NYU Tax Policy Colloquium, week 13: Jane Gravelle's "Policy Options to Address Corporate Profit-Shifting: Carrots or Sticks?"

Yesterday Jane Gravelle presented the above paper, which she actually wrote for our session.  It addresses possible responses to profit-shifting by U.S. multinationals, either via carrots or sticks.  The carrots, or incentives to reduce profit-shifting, that it discusses are (1) lowering statutory tax rates, (2) patent or innovation box proposals, and (3) a lower tax rate on royalties earned abroad.  The sticks, or compulsory measures to reduce profit-shifting, that it discusses include (1) ending deferral and possibly cross-crediting, (2) restricting deferral and cross-crediting through interest allocation and foreign tax credit pooling, (3) expanding the scope of subpart F, (4) anti-inversion rules, and (5) formulary apportionment.

A starting point for the paper's analysis is a brief review of the empirical literature of the magnitude and U.S. tax rate elasticity of profit-shifting.  It concludes that the elasticity is fairly low.  Thus, for each dollar of tax revenues lost by lowering the U.S. corporate tax rate, only between one and nine cents would be recouped via reduced profit-shifting.

In principle, one might expect profit-shifting to be highly elastic.  After all, it's defined as finding ways to change the jurisdiction in which income is reported without actually changing anything significantly on the ground.  Nonetheless, a low elasticity measure makes intuitive sense given that profit-shifting typically permits the underlying income to be placed in a tax haven and taxed at zero percent.  Also, while  we don't have really have great models regarding how to think about profit-shifting, it's plausible that it requires incurring certain fixed costs, but then has low marginal costs for a while until somehow it reaches its limit.  (Not all of multinationals' profits end up in tax havens, after all.)  Is there a "cliff" at the end?  Or a range of rising marginal costs that suddenly grow steep?  (These could involve, e.g., audit risk and/or inconvenience from tying up internal funds.)  It's not entirely clear. However, low elasticity makes intuitive sense if, to some extent, companies are asking themselves - once the fixed costs have been incurred, and if there's a "cliff" that they've already reached - whether they'd rather pay tax at zero or at the U.S. rate.  From that standpoint, 25% might not be that much different than 35%, implying low elasticity.

This empirical point governs the paper's analysis of using carrots to reduce profit-shifting.  It suggests that one should not enact tax cuts for multinationals just so they'll do less profit-shifting, because there's still likely to be a large revenue loss.

The paper takes the view that the main problem associated with profit-shifting is revenue.  Once that's the framework, then of course one shouldn't lower tax rates in response to profit-shifting, unless we're above the peak of the Laffer curve, which the low elasticity estimates contradict.

I agree that there's a fallacy or non sequitur in arguments for lowering the corporate rate, etc., in response to profit-shifting.  But, if one is thinking about what international tax policy ought to look like, rather than about bad arguments that are  currently being made in Washington, the issue raised by profit-shifting isn't revenue - it's revenue in relation to deadweight loss (plus of course distribution issues, although these require thinking about corporate tax incidence).

Profit-shifting surely does waste some resources (both directly in terms of its enabling mechanisms, and indirectly via the operation of deferral), but the core point about it is that it enables multinationals to reduce their effective tax rates.  So the big question is what  their effective tax rates should be, and and also how one gets there (e.g., what role, if any, should deferral and foreign tax credits play).

There are tax neutrality reasons for wanting multinationals (both U.S. and foreign) to pay the same effective tax rate on their U.S. economic activity as purely domestic businesses.  On the other hand, there are tax elasticity arguments for allowing multinationals to pay a lower effective tax rate, since they have more of an option to leave.  I regard these issues as fundamentally intertwined with the question of how best to respond to profit-shifting (which might be seen as having, in recent years, overly lowered multinationals' effective tax rates, even if one would be fine with their doing so up to a lesser point).

Plus, as I've written about elsewhere, there are major problems with how the U.S. rules get to the effective tax rates that they end up imposing.  Not to expatiate at length on all that here, but I regard both deferral and foreign tax credits as terrible rules (compared to simply having a lower statutory tax rate for foreign source income) that happen to have the odd effect of somewhat offsetting each other.  Less "lockout" if you can claim foreign tax credits; less dampening of the incentive to avoid foreign tax liabilities if you will be claiming deferral indefinitely.

So there's clearly a broader conversation needed, beyond just revenue.  But the low elasticity estimates do indeed suggest that "carrots" shouldn't be adopted on revenue grounds in response to profit-shifting.