The study from this project

International Tax Competition: Is it harmful?

• Includes an assessment of in which areas (i.e. fields of taxation) there may potentially be significant international tax competition, and points to implications for production and welfare.
• Aims to establish to what extent competition is harmful, and in what ways – based on recent empirical evidence for tax competition and profit shifting across borders.
• Discusses how to alleviate the problems of international tax competition.

The project has been conducted within the framework of the programme

Global Markets and Governance commissioned by the Norwegian Ministry of Foreign Affairs, and has been carried out at Centre for International Economics and Shipping (SIØS), at Norwegian School of Economics and Business Administration (NHH) and Foundation for Research in Economics and Business Administration (SNF).

Summary

Over the years the modelling of tax competition has seen a steady increase in the incorporation of real life features. This in turn has made it less straightforward to predict the outcome of tax competition. Furthermore, from the political branch of the tax competition literature comes the encouraging message that tax competition may increase welfare. A reasonable assessment of the literature is therefore that it is divided in its view on tax competition; taxes may fall but it is not always a ‘race to the bottom’; nor is a fall in tax rates always bad even when governments maximize the welfare of their own citizens. The literature on multinationals and corporate tax competition is less encouraging. The basic message here is that MNCs seem to have considerable discretion in setting prices on intra-firm trade and that MNCs are sensitive to statutory tax rates. As a consequence income is shifted to low tax countries. Competition over scarce capital in this context seems to lead to a downward pressure on tax rates.

Introduction

The past two decades have witnessed a growing trend towards economic integration where national borders have diminished in importance, and capital, firms, and labor have become more mobile internationally. Hand in hand with the economic integration of independent economic systems -- local, national, and otherwise -- has been the immense growth of multinational enterprises. Multinational corporations (MNCs) are firms that engage in foreign direct investment (FDI), defined as investments where the firm sets up a subsidiary in a foreign country or acquires a controlling interest in a foreign firm. Most of these investments turn out to be horizontal direct investments, that is, foreign production of products and services similar to those the firm produces for its home market. Vertical investments in contrast geographically fragment the production process by stages of production.

FDIs have grown rapidly throughout the world, with particularly strong surges in the late 80s and 90s. For example, at the end of 1997, the gross product (value added) of all multinational corporations including parent firms stood at an estimated $8 trillion, comprising roughly a quarter of the world's gross domestic product. 1World Investment Report 2000, Ch. 1, United Nations Furthermore, a significant share of world trade is intra-firm trade (about 30%). Developed countries account for most of outward and inward FDI, and that there is a substantial amount of two-way FDI flows between pairs of developed countries.

This paper focuses on MNCs and the challenges they pose for national autonomy in fiscal policy. The second part of the paper provides a short review of the empirical and theoretical literature on tax competition and offers some conclusions on this subject. The issues of multinationals and tax policy are treated separately.

Multinational corporations (MNCs) and transfer pricing

Transfer pricing arises when two affiliates of an MNC transfer a tangible or intangible good or service between them. If the price on the intra-firm transaction deviates from the price that would have occurred if the parties had not been related (often referred to as the arm’s length price), transfer pricing is the result. Transfer pricing is relatively easy for tax authorities to prevent if the market for the asset sold is well functioning. However, with MNCs the transferred assets are often specialized or intangible in nature (like technology). Hence, accurate information on the true value of the good will be difficult to find and the MNC may have considerable discretion in setting its transfer price.

Determinants of transfer pricing It is recognized in the literature on MNCs that transfer pricing arises for at least two reasons. The first pertains to tax and tariff reasons, while the second relates to market strategy and strategic commitment.

The tax motive for transfer pricing arises when intra-firm trade takes place between subsidiaries in different tax jurisdictions. 2The seminal work by Copithorn (1971) and Horst (1971) initiated the research on profit shifting. Gresik (2001) provides a survey of the literature. In such cases the MNC would seek to save tax payments by shifting income from high-tax to low-tax jurisdictions by choosing transfer prices on intra-firm transactions that increase the costs in high-tax jurisdictions and the income in low-tax jurisdictions. The tariff motive arises if the importing subsidiary must pay tariffs on intra-firm traded goods. An ad valorem tariff on imports means that the MNC underinvoices its sales to the importing subsidiary. In some cases the MNC must take into consideration both tax and tariff policy when setting the transfer price. If tax considerations dictate a high transfer price (i.e., shifting profits away from the importing affiliate), but tariff considerations warrant a low transfer price, the policy of the MNC will be determined by the relative importance of these two effects. In essence, a high transfer price will be the result if the effective relative tax on profits on the hand of the importing subsidiary is higher than the effective tariff.

