Profit Shifting: Let’s Define The Problem Before We Rush To The Solution

This happens due to “profit-shifting” or the relocation of profits from high tax to low tax jurisdictions within firms that operate across multiple countries. The recent two-part OECD/G20 initiative – first, to reallocate taxing rights to countries that are markets for companies, and second, to impose a global minimum tax at a jurisdictional level – suggests that efforts to curb these avoidance activities will subject an additional US$125-150 billion in profits to tax.[i] This is the impetus behind the OECD Base Erosion and Profit Shifting Project (BEPS) that began in 2013 and that has taken recent shape in the two-pillar approach. However, despite nearly a decade of work by the OECD on this issue, profit shifting remains an ill-defined term. We know surprisingly little about the true extent of profit shifting across countries, and how profit shifting impacts the real economy. Before countries fundamentally reorganise their tax systems to address the challenge of profit shifting, perhaps we need to pause and take stock of what we know.

A Range Of Estimates Of Profit Shifting

An early strand of research documented evidence of corporate tax competition amongst countries, showing that firms responded to lower relative tax rates across countries by locating real activity and profits in lower tax jurisdictions.[ii] Economist Dhammika Dharmapala (2014) does an overview of this early literature from the 1990s and 2000s, and shows that estimates of profit shifting vary considerably across studies using different methodologies, with some finding no evidence of profit shifting and others finding somewhat larger responses.[iii] Dhammika and Riedl (2013) contribute original analysis to suggest that the extent of profit shifting is no more than 2-4 per cent of parent income.[iv] Jim Hines (2014) goes further to say that this additional revenue “would make an extremely modest contribution to the government finances of most countries.”[v] And that to some extent, the fact that businesses choose to locate real activity in low tax jurisdictions goes against the idea that paper shifting of profits can be done with “impunity”.

More recent research also swings between finding low or large values of profit shifting. In a 2022 paper, Torslov et al. define profit shifting by comparing the ratio of profits-to-wages for foreign subsidiaries in tax havens versus local firms in the same country.[vi] They find that foreign firms have significantly higher ratios relative to local firms, suggesting high levels of profit shifting activity. Using as a counterfactual the profits of local firms, they find that approximately 0.8 per cent of US GDP or US$143 billion was shifted out of the US by US and non-US multinationals in 2015.[vii] Guvenen et al. find that over the period 1982-2016, 38 per cent of profits reported as foreign by US MNEs should in fact have been reported in the US, amounting to US$150 billion per year in recent years.[viii] Beer, De Mooij and Liu find that in 2015, profit shifting resulted in a loss of 17 per cent of the US tax base, so approximately half the share reported by Torslov et al. and Guvenen. For 2012, Clausing (2016) estimates a loss of US$77-111 billion in revenues (not the tax base) for the US, while Blouin and Robinson, for the same year and accounting for the “correct distribution of income” suggest that the loss was US$10-20 billion.[ix]

Surveying this literature, it is hard to come up with a clear picture of the true extent of profit shifting. One reason for the differences in estimates across studies is the use of different data, definitions and methodologies. Some use microdata on firms, while others use macrodata and government statistics, financial databases and tax returns. Blouin and Robinson discuss in detail how different data sources show different aggregate amounts of US MNE profits, making such analyses hard to reconcile. Further, while some estimate the response of profits to differences in country tax rates, others compare macrodata on foreign firms to local firms to define profit shifting. In a recent review of the literature, Asen (2021) reports more than 400 estimates across 37 academic papers of the responsiveness of firm level pre-tax incomes to differences in country tax rates, citing a meta-analysis by Beer, De Mooij and Liu.[x]

How Does Profit Shifting Occur?

