the reallocation of talent towards what’s otherwise unproductive activity. But it’s, furthermore, really significant distortions to organizations and real investment decisions that are basically being driven by the desire to game against tax rate differences.
So those are the range of activities that we might be worried about. In particular, if we think about intra-firm debt, if we think about licensing arrangements, those are clearly the bread and butter for what’s going to be influenced by transfer pricing activities.
We have talked about more philosophical and technical aspects of profit shifting. There might be an emotional component in this. Does profit shifting matter?
It matters for two to three reasons… the first, again, is the revenue. If there is tax revenue that’s being transferred from one jurisdiction to another jurisdiction, one might be worried about that. One worries about it because of the reallocation of talent in the economy toward activities that are fundamentally about transfer pricing. And then third, one worries about it because of the real activities…
I'm obviously, as you can tell from my comments, most interested in the real activities as being what we should be concerned about and the host of unintended consequences that come from our current international tax rules and the activities that they promote.
The preface to your question alluded to some of the more emotional reactions to profit shifting. And that's where things get a little more complicated. They get complicated because to be deeply, deeply worried about profit shifting one has to really feel great about the corporate tax as a tax. Many economists believe the corporate tax is not a great tax. And there are many other more efficient taxes. So while it attracts a great deal of political salience and attention because large corporations are viewed as actors who are somewhat evil by reallocating profits in this way… the reality is somewhat more fragile. Which is, it's hard to get terribly excited about corporate tax losses, in part because it's not a great tax.
The real loss of course is that, if the public views some taxpayers as being able to manipulate their positions, then we do suffer, because that undercuts the integrity of the tax system as a whole.
Has profit shifting increased over time?
That’s a hard question to answer. But most of the evidence I think is consistent with it increasing. It has not ballooned in the way that, I think, some reports would suggest. But measured elasticities over the last twenty to thirty years of how firms respond to tax rate differences with profits have gone up. And so I think that’s consistent with those three underlying drivers we talked about. Globalized production has increased, knowledge‐intensity of firms has increased, and the distinctiveness of the U.S. tax system has increased. So one would not be surprised if it had increased.
Moreover, in the last 10 to 15 years, the shift away from worldwide systems by many countries and the U.S. tax holiday in 2004 have also increased folks’ attention on these issues and their willingness to undertake activity in this way.
The responsiveness of firms to tax rate differentials and the absolute dollar value of profits shifted—have those two moved in the same direction or has one stayed relatively more constant compared to the other?
My instinct is that both have probably increased. If measured elasticities have increased, we would expect the dollar amounts to have increased, if for no other reason than that the base also has grown, meaning firms are more and more globalized so you are going to have more and more activity around the world.
I'm a little dubious of some of these dollar value estimates that are out there, because I don't know that they have that much foundation. They certainly are useful for people who want to write headlines. But I have never found them terribly substantive.
What’s the best estimate of profit shifting out of the U.S.? Or is there any range or even percentage of corporate tax revenues that you would want to highlight?
No, I’m not in that business. But I think that there are people who have put out numbers. My understanding of those numbers and the foundations for them is that they are not entirely informed by hard data. They are speculative. I don't fault the people who make them, but I don't really engage in that.
It seems there are still parts of this phenomenon that we don't fully understand. What’s missing for a better understanding of profit shifting?
I think the most important aspect of this that we don't fully understand is the real activities that are being distorted in order to facilitate the profit shifting. So in the limit you can imagine that firms, because they have a particular set of profit shifting goals or tax goals, are choosing to relocate production or outsource production in a variety of ways to enable that profit shifting. And that’s very worrisome. And that's the most important piece of the puzzle here, because we don't know enough about that and because that distortion is very, very relevant.
I think the second piece that we don't know as much about that we should know about… is: How do we as Americans think about profits shifted out of the U.S. and how do we think about profits shifted out of foreign countries to, for example, Ireland?
So then it becomes more interesting, which is: Do we care about profit shifting activities by our multinational firms when they perhaps shift profits out of a high-tax foreign jurisdiction to a low-tax foreign jurisdiction? I don't think we know very much about that. And that's very interesting.
I think the third thing that we know less about than we should know about and would be very interesting to know more about is the activities of foreign multinational firms in the U.S. And how it is and why it may be that just as American multinational firms may be transfer pricing profits out of foreign jurisdictions, why and how it is that foreign multinational firms may have a relative ability to transfer price profits out of the U.S. So, that I think is another set of investigations about CFC rules and how they work that would be very interesting to try to understand.
So roughly speaking I think those are the areas that are really, perhaps, underexplored and really of interest.