The transfer price may also take on a role as a strategic instrument. 3See Schjelderup and Sørgard (1997) for an analysis. If the headquarters of the MNC determine the transfer price, but delegate decisions about prices or quantities abroad to its subsidiaries in these markets, profits will increase if local competitors react favorably. This is the principle of delegation, borrowed from the Industrial Organization (IO) literature and used in the context of multinationals. 4The gains from delegation have been discussed extensively in the IO-literature and Basu (1993) provides a survey of the literature. To illustrate how it works, suppose that an affiliate in a foreign market faces a local competitor and quantity is the strategic variable. The central authority within the MNC may benefit from setting a low transfer price (below marginal costs). Such a price will render its affiliate a low cost firm that behaves aggressively by selling a larger quantity. The first best response of the competitor to such aggressive behavior is to reduce its own sales, thus, enabling the affiliate and the MNC as a whole to earn greater profits. 5These precommitment gains have been shown to exist even if one allows for renegotiation of the contract between the principal and the agent, see Caillaud et.al. (1995). See Elitzur and Mintz (1966) and Gabrielsen and Schjelderup (1999) for other applications of incentive schemes in the context of MNCs.

If tax and strategic considerations coexist, transfer pricing may be guided by conflicting incentives. Strategic incentives may warrant a low transfer price while tax considerations dictate a high transfer price. However, both effects may also go in the same direction providing strong incentives to either under- or overinvoice.

Taxing multinationals At present, taxation of profits of MNCs is in most countries based on Separate Accounting (SA) principles. Under SA, the total income of the MNC is divided among its affiliates based on each affiliate's accounts and the application of an arm's length pricing standard for intra-firm transactions. Since the price on such intra-firm transactions is often not observable in the market place, national tax authorities rely on several methods to impute the price that would have been obtained between independent parties. These methods involve either the use of (a) comparable arm's length prices for similar transactions, (b) estimated costs plus a profit margin, (c) the resale price (achieved by subtracting a measure of profits from the sales price), (d) split profits (that is, partitioning of profits between the vendor and the purchaser), or (e) comparable profit measures. 6The US has recently enacted laws that allow the use of quite different schemes to curb transfer pricing such as the Comparable Profits method (see Schjelderup and Weichenrieder (1999), for an analysis) and the Advanced Pricing scheme. Not only are these methods imperfect and costly to administrate, but the use of arm's length pricing standards is not coordinated internationally. Hence, there is a potential for conflict between states that happen to use different standards for the same transaction. 7Raimondos-Møller and Scharf (1998) investigate the problems that arise in such cases.

The empirical evidence for transfer pricing

There is substantial evidence for tax-motivated transfer pricing. These studies can be grouped into two. The first group studies transfer pricing in various industries. Their findings are not uniform across industries. 8For a survey of this literature, see Hines (1999) Diewert (1985) and Eden (1985) study Colombian affiliates of U.S. MNCs. They find evidence for markups ranging from 25% in the chemical industry to 155% in the pharmaceutical industry. Industry markups are also found in Grubert and Mutti (1991) and Hines and Rice (1994) who analyze the aggregate reported profitabilities of U.S. affiliates in different foreign locations in 1982. Both studies find strong indirect evidence for transfer pricing in that high taxes reduce the reported profitability of local operations. Different from these studies are Bernard and Wiener (1990) who find no evidence for transfer pricing in the petroleum industry in the period 1973-1984. Chan and Lynne (1997) investigate industry level data and find only weak evidence for tax-induced transfer pricing but find that firms are using transfer pricing in connection with foreign exchange transactions.