When the average person hears the term profit shifting, they are likely to think of tax scams and fraudulent tax avoidance. In fact, as most research cited above acknowledges, profit or income shifting largely occurs through the pricing of intra-company transactions. Transfer pricing relies on the concept of arms-length pricing—in other words, all transactions within a company should follow the same pricing rules as a transaction with a third party. This is not a straightforward calculation and that leads to uncertainty and also allows for some flexibility on the part of companies to define what these prices should be. This is particularly hard to do for intangibles.[xi] In an earlier paper, Hines (1990) discusses the challenges with applying transfer pricing or arms-length pricing rules in practice.[xii] Since arms-length prices cannot be observed for all types of transactions, this creates a range of prices at which trade can happen between a firm and its subsidiary if they were to behave as unrelated parties, for example, as bilateral monopolies. More importantly, the reason that firms integrate is partly to exploit economies of scale and to not have to engage in transactions with unrelated parties across national borders and not face double taxation. So it’s often not clear what the “right” price is and how to enforce it. While some level of paper profit shifting presumably exists, what is the true allocation of income across jurisdictions?

A second means is through interest payments. By borrowing at high interest rates from low tax jurisdictions, companies might be able to offset some tax costs since interest payments are typically tax deductible. A final, and probably the most important, is the transfer of intangibles to low tax jurisdictions. Any income earned on intangibles, such as royalties or interest, is then taxed at lower rates. The issue with intangible assets is that by definition, there is no physical aspect to them, which makes it easier to “shift” these for tax purposes. Further, accounting rules also do not offer much clarity in terms of determining the value of these assets, which makes it easier to shift their value into low tax jurisdictions. Recent analysis shows that profit shifting is more common amongst firms with higher ratios of intangible to total assets.[xiii]

Real Impacts Of Profit Shifting

But what about the real economic impacts of profit shifting? While much of the focus has been on revenues, some papers suggest that the presence of tax havens may have beneficial effects on domestic employment and investment since firm profitability net of taxes is improved.[xiv] Using a tax law change that limited the ability of US MNCs to shift profits to Puerto Rico, Serrato (2019) finds that the tax rate of US MNCs increased by 5 to 6 percentage points which resulted in unintended negative effects on US domestic investment and employment. Other papers, like Desai, Foley and Hines (2014) show that foreign investment in tax havens is complementary to domestic investment.[xv] These impacts on investment and employment due to higher effective corporate tax rates can also impact worker wages. In one of the first empirical studies of corporate tax incidence, Hassett and Mathur (2015) show that higher statutory and effective tax rates across countries lead to lower wages for workers, working through the channel of lower direct investments.[xvi] A series of papers that have emerged over the last several years show varying levels of incidence of higher corporate income taxes on workers. Fuest et al. show that profit shifting may in fact dilute the impact of higher corporate taxes among firms who can shift income overseas, thus protecting workers from a decline in wages when statutory rates go up.[xvii] The takeaway from this research (for me) is not that we should encourage profit shifting to tax havens, but that competitive domestic corporate tax rates can lead to increased investment and employment in domestic countries. Hence reductions in corporate tax rates, such as what happened in the US in the Tax Cuts and Jobs Act, might reduce incentives to reallocate incomes and real activity overseas.

Impact On Revenues

Recent efforts by the OECD and the 2017 Tax Cuts and Jobs Act in the US try to address income shifting concerns by imposing minimum taxes on foreign profits irrespective of where profits are earned, putting restrictions on intra-company transactions through BEAT, and putting limits on interest deductibility. A salient question is, how much revenue would the US gain if we stopped profits from being shifted out of the US? At the top end of the range, if we assume that US$100-150 billion of income would be returned to the US annually, then at a statutory rate of 21 per cent, this would yield US$21-31 billion in additional revenues per year. However, at an effective rate of 15-16 per cent, this would yield even less. To put this in context, US corporate tax receipts were US$376 billion in 2021. So while there are possible revenue gains from going after shifted income, they are probably less significant for countries like the US.