I actually will mention one last one, which is that I think there is a set of things about managers and managerial incentives that we know less about than we should. Up until now, we have been talking about profit shifting as an activity that benefits the firm privately. It’s conceivable… that it may benefit managers who have earnings targets in the short run. But it may not necessarily benefit shareholders because in effect you have given a device to managers who may want to just manufacture earnings without necessarily attributing them to tax savings. I think there is a set of agency issues around transfer pricing which is very interesting and perhaps underexplored.
What do we need to gain a better understanding of profit shifting? Is it data, better models, or something else?
We need more researchers who are interested in this. I think we need more data that gets us at a much more micro-level and maybe a tax return level. That would be helpful. I think we need more qualitative efforts to understand what firms are doing. I think we need to just fill out the picture about how and why firms are doing what they are doing.
I think that some combination of more brain power being applied to the problem, more and better data that combines, for example, IRS data with publicly available data and creates an ability to both map between, for example, what's known as the BEA data, the IRS data, and even Compustat data. I think that would be powerful.
And then third, I just think that we need to better understand from a qualitative perspective what practitioners are doing.
In the discourse, multinationals are often portrayed as a homogeneous group, at least with respect to profit shifting. Is that the case?
I think clearly not. I think one of the great paradoxes here is that there is just a great deal of heterogeneity across firms in what they do and in terms of what they want to have happen. And that, of course, is one of the reasons why reform is so complicated. So briefly, I think that heterogeneity is a function of three things.
The first is scale and talent. Some firms are big and really smart about these things. And they are very, potentially, aggressive. And so, there is heterogeneity in the amount of people who are being applied to this problem inside multinational firms and the quality of those people. And that’s going to matter a whole bunch.
The second type of heterogeneity is associated with their industry and their ability to do profit shifting. A paradigmatic example of this might be a retailer where profit shifting is just not that interesting. Versus the pharma and tech sectors, where you potentially have much greater potential to do profit shifting because of the IP.
The final dimension of heterogeneity that I think is underappreciated is young versus old firms. So even in the tech sector, or even in the pharma sector, or life-sciences industry, young firms may have very different incentives than older firms. For example, older firms may have large stocks of foreign earnings that were taxed at very high rates; they may have global footprints that are very different than the younger firms. So when we talk about tech companies or we talk about life-sciences companies, it's quite different if one thinks about Facebook versus Microsoft or IBM. Similarly, it's very different if one thinks about Valiant versus Pfizer. So that dimension, I think, is very underappreciated.
What solutions are there to address profit shifting?
Well, let's begin from a policy perspective… I think the first order of things that one could think about doing is trying to bring the U.S. rate more in line with where the rest of the world is on a statutory basis. Of course, people like to characterize U.S. firms as bearing very high taxes or very low taxes. The truth is we have the worst of all worlds, which is we have high statutory rates which dictate profit shifting incentives and medium average rates, which means we are not even raising that much revenue from it. So we should really be working towards a corporate tax reform that brings the statutory rate significantly down. And that’s the surest way to think about curbing profit shifting.
And my own ideas about that I have tried to outline in an article, which suggests that some combination of a reduction, switch to territoriality, thinking about pass-through entities as a revenue source, and aligning book and tax income can lead to a revenue neutral tax reform that might be useful. That's the first piece, which is getting that part of the puzzle fixed.
The second part is really thinking about the worldwide system and the deferral incentives that are currently in place, which can give firms a reason to keep profit overseas and potentially accelerate the way they keep profits overseas. I think that would be the second largest policy lever that one could think about doing.
The third most interesting policy lever is to really explore alternatives to the standard arm’s length method. And if you are in enforcement and you try to think about this problem, then I think the arm’s length method is complicated and problematic. And it’s problematic perhaps because it's hard to imagine an arm’s length transaction between two subsidiaries of a multinational firm for a patent. So re-investigating that would be useful.
One possibility that I have raised in a paper with Dhammika [Dharmapala] is to really think more closely about using the firm’s characterization for managerial purposes of where profits are when examining transfer pricing activities generally. And to try and build on the information set that the firms have on where value is created I think would be useful.
And so those would be three things to do from a policy perspective.
And then I would say that the other place which we should be looking at is thinking a little bit more about corporate tax responsibility generally. We talk very liberally about corporate social responsibility and everyone trumpets their corporate social responsibility activities. Yet we don't really have a well-defined notion of what kind of tax practices are responsible for a multinational firm. So some kind of a private effort where private actors come together and try to come to some understanding of what kind of activities are pushing the envelope too hard and what kind of activities are legitimate. I think that’s a hard effort, but I think it’s valuable.
Obviously, governments need to do things. The U.S. government needs to do things like cut its rate and bring down incentives for these transfer pricing activities. But I also think there is significant work to be done by managers to really understand when they are pushing the envelope too hard and when they are actually doing things that are completely legitimate.
We have some large leading firms which are known to be quite active on the tax front, but who also simultaneously trumpet their contributions to the world.
