Kimberly A. Clausing (firstname.lastname@example.org) is the Thormund A. Miller and Walter Mintz Professor of Economics at Reed College in Portland, Oregon.
In this report, Clausing summarizes her recent research estimating the effect of profit shifting on corporate tax base erosion in the United States. She also extends her analysis for a speculative estimate of base erosion consequences for other countries and discusses the policy implications of the steadily increasing base erosion and profit-shifting problem. The expanded version of Clausing's paper, "The Effect of Profit Shifting on the Corporate Tax Base in the United States and Beyond," is available on SSRN, papers.ssrn.com/sol3/papers.cfm?abstract_id=2685442.
Copyright 2015 Kimberly A. Clausing.
All rights reserved.
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Table of Contents
II. Prior Work
III. The Magnitude of Income Shifting
A. Estimating the Cost of Profit Shifting
IV. A Speculative Extension to the World
V. Policy Options
A. The OECD/G-20 BEPS Process
B. More Fundamental Reforms
Corporate tax base erosion from profit shifting is a large and consequential problem. It is a matter of simple mathematics that reduced revenue from the corporate tax base must result in lower government spending, higher tax revenue from other sources, or increased budget deficits. Each possibility is likely unattractive.
Beyond revenue consequences, corporate tax base erosion and profit shifting also affects the larger integrity of the tax system. National (or subnational) governments set tax policies, yet in an increasingly global economy, the effects of these policy actions stretch beyond borders. Multinational companies adroitly respond to differential tax treatment, changing the geographic location of economic activity and profits. Governments, realizing the mobility of global business, set tax policies that explicitly (or often, less transparently) lower tax rates on global companies. These tax competition pressures suggest that the design of the international tax system needs to be updated in the face of globalization.1
Further, corporate tax base erosion has consequences for the distributional burden of the tax system as a whole, consequences that are noteworthy because of the large documented increases in income inequality in recent decades. Most relevant evidence suggests that the corporate tax falls largely on capital or shareholders, but even if one assigns a fraction of the burden of the corporate tax to workers, it is still a more progressive tax instrument than other major sources of revenue, including the individual income tax, the payroll tax, and the VAT. Further, much capital income goes untaxed at the individual level, because a majority of that income is held in nontaxable form.2 Thus, the corporate tax has an essential role in taxing capital income, which is far more concentrated than labor income.
In this context, it is important to estimate the size of the problem at hand. Almost all observers, both in the press and in academic research, describe corporate BEPS as an increasing problem. Indeed, the analysis below suggests that BEPS is a larger problem today than ever before. I find that the revenue cost to the U.S. government from profit shifting has been increasing steadily over the previous decades and that it was likely between $77 billion and $111 billion per year by 2012. For the world as a whole, including the United States, revenue losses may exceed $280 billion in 2012.3
The results here are broadly consistent with prior published findings in the literature discussed in Section II.4 Although there is some work using financial statement data, particularly from Europe, that suggests that the profit-shifting problem may be shrinking, that work is based on incomplete data.5
This report summarizes a longer paper on these questions.6 After briefly reviewing current knowledge on BEPS, I discuss my own estimates of the size of the problem for the United States, and I extend those estimates for a speculative estimate of base erosion consequences for other countries. I conclude with an overview of policy implications.
II. Prior Work
There is a large body of work on international profit shifting, indicating that the corporate tax base is quite sensitive to tax rate differences across countries.7 Recently, the OECD (2015) finds that the annual net tax revenue loss from tax planning is about $100 billion to $240 billion and compares its estimates with those of the IMF, the Joint Committee on Taxation, and others.8 A study by three IMF economists (Crivelli, Keen, and de Mooij (2015)) also finds that base erosion problems are large. Their short-run estimates indicate that OECD countries lose $207 billion in revenue (0.23 percent of GDP) and that developing countries lose $105 billion in revenue (0.84 percent of GDP). Long-run estimates are $509 billion for OECD countries (0.6 percent of GDP) and $213 billion for developing countries (1.7 percent of GDP).
Keightley and Stupak (2015) and Gravelle (2015) describe the large and increasing problem of BEPS in the United States and elsewhere. Indeed, the stylized facts are overwhelming in their confirmation of the scale of the profit-shifting problem. For U.S. multinational corporations, the share of income reported in foreign countries has been steadily increasing, and income booked in low-tax countries is implausibly high by any reasonable metric. As reported by Gravelle (2015), U.S. affiliate corporate profits were 645 percent of Bermuda's GDP and 547 percent of the Cayman Islands' GDP in 2004.9 As absurd as those numbers are, by 2010 they had increased to 1,614 percent for Bermuda and 2,065 percent for the Caymans. Further, estimates indicate that U.S. multinational corporations have accumulated more than $2 trillion in permanently reinvested earnings in low-tax locations, more than $1 trillion of which is held in cash.10
Because of the large amounts of income booked in low-tax countries and havens, the estimated costs of deferral have been increasing in recent years, and the JCT now estimates this tax expenditure at $83.4 billion for 2014. Office of Management and Budget estimates are somewhat lower, at $61.7 billion in 2014.11 Zucman (2014, 2015) uses balance-of-payments data to conclude that profit shifting to low-tax jurisdictions is reducing U.S. corporate taxes by about 20 percent, or about $130 billion annually.
Further, there is no question that this issue extends beyond U.S. multinational corporations. Americans are clearly not the only tax planners. In fact, analyses using Orbis data on disproportionately European companies, even when the data cannot examine tax haven affiliate observations in detail, still finds substantial magnitudes of income shifting, as shown by the OECD (2015) and others.