The second group studying transfer pricing uses firm level data. Harris et al. (1993) report that U.S. tax liabilities of American firms with affiliates in tax havens are significantly lower than those of comparable domestic firms over the 1984-1988 period. They estimate that through profit shifting these firms reduce the U.S. tax liability by 52 percent. Studies by Grubert, Goodspeed and Swenson (1993) also find evidence for profit shifting through transfer pricing using U.S. firm level data. Grubert and Slemrod (1998) report income shifting among U.S. firms operating in Puerto Rica. Recently, Collins, Kemsley and Lang (1998) have studied a pooled sample of U.S. multinationals. They find that `normalized' reported foreign profitability exceeds U.S. profitability among firms facing foreign tax rates below the U.S. rates. In Europe, Weichenrieder (1996) presents evidence that German firms have taken advantage of the low Irish tax rate in the manufacturing sector by shifting the returns to financial assets (passive income) to their subsidiaries in Ireland. Subsequent German tax legislation that restricted the ratio of passive to active income that could be earned in a foreign country led to a shift from financial to real investment in Ireland, in order to avoid the new constraint.

Tax competition, in the presence of multinationals and transfer pricing

The reform of existing corporate tax systems in the OECD countries in the presence of multinationals has been a long-standing issue in both policy and academic debates. In particular, the switch to a cash-flow income tax, which leaves new capital formation untaxed, has long been advocated. Today the full exemption of investment and savings from tax continues to be a frequently demanded tax reform in North America and underlies the `flat tax' proposed by Hall and Rabushka (1995). In the European Union, similar proposals have been made by the IFS Capital Taxes Group (1991) and the switch to a cash-flow tax has also been recommended as an alternative to the EU-wide harmonization of corporate income taxes (Cnossen and Bovenberg, 1997).

However, corporate tax reforms in OECD countries since the 1980s have, if anything, gone in the opposite direction. Elements of cash-flow taxation, as were introduced in the United States through the Accelerated Cost Recovery System (ACRS) as well as in the United Kingdom, were partly taken back in subsequent tax reforms. More generally, statutory corporate tax rates have been reduced substantially in many OECD countries while effective marginal tax rates on capital have remained surprisingly stable over the past decade. This indicates that the cut in corporate tax rates has, on average, been accompanied by a simultaneous broadening of the corporate tax base.

One possible reason for this discrepancy between policy recommendations and actual corporate tax reforms may lie in the increasing internationalisation of national economies, in particular through the growing importance of multinational corporations (MNCs). In the period from 1983 to 1995, earnings from foreign direct investment have increased by more than 600 per cent worldwide, rising from less than 50 billion U.S. Dollars in 1983 to almost 300 billion Dollars in 1995 (International Monetary Fund, 1996). Much of this new investment has taken place between OECD countries, where the stock of both outward and inward foreign direct investment as a share of GDP is substantially above the world average (cf. Markusen and Venables, 1998). Several authors have stressed that, as a consequence of these developments, corporate tax bases in the OECD have become more vulnerable to strategic transfer pricing and other profit shifting activities by MNCs, which respond primarily to differences in statutory tax rates between countries (see, e.g., Devereux 1992; Keen, 1993).

Several recent papers have addressed corporate tax competition in the presence of multinational firms. Transfer pricing by the MNC is explicitly introduced in the analyses of Mansori and Weichenrieder (1997) and Raimondos-Møller and Scharf (1997), who model competition in transfer pricing regulations by the two governments. In both studies a ‘race to the bottom’ may be the outcome of tax competition. Elitzur and Mintz (1996) discuss corporate tax competition under alternative transfer pricing rules when the transfer price affects both the overall tax payment and the incentives for the subsidiary's managing partner. They find that the transfer price can be used to shift profits as well as to affect performance of the firm.

Janeba (1998) reconsiders the strategic trade policy problem of Brander and Spencer (1985). Brander and Spencer show that if two firms, each located in a different country, compete by exporting to the world market, each government has a unilateral incentive to subsidize its firm’s exports. The subsidy basically acts as a commitment device to expand the firm’s market share. Since both governments have the same incentive, however, the two countries end up in an inefficient subsidy race. Janeba uses this framework, but allows firms to choose the location of production. The location decision depends on the subsidies (or taxes) offered by both governments. When governments cannot discriminate between the two firms, the noncooperative equilibrium entails zero subsidies/taxes. Thus mobility of firms leads to lower subsidies (or higher taxes) than in the case without mobility and both countries prefer the new outcome. The basic intuition for this result is that neither government wants to subsidize the other’s firm. The unilateral move from an equal subsidy to a slightly less generous subsidy means that outputs and profits are basically unchanged, but the change of the firms’ location reduces the subsidy bill. The outcome with mobility is not efficient because in an oligopolistic market output is either too high in the absence of consumer surplus considerations or too low when consumer surplus matters.

