Over the last decade there have been serious efforts by many countries to change 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. rules to address profit shifting by multinational businesses. Research on the size and the scope of these behaviors has continued to drive policymakers to explore policies to address these issues. If businesses in high-tax countries are structuring so their profits arise in countries with very low corporate tax rates, then the high-tax countries are potentially missing out on tax revenues.
However, measuring the level of 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. and the potential for reclaiming lost revenues has been a subject of serious debate. In 2014, economist James Hines highlighted that surveys of the evidence at the time should lead to the conclusion that relatively small amounts of corporate tax revenue could be raised from eliminating profit shifting.
In the years since Hines’ 2014 paper, the challenge of measuring profit shifting and the effects of eliminating those opportunities has been consistent. Researchers have used a variety of approaches that look at different outcomes, so findings are not always directly comparable.
The Evidence on Profit Shifting
A 2018 review by economist Nadine Riedel found a wide range of estimates for profit shifting.
Riedel notes that studies of profit shifting levels consistently show an inverse correlation between statutory tax rates and reported profits. Riedel notes that could be intuitive for a few reasons. First, high statutory rates unambiguously reduce after-tax profits, so businesses will likely sort highly profitable projects to lower-tax jurisdictions even without separating economic activity and income. Second, a contrary force could apply if investor requirements for higher pretax returns in high-tax countries means that some businesses sort their more profitable projects to higher-tax jurisdictions. Third, high corporate taxes may lead to lower efforts in higher-tax jurisdictions.
Taken together, real decisions by firms (not just paper profit shifting) can lead to results where more profits are generated in lower-tax jurisdictions.
In evaluating studies that measure profits shifted from high-tax business entities to lower-tax entities, Riedel finds estimates range from less than 5 percent of income being shifted to more than 30 percent being shifted. Riedel points out that studies on specific channels of profit shifting are scarce, and concludes, “It is thus too early to draw final conclusions on the quantitative importance of international tax avoidance activities.”
Reliance on BEA Data and Double-Counting
In addition to the need for more evidence, methods for measuring profit shifting have also been a subject of debate.
One approach that has been used to measure profit shifting relies on data from the Bureau of Economic Analysis (BEA). Economist Kimberly Clausing has used BEA data to estimate the level of profit shifting by U.S. multinationals from 1982-2012. Clausing’s 2016 study shows a loss of between $77 billion and $111 billion in U.S. corporate tax revenues in 2012.[1] Total U.S. corporate tax receipts in 2012 were $242 billion.
However, academic accountants Jennifer Blouin and Leslie Robinson have questioned the approach that Clausing takes. Arguing that Clausing failed to account for errors due to double-counting, Blouin and Robinson suggest that the 2012 levels of revenue lost due to profit shifting were between $10 billion and $32 billion.
In a response to Blouin and Robinson, Clausing reestimated lost revenue due to profit shifting relying on new 2017 data and found that (using 2017 tax rates) lost revenues were over $100 billion. Clausing also contends that the Blouin and Robinson method has issues as well and may exclude some channels for profit shifting.
Debates over methods are important to move closer to the evidence, but the speed at which policy is changing has led to much research on this topic consistently being out-of-date.
A Revolution in Policy
As economist James Hines pointed out in 2014, the level of political effort to address profit shifting seemed inconsistent with the evidence. Unfortunately, as countries have implemented reforms, the evidence on the impact of reforms has lagged. This is mostly due to data constraints and the length of time it takes to complete research projects.
The OECD/G20 Base Erosion and Profit Shifting (BEPS) project has led many countries to address profit shifting opportunities with tighter transfer pricing regulations, controlled foreign corporation rules, country-by-country reporting of tax data, and limits on interest deductibility. Cumulatively, these policies have increased government revenues from corporate taxes while changing the incentives for profit shifting and real investment.
Significantly, the United States enacted a major reform to its international tax rules in 2017. However, the final rule implementing those changes has yet to be adopted. At the time, the Joint Committee on Taxation estimated that the two new major anti-avoidance mechanisms would bring in $261.6 billion over the 2018-2027 period.[2] However, the most recent CBO outlook has included revisions to the expected revenues from taxes on international business activities, specifically citing regulatory implementation.
