The Missing Profits of Nations

Perhaps the most striking development in tax policy throughout the world over the last few decades has been the decline in corporate income tax rates. Between 1985 and 2018, the global average statutory corporate tax rate has fallen by more than half, from 49% to 24%. In 2018, most spectacularly, the United States cut its rate from 35% to 21%.

Why are corporate tax rates falling? The standard explanation is that globalization makes countries compete harder for productive capital, pushing corporate tax rates down. By cutting their rates, countries can attract more machines, plants, and equipment, which makes workers more productive and boosts their wage. This theory provides a consistent explanation for the global decline in tax rates observed over the last twenty years and offers nuanced normative insights (see Keen and Konrad, 2013, for a survey of the large literature on tax competition).

Our paper asks a simple question: is this view of globalization and of the striking tax policy changes of the last years well founded empirically? Our simple answer is “no.” Machines don’t move to low-tax places; paper profits do. By our estimates, close to 40% of multinational profits are artificially shifted to tax havens in 2015. The decline in corporate tax rate is thus the result of policies in high-tax countries—not a necessary by-product of globalization. The redistributive consequences of this process are major: instead of increasing capital stocks in low-tax countries, boosting wages along the way, profit shifting merely reduces the taxes paid by multinationals, which mostly benefits their shareholders, who tend to be wealthy.

Another simple question one might ask is: if the costs for governments in high-tax countries really is substantial, why does this form of tax avoidance persist? Our paper bridges this gap by making two contributions, one empirical and one theoretical.

Our first—and most important—contribution is to produce new estimates of the size of global profit shifting using the macroeconomic data of tax havens. We construct and analyze a simple macro statistic: the ratio of pre-tax corporate profits to wages. Thanks to the new foreign affiliates statistics exploited in this paper, we can compute this ratio for foreign vs. local firms separately. Our investigation reveals spectacular findings. In non-haven countries, foreign firms are systematically less profitable than local firms. In tax havens, by contrast, they are systematically more profitable—and hugely so. To understand the high profits in tax havens, we provide decompositions into real effects (more productive capital used by foreign firms in tax havens) and shifting effects (above-normal returns to capital and receipts of interest). The results show that the high profits-to-wage ratios of tax havens are essentially explained by shifting effects.

In the second step of our empirical work, we use new bilateral balance of payments statistics to trace the profits booked in tax havens to the countries where they have been made in the first place—and would have been taxed in a world without profit shifting. This allows us to provide the first comprehensive view of the cost of profit shifting for governments worldwide. We find that governments of the European Union and developing countries are the prime losers of this shifting. By our estimate, tax avoidance by multinationals reduces E.U. corporate tax revenue by around 20%. When we look at where the firms that shift profits are headquartered, we find that U.S. multinationals shift comparatively more profits than multinationals from other countries.

Our second contribution is to explain why, despite the high revenue costs involved, high-tax countries in Europe, developing countries, and the rest of the world have been unable to protect their tax base. Our innovation is to focus on the incentives faced by tax authorities, which had not been studied until now.

We show theoretically that the fiscal authorities of high-tax countries do not have incentives to combat shifting to tax havens, but instead have incentives to focus their enforcement effort on relocating profits booked by multinationals in other high-tax countries. Chasing the profits booked in other high-tax places is feasible (the information exists), cheap (there is little push-back from multinationals, since it does not affect much their global tax bill), and fast (a framework exists to settle disputes between high-tax countries quickly). This type of enforcement crowds out enforcement on tax havens, which is hard (little data exists), costly (as multinationals spend large resources to defend their shifting to low-tax locales), and lengthy (due to a lack of cooperation between haven and non-haven countries).

We provide the first analysis of data on tax disputes between tax authorities. Our analysis shows, consistent with the theory, that the vast majority of high-tax countries enforcement effort are directed at other high-tax countries.

This policy failure is reinforced by the incentives of tax havens. Although some of them like Bermuda have 0% corporate tax rates, most, like Ireland and Luxembourg, have low but positive rates. By lightly taxing the large amount of profits they attract, they have been able to generate more tax revenue, as a fraction of their national income, than the United States and non-haven European countries that have much higher rates. The low revenue-maximizing rate of tax havens can explain the rise of the supply of tax avoidance schemes documented in the literature. Our findings have implications for policy.

First, they suggest that cutting corporate tax rates, is less likely to generate quick positive effects on wages than textbook economic models suggest. For wages to rise, productive capital needs to increase, which can happen fast if capital flows from abroad, much less so if only paper profits move. Second, profit shifting reduces the effective tax rates paid by multinational corporations compared to what local firms pay. Whatever one’s view about the efficiency cost of capital taxes, this seems difficult to justify—especially if part of the profits of multinationals derive form rents, which standard models suggest should be taxed.

Our results also suggest that some of the current policy efforts aimed at reducing tax avoidance by multinational corporations may in fact exacerbate it. The OECD has launched an initiative to curb base erosion and profit shifting. Action 14 of this plan calls for more effective dispute resolution mechanisms (OECD, 2015). But the easier it is for, say, the French tax authority to relocate profits booked in Germany, the less resources it will devote to chasing the profits shifted to Bermuda—increasing shifting to low-tax locales and reducing corporate tax revenue globally.

Last, our findings show that headline economic indicators, including GDP, corporate profits, trade balances, and corporate labor and capital shares, are significantly distorted. The flip side of the high profits recorded in tax havens is that output, net exports and profits recorded in non-haven countries are too low. We provide a new database of corrected macro statistics for all OECD countries and the largest emerging economies. Adding back the profits shifted out of high-tax countries increases the corporate capital share significantly.

The complete paper is available for download here.