Of course one of the difficulties in estimating the scale of the profit-shifting problem is the limited data available, as well as the difficulty associated with establishing the counterfactual levels of profit in each country absent profit-shifting incentives. In the 2015 report "Measuring and Monitoring BEPS," the OECD describes this problem in detail, noting that existing data sources are far from ideal. For example the report highlights the difficulties associated with using financial reporting data to make inferences regarding profit-shifting behavior. Much of the relevant information is absent from financial statement data because of missing country coverage or missing information. Data are particularly likely to be missing for tax haven countries, and there are few if any observations of affiliate companies in havens that include the relevant data fields.12 Because tax havens are the destination for much profit-shifting activity, making inferences on the scale of profit shifting from data that exclude those observations can be problematic. As an example, my estimates below suggest that 82 percent of profit shifting by U.S. multinational corporations is destined for just seven tax havens.
The OECD13 also discusses other sources of information on BEPS activity. They highlight both U.S. Bureau of Economic Analysis (BEA) data, the data used in the current analysis, and tax return data as examples of best practices in data collection for analyzing BEPS. In one example of nearly ideal data, Dowd, Landefeld, and Moore (2014) provide a very careful and persuasive study on the scale of profit shifting using U.S. tax return data from 2002 to 2010. They find a nonlinear tax response, with far more responsiveness at lower tax rates than at higher ones. Findings indicate tax semi-elasticities of -4.7 at corporate tax rates of 5 percent and -0.6 at tax rates of 30 percent.
My estimates below confirm the large scale of the profit-shifting problem, alongside the work of the OECD (2015); Crivelli et al. (2015); Keightley and Stupak (2015); Dowd, Landefeld, and Moore (2014); Zucman (2014, 2015); and many earlier studies reviewed in de Mooij and Ederveen (2008). The estimates below rely on U.S. BEA survey data; these data are more suited to capturing the profit-shifting problem than many data sources.
III. The Magnitude of Income Shifting
The BEA conducts annual surveys of U.S.-based multinational corporations and their affiliated companies abroad. The data indicate a large discrepancy between the physical operations of U.S. multinational corporate affiliates abroad and the locations in which they report their income. For example, Figure 1 shows the top 10 locations of U.S. multinational corporate affiliate gross profits in 2012; gross profits are net income with foreign income tax payments added.14 Of the top 10 locations, seven are tax havens with effective tax rates of less than 5 percent: Bermuda, Ireland, Luxembourg, the Netherlands, Switzerland, Singapore, and the U.K. Caribbean Islands (including the Cayman Islands). Effective tax rates are calculated as foreign income taxes paid by all affiliates in a given country relative to their income (net income plus foreign tax payments). These countries alone account for 50 percent of all foreign income earned by affiliates of U.S. multinational corporations but only 5 percent of all foreign employment of those companies. Further, the economic size of these countries is quite small relative to this disproportionate profit; their combined population is less than that of Spain or California.15
In contrast, the top employment countries are all large economies with big markets. Effective tax rates are not particularly low for this set of countries. None of the top 10 employment countries have effective tax rates below 12 percent. Regression analyses confirm these patterns. As shown in the companion paper, employment and plant, property, and equipment do not show a statistically significant relationship with the effective tax rate, but assets -- and especially income and earnings -- are negatively related to effective tax rates. This is confirmed both with and without country-specific fixed effects.16
Figure 1. Top Gross Income Countries, Affiliates of U.S.
Multinational Firms, 2012
(shown as share of total income)
Note: Gross income is net income with foreign tax payments added. Seven of the top 10 countries have effective tax rates under 5 percent in 2012: Netherlands, Ireland, Luxembourg, Bermuda, Switzerland, Singapore, and U.K. islands. Together, these seven countries account for 50.1 percent of all foreign profits.
The evidence is consistent with extensive literature in the field of public finance that has emphasized a hierarchy of behavioral responses to taxation whereby timing and financial decisions are more tax-sensitive then real decisions about levels of economic activity.17
A. Estimating the Cost of Profit Shifting
My recent research uses regression analysis and simple computations to estimate how U.S. government revenue is affected by profit-shifting activity. The analysis begins with regressions that relate affiliate profits to tax rates. The results from the regressions are used to calculate how the distribution of profits would differ absent tax rate differences among countries. Then some fraction of the lower foreign profits is attributed to the U.S. tax base.
In the companion paper, I provide eight alternative specifications that suggest large, negative, and statistically significant relationships between profits and effective tax rates. The semi-elasticities range from -1.85 to -4.61, with an average estimate of -2.92. Estimated elasticities are quite similar if one instead uses data on the BEA direct investment earnings series. This average is in line with much of the prior literature on tax base elasticities, and it is similar to averages found in the meta-analyses of de Mooij and Ederveen (2003, 2008) and de Mooij (2005).
If one follows Dowd, Landefeld, and Moore (2014) and allows for a nonlinear tax response, results indicate higher elasticities at lower tax rates. Replacing the calculations below with calculations using nonlinear tax elasticities raises the magnitude of my estimates of profit shifting. This is not surprising, since the majority of income is booked in countries with very low effective tax rates. Nonetheless, to err on the side of caution, I used the linear elasticities here. However, this consideration strengthens the case for using a higher benchmark elasticity.18
This elasticity is then used to calculate what profits would be in the countries of operation of U.S. affiliates absent differences in tax rates between foreign countries and the United States. The United States has a statutory tax rate of 35 percent, although in this analysis, I assume that the U.S. effective tax rate would be lower (30 percent) and that this lower tax rate would apply to any increased income in the U.S. tax base.