Over 135 countries have come together as part of the OECD BEPS project. In October 2021, the G20 countries agreed to the proposed 15 per cent global minimum tax, one of the two pillars of the OECD approach to tackle tax avoidance. Debate on Pillar One, and details around the implementation of Pillar Two, will continue for the next several years. The work has created buzz in policy circles and in the media, and put companies under scrutiny (sometimes warranted) about their international tax planning efforts. Yet it is hard to reconcile the certainty with which these “solutions” are being adopted with the uncertainty which currently exists amongst researchers about the extent of the problem. How much of a problem is profit shifting? How do we differentiate between paper shifting of profits versus true income allocation? How much better off would the US be if we eliminated all tax planning by our MNCs? And most importantly, if we cannot define how much of a problem profit shifting is, then how will we know when we have won the war on it?

How much profit shifting is too much? I suspect we will be debating these questions for a long time to come.

Footnotes:

[i] https://www.oecd.org/tax/international-community-strikes-a-ground-breaking-tax-deal-for-the-digital-age.htm

[ii] Some of the earliest academic efforts to understand whether income and profit shifting exists come from papers by Grubert and Mutti (1991), Harris et al. (1993) and Hines and Rice (1990). See Dharmapala (2014) for an overview. 

[iii] https://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=2385&context=law_and_economics

[iv] https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1475-5890.2014.12037.x

[v] https://repository.law.umich.edu/cgi/viewcontent.cgi?referer=&httpsredir=1&article=2378&context=articles

[vi] https://gabriel-zucman.eu/files/TWZ2022Restud.pdf

[vii] https://www.nber.org/system/files/working_papers/w30673/w30673.pdf

[viii] https://pubs.aeaweb.org/doi/pdfplus/10.1257/aer.20190285

[ix] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3503091

[x] https://files.taxfoundation.org/20210621154304/What-We-Know-Reviewing-the-Academic-Literature-on-Profit-Shifting-TN-Fed.pdf?_gl=1*gm6wfp*_ga*MzE3NzA2NjY2LjE2Nzc1MTIzMDI.*_ga_FP7KWDV08V*MTY3NzY4NDQ4MS4zLjEuMTY3NzY4NDQ5MC41MS4wLjA.

[xi] Devereux and vella (2017)

[xii] https://www.nber.org/system/files/working_papers/w3538/w3538.pdf

[xiii] https://cepr.org/voxeu/columns/global-evidence-profit-shifting-role-intangible-assets

[xiv] https://www.nber.org/system/files/working_papers/w24850/w24850.pdf

[xv] https://www.bus.umich.edu/otpr/WP2005-2.pdf

[xvi] https://www.tandfonline.com/doi/abs/10.1080/00036846.2014.995367

[xvii] https://www.aeaweb.org/articles?id=10.1257/aer.20130570

Aparna Mathur
Aparna Mathur is a former Senior Fellow at Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government where she is researching the US social safety net. She is a Visiting Fellow at FREOPP and a Senior Research Manager in Economics at Amazon. Aparna spent a year as a Senior Economist at the Council of Economic Advisers during the pandemic. She joined the Council as part of the COVID-19 response task force at the peak of the crisis in April 2020 and worked with epidemiologists on the health aspects of the crisis, while also tracking the economic downturn that came with the lockdowns. Prior to joining CEA, she was a resident scholar in economic policy studies at the American Enterprise Institute. At AEI, she directed the AEI-Brookings Project on Paid Family and Medical Leave, building bipartisan momentum on paid leave, for which she was recognized in the Politico 50 list for 2017. Her academic research has focused on income inequality and mobility, tax policy, labor markets and small businesses. She has published in several top scholarly journals including the Journal of Public Economics, the National Tax Journal and the Journal of Health Economics, testified several times before Congress and published numerous articles in the popular press on issues of policy relevance. Her work has been cited in leading news magazines such as the Economist, the New York Times, the Wall Street Journal and the Washington Post. She has regularly provided commentary on prominent radio and television shows such as NPR’s Marketplace and the Diane Rehm Show, as well as CNBC and C-SPAN. She has been an adjunct professor at Georgetown University’s McCourt School of Public Policy. She received her Ph.D. in economics from the University of Maryland, College Park in 2005, and is currently serving on the University of Maryland Economics Leadership Council. She is also on the Board of the National Academy of Social Insurance, Simply Green and the National Economists Club.