Making Sense of Profit Shifting: Nadine Riedel
June 15, 2015
Nadine Riedel is Professor of Public Finance and Economic Policy at Ruhr University Bochum in Germany.
Professor Riedel is a leading researcher and rising star in the field of international taxation and tax competition. A prolific author of peer-reviewed publications, Professor Riedel has published studies across a broad spectrum of areas related to the taxation of multinational firms and profit shifting.
Professor Riedel is a Research Professor at the German Institute for Economic Research (DIW Berlin), an International Research Associate at the Oxford University Centre for Business Taxation, and a Research Affiliate at CESifo in Munich, Germany.
Professor Riedel recieved her Ph.D. in Economics from the Ludwig Maximilian University of Munich.
In this interview with the Tax Foundation, Professor Riedel provides her latest insights into profit shifting, examing the nature, drivers, and economic effects of the phenomenon. Specifically, Professor Riedel highlights current estimates of the magnitude of profit shifting and emphasizes the importance of understanding the scale of profit shifting in prescribing policy responses. 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?
Nadine Riedel: What we know from media reports and parliamentary inquiries is that some multinationals do engage in profit shifting. And we know that there are several channels through which multinationals manage to reduce their tax bill. This occurs via mispricing of intra-firm trade, debt-shifting activities, the strategic location of intellectual property (IP) in low-tax countries, or by exploiting mismatch arrangements [in countries’ tax law].
And then there's the academic literature, where I have been involved, where we look at large firm-level data sets and see whether there are behavioral responses of multinational firms to tax reforms, for example. The observed behavioral responses from multinational firms strongly suggest that they transfer profits to low-tax countries. What many researchers in the literature have, for example, shown is that if countries reduce their corporate tax rate, then the pretax profitability of multinational firms’ subsidiaries in those countries increases, which points to shifting activities.
TF: Which are the most important areas of profit shifting that researchers currently know the least about? What is still in the realm of the unknown with respect to profit shifting?
Riedel: I think what we know—or at least there's a lot of evidence in a qualitative sense—is that multinationals do engage in profit shifting. So, for example, we see that if corporate tax rates change, pricing of intra-firm trade changes in a way that is consistent with profit shifting to low-tax countries. We see that debt-equity structures change in a way consistent with debt shifting. We see that multinationals respond to tax changes by relocating the IP within the multinational firm. So in a qualitative sense, we see many bits of evidence which point to the fact that multinationals somehow relocate income to low-tax countries.
I think what is much, much more difficult is to put a number on this. Recently, people have approached academics and requested, "Put a number on profit shifting and tell me how much is shifted out of country X." This is much more difficult to determine. The range of existing academic estimates is pretty large. It’s in general important to keep in mind that firms try to hide profit shifting activities from the public. And so it’s difficult to measure it for researchers and all existing approaches rely on non-trivial underlying assumptions.
While much of the focus in the literature and in the public discourse has been on how much tax revenue is lost in high-tax countries due to profit shifting, another important question is how profit shifting distorts other areas, for example, product market competition. Large multinationals can reduce their tax costs. They obviously get some type of cost advantage, and does that harm national firms? We don’t know much about that.
Another area of interest that is underexplored is equity concerns related to multinational tax avoidance. If governments lose revenue, in terms of corporate taxes, as a result of profit shifting, they have to raise taxes from other areas or taxpayers. And how the burden of taxation shifts within a country as a consequence is of high interest but not extensively explored.
What are the unique factors or drivers underlying the profit shifting phenomenon?
I think IP intensity and R&D intensity are important drivers. IP is a great way to transfer a lot of income to low-tax countries—for example, by setting up patent holding affiliates in tax haven economies. And in many modern multinationals, IP earns a major fraction of company income, and you can disentangle it from the rest of the production process at very low cost. Transfer pricing with respect to IP is moreover really difficult to prevent, because it’s firm-specific. There are no arm’s-length prices.
And that’s also what we observe in the data. Profit shifting tends to be larger for firms that have a lot of IP and are very R&D intensive. And I think that has also been one major issue highlighted by the OECD’s current BEPS process. So there's some awareness that IP is a major area. In general, empirical evidence suggests that debt shifting is less relevant than transfer pricing or IP relocation, in terms of the size of profit shifting.
Fifteen years ago, retrospectively, IP intensity was substantially lower, but profit shifting still occurred at that time. What else is driving profit shifting besides IP? And what role do differences in countries’ tax law play?
Of course, the incentive to shift income is related to tax differentials across countries. And those have existed for a long time and were actually larger in the 1990s. So if you look at tax differences across countries today, they tend to be smaller than in the 1990s. In Germany, for example, we had about a 60 percent corporate tax rate in the 1990s, and nowadays it’s around 30 percent. So the incentive to shift out income from Germany, based on tax rate differentials, has declined over time.
