NYU Tax Policy Colloquium, week 6: Ruud de Mooij on profit-shifting (semi-)elasticities

Yesterday at the Tax Policy Colloquium, Ruud de Mooij of the IMF presented his paper (coauthored by Sebastian Beer and Li Liu at the IMF), International Corporate TaxAvoidance: A Review of the Channels, Magnitudes, and Blind Spots.

The piece is a meta-study of profit-shifting by multinational corporations (MNCs). That is, it in effect combines all the prior studies, using them as data to be amalgamated towards seeking an overall empirical bottom line from research to date. The prior studies’ weighting may be affected by the numbers of observations they had, confidence intervals that they found, etc., but not by the meta-studier’s (so to speak) view that, say, some were better studies than others.

Profit-shifting here means “the international reallocation of profits by an MNC in response to tax differences between countries, with an aim to minimize the global tax bill. Hence, we ignore reallocation of real capital in response to tax.” In other words, the response being studied is formal or artificial profit-shifting, not actual changes in where substantial economic activity takes place. In practice, of course, and as the paper notes, real and artificial reallocations are richly intertwined with each other – e.g., an MNC may put a factory here rather than there not just due to statutory tax rates, but because of how it can or can’t profit-shift, with respect either to this particular factory or anything else it might happen to be doing around the world.

The paper’s headline finding is that the average semi-elasticity over the period from 1990 to 2015 was 0.98, but this reflects an upward trend from 0.6 in 1990 to 1.5 in 2015. But let’s build in a bit more background about why and how the issue is of interest, before discussing what the headline empirical finding here actually means.

What is profit-shifting? – Reallocation of profits by reason of tax rate differences presupposes a prior allocation that would have prevailed otherwise. It’s of course well-known that source issues regarding where profits arose often lack clear answers, even assuming that one has (controversially) decided on the question of what it means for a dollar of profit to have arisen here rather than there (e.g., when there is a multi-jurisdictional productive integration or else a cross-border sale). The underlying conception one has in mind might involve both “true” profit-shifting relative to a correct standard, and tax rate-motivated interpretation of source rules that leave one room to place a dollar of profit here rather than there, even holding constant one’s relative substantial economic decisions about what to do where.

Why does profit-shifting matter? – The two inputs into a given MNC’s source-based income taxation in a given country are the rate and the base. Suppose we think of the latter as “true” source-based income (despite that concept’s limitations, as noted above) as adjusted for profit-shifting. In a high-tax country, this will presumably tend to be net profit-shifting out of, rather than into, the jurisdiction.

Given that the MNC’s tax liability is a product of the rate and the base, profit-shifting’s effect on the latter does not automatically matter all by itself. Rather, one needs to push a bit further to establish why and how it might matter.

Suppose that a given country wants to impose a 15 percent effective tax rate on MNCs’ true source-based income. Without more to the question, one might be indifferent about whether it got there by (a) measuring the MNCs’ income accurately and directly imposing a 15% rate, or (b) allowing 40 percent of the profits to be out-shifted and imposing a 25% rate on the rest.

But why not just measure the income accurately and impose the rate one likes? Well, it’s not as simple as that. For one thing, if monitoring profit-shifting is costly, it might make sense to up the nominal rate in lieu of spending the extra resources to get it exactly right.

But I think there are two main considerations here, in terms of why care about profit-shifting, with greater practical force than just that::

a) For optical reasons, both domestic and international, one may want to apply the same statutory rates to MNC income and that earned by purely local businesses. Yet one may want the MNCs to face lower effective rates, because they are more mobile. A relatively extreme example would be Ireland’s quite rationally, from a unilateral national welfare standpoint, offering Apple a special tax deal. Allowing just the “right” amount of profit-shifting, but not “too much,” may be a convenient (if not exactly first-best) way of getting there.

b) Despite its artificial character, profit-shifting generally isn’t costless, so requiring companies to engage in it may create deadweight loss. (Then again, differential tax rates around the globe may also lead companies to incur deadweight loss, and profit-shifting opportunities can enable them to reduce that other DWL.) But even insofar as profit-shifting induces MNCs to incur extra DWL, a given jurisdiction may not care much about it, on the view that the individuals bearing it may be foreign (e.g., shareholders across global capital markets) rather than domestic.