Table 1 shows the major locations where income is shifted. For high-tax-rate countries with effective tax rates above my assumed U.S. rate (for example, Argentina, Chile, Denmark, India, Italy, Japan, Peru, and others in 2012), foreign profits would be higher in the counterfactual, but in many other cases, foreign profits would be lower. It is estimated that in 2012, profits in high-tax countries were too low by $26 billion because of income-shifting incentives, that profits in medium-tax (15 to 30 percent) countries were too high by $36 billion, and that profits in the lowest-tax countries (with effective tax rates less than 15 percent) were too high by $595 billion because of tax incentives. As these numbers indicate, most of the profit shifting is done with the lowest-tax countries, and this finding corresponds with the stylized facts above.
Table 1. Key Locations of Profit Shifting, 2012
Income Percent of
Gross Income Without Total
Reported Shifting Excess Income
Country (billions) (billions) in Location
Netherlands $172.3 $33 23%
Ireland $122.3 $23.6 16.3%
Luxembourg $96.11 $15 13.4%
Bermuda $79.7 $9.9 11.5%
Switzerland $57.9 $14.6 7.2%
Singapore $42.4 $10.5 5.3%
U.K. (Caymans) $40.9 $8.7 5.3%
All others under $188.6 $89.8 16.3%
Total under $800 $205 98.4%
All others with $267 $257 1.6%
FOOTNOTE TO TABLE 1
a Note that the total of gross income in 2012 ($1,219 billion)
is larger than the income that is reported in particular countries analyzed
here ($1,067 billion); some income is earned in "other" countries that are
END OF FOOTNOTE TO TABLE 1
Indeed, the estimates of excess income booked in just the seven important tax havens highlighted in Figure 1 account for 82 percent of the total. Of the income booked in Bermuda ($80 billion), the Caymans ($41 billion), Luxembourg ($96 billion), the Netherlands ($172 billion), and Switzerland ($58 billion), this method suggests that profits absent income-shifting incentives would instead be $10 billion in Bermuda, $9 billion in the Caymans, $15 billion in Luxembourg, $33 billion in the Netherlands, and $15 billion in Switzerland. As a comparison, profits booked in France and Germany are currently $13 billion and $17 billion, respectively.
Once these profits are adjusted, a fraction (38.7 percent in 2012) of the hypothetically lower foreign profits (on aggregate) is attributed to the U.S. tax base. The assigned fraction is based on the share of intracompany transactions that occur between affiliates abroad and the parent company in the United States, relative to all intracompany transactions undertaken by affiliates abroad (with both the parent and affiliates in other foreign countries). Thus, in 2012 foreign affiliates of U.S. parent multinational corporations undertook 38.7 percent of their affiliated transactions with the United States; the remaining 61.3 percent were with other affiliated companies abroad. Of course this fraction itself is just a plausible benchmark.
Finally, this number is scaled up, under the assumption that foreign multinational corporations also engage in income shifting out of the United States. While the data do not allow a separate estimate of their profit-shifting behavior, I assume that it would increase the revenue costs of income shifting by a factor that is based on the ratio of the sales of affiliates of foreign-based multinational corporations in the United States (a proxy for the ability of foreign multinational corporations to shift income away from the United States) to the sales of affiliates of U.S.-based multinational corporations abroad (a proxy for the ability of U.S. multinational corporations to shift income away from the United States). Sources of underestimation and overestimation are discussed below.
Table 2 summarizes these estimates, including the main estimate using the BEA income series (net income plus foreign taxes paid), as well as an alternative estimate using the BEA direct investment earnings series. Column 2 shows the total income earned abroad by foreign affiliates of U.S. corporations. Column 3 shows the estimated increase in the U.S. tax base if income-shifting incentives were eliminated. Column 4 shows the reduction in U.S. corporate income tax revenue as a result of income shifting, assuming that marginal revenue is taxed at 30 percent. Revenue estimates would of course be higher if one assumed that marginal additional profits would be taxed at the statutory rate. Column 5 shows actual corporate tax revenue in the corresponding year as a comparison. By 2012 the revenue cost of income-shifting behavior is estimated at $111 billion.
Table 2. Estimates of Reduced Revenue Due to Income Shifting, 2004-2012
Total Increased Reduction Actual
Reported U.S. Tax in Corporate
Income/ Base Revenue Tax
Earnings Without Due to Revenue,
in Foreign Income Income Federal
Affiliates Shifting Shifting Level
Year (billions) (billions) (billions) (billions)
Estimate Using Gross Income in Foreign Affiliates
2004 $525 $148 -$44 $189
2008 $925 $257 -$77 $304
2012 $1,219 $371 -$111 $242
Alternate Estimate Using Direct Investment Earnings Data
2004 $422 $101 -$30 $189
2008 $754 $154 -$46 $304
2012 $923 $258 -$77 $242
The alternative estimate uses the BEA direct investment earnings series. This series avoids double-counting but also eliminates some types of income shifting. Column 2 indicates total direct investment earnings abroad over the period 2004-2012. Data from the BEA are adjusted to include foreign taxes paid and to reverse the BEA's adjustment of the data by the U.S. parent equity ownership percentage. Column 3 shows the estimated increase in the U.S. tax base, again employing the method used for the main estimates. Using this series, the resulting revenue reduction estimates are lower because of the combined effects of the elimination of double-counting and the omission of some types of income. Unfortunately, with available data, one cannot separate these two effects.