I don't necessarily think it’s wrong, but it’s something that we should at least be talking about. Which is, why don't we think about one's obligations to governments the same way? And maybe there are good reasons, but we should at least talk about it more than we talk about it now. And then try to figure out what the right way to think about it is.
Is convergence with the OECD in terms of moving towards a territorial system and a corporate tax rate reduction a desirable path for the U.S.?
I might not use the word convergence… because convergence with the OECD can mean many things these days, but I think we should be significantly reducing the rate and moving to a territorial system. I testified in 2014 on international tax reform and the current territorial proposals in the U.S., and one of the unique things about them is that they are very different than territorial proposals around the world, because they often feature a minimum tax. And so I would hope for something that’s more like a significantly lower rate and what one might articulate is a simple territorial system. In part because once one layers on complexity in the international tax regime, as we have been doing for the last 20-30 years, it really just opens up planning opportunities. So the notion that we are going to have a minimum tax with allowance for corporate equity on a per-country basis, which is in part what some of the territorial proposals are today, I think, is a real recipe for a lot of complexity and, as a consequence, a lot of planning…
When I recently testified on tax complexity and the importance of simplification, I tried to make the case that minimum taxes lead to a variety of complications that I think are also going to lead to more planning, more than anything else.
Can multilateral cooperation be a cure to profit shifting on a global basis?
I don't know the answer to that question. And clearly we have had two kind of examples of those efforts in the last fifteen years. The first was the OECD effort on harmful tax practices. And I think the lesson from that was that it turned out to be a fairly modest effort and goals were sufficiently incongruent that it prevented any real meaningful effort.
Right now, we're underway with a very significant effort by the OECD on base erosion and profit shifting. That came from a very significant mandate by the G20 countries. And we are seeing what’s going to come of that.
I certainly think they're being very active. And they have generated a lot of activity and spilled a lot of ink. But I don't yet know fully what it means. I guess, in my gut, I'm somewhat skeptical about what multilateral coordination can do and how jurisdictions can come together. But I certainly could be proven wrong.
Moreover, stepping back, I think one would want to ask whether global coordination is a good thing. And I think it's not clear, in part because one of the debates in the literature in this area has always been the degree to which we should be worried about American welfare and foreign welfare. And it's not at all clear that American citizens care if Starbucks is paying taxes in the UK or if Amazon has stripped profits out of Germany and put them in Ireland. It's not clear how Americans should think about that problem. And as a consequence, the whole notion of global coordination is still something we need to explore much more fully.
From a researchers perspective, what do you expect in terms of new findings in the next 1-2 years?
I think we are going to understand a lot more about recent inversions and how they work and why they happen, and I think that’s exciting. I think we are going to learn more about the corporate control market and how mergers are being influenced by taxes. I think that we are going to learn more about the links between real activity and transfer pricing and I think that's exciting. I think we will learn more about the corporate tax and its incidence, which I think is really important. So I think we could learn a lot on a lot of these dimensions, and I think that’s something to look forward to.
From a U.S. perspective, what are the chances of a change to corporate taxation?
I think from a U.S. perspective, I’m actually moderately optimistic. I continue to believe that if anything happens in Washington in the next one to two years it will be corporate tax reform, and I think that's feasible. Now, of course, many things are not happening in Washington. So nothing may happen. But if something does happen, I think it’s likely to be corporate tax reform.
I think we will see something that’s in the direction that we would hope for, along the lines I suggested—hopefully without a minimum tax. And I think that could be possible. I think there has been a lot of good work laid down by people like Dave Camp and others who have really tried to put out proposals and get the ground fermenting on these issues. So I think that's feasible…
If we talk again in ten years, will we have a worldwide system as we do now? I think the answer to that is no. I'm pretty confident of that. Whether it happens in the next year or two, or in the next four years, I just don't know. But I'm quite confident that in ten years we wouldn't. Just because I think we are swimming against the tide in such a significant way and the distortions to our corporations are so large that people will recognize that.
What is the future of the corporate tax base?
It’s being impacted by two large trends. It's being impacted by international tax rules, which are making investment in the U.S. and subsequent transfer pricing of profits out of the U.S. more and more attractive. And it's being impacted by the remarkable proliferation of pass-through entities. And those two trends are massive trends and as a consequence of them I think the corporate tax base, unless we do some kind of reform, is in question.
What are some of your own favorite papers or resources you would point to for someone who would like to better understand profit shifting?
My co-author Dhammika has an excellent review paper on profit shifting. I think that's the best, most recent source, and it has a lot of references in it. I think it takes a really interesting point of view.
The testimony I gave and that has been given on international tax rules by myself and by others is the most accessible way to understand some of these issues. And then finally I will just point out that at Oxford there is a wonderful center for business taxation that has generated a lot of really great research on these issues that’s being run by Mike Devereux.