I have also conducted a study that suggests that profit shifting declined over time in Europe, partly because of the anti-profit shifting programs which were introduced in the past fifteen years in many countries. But from my perspecitve, it is still a rather open question how profit shifting volumes have developed over time, and I guess we will see more contributions on that in the academic literature in the years to come.
So, given the firm’s desire to minimize its tax burden, the underlying reason for profit shifting occuring is because there are tax law and tax rate differences across countries and the primary driver of the phenomenon is IP?
I would say so. But that doesn't mean that other companies, for example non-IP intensive companies, do not shift profits at all. It just means that there are less opportunities to do so for non-IP intensive companies.
If you trade crude oil, it's really difficult to distort your pricing from the arm’s-length price because everybody knows the price of crude oil. But if you trade your firm-specific IP and charge a royalty on that, nobody knows the real price for that, which in turns means that the tax authority has a hard time to determine the true underlying price. This offers firms a great opportunity to shift profit to low-tax entities by distorting royalty prices. So if you're an IP intensive firm, your shifting opportunities are just much greater.
How does profit shifting alter the behavior of firms?
Firms alter their behavior in two different areas. One area is the behavioral response directly related to profit shifting. Firms misprice, they relocate their IP, and change their debt-equity structures to transfer income to low-tax countries.
Another area that is important, which is not discussed so much in the public discourse at the moment, is that firms may change their real investments. There are some academic papers which suggest that because multinationals have the option to shift profit out of high-tax countries, they may not actually alter their real investment decisions.
Firms may keep the factory in the high-tax country because they know that they can reduce their effective tax burden by shifting profit. If you cut that opportunity, multinationals may then take the whole factory to Ireland or Switzerland.
So from the perspective of high-tax countries, it's ambiguous. It's not clear-cut whether they want to restrict income shifting. High-tax countries could lose on the real investment side, in terms of, for example, jobs.
I would like to focus for a moment on the role of parent firm headquarters and the dynamics between the parent firm and its subsidiaries, by discussing your paper, "The Role of Headquarters in Multinational Profit Shifting Strategies,” which you have co-authored with Matthias Dischinger and Bodo Knoll. What is the role of the headquarter or the parent firm in the context of profit shifting?
What we found in that paper is that profit shifting is somewhat smaller out of headquarter countries. And we explained that finding as multinationals, to some extent, being reluctant to shift high-value assets and profits in general out of the headquarter countries due to, for example, agency reasons. We also spoke with companies, and they confirmed our presumptions and findings.
See Professor Riedel’s paper, ”There's No Place like Home: The Profitability Gap between Headquarters and their Foreign Subsidiaries” for a related discussion concerning the differences in profitability that can be observed between headquarters and foreign subsidiaries.
So for the location of valuable intangible assets, companies are biased towards the country where their headquarter is located?
Exactly. So this is, by the way, something that we see in patent data sets in general. Even if the R&D was conducted abroad, we see that patents are often filed from and held at the parent location. This may help to explain lower income transfers out of the parent country.
For a related discussion of the role of intangible assets and intellectual property in profit shifting, see Professor Riedel’s following two papers, ”Corporate Taxation and the Choice of Patent Location within Multinational Firms,” and, ”Corporate Taxes and the Location of Intangible Assets within Multinational Firms.”
In the public discourse, multinationals are commonly portrayed as an essentially homogenous group. Are they?
For sure not. This is actually something that I think many people in academia have recently become aware of.
A recent paper by Ronald Davies and co-authors, for example, using a French data set and looking at transfer pricing, suggests that it's mainly large firms that engage in profit shifting to low-tax countries.
So firms are heterogeneous on multiple dimensions. For example, my paper that you highlighted suggests that profit shifting from headquarters is different from profit shifting from subsidiaries. And we have already talked about that IP intensive companies have more options to shift profits than non-IP intensive companies. This already suggests that heterogeneity is really important. And as researchers, we probably haven't yet portrayed every important dimension of firm heterogeniety.
Does profit shifting matter?
I think this comes back to the question of: How big is it? So, how much profit do multinationals shift? Is this phenomeon tiny or is the magnitude large? The estimates in the academic literature are much smaller than the numbers that are sometimes published in the media by some NGOs, like the Tax Justice Network.
Academics would say that the difference is related to researchers having more reliable empirical strategies to assess profit shifting and that therefore other estimates are biased. But we still have to admit that our range of estimates, in the literature, is also really large.