Figure 2 illustrates the changes in these estimates of revenue loss from profit shifting over the period of the study, 1983-2012, using the BEA income series. (The alternative estimates are also presented in the companion paper, using the direct investment earnings series.) The strong upward trend is not a reflection of increasing tax responsiveness in terms of the elasticity of the tax base for a given tax rate difference, since that is assumed to be constant over this period. Instead, it is the result of two factors. First and most important, the total amount of foreign profits is increasing dramatically over this period. Income of all foreign affiliates was $525 billion in 2004, and it grew to $1.2 trillion by 2012; direct investment earnings increased by similar magnitudes, more than doubling in eight years. Second, the average foreign effective tax rate has continued to fall over this period, also contributing to income-shifting incentives.
Figure 2. Estimates of Revenue Loss Due to Income Shifting
(estimates using U.S. BEA gross income series)
Of course several assumptions are required for this analysis that generate uncertainty surrounding these estimates. In the full paper, I enumerate the sources of uncertainty and discuss their possible effects on the estimates. Most assumptions have no direction of bias, but when an assumption could lead to an overestimate, I provide alternative estimates.
IV. A Speculative Extension to the World
As noted above, these estimates pertain only to the behavior of U.S. multinational corporations. Nonetheless, the overall scale of the problem for the world at large can be approximated by relating these estimates to larger aggregates. Although the precise magnitudes of the problem are probably unknowable, one can still get a sense of the scale of corporate BEPS for major countries.
A serious hurdle in scaling up the estimates for the United States is the absence of comparable publicly available survey data for most countries. However, one can use data from the Forbes Global 2000 list of the world's largest corporations; these data indicate the location of corporate headquarters and the overall level of worldwide profits for the world's biggest corporations. Still, the current extension is limited by data constraints to the major countries that headquarter large multinational corporations. Data on less-developed countries are sparse.
Twenty-five countries are home to 95 percent of the profits earned by the companies on the Global 2000 list. I use this collection of countries to estimate the global scale of corporate tax base erosion. This estimation, while speculative and indicative only of approximate magnitudes, proceeds in several steps:
1. Because we lack detailed data on the location of affiliates of worldwide multinational corporations, I proceed from the assumption that all multinational corporations have affiliates in two types of countries: low-tax countries and high-tax countries. For example, for the United States in 2012, multinational companies report $1.2 trillion in income abroad, of which $800 billion is booked in 17 low-tax countries. These are the countries that I consider destinations for artificial income shifting abroad. Not all these countries are havens, but all have effective tax rates that are less than 15 percent, which is the arbitrary cutoff that I use for low-tax countries. As shown in Table 1, these countries are the destinations for 98 percent of the estimated profit shifting for U.S. multinational corporations.
2. For countries that are headquarters to Global 2000 companies but are not low-tax countries, I assume that their share of income booked in low-tax countries is proportionate to the share of U.S. multinational corporation foreign income that is booked in low-tax countries. For example, because the United States headquarters 33.3 percent of the global profits of Global 2000 companies, and Germany headquarters about 3.3 percent of the global profits of Global 2000 companies, I assume that German multinational companies have about 10 percent of the U.S. level of profits in low-tax countries, or about $80 billion.
3. I assume that foreign-country effective tax rates on foreign income are 5 percentage points less than their statutory rates (inclusive of subfederal taxation). For example, in the case of Japan, the statutory tax rate (including subfederal taxation) is 39.5 percent in 2012, so I assume an effective tax rate of 34.5 percent on corporate profits, allowing for some degree of tax base narrowing.
4. Then I model profit shifting between the higher-tax headquarters countries and the low-tax countries identified in step one, which on average have an effective tax rate of 6.6 percent. I use this average tax rate to calculate the tax difference between the headquarters country and the low-tax countries, apply a semi-elasticity of 2.92 (as used above) for tax rate differences, and then calculate the likely magnitude of profit shifting to low-tax countries. Although this elasticity is based on the U.S. estimates above, it is a reasonable benchmark, because the focus here is solely on the subset of countries with very low tax rates, and tax elasticities for foreign-country tax rates are likely nonlinear.
5. Estimates from step four are used to create a global estimate of how much excess income is booked in low-tax countries. For the United States, this method suggests that of the $800 billion booked in the 17 low-tax countries, about $545 billion would not be booked in those countries absent the tax rate difference. For the group of big headquarters countries that are not low-tax countries, including the United States, the total is $1.076 trillion.
6. The excess $1.076 trillion is assigned to the tax bases of higher-tax headquarters countries based on their share of GDP for this higher-tax group of countries. For example, Germany has 6.3 percent of the higher-tax headquarters countries' total GDP, so they are assumed to recoup 6.3 percent of the $1.076 trillion that is artificially in low-tax countries, as a higher German corporate tax base. The assumed German revenue gain is then the German effective tax rate multiplied by this additional tax base, or $17 billion.
Under these calculations, the United States recoups 29 percent of the excess $1.076 trillion booked in low-tax countries, which, assuming a 30 percent effective tax rate, generates a revenue loss of $94 billion from profit shifting. Note that the U.S. result is different from those in Table 2 because it uses a different assumption about how excess income in low-tax countries would be booked in the counterfactual (that is, based on GDP shares rather than affiliate transaction shares). The current analysis also uses a more aggregated estimate of income shifting, based on shifting between the home country and a group of 17 low-tax countries, whereas the analysis above considered bilateral-shifting incentives instead. Yet the estimate here is similar to those of Table 2, falling between the two estimates of $77 billion and $111 billion.
