New Evidence on Territorial Taxation

In the current globalized economy businesses have supply chains that can cross borders multiple times. Multinational businesses also make choices in how they want to reach their customers. A country headquartered in the United States that wants to sell products in Germany needs to answer several questions:

• Do we produce everything in the U.S. and then ship our products to Germany?
• Do we invest in a subsidiary in Germany to build a factory to produce our goods for German customers?
• Do we invest in a different country that is geographically close to Germany, but is a better location for production?

Each of these questions has both broad economic and 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. implications. The first question relies not only on how easy it is to ship goods to Germany or whether the goods you would be shipping might get damaged in transit, but also on tariffTariffs are taxes imposed by one country on goods or services imported from another country. Tariffs are trade barriers that raise prices and reduce available quantities of goods and services for U.S. businesses and consumers. rates that might apply when shipping to Germany.

The second question has tax consequences because the tax implications of producing in the U.S. are different from those of producing in Germany as the countries have different tax systems.

The third question could also have tax consequences because not only might there be different tax implications for producing in that third country, but there could also be tariff implications depending on where that third country is.

For policymakers who are interested in domestic production, there is yet another question to consider. How will my country be impacted if a domestic business is investing abroad instead of at home?

It is often assumed that if a business chooses to locate its production abroad, the home country faces negative economic consequences. However, economic evidence shows that outbound investment can be complementary to domestic investment.

This means that even if a U.S. business builds a factory in Germany, the U.S. is not necessarily a net loser. The choice to locate production in Germany could mean lower costs of production relative to producing in the U.S. Those cost savings could be reinvested in U.S. production or create value for U.S. shareholders.

Tax policy can create frictions that increase the costs of foreign investment, though. One way that countries around the world have been reducing these frictions is by changing their 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 from “worldwide” taxation to “territorial” taxation.

A worldwide approach to international taxation means that a country will apply tax to the profits of its domestic businesses regardless of where those businesses earn their income around the world. A territorial approach generally only taxes profits that are generated in the home country.

For example, if a business generates $1 million in profits from foreign earnings that are taxed at 15 percent in a foreign country, a worldwide system in a country with a 25 percent tax rate would apply an additional 10 percent tax to those profits when they are brought back to the home country (repatriationTax repatriation is the process by which multinational companies bring overseas earnings back to the home country. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the U.S. tax code created major disincentives for U.S. companies to repatriate their earnings. Changes from the TCJA eliminate these disincentives. ).

A territorial system would not apply any additional tax on those foreign earnings.

New research by Li Liu, an economist at the International Monetary Fund, explores the impact of such a shift from worldwide to territorial taxation in the UK. The UK moved away from worldwide taxation and adopted a territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. in 2009.

The main reform was to eliminate UK taxation of foreign-earned dividends. Prior to the reform, repatriated earnings would face an extra layer of tax if those earnings came from countries with lower taxes than in the UK. At the time in 2009, the UK corporate tax rate was 28 percent, meaning that the tax differential between the UK and for example Ireland (corporate tax rate of 12.5 percent) was significant.

Liu’s analysis focuses on the ways that business investment responded to the reform and identifies where those investment responses were most pronounced. Using data that allows for analyzing business investment patterns in 27 European Union countries, Liu finds that UK multinationals increased their investment rate in low-tax countries by 16.7 percentage points. The investment rate is the amount of gross investment spending in a year relative to a company’s existing capital stock.

In total, the predicted investment increase is €5.5 billion (US $6.9 billion). Specifically, Liu estimates that the countries that were the largest beneficiaries of the new UK investment included Ireland, Sweden, the Czech Republic, and Poland.

Since the prior system had a relatively larger burden for repatriating foreign earnings from lower-tax jurisdictions, it is not surprising that the shift to a territorial system led businesses to invest more in those lower-tax jurisdictions.

Liu also compares the amount of new foreign investment to the expected revenue loss to the UK based on analysis prior to the reform. Using this approach, Liu shows that investment increased nine times more than the expected revenue loss. Liu caveats that this is likely an upper bound on the “bang-for-the-buck” analysis because the actual forgone revenue is likely much larger than UK’s HM Revenue & Customs estimate suggests.

The question remains, though, did the UK lose out on investment after this reform? Liu shows that businesses did not shift their investment from high-tax countries or the UK to lower-tax countries following the reform. Instead, the reform led to new investment abroad.

Liu finds that the most common recipients of foreign direct investment from UK multinationals following the reform were financially constrained affiliates. Prior to the reform, a UK multinational may have had a subsidiary in Sweden that had investment opportunities but did not have the financial resources to act on those opportunities. Following the reform that subsidiary would be a likely candidate for new investment from the UK parent.

As those investments become profitable, the lower dividend tax on repatriated earnings means that there is more value that can be driven back to the parent company in the UK with the opportunity to redeploy those earnings in new investments or distribute dividends to their shareholders.

Liu’s research has lessons for policymakers in other countries as they analyze how territorial taxation may change business investment behavior. The U.S. recently adopted a hybrid territorial tax system that could result in effects that are similar to those for the UK. Liu notes that the result focused on financially constrained affiliates may be key to whether impacts from the U.S. reform are like those following the UK changes. Other international rules introduced in the U.S. will also change the overall impacts.

Lowering barriers to international investment not only improves opportunities to invest abroad, they can also create value in home countries. The shift toward territorial taxation in recent years has been paired with new policies countries use to protect from 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. . Balancing support for cross-border investment against priorities to minimize profit shifting opportunities is challenging, but policymakers should recognize that benefits from trade and foreign investment can create value at home and abroad.

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