Governments and Multinational
Corporations in the Race to the Bottom
Rosanne Altshuler (Rutgers University) and
Harry Grubert (U.S. Treasury Department)
Tax competition and the “race to the bottom”
• Focus tends to be on host countries using tax policy
instruments such as statutory tax rates and tax incentives
to compete for mobile capital, but
– neglects role of corporate tax planning by multinational
corporations (MNCs)
– neglects role of home governments that facilitate this
planning through their tax codes
• There are three parties in the “race to the bottom”
– host governments, home governments, and MNCs
– tax havens play a passive role only
Goal of paper
• Understand role of the three parties in explaining the
reduction of corporate tax burdens worldwide
• Use data on operations of US MNCs to illustrate role of
each of the actors and how these roles may have evolved
– No single data set gives complete picture
• Country- and subsidiary-level data from Treasury tax files
• Data on foreign direct investment and country affiliate income
from Bureau of Economic Analysis (BEA)
• Focus on 1992 to 2002
– Emphasis on period after 1996
– Treasury regulations issued in 1997 greatly simplified
use of more aggressive tax planning strategies
Plan of today’s talk
• Background on new tax planning strategies
• Evidence on tax planning
–
–
–
–
Changes in firm level effective tax rates
The growth of income shifting at the subsidiary level
The location of income and real capital
Revenue estimate of the tax savings to US companies
due to new tax planning strategies
The new tax planning strategies
• What is a hybrid?
– An entity that is incorporated from the host country point
of view and a branch from the US point of view (or viceversa)
• What is the advantage of using hybrid?
– Allows US companies to avoid the current US tax under
the CFC rules on inter-company payments like interest,
royalties, and dividends
– A hybrid entity makes this payment invisible to the US
because it all occurs within one combined entity
• Setting up hybrids simplified by check-the-box regulations
passed in Dec. 1996 and effective Jan. 1, 1997
– All the company had to do to create a “disregarded”
entity was check the box on a tax form
– Once the box is checked, the entity disappears from the
US view
Hybrid entities
•
Parent injects equity into tax haven
•
Tax haven lends to high-tax affiliate
•
High-tax affiliate makes interest payments
–
•
But, check-the-box on the high-tax affiliate
–
•
Transaction invisible to Treasury which regards
combined tax haven - high-tax operation as a
consolidated corporation
Result
–
–
–
–
•
Interest would be taxable currently under US CFC
rules
Interest escapes current U.S. taxation
Interest deduction in high-tax country
Income deferred in tax haven
Interest not taxed anywhere!
Parent MNC
Equity
Tax
haven
affiliate
Interest
Loan
Data issue
–
In reports to the Treasury, the parent can elect to list
the surviving consolidated corporation as
incorporated in the high-tax location or the tax haven
Hightax
affiliat
e
More tax planning strategies with hybrids
• Move income across locations without tax implications
through payment of inter-company dividends
– Typically pay to “holding companies” in countries with
favorable regimes (exempt dividends and impose low
withholding taxes)
• Shift income from intellectual property like patents to tax
havens
– Tax haven engages in a cost-sharing agreement with
parent
– Haven affiliate licenses resulting technology to other
affiliates in exchange for royalty payments.
• These inter-company payments are invisible with check
the box.
• “Hybrid securities”
– Considered debt by host country and equity by
company receiving payments (more relevant for
dividend exemption countries)
Tax planning and changes in effective tax rates
Average Effective Tax Rates in Manufacturing for 58 Countries
Year
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Average
Effective Tax
Rate (AETR)
0.33
0.34
0.34
0.32
0.31
0.26
0.25
0.22
0.23
0.24
0.21
Standard
Deviation
0.85
0.98
1.03
1.05
1.09
0.89
0.86
0.72
0.79
0.77
0.67
AETR = taxes paid in host country/ E&P in host country
Data from Treasury tax files.
What explains the recent decreases in AETRs?
• Is country behavior (tax competition) or company behavior
(tax planning) responsible?
– Simple regression analysis of country level data from
1992 and 1998
– Results suggestive of a tax competition story
• Countries losing share of U.S. capital relative to their neighbors
cut their effective tax rates the most
• Countries with relatively high AETRs in 1990 and small countries
cut their rates more than the average
Company versus country behavior?