I have written a small survey paper, where I looked at quantitative estimates in the literature. And what I found, as a broad range, was that 2-30 percent of corporate income could be shifted out of high-tax countries, according to academic estimates.
But there's a large degree of uncertainty surrounding these estimates. Your question is a very fair and important one, but it’s difficult to answer. What we can say with some confidence is that the problem is most likely not as huge as sometimes discussed in the public and as suggested by numbers published by non-academics.
In general I agree that we need more work on this as it is of core interest to determine the size of profit shifting, of course. If governments decide to put effort into restricting profit shifting, this legislative and aministrative effort may distort company behavior and often implies non-negligible compliance and administration costs. If you want to engage in restricting profit shifting, then you have to be sure what you get back from it. From that perspective, it’s the core question: How large is the magnitude of profit shifting?
Has profit shifting increased over time?
I have a paper where we use European data that suggests that profit shifting declined over the recent decade. And our data points to the fact that this is related to anti profit-shifting legislation enacted in Europe in the last 10-15 years. There are also other papers that suggest that anti-shifting legislation is effective in restricting profit shifting behavior.
What we can also observe is a general decline in corporate tax rates, which means a decline in tax differentials and shifting incentive. So this also points to less shifting.
As you rightly mentioned previously, IP is, in turn, a potentially bigger issue today than 15 years ago. So I think the decline in tax differentials, tighter anti-shifting legislations and the increase in IP intensity are potentially countervailing factors.
There are not many papers out there looking at this question. And I would say my paper is not necessarily the last paper on the topic. There are some papers from the U.S., suggesting that profit shifting has increased over time. I would be a bit cautious in giving a straight answer on the directional trend of profit shifting. That’s, to some extent, unresolved.
What is the difference between the European data and the U.S. data that is used in some of these studies measuring profit shifting? It seems that studies using U.S. data tend to suggest that profit shifting has increased over time, while studies using European data suggest that profit shifting has decreased over time. Can you reconcile those two opposing indicators?
You always have to look at which data sets are used and which companies are included in each study. But I think it's a difficult question to answer. There's an underlying notion that profit shifting is a bigger issue for U.S. companies, that they are more aggressive in shifting profits, but I have not seen a clear-cut study really trying to make that comparison.
What is the magnitude of profit shifting within or out of Europe; can you give a broad estimate?
We usually never really look at profit shifting within Europe or out of Europe. But we can use certain assumptions to derive such estimates.
In general, we measure profit shifting by checking if countries have changed their corporate tax rates and how that change affected pretax profits reported by multinational firms. Then, assuming that the change in reported pretax profits is due to profit shifting, you can come up with some kind of estimate. This is mostly related to a corporate tax reform in a specific country. And then you can potentially extrapolate profit shifitng out of Europe as a whole or for other countries. But this is relying on assumptions, and that’s important to understand.
As I noted earlier, academic estimates range between 2-30 percent of multinationals’ income being shifted out of high-tax countries to low-tax countries. But this is a broad range, and I would always add that there's uncertainty related to these estimates. All approaches rely on assumptions and if the empirical assumptions don't hold, then the estimates end up being biased.
See, ”Earnings Shocks and Tax-Motivated Income-Shifting: Evidence from European Multinationals” for Professor Riedel’s (together with Dhammika Dharmapala) novel approach to estimating the magnitude of profit shifting.
What is missing for a better understanding of profit shifting? Is it data, better models, or something else?
I think it's data. So if you look at how academics, for example, try to identify and quantify profit shifting, they usually rely on accounting data. But accounting data and tax return data may not coincide, and the profit shifting may only show up in the tax return data.
In the U.S., researchers have, subject to strict confidentiality requirements, had some access to tax return data. In Europe, access to tax return data is still rather difficult to come by, although things are improving. What would be great to have is some kind of access to tax return data and the ability to link that to the accounting information and especially the ownership information of the multinational group.
In general, it would be useful to see how much income multinational groups report in their tax returns in different countries. And how much activity they have in these countries. This is related to the country-by-country reporting mechanism that the OECD is pushing in their action plan. The question is whether this is really coming because businesses are, of course, really cautious of this type of measure. There could be a lot of issues related to country-by-country reporting. But from a purely academic point of view, if this data was made available, researchers could probably come up with better profit shifting estimates.
Let's talk about possible solutions to address profit shifting. Is multilateral cooperation and coordination a solution?
I think that’s a difficult question to answer. To some extent, countries can also address profit shifting on a unilateral basis. If anti-profit shifting legislation—like transfer pricing laws, thin capitalization laws, and CFC laws—are effective, then you can also address profit shifting on a unilateral basis.