Table 3. Speculative Estimates of Corporate Tax Base Erosion, 2012
Estimated Income of Share
Profits Effective Booked group of All
in 17 Tax Rate in GDP x Corporate
Low-Tax (Combined Low-Tax $1,079 Revenue,
Countries Statutory Countries billion) Including
(billions) Rate -- 5%) (billions) (billions) Subfederal
Australia $67.7 25% $36.3 $7.4 9%
Brazil $71.1 29% $46.4 $13.5 17%
Chile $4.3 15% $1.1 $0.8 --
China $204.5 20% $79.7 $32.7 11%
Czech $1.9 14% $0.4 $0.6 8%
Denmark $7.2 20% $2.8 $1.3 13%
Finland $5.3 20% $2 $1 18%
France $90.5 29% $60.2 $15.3 23%
Germany $80.4 25% $43.5 $17.2 28%
Greece $2.2 15% $0.5 $0.7 26%
India $55 27% $33.3 $9.7 14%
Indonesia $7.4 20% $2.9 $3.6 8%
Italy $31 23% $14.3 $9 16%
Japan $129.9 35% $105.7 $39.8 18%
Mexico $14.4 25% $7.7 $5.7 --
Norway $19.2 23% $9.2 $2.3 4%
Poland $8.4 14% $1.8 $1.3 13%
Portugal $8.2 27% $4.7 $1.1 19%
Russia $86.7 15% $21.1 $5.8 7%
South $21.6 25% $11.3 $1.9 9%
South $18.5 15% $4.5 $2.1 --
South $56.9 19% $20.8 $4.5 10%
Spain $33.1 25% $17.7 $6.6 24%
Turkey $10.6 15% $2.6 $2.3 14%
U.S. $800.2 30% $545.3 $93.8 26%
Total $1,836 -- $1,076 $279 20.1%
Note: For countries other than the United States, the tax rate is the
combined rate of federal and subfederal rates (when countries have subfederal
taxation); for the United States, I use the same assumption as the above
analysis. Corporate tax revenue data are not available for all countries.
Table 3 shows the results of these calculations for other countries. Although this analysis is far more broad-brush than the analysis for the United States, it does give a back-of-the-envelope estimate of the likely magnitude of this problem for other countries that do not have low tax rates. Overall, revenue losses total about $280 billion for this group of countries, 20 percent of their total corporate tax revenue. This estimate is in line with the short-run estimates of Crivelli et al. (2015).
The sources of uncertainty are larger here than they are for the U.S. analysis, so these estimates should be viewed as merely indicative. Key sources of uncertainty are discussed in the full companion paper, which also provides an alternative estimate that uses a smaller tax elasticity. To the extent that foreign multinational corporations have a more compliant tax culture or more effective corporate tax base erosion protections, the alternative estimate may be more appropriate. Still, the Dowd, Landefeld, and Moore (2014) analysis suggests that higher tax elasticities may apply, because the income shifting is occurring toward countries with very low taxes.
V. Policy Options
A. The OECD/G-20 BEPS Process
Both the prior literature and the current analysis indicate that profit shifting is probably eroding the corporate tax base in many countries. In response to pressing concerns about income shifting, reflected as a priority in recent G-8 and G-20 meetings, the OECD undertook the BEPS project. The final BEPS project reports were issued in October 2015, totaling nearly 2,000 pages. These attempts to better connect taxable profits to economic activity are helpful, and the suggested measures are likely to incrementally curb profit-shifting activity. The OECD/G-20 process is commendable for advancing efforts toward international cooperation in this area.
However, there are many reasons to suspect that profit-shifting problems are not over. For one thing, country adoption of the proposals is likely to be uneven and incomplete since the OECD recommendations are not binding. Also, fundamental problems will probably continue to vex policymakers in years ahead. An essential difficulty lies in the challenge of establishing the source of income for companies that are truly globally integrated. Because multinational corporations earn more than their component parts would have earned alone, it is an arbitrary exercise to figure out where the additional profit should reside. Further, much economic value is based on ideas and innovations that are truly intangible, and this makes it even more difficult to establish the source of economic value.19
These conundrums are compounded by the fact that multinational corporations have every incentive to redirect profits to low-tax locations through clever financial and accounting arrangements. The tax departments of major multinational companies are widely thought of as profit centers, and armies of accountants and lawyers are working to develop innovative tax minimization strategies, often several steps ahead of government treasuries.
Thus, although many parts of the OECD recommendations are helpful, including the steps toward country-by-country reporting, one wonders if the requisite political will can be mustered to close the loopholes that enable pervasive profit shifting. And even as changes are made, tax planners may remain several steps ahead of policymakers. It remains to be seen whether the OECD's efforts will be sufficient to reduce the problem substantially.
B. More Fundamental Reforms
1. Worldwide consolidation. Under worldwide consolidation, discussed in JCT (2011) and favored by Kleinbard (2011) and Avi-Yonah (2013), a multinational corporation would be required to consolidate the income earned across the parent company and its affiliates, and all income would be taxed currently, allowing a credit for foreign taxes.
A worldwide consolidation approach has several advantages over the current system. There would be less tax-motivated shifting of economic activity or book income to low-tax locations because that shifting would likely not affect a multinational company's overall tax burden.20 There would thus be fewer concerns about inefficient capital allocation or corporate tax base erosion. Also, there would be no "trapped cash" problem because income would be taxed currently.