When governments lack commitment power, mobility of firms can lead to lower equilibrium tax rates, like in the traditional tax competition literature, but this may be efficiency enhancing. In Janeba (2000) a multinational firm has to invest in capacity before production can take place. If the government lacks commitment power and taxes the firm only after the firm has made its investment (and before output is produced), a standard time-consistency problem arises: Once the firm has made its sunk investment, the government levies a high tax rate, which - when anticipated by the firm - leads to no investment because the firm is unable to recoup its investment cost. The problem is quite different if the firm has the option to invest in multiple countries even when all of them lack commitment power. By holding more capacity in several plants than necessary to serve the market, the firm can induce tax competition for capacity utilization. If tax rates come down sufficiently, the cost of investing in excess capacity is recouped.

Haufler and Schjelderup (2000) analyse the effects of cross-border profit shifting on corporate tax systems and show that the tax-rate-cut-cum-base-broadening reforms observed over the past decade can be motivated as an optimal policy adjustment to the rise in foreign direct investment. In their framework two small countries face a fixed world interest rate. Each government can endogenously choose both the rate and the base of the corporation tax, but is constrained by the assumption of a fixed revenue constraint. In the absence of foreign direct investment and transfer pricing, the first-best policy in each country is to allow a full deduction of domestic investment expenditures and to set the corporate tax rate high enough to satisfy the budget constraint. When foreign direct investment and transfer pricing are incorporated, however, the corporate tax rate introduces an additional and independent distortion from the perspective of each taxing country. It then becomes optimal to allow only an imperfect deduction of investment expenditures and thus distort the firm's investment decision, since this permits a lowering of the corporate tax rate and a reduction in the incentive to shift profits abroad. 9These results are cast in a tax competition framework by considering the properties of the Nash equilibrium when both countries simultaneously choose their optimal tax systems. The findings in the paper by Haufler and Schjelderup thus indicate that recent tax reforms with reduction in statutory tax rates and broadening of tax bases can be an optimal response to the increased presence of multinationals.

The empirical evidence for tax competition

Although the early models of tax competition suggest that taxes on mobile capital should fall, refinements of these models in general dampen the downward trend of taxes, and in some cases show that taxes may even increase. Investigation of statutory tax rates shows that they fell in the 80s and 90s seemingly supporting the hypothesis that countries compete over capital. Sørensen (2000), for example, shows that in OECD countries average tax rates on retained income fell from 51.1 percent in 1985 to 38.1 percent in 1999. One should, however, be careful when interpreting such numbers since recent tax reforms in OECD countries have combined cuts in statutory tax rates with measures to broaden the tax base. Furthermore, data show that corporate tax revenues have been stable over the years both as a share of GDP and as a share of total tax revenue. 10See Chennels and Griffith (1997) and Bond and Chennels (2000). Taken at face value, these numbers suggest that the competitive pressures affecting taxes on mobile capital are weak. However, data also show that for the OECD countries, the overall tax burden over time has increasingly fallen on labor indicating that governments try to shift the burden of taxation towards immobile factors of production. > 11See Sørensen (2000). It is also generally accepted that portfolio investments are more mobile internationally than foreign direct investments, and the sharp drop in statutory tax rates can be interpreted as fierce competition over portfolio investments. A reasonable conclusion is therefore that in order to assess if countries do compete over capital, one needs to undertake empirical studies.

Empirical studies on tax competition suffer from lack of good data. The corporate tax, for example, falls on both mobile and immobile activities, and it is impossible to find data that separate the two from each other. It is also difficult to find data that separate corporate income from income arising from taxing portfolio capital. Other problems pertain to the large variation over time in the way tax bases are defined across countries. These problems create obstacles for analysis that may affect conclusions. 12For a discussion of these problems in more detail see Devereux and Griffith (2001).

In examining evidence for tax competition one can look for direct or indirect evidence. Indirect evidence is if studies show that firms’ location decisions are sensitive to changes in taxes on capital. If this were the case, welfare maximizing governments would lower their taxes in order to attract capital. A number of studies have examined indirect evidence for tax competition. The general conclusion from this literature is that the allocation of capital is very sensitive to tax policies. 13See Hines (1999) for a full review of this literature.