The OECD argues that if one country closes down profit shifting, profit shifting may move to other countries. Multinationals may start shifting more income out of France if Germany is tougher on profit shifting. I don't know whether this is happening. If it’s happening, then it's definitely an argument for multilateral coordination. But I don't know the importance of that mechanism.
One area that I potentially see could call for multilateral coordination is when countries may be cautious to implement anti-profit shifting legislations because they may feel that multinationals could relocate real investments to other countries less tough on profit shifting. If coordination on a multilateral basis is achieved, this problem could vanish. So this is perhaps the single most important area I see for mulitlateral coordination.
But, nevertheless, countries can close off profit shifting channels on a unilateral basis.
For an individual country, what are some solutions to address profit shifting? And how does a territorial versus a worldwide system compare in this context?
From a theoretical point of view, worldwide systems should reduce the incentive to shift profits. But what we have seen, at least in the U.S., is that companies apparently have shifted out a lot of income over the last decade or decades. So with the deferral of repatriation, apparently shifting opportunities still exist.
I can't point to a study which says, ”If you abolish worldwide taxation then you're more prone to outward shifting.” But from a theoretical perspective, worldwide taxation should, to a larger extent, hinder shifting of income. But apparently it doesn't abolish shifting incentives. We’ve seen that in the U.S.
In terms of solutions to address profit shifting, reducing the corporate tax rate would directly limit or eliminate the incentive for multinationals to shift profits. A cut in the corporate tax rate, however, constrains your ability to tax corporate income.
Other possible measures to address profit shifting are thin capitalization rules, CFC rules, and transfer pricing regulations. There are studies suggesting that these rules ”bite.” So if you implement these rules, there's less shifting out of high-tax countries. This is a fairly young literature. But there's a growing number of papers all pointing in the direction that these rules are effective and affect multinational companies.
Again, the question is to what extent—in relation to the overall magnitude—these regulations impact and reduce outward shifting.
What is the future of the corporate tax base in a world where capital is becoming increasingly mobile, the economies of the world are becoming more tightly integrated, and we see the use of intellectual property skyrocketing? Against that backdrop, is there a future for the corporate tax base?
The key question is whether the OECD’s BEPS process and the anti-profit shifting legislation, like CFC, thin capitalization, and transfer pricing rules, can really keep profit shifting at bay—and help the corporate income tax to survive—or whether we have to move towards a totally different system. In academia, there is still a debate on this. But that’s not very much the case in the public discourse.
The corporate tax system that we have is not well-suited for the modern economy, especially given the mobilty of IP and all the profit shifting options that exist. There's a debate about moving to a different international tax system, for example, a system based on tax base consolidation and formula apportionment.
With this type of system, profit shifting incentives are essentially abolished because you consolidate tax bases around the world, and then you apportion it based on some activity measure. Of course, then we would have to think about an appropriate activity measure for allocating the tax base, one that companies can't game.
In Europe, the European Commission had proposed a formula apportionment regime a couple of years back. But that process is dead at the moment.
Currently, the G20 is committed to the OECD BEPS process and to tie in anti-shifting legislation within the current system, to try and keep profit shifting at bay.
But it's to be seen how effective these anti-shifting legislations are going to be in the next couple of years. If the evidence shows that they are not as effective as hoped, that multinationals may find new ways around them, then perhaps this debate may be placed even higher up on policy makers’ agendas.
What developments do you expect in the next 1-2 years with respect to research?
There are still many unresolved questions. For instance, regarding the magnitude, which companies do engage in profit shifting, and the real economic distortions that may occur, such as implications for market competition. To the extent that better data become available, we might see progress in these areas. If country-by-country reporting, for example, is implemented and that data is made available to researchers, then I imagine that we will see new developments and better estimates in the future.
What are some of your own favorite papers or resources related to profit shifting?
I would always point non-academics to survey papers. Dhammika Dharmapala has a great and very well-known survey paper from 2014. And I have also recently authored a survey paper. For non-academics, this is probably the best introduction. It’s non-technical and just surveying the academic literature.
I also like some of the recent empirical papers, mostly those that look at specific profit shifting channels as they test the profit shifting hypothesis in a very direct way, and it is unlikely that the estimates pick up mechanisms unrelated to income shifting. I already mentioned the paper by Ron Davies and co-authors studying France. They use firm-level data matched with trade statistics to identify mispricing of intra-firm trade, and there's also a similar recent paper for Denmark. These data sets are really nice and really rich. They are based on official statistics, so the data quality is high. There are also a number of similar papers on multinational debt shifting behavior, using German official statistics data from the MiDi database of the German Bundesbank, which I would recommend.
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