Tax policy colloquium on transfer pricing regulations

Yesterday at the colloquium, Li Liu of the IMF presented her paper (co-authored with her colleague Ruud de Mooij), At a Cost: The Real Effects of Transfer Pricing Regulations. This paper finds interesting and significant results regarding the play-out when certain EU countries, between 2006 and 2014, adopted tougher and more fully specified rules regarding transfer pricing by multinational companies (MNCs). I found the results credible, both intuitively and in terms of how the paper reached them, although the authors would be the first to agree that, because this is a fairly novel research area, more work is needed to see if similar results arise using different periods and data sets.

I'll offer comments on it here in three buckets: the model it uses, several of its main empirical results, and international tax policy takeaways.

1. THE MODEL

Suppose an MNC is deciding whether to add marginal real investment (e.g., buildings, factories, offices, or stores, whether owned or rented) in a given country where it already has some sort of physical presence. In a standard economic model, this depends on the marginal investment's expected after-tax return (treating, let us say, the MNC as risk-neutral).

If productive inputs would be needed with respect to using the marginal real investment, then one choice the MNC faces is whether to acquire such inputs (a) in-house, or (b) from third parties. Absent tax considerations, this might be a fairly straightforward analysis. But once we have source-based taxation that makes use of transfer pricing under the arm’s length standard, things complexify a bit. Use of a cross-border affiliate permits the MNC to engage in profit-shifting, via the use of a transfer price that is either “too high” (if the source country’s tax rate exceeds that of the affiliate’s country) or “too low” if it’s the other way around.

The more aggressive the transfer price – at least, if it is too high, and one is profit-shifting OUT of, not into, the particular source jurisdiction – the greater the chance that it will be challenged by the local tax authorities. In the model, this triggers two kinds of costs: (a) the chance of a penalty, including via the ultimate selection of a transfer price less favorable than the MNC could have gotten away with had it been less aggressive, and (b) its triggering extra compliance costs, such as from mass document production or paying experts to support one’s position. So there is in principle an optimal level of aggressiveness here.

Suppose that the country initially just had a vague and general “arm’s length” requirement in its substantive law. But then it adopts more detailed substantive transfer pricing regulations (TPR) that specify particular methods, etc.

Focusing for now just on the outbound profit-shifting, the MNC may now find that the optimal level of aggressiveness in its transfer pricing has declined. So it will now expect to face a higher domestic tax liability (including from compliance costs) than before TPR was adopted. It might even switch from using in-house to third party suppliers for some of the productive inputs, but this would only mitigate the expected cost, not make things as wonderful as they were pre-TPR (given that it had previously been using affiliates).

By lowering the expected after-tax return from the marginal investment (or equivalently in the model, increasing the cost of capital), the adoption of TPR would be expected to reduce marginal real investment in the jurisdiction.

As we will see, an important further aspect of the model is that TPR might also constrain inbound profit-shifting from higher-tax jurisdictions. Even though the source country’s tax auditors are unlikely to pose angry challenges to inbound profit-shifting, which increases domestic tax revenues, I presume that the idea here is that, by specifying the applicable rules, TPR restrains what the MNC is able to do in this dimension, consistently with following the new rules. Therefore, and I’ll return to this below as it’s an important point, TPR is assumed to have what I call two-sided, not just one-sided, effects. (It would be one-sided if it only restricted outbound profit-shifting.) The data appear to confirm that this is actually happening.

With two-sided transfer pricing effects, the adoption of TPR need not be a revenue-raiser even if the MNC’s real activity choices are unaffected thereby. But with the adverse effect on the expected after-tax return from the marginal real investment (which might be increased by reduced ability to use it for inbound profit-shifting from higher-tax jurisdictions), one would expect the rate of new real investment in the jurisdiction by the MNC to decline. The paper’s main, but not only, research question is: Does it indeed decline, and if so, then by how much?

Why would the country care if marginal real investment by the MNC declines? While leaving for further discussion below the question of what the country’s full policy aims might be, the paper’s answer is that this might negatively affect positive productivity spillovers that would accrue to the benefit of the country’s residents.

This answer appears to invite (although it does not require) thinking in terms of a conventional two-factor production model (capital plus labor) in which real investment increases local workers’ productivity, and thereby their wages. But often talk of inbound MNC investment focuses on potential knowledge spillovers. More on that distinction shortly.