The direct evidence in support of direct tax competition is more fragmented. For the US and European countries there is support for the hypothesis that local governments compete. > 14Brueckner (2001) provides a survey of these findings for the US, while Murdoch, Sandler and Sargent (1997) provide a cross-country study of European countries. Interdependent tax setting has been shown to arise from expenditures in one jurisdiction that affect neighbouring jurisdictions (for example money spent on reducing pollution); from ‘yardstick competition where voters in one region judge politicians in other regions in order to assess how their own politicians perform; and from competition to attract mobile capital.

The evidence supporting that countries engage in tax competition is less conclusive and the number of studies is scant. Chennels and Griffith (1997) calculate effective and implicit tax rates for the period 1979-1994. The aim of their study is to confirm findings in theory that; (a) small countries set lower taxes than large countries, (b) that the differences in tax rates between small and large countries depend on the mobility of capital, and (c) that importing countries set their tax rates at (or below) a dominant capital exporter. They do not find support for any of these hypotheses. Devereaux, Lockwood and Redoano (2001) construct countries’ reaction functions by using ‘forward looking’ effective tax rates. They find evidence to suggest correlation between statutory and average tax rates among countries, but not marginal tax rates. Their study concludes that there is evidence for international tax competition. Finally, Besley, Griffith and Klemm (2001) estimate whether the tax setting behavior of OECD countries is interdependent. Their study asks if taxes on mobile factors are lower than on immobile factors, and if interdependency in tax setting is greater between countries where capital is more mobile (say within the EU). Their findings support both hypotheses.

Tax coordination

A final question pertains to international coordination of tax policy and if such coordination can alleviate the effects of competition. Assuming that tax competition leads to lower taxes on capital and reduces welfare, it has been shown that a group of countries (like the EU) as a whole can gain from reaching an agreement on harmonizing taxes even if the rest of the world does not follow suit. The gain from the harmonization effort will then depend on the strategic response from countries outside the agreement. Konrad and Schjelderup (1999) show that harmonization among a subset of countries increases welfare for all countries (i.e., both within and outside the harmonizing coalition) if tax rates are strategic complements. Strategic complementarity means that harmonizing tax rates by increasing the rate to a common level among the coalition partners triggers a tax increase by the countries not part of the harmonizing coalition. Huizinga and Sørensen (2000) show that a tax increase in a EU tax haven will increase welfare in the EU partner country, despite the presence of an outside tax haven. Finally, Sørensen (2000, 2001) carries out numerical simulations that indicate a gain to all EU countries if they coordinate their tax policy and increase capital tax rates. His simulations are shown to hinge on the basic result provided by Konrad and Schjelderup (1999). These studies, although small in numbers, lead us to conclude that there is support for the notion that international cooperation can alleviate the downward pressure on tax rates.

Conclusions

Over the years the modelling of tax competition has seen a steady increase in the incorporation of real life features. This in turn has made it less straightforward to predict the outcome of tax competition. A good example is the recognition among academics that the public sector also provides public input goods that have a positive effect on firms’ performance, which may dampen the effect of tax competition. Furthermore, from the political branch of the tax competition literature comes the encouraging message that tax competition may increase welfare. In these models re-election concerns and the ‘forces’ of competition lead government officials to provide public good ‘packages’ that better suit the preferences of voters. A reasonable assessment of the literature is therefore that the literature is divided in its view on tax competition; taxes may fall, but it is not always a ‘race to the bottom,’ nor is a fall in tax rates always bad even when governments maximize the welfare of their own citizens.

The literature on multinationals and corporate tax competition is less encouraging. The basic message here is that MNCs seem to have considerable discretion in setting prices on intra-firm trade and that MNCs are sensitive to statutory tax rates. As a consequence income is shifted to low tax countries. Competition over scarce capital in this context seems to lead to a downward pressure on tax rates.

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Correspondence

Guttorm Schjelderup, Norwegian School of Economics and Business Administration, 5003 Bergen, phone +47 55959450, fax +47 55 95 95 43, e-mail guttorm.schjelderup@nhh.no

Ministry of Foreign Affairs, contact Torbjørn Frøysnes, phone +47 22243339, or Dagfinn Sørli,

phone +47 22243511, e-mail: torbjorn.froysnes@mfa.no or dagfinn.sorli@mfa.no