Semi-elasticities vs. elasticities – Again, the paper finds an MNC profit-shifting semi-elasticity of 0.98 for the entire period from 1990 to 2015, but rising throughout the period so that by 2015 it stood at about 1.5. What does this mean in plainer English.

A semi-elasticity, in this particular context, is a change in reported profits per 1 percent change in the corporate tax rate. Thus, if the semi-elasticity is 1.5 percent throughout, then reported profits – holding the real location of investment constant – will decline by that percentage whether the corporate rate rises from (say) 20% to 21%, 33% to 34%, or 66% to 67%.

Econometric research often offers elasticities, rather than semi-elasticities. Had the paper’s measure been stated in terms of elasticities, rather than semi-elasticities, it would have offered a number for the change in reported profits, by reason of changes to profit-shifting, as the corporate tax rate changed by a percentage of its prior level.

If the corporate rate rises from 20% to 21%, it has increased by 5% of its prior level. Accordingly, here a semi-elasticity of 1.5 = an elasticity of .3 (i.e., as stated in terms of a 1% change in the prior corporate rate, as distinct from in the absolute corporate rate).

Likewise, a semi-elasticity of 1.5 as the corporate rate increases from 33% to 34% (i.e., by 3% of its prior level), equates to an elasticity here of .5.

And a semi-elasticity of 1.5 as the corporate rate increases from 66% to 67% (i.e., by about 1.5% of its prior level) equates to an elasticity here of 1.0. This would imply, all else equal, that 66% was the revenue-maximizing corporate rate.

In short, constant semi-elasticities would imply rising elasticities, since the same 1% increase in the absolute corporate rate becomes an ever-smaller relative increase as we get higher up.

The fact that the U.S. corporate rate just changed by so much – from 35% to 21% counting the federal component only, adds interest to the question of whether one should think of the semi-elasticity as likely to be comparable at different absolute rate levels. Other changes to the U.S. corporate tax rate by reason of the 2017 tax act may also affect the answer to this question. Thus, suppose we think of the enactment of GILTI as meaning that U.S. MNCs are no longer looking at driving their global tax rate down from 35% to 0% when they profit-shift out of the U.S., but instead just from 21% to 13.125%. (This is based on the GILTI marginal rate of effectively 10.5%, increased for the foreign tax liability that would be needed to zero out one’s GILTI liability, given that foreign taxes are only 80% creditable thereunder.) This might conceivably reduce both the elasticity and the semi-elasticity of profit-shifting for such MNCs for the post-2017 period, relative to pre-2018.

One also should presumably be cautious about assuming that the same semi-elasticities apply to very large, as opposed to much smaller, tax rate changes. For example, suppose that the semi-elasticity is simply 1.5 throughout. Then lowering the U.S. corporate tax rate from 35% to 21% would have caused about a 23 percent increase in the reported U.S. corporate tax base. As per the paper’s Table 6 (on page 20), a 23 percent increase in the reported 2015 U.S. corporate tax base would have caused it to be more than 100 percent of the year’s “true” corporate tax base. (This is basically 1.5 percent times 14, upped slightly by reason of compounding.)

This would have been by no means paradoxical or inconsistent. It would simply have meant that there was now, in the hypothetical 2015 to which 2018 law applied, net inward profit-shifting to the U.S., rather than net outbound from the U.S.

Nonetheless, I personally would have thought that a surprising result, given that there are still plenty of tax havens out there. On the other hand, it is true that some set of things constrains profit-shifting, or else reported profits would be zero everywhere apart from in the havens. But I don’t think that either I personally, or we collectively, have a good handle on the cost functions and everything else that determine how much profit-shifting occurs. What exactly limits it? We may have some general ideas, but not very well-honed and specific ones.

Doing some simple arithmetic with the numbers in Table 6, had the 2015 U.S. reported corporate tax base been 23 percent greater, but the tax rate 14% lower, there would have been an overall revenue loss of about $80 billion. Although this ignores real (as opposed to mere profit-shifting) effects on where investment and economic activity are actually located, it helps one to see why it was so totally obvious (at least to the fair-minded) that the 2017 U.S. corporate rate cut would lose a ton of revenue, unless there was a wildly unrealistic level of inbound real responses.