In terms of thinking about the model’s real-world application, I would add or emphasize the point that often, the relevant MNCs are earning global rents or quasi-rents (from now on, I’ll just say “rents,” for concision) by reason of their valuable intellectual property (IP). Given that the IP already exists, marginal real investment in the jurisdiction is likely only to earn a normal or routine return, at least in terms of its own productive contribution to the process.

Consider, for example, a pharma company producing one of its hot new products at a production facility in a tax haven. The value lies in the patent, and likely not much (if at all) in any of the production facility’s (or its managers’ and workers’) distinctive attributes. Thus, in a true arm’s length negotiation between the pharma company and a third party producer, the latter would likely only be able to capture a normal or routine return.

Ditto for Starbucks operating coffee shops in a given country (which I discuss a bit in my new paper that is nominally or partly about digital service taxes). Whatever large profits the Starbucks global group may be able to rake in by reason of its having, say, a shop every 50 feet (it can almost seem) in London, the value isn’t being added by the local drudges who manage and work in the facility. If Starbucks mainly used franchising in lieu of company-owned stores (and could do this without hurting the brand), you can bet they would extract what they could from the third party franchisees, leaving the latter with only normal or routine returns.

But once we have transfer pricing between affiliated entities, and in the absence of any global consensus that MNC profits should be taxed purely in the true production countries – which is not necessarily where the MNCs have located their IP for tax purposes! – the countries in which these routine production facilities have been placed may have an opportunity to capture some of the rents, under the (probably false) premise that the MNC would have had to share these with the local affiliate, despite its likely quite modest contribution to true value and profitability.

Back to the model and the MNC’s marginal real investment decision: adding such investment in the country might often reasonably be viewed as (a) offering only a modest pretax boost to profitability, since the real assets are likely to earn just a normal return so far as their contribution is concerned, (b) allowing the MNC through aggressive transfer pricing – like Starbucks’ in the UK – to claim zero or even negative taxable income in the country, if it likes, and (c) allowing the country, if it more assertively takes on the transfer pricing challenge, to use it as a vehicle for taxing some of the MNC’s global rents.

With TPR allowing the government to do some of this that is tied to the level of the MNC’s real investment in-country, I think it can usefully be thought of as akin to the case in which local tax profits depend partly on the use of property-based formulary apportionment (FA). Property-based FA operates somewhat like a property tax, except that the local percentage of the MNC’s global property is then applied to global profits that include rents, wherever one thinks they were “actually” created or realized.

Just like TPR as modeled in the paper, property-based FA is two-sided. It can shift profits either into the country or out of it, compared to a method in which true productive contributions were being taxed in the places where they “truly” happened. And TPR as modeled in the paper, just like property-based FA, can mean that inbound real investment carries a property tax-like domestic tax price in the form of having greater domestic tax profits that are not necessarily linked to the marginal real investment’s true (and presumably merely normal or routine) contribution to the MNC’s global profits.

2. MAIN EMPIRICAL RESULTS

The paper is based on studying EU data from the years 2006-2014. During this period, 6 countries introduced transfer pricing regulations (TPR) within the paper’s criteria. All of these countries were fairly small: Bosnia & Herzevogina, Finland, Greece, Luxembourg, Norway, and Slovenia. This raises questions regarding the findings’ more general applicability when larger EU countries – say, the UK (for the moment), France, and Germany – or other countries that are one or both of large and non-EU make similar changes.

That said, the paper’s main empirical results include the following:

a) The average TPR adoption reduced MNCs’ marginal rate of inbound investment by 11 percent.  What is more, the MNCs appear to be investing just as much worldwide as they would have absent TPR’s adoption, suggesting that marginal investments are being shifted to other countries, not reduced. The paper further finds that purely domestic businesses do not appear to be offsetting the reduction in inbound MNC investment by picking up the slack themselves.

Comment: This lives up to the paper’s title – suggesting that TPR comes “at a cost” even if one wants to raise revenue and reduce profit-shifting. But I will return below to the question of how one might think about the relationship between marginal real investment and positive productivity spillovers, given that this may depend on knowledge inflows, as much or more as on the application of a standard capital plus labor production model.

b) TPR’s effects on marginal real investment, as well as on other things such as reported domestic profits, are much greater if the adopting countries also have thin capitalization rules (TCR) than if they don’t.