However, depending in part on the corporate tax rate that would accompany this change, the proposal may raise concerns for high-tax countries if companies would face rising foreign tax burdens under consolidation. Some also worry that this proposal would put stress on the definition of residence. Although some have argued that residence is increasingly elective,21 others argue that relatively simple legislation would make it difficult to change residence for tax purposes. Governments could require that corporate residence indicate the true location of the "mind and management" of the corporation. A similar U.K. definition of residence is deemed effective by both Avi-Yonah (2013) and Kleinbard (2011). It is also feasible to develop anti-inversion measures along the lines of those suggested by Clausing (2014b), Kleinbard (2014), or Shay (2014).
Finally, although there is little real-world experience with such a system, it still falls within international norms, since double taxation is prevented through foreign tax credits. The proposal could be implemented without disadvantaging major trading partners, and it could be adopted unilaterally, although Avi-Yonah (2013) recommends that countries take a multilateral approach.
2. Formulary apportionment. Under formulary apportionment, worldwide income would be assigned to individual countries based on a formula that reflects their real economic activities. Often, a three-factor formula is suggested (based on sales, assets, and payroll), but others, including Avi-Yonah and Clausing (2008), have suggested a single-factor formula based on the destination of sales.22
The essential advantage of the formulary approach is that it provides a concrete way to determine the source of international income that is not sensitive to arbitrary features of corporate behavior such as corporations' declared states of residence, their organizational structures, or their transfer pricing decisions. If multinational corporations change those variables, it would not affect their tax burdens under formulary apportionment.23
Most important, the factors in the formula are real economic activities, not financial determinations. Saez, Slemrod, and Giertz (2012); Slemrod and Bakija (2008); and Auerbach and Slemrod (1997) summarize a vast body of research on taxation that suggests this hierarchy of behavioral response: Real economic decisions concerning employment or investment are far less responsive to taxation than are financial or accounting decisions. For multinational corporations, this same pattern is clearly shown in the data analyzed above. There is no doubt that disproportionate amounts of income (compared with investment, sales, or employment) are booked in low-tax countries.
With a formulary approach, companies have no incentive to shift paper profits or to change their tax residences, because their tax liabilities are based on their real activities. However, concerns may remain. Under a three-factor formula, there is still an incentive to locate real economic activity in low-tax countries, which raises questions regarding efficient capital allocation. This is somewhat less of a problem under a sales-based formula, since companies will still have an incentive to sell to customers in high-tax countries.24 Also, prior experience in the United States, which uses formulary apportionment to determine the corporate tax base of U.S. states, has indicated that formula factors (payroll, assets, and sales) are not particularly tax sensitive.25
Ideally, formulary apportionment would be adopted multilaterally, and there would be few concerns about competitiveness, double taxation, or double nontaxation. However, if some countries adopt, there are mechanisms that would encourage other countries to follow early adopters.26
Another related approach is to use a formulary profit-split method. The tax base would be calculated as a normal rate of return on expenses, with residual profits allocated by a sales-based formula. With careful implementation, that approach might ease concerns regarding tax competition under a formulary approach. Elsewhere, I provide more detail on the advantages and disadvantages of formulary approaches.27
This report summarizes my recent analysis of corporate tax base erosion from profit shifting. Using survey data from the BEA, I find that profit shifting is likely to have cost the U.S. government between $77 billion and $111 billion annually by 2012. The scale of the revenue loss is commensurate with several stylized facts about the size of the problem, including the large magnitudes of income booked in tax havens. I also find that estimates of the revenue cost of income shifting are increasing over time. This trend reflects the increasing magnitude of profits booked in low-tax countries, as well as continued corporate tax rate reductions abroad.
These estimates have the advantage of using comprehensive survey data that includes operations in many tax havens, unlike many studies that rely on financial data. While all these estimates entail many assumptions, I have attempted to err on the side of caution in my assumptions, and I also provide alternative estimates.
Further, using data on the Forbes Global 2000 list of the world's largest corporations, I provide a speculative extension of the estimates to other countries. I assume that multinational corporations based in other countries also shift income to low-tax destinations in proportion to the tax rate difference between the home market and the low-tax country group. I find that profit shifting to low-tax countries may be costing headquarters countries without low tax rates about $280 billion annually, including revenue losses to the United States. These estimates entail several assumptions that are probably more speculative than those in the analysis for the United States. If foreign multinational corporations are based in countries with tough tax base protections or if these companies are simply less responsive to tax rate differences, that could lower these estimates.
Still, the world is larger than the set of countries that act as headquarters to major multinational corporations, and other countries are ignored in this analysis, understating the scope of the profit-shifting problem. Crivelli et al. (2015) discuss how profit-shifting problems are likely to be especially pressing in less-developed countries relative to the size and affluence of their economies. Further, less-developed countries will often have insufficient institutional capacity to handle the myriad enforcement difficulties associated with profit-shifting behavior.
These concerns highlight the importance of policy action to address the problems associated with tax competition and corporate tax base erosion. The OECD/G-20 BEPS process has promising elements, and it is a useful step. Still, we face essential difficulties in establishing the source of income in an increasingly global world economy. More fundamental reforms, such as worldwide consolidation or formulary apportionment, are likely to be more successful at stemming corporate tax base erosion in an era of globally integrated business and agile taxpayers.
- Auerbach, Alan J. and Joel Slemrod, "The Economic Effects of the Tax Reform Act of 1986," 35 J. Econ. Lit. 589 (1997).
Avi-Yonah, Reuven S., "Hanging Together: A Multilateral Approach to Taxing Multinationals," U. Mich. Public Law research paper no. 364 (2013).