Recent data on a UK anti-profit shifting mechanism, the Diverted Profits Tax (DPT), show the policy raised ₤2.4 billion (U.S. $3.2 billion) during the 2018-2019 fiscal period.
The elimination of tax arrangements like so-called double-Irish (which expired at the end of 2019) and new anti-avoidance legislation (like the ATAD) are likely to also change where and how much companies pay in taxes. There will likely also be real impacts on business decisions on where to place physical investments.
The Impact of anti-BEPS Policies
Unfortunately, data follows policy implementations with a lag, and even the most recent studies mentioned earlier do not take the new U.S. tax rules into account. Several studies have pointed to the impact of specific policies from the BEPS project.[3]
A 2015 study by economists Peter Egger and Georg Wamser found the design of Germany’s controlled foreign corporation legislation led German multinationals to reduce investment in fixed foreign assets by an average estimated €7 million ($7.8 million). Thin capitalization rules studied by economist Thiess Buettner and his coauthors in 2014 increase the cost of capital and have negative effects on employment and investment, particularly foreign direct investment. IMF economists Ruud de Mooij and Li Liu found in a 2018 study that the impact of tighter transfer pricing regulations is similar to the effect of increasing the corporate tax rate by one quarter. A study (most recently revised in 2019) by economists Michael Overesch and Hubertus Wolff found that transparency measures like country-by-country reporting increase compliance costs and effective tax rates.
Even more recently, a study by IMF economists Alexander Klemm and Liu points out that limiting profit shifting increases the costs of capital and can thus have direct effects on investment decisions and tax competition. Theoretically, if governments compete for real investment from businesses partially through lower rates and perhaps lax attitudes toward profit shifting, eliminating the benefits of profit shifting will change the incentives for businesses as they decide where to invest and governments as they set their tax policies. Klemm and Liu back up their argument by pointing to research (including some studies cited earlier) showing the connection between profit shifting costs and investment effects.
There is a clear theme, and many other legislative changes have come more recently, and studies of their impact have not yet been added in evidence. To the extent that profit shifting is a problem, surely these policies are making an impact.
Looking Ahead
This brings us to the current challenge where countries around the world are exploring potentially dramatic changes that will further impact where and how much multinational businesses pay in taxes. Despite inconsistent evidence and evidentiary constraints that do not yet allow studies of policy changes since 2017, policymakers are moving forward.
The OECD has been working to assess the impact of their program of work, and it will be critical for this assessment to take into account impacts not only on revenues, but also on growth and investment.
The latest data is always out of date, so it will be important to infer from the available evidence how taxpayers (and governments) might react in a new system. Higher tax costs impact real investment decisions and the compliance costs associated with the proposed policies could change incentives for businesses when entering new markets.
Implementing a design that minimizes these impacts will be a challenge, to say the least.
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Subscribe[1] The range represents estimates from two different approaches, both using BEA data. The lower number is derived using direct investment data while the higher number relies on gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” in foreign affiliates.
[2] Revenue estimates for the current tax on Global Intangible Low-taxed Income (GILTI) and the Base Erosion and Anti-abuse Tax (BEAT).
[3] For reviews of studies of economic effects of anti-BEPS measures see Daniel Bunn, “Ripple Effects from Controlled Foreign Corporation Rules,” Tax Foundation, June 13, 2019, https://taxfoundation.org/controlled-foreign-corporation-rules-effects/; Elke Asen, “The Economics Behind Thin-Cap Rules,” Tax Foundation, June 27, 2019, https://taxfoundation.org/thin-cap-rules-economics/; Daniel Bunn, “The Impacts of Tightening up on Transfer Pricing,” July 11, 2019, https://taxfoundation.org/impacts-of-tightening-up-on-transfer-pricing/; and Daniel Bunn, “The Trade-offs of Tax Transparency Measures,” Tax Foundation, July 25, 2019, https://taxfoundation.org/trade-offs-tax-transparency-measures/.
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