• Add statutory tax rate to analysis
– Statutory tax rate indicates incentives for company tax
planning at the margin
– Find that statutory tax rate plays no role in explaining
decreases in AETRs over the 1992-1998 period
• But, the story changes in 2000
– Change in capital share and initial effective tax rates no
longer explain differences in declines in AETRs
– Statutory tax rate has greater explanatory power
• Company rather than country behavior seems to be
explaining changes in AETRs in the most current data
Tax planning and changes in firm-level ETRs
•
Cannot directly observe extent to which tax planning has lowered
ETRS
•
Can look at whether factors explaining the variation in ETRs at the
firm-level have changed in recent years
– Hybrid entities and securities that allow income to be stripped out
of high-tax countries may weaken the relationship between
statutory rates and ETRs
•
Compare CFC level data for 1996 and 2000
– Statutory rate is smaller and much less significant determinant of
ETRs in 2000 than in 1996
– Role of profitability in explaining differences in ETRs has changed
• Higher profitability now associated with lower ETRs
– R&D intensive CFCs in 2000 have lower ETRs
• Suggests that companies are able to shift income from R&D projects in hightax countries to hybrid entities in tax havens through royalty payments
Evidence on the location of income and real capital
1996
2000
$160.8
$231.1
44%
36.5
82.5
126
6.4
19.8
209
Tangible capital in all countries (net plant & equipment plus
inventories)
767.5
982.4
28
Tangible capital in five major holding company low-tax
countries
(Bermuda, Cayman Islands, Netherlands, Luxembourg,
Switzerland)
51.7
145.9
182
Earnings and profits of CFCs with parents in finance in the
seven major low-tax countries
5.1
5.6
10
Total pre-tax earning and profits
Earnings and profits in seven major low-tax countries
(Ireland, Singapore, Bermuda, Cayman Islands,
Netherlands, Luxembourg, Switzerland)
Dividends received in the seven major low-tax countries
Dollars in billions. Tabulations from Treasury tax files. All CFCs.
Growth
Evidence on income shifting
• Subsidiary level data from Treasury tax files
• Compare income shifting behavior in 1996 and 2000
• Results
– Significant widening in the profitability disparities
between high-tax and low-tax countries
• Possible explanations
– High-tax countries may have reacted to increasing tax
sensitivity of investment by easing up on transfer pricing
and thin cap rules to attract mobile corporations
– Some highly profitable subsidiaries in high-tax countries
may have disappeared
Evidence of tax planning in the BEA data
• Information from majority owned foreign affiliates (MOFAs)
• US parents are instructed to include income from equity
investments in foreign affiliates in their report of total
income for each MOFA
– Advantage: includes information from disregarded
affiliates
– Disadvantage: double counting of inter-company
dividends
• In fact, almost 100% of the growth of pre-tax income in seven
major low-tax locations between 1997 and 2002 is attributable to
the equity in the income of other foreign affiliates
Evidence of tax planning in the BEA data
All countries
Income
from equity
investments
Pre-tax
income
Income from
equity
investments
Pre-tax
income
Growth in
income
from equity
investments
1997
1997
2002
2002
1997-2002
Growth in
pre-tax
income
1997-2002
$41,781
$188,092
$120,782
$255,225
189%
36%
Ireland
1,414
9,359
8,502
26,835
501
187
Luxembourg
1,935
2,352
18,995
18,405
882
683
Netherlands
9,249
17,612
15,238
20,802
65
18
Switzerland
6,326
9,709
11,515
14,105
82
45
Bermuda
1,649
5,933
22,142
25,212
1,243
325
Cayman Islands
1,046
2,678
2,268
2,809
117
5
578
5,765
2,465
7,533
326
31
22,197
53,408
81,125
115,701
265
117
Selected low-tax
countries
Singapore
Total
Dollars reported in millions.
Inter-company income and worldwide tax payments
• Inter-company payments may be deductible in host
country and thus save host country taxes
• We estimate inter-company payments deductible in the
paying country but exempt from tax in the receiving
country saved US MNCs $7 billion in foreign taxes in 2002
compared with 1997
– About 4% of total foreign affiliate income --- a
substantial reduction in a short period
Conclusions
• Suggestive evidence that the roles of the three parties may
have changed over the last decade
• From 1998 on, tax planning by companies seems to be
much more significant, facilitated by the more permissive
US rules introduced in 1997
• Results illustrate importance of including both company tax
planning and the cooperation of governments in any
accurate depiction of race to the bottom
• Results show the difficulty of using the data to understand
the “real” location of profits and how it has changed over
time