Avi-Yonah and Kimberly A. Clausing, "Reforming Corporate Taxation in a Global Economy: A Proposal to Adopt Formulary Apportionment," in Jason Furman and Jason Bordoff (eds.), Path to Prosperity: Hamilton Project Ideas on Income Security, Education, and Taxes (2008).
Avi-Yonah, Clausing, and Michael C. Durst, "Allocating Business Profits for Tax Purposes: A Proposal to Adopt a Formulary Profit Split," 9 Fla. Tax Rev. 497 (2009).
Clausing, "The Nature and Practice of Capital Tax Competition," in Peter Dietsch and Thomas Rixen (eds.), Global Tax Governance (coming).
Clausing, "The Impact of Transfer Pricing on Intrafirm Trade," in James R. Hines Jr. (ed.), International Taxation and Multinational Activity (2001).
Clausing, "Tax-Motivated Transfer Pricing and U.S. Intrafirm Trade Prices," 87 J. Pub. Econ. 2207 (2003).
Clausing, "International Tax Avoidance and U.S. International Trade," 59 Nat'l Tax J. 269 (2006).
Clausing, "Multinational Tax Avoidance and Tax Policy," 62 Nat'l Tax J. 703 (2009).
Clausing, "The Revenue Effects of Multinational Firm Income Shifting," Tax Notes, Mar. 28, 2011, p. 1580 .
Clausing, "Lessons for International Tax Reform From the U.S. State Experience Under Formulary Apportionment" (June 2014) (2014a).
Clausing, "Corporate Inversions," Tax Policy Center (2014) (2014b).
Cobham, Alex and Simon Loretz, "International Distribution of the Corporate Tax Base," ICTD working paper, at 27 (2014).
Crivelli, Ernesto, Michael Keen, and Ruud A. de Mooij, "Base Erosion, Profit-Shifting, and Developing Countries," Oxford University Centre for Business Taxation working paper WP 15/09 (2015).
De Mooij, "Will Corporate Income Taxation Survive?" 153 De Economist 277 (2005).
De Mooij and Sjef Ederveen, "Taxation and Foreign Direct Investment: A Synthesis of Empirical Research," 10 Int'l Tax & Pub. Fin. 673 (2003).
De Mooij and Ederveen, "Corporate Tax Elasticities: A Reader's Guide to Empirical Findings," 24 Oxford Rev. Econ. Pol'y 680 (2008).
Dietsch and Rixen, Global Tax Governance (forthcoming).
Dowd, Tim, Paul Landefeld, and Anne Moore, "Profit Shifting of U.S. Multinationals," Joint Committee on Taxation working paper (2014).
Gravelle, Jane G., "Tax Havens: International Tax Avoidance and Evasion," Congressional Research Service report R40623 (Jan. 15, 2015) .
Gravelle and Thomas L. Hungerford, "Corporate Tax Reform: Issues for Congress," CRS report RL34229 (Apr. 6, 2010) .
Hines, James R., "Lessons From Behavioral Responses to International Taxation," 52 Nat'l Tax J. 305 (1999).
JCT, "Present Law and Issues in U.S. Taxation of Cross-Border Income," JCX-42-11 (Sept. 6, 2011) .
Keightley, Mark P., "An Analysis of Where American Companies Report Profits: Indications of Profit Shifting," CRS report R24927 (Jan. 18, 2013) .
Keightley and Jeffrey M. Stupak, "Corporate Tax Base Erosion and Profit Shifting (BEPS): An Examination of the Data," CRS report R44013 (Apr. 30, 2015) .
Kleinbard, Edward D., "The Lessons of Stateless Income," 65 Tax L. Rev. 99 (2011).
Kleinbard, "'Competitiveness' Has Nothing to Do With It," Tax Notes, Sept. 1, 2014, p. 1055 .
OECD, "Measuring and Monitoring BEPS: Action 11 Final Report" (2015) .
OSPIRG Foundation and Citizens for Tax Justice, "Offshore Shell Games 2015" (2015).
Saez, Emmanuel, Joel Slemrod, and Seth H. Giertz, "The Elasticity of Taxable Income With Respect to Marginal Tax Rates: A Critical Review," 50 J. Econ. Lit. 3 (2012).
Shaviro, Daniel, "The Rising Tax-Electivity of U.S. Corporate Residence," 64 Tax L. Rev. 377 (2011).
Shay, Stephen, "Mr. Secretary, Take the Tax Juice Out of Corporate Expatriations," Tax Notes, July 28, 2014, p. 473 .
Slemrod and Jon Bakija, Taxing Ourselves (2008).
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1 See, e.g., Clausing (coming) and other contributions to Dietsch and Rixen, eds.
2 Gravelle and Hungerford (2011) note that more than 50 percent of individual passive income in the United States is held in tax-exempt form through pensions, retirement accounts, life insurance annuities, and nonprofits. More recent analysis suggests that the share of U.S. equities held in taxable accounts is below 30 percent.
3 The following analysis is limited to the other countries of the world that act as headquarters to major multinational corporations.
4 See, e.g., Dowd, Landefeld, and Moore (2014); OECD (2015); Crivelli et al. (2015); de Mooij and Ederveen (2008); and de Mooij (2005).
5 Often this research uses the Orbis data, which have extremely limited information on tax haven countries. Even when observations exist, key data fields are often missing. Analysis using these data excludes the observations that are driving most of the income-shifting behavior.
6 For the full paper and analysis, see Clausing, "The Effect of Profit Shifting on the Corporate Tax Base in the United States and Beyond," available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2685442.
7 An early review of literature in this area is provided by Hines (1999), and subsequent reviews by de Mooij and co-authors have confirmed a large and increasing problem of income shifting (de Mooij and Ederveen (2003); de Mooij (2005); and de Mooij and Ederveen (2008)). My own prior work has provided a great deal of evidence of the tax sensitivity of transfer prices (Clausing (2001, 2003, 2006)), as well as the large consequences of profit-shifting behavior for U.S. government revenue (Clausing (2009, 2011)).
8 See OECD (2015), at 104-115.
9 Similar stylized facts regarding the scale of the problem are reported by many sources, including Keightley (2013) and OSPIRG/Citizens for Tax Justice (2015).
10 See, e.g., Edward D. Kleinbard, "Why Corporate Tax Reform Can Happen," The Wall Street Journal, Mar. 23, 2015; and Kleinbard, "Indefinitely Reinvested Foreign Earnings on the Rise," CFO Journal, May 7, 2013. These funds are often held in U.S. financial institutions and are thus available to U.S. capital markets, but U.S. multinational corporations are constrained in their use of them. These funds are assets of the company that increase its credit worthiness; however, companies cannot return the cash to shareholders as dividends or share repurchases without incurring U.S. corporate tax liabilities upon repatriation.
11 This represents the estimated revenue cost associated with allowing deferral of the U.S. tax on foreign income until it is repatriated. See JCT, "Estimates of Federal Tax Expenditures for Fiscal Years 2014-2018," JCX-97-14 (Aug. 5, 2014) ; and Office of Management and Budget, "Fiscal Year 2016: Analytical Perspectives of the U.S. Government." Available at https://www.whitehouse.gov/sites/default/files/omb/budget/fy2016/assets/spec.pdf.
12 Cobham and Loretz (2014) document that data coverage in these financial data sets, and in particular Orbis, can be particularly weak or nonexistent in situations in which tax havens and less-developed countries are concerned. Dowd, Landefeld, and Moore (2014) an important weakness of studies relying on financial reporting data: "It can be difficult to get information on subsidiaries incorporated in some tax havens, such as Bermuda and the Cayman Islands, and therefore studies using this data leave out some of the major locations for income shifting." My own discussions with several researchers who use these data have confirmed that this is a significant problem.
13 OECD (2015), at 33-34.
14 2012 is used since it is the most recent year with publicly available (albeit preliminary) data. Other recent years display similar patterns.
15 The data include "income from equity investments," some of which are counted more than once if there are tiers of ownership within the same country. Unfortunately, with existing data, it is impossible to accurately account for this double-counting. Still, one can use an alternative data series, also from the BEA, on direct investment earnings. This series eliminates the possibility of double-counting, but it is also incomplete, since income from investments is excluded. Still, if one uses that series instead, the same seven countries with low effective tax rates are in the top 10 countries: Bermuda, the Cayman Islands, Ireland, Luxembourg, the Netherlands, Singapore, and Switzerland. Together, they account for 52 percent of all foreign direct investment earnings.
16 Country-fixed effects may be important, since country-specific influences are surely essential determinants of multinational corporate activity and econometric tests indicate that their inclusion is warranted. However, in these specifications, the relationships between effective tax rates and the dependent variables (which measure multinational activities) are estimated based solely on variation in tax rates within countries over time, since between-country variation in tax rates and other matters are captured by the country-specific fixed effects.
17 Saez, Slemrod, and Giertz (2012); Slemrod and Bakija (2008); and Auerbach and Slemrod (1997) summarize a vast body of research on taxation that suggests this hierarchy of behavioral response.
18 As previously discussed, some studies using financial-Orbis data have found smaller elasticities, but one should also note that these studies are using data that neglect the very observations that are driving the profit-shifting phenomenon: affiliates operating in tax havens. There is very little information on those operations in the financial databases.
19 A particularly colorful description of this problem is found in Brian O'Keefe and Marty Jones, "How Uber Plays the Tax Shell Game," Fortune, Oct. 22, 2015.
20 For corporations with excess tax credits, there would still be an incentive to avoid earning income in high-tax countries and to earn income in low-tax countries. Excess tax credits are likely only if the average effective foreign income tax rate exceeds the residence country tax rate.
21 E.g., Shaviro (2011).
22 As an example, if a multinational company earned $1 billion worldwide and had 30 percent of its payroll and assets in the United States but 60 percent of its sales in the United States, its U.S. tax base would be $400 million under an equal weighted formula (((0.3 + 0.3 + 0.6)/3) x $1 billion) and $600 million under a single sales formula ((0.6) x $1 billion)).
23 This assumes that the multinational corporation has a taxable presence (i.e., nexus) in the locations where it has employment, assets, and sales.
24 This is particularly the case for final goods. For intermediate goods, this is more problematic.
25 See Clausing (2014a) for an in-depth analysis of this question. Whether this tax-insensitivity would hold at higher corporate tax rates is an empirical question. Still, the forces of tax competition (mobility of production, competitive pricing, etc.) are likely stronger between U.S. states than between foreign countries.
26 There is a natural incentive for countries to follow suit, as discussed in Avi-Yonah and Clausing (2008). Once some countries adopt formulary apportionment, remaining separate accounting countries would lose tax base to formulary apportionment countries, because income can be shifted away from separate accounting countries to formulary accounting countries without affecting tax burdens in formulary accounting locations (because they are based on a formula).
27 This work includes Avi-Yonah and Clausing (2008); and Avi-Yonah, Clausing, and Durst (2009).
END OF FOOTNOTES
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