Comment: This is both plausible and interesting. It suggests that MNCs use transfer pricing and the sorts of intra-group interest flows that TCR can address as substitutes for each other. Hence, countries that want to address profit-shifting need to consider broad-ranging, integrated approaches – as to which, of course, they also need to think about the full range of likely effects.

c) TPR appears significantly to reduce reported domestic tax profits, and thereby tax revenues (under constant statutory corporate income tax rates) in low-tax countries. In high-tax countries, there was a smaller finding of reduced profits and tax revenues, but it lacked statistical significance.

Comment: An issue about the paper’s distinction between high-tax and low-tax countries concerns the small group of 6 (themselves small) EU countries that adopted TPR during the period under study. This implies just 3 countries in each group (although a given country’s status as high-tax or low-tax may have differed as between years), and one wonders also about the classification metric. Luxembourg, for example, has a reputation for being lower-tax in practice, and deliberately so, than one might have thought from merely consulting its statutory rate. And even if the other 5 countries weren’t trying as hard to be accommodating to MNCs, issues of their (possibly either low or heterogeneous) capacity to audit effectively might affect what status they really ought to have in this regard.

Explaining this result – especially given finding (d), which I’ll discuss next – appears to require placing some weight on the two-sided character of TPR changes. Low-tax countries would have in particular the prospect of revenue loss from reduced inbound profit-shifting. And that’s one of only two mechanisms to explain the finding – the other, of course, being reduced inbound investment by reason of TPR’s adoption.

If we fully accept this result, it’s potentially pretty decisive in its impact on the question of whether, from a unilateral national welfare standpoint, a country like the 6 in the study ought to push ahead and adopt TPR. Losing revenue while ALSO marginally discouraging inbound real investment does not sound like a great step forward.

d) Adopting TPR causes what the paper calls the “TPR-adjusted corporate income tax rate” to be 23% higher. This is not a finding about post-TPR effective tax rates. Rather, it concerns MNCs’ sensitivity to the statutory rate. Apparently, for such purposes it’s as if this rate has increased by 23% of its pre-TPR level, presumably given that outbound profit-shifting (if desired) is now harder to accomplish than it had been previously.

Thinking about this finding in conjunction with finding (c) suggests to me that TPR may significantly increase expected compliance costs. After all, why act as if the rate were now 23% higher if one isn’t actually going to be reporting more profits and paying higher taxes? The relationship I suggest here may not be entirely certain, but would make it easier to explain why an MNC might be reporting lower profits, paying lower taxes, and yet being more averse than previously to the unchanged statutory rate.

3. MAIN POLICY TAKEAWAYS

Two in particular occur to me:

a) The “at a cost” framing and empirical takeaway (from reduced inbound real investment) fits well into my general normative framework these days for thinking about international tax policy – which is that countries face a host of what I call “Goldilocks issues.” The little girl in the Three Bears fairytale liked her porridge best if it was “just right,” rather than too hot or too cold. Likewise, countries that are setting their policy at a number of different margins – e.g., how to tax inbound investment from MNCs that may be more tax-elastic than purely domestic businesses, how to tax outbound investment by resident MNCs, and how much outbound profit shifting by MNCs to tolerate – often don’t have a clear right answer at a given 1-or-zero pole. Rather, tradeoffs place them somewhere in the middle, although unfortunately “just right” is likely to be harder to find than it was in the fairytale for Goldilocks herself.

Revenue-raising TPR that reduces inbound real investment would very plausibly raise exactly these sorts of tradeoffs and intermediate solutions. So I welcome empirical research that may help us in evaluating tradeoffs, and indeed in understanding what they are.

b) Adopting TPR looks like it was a bad idea in the particular circumstances that the paper examines. But that might crucially depend on its two-sided character, rather than on the inherent challenges (real though they are) of responding to tax competition unilaterally.

What might be a plausible unilateral national welfare objective for a country, like the 6 that adopted TPR in the survey data? It might be: revenue-maximization from MNC taxation, adjusted for any negative effect on positive productivity spillovers.

Two considerations make the revenue maximization piece especially plausible here. First, at least for the likes of those 6 countries, the MNCs are likely to be almost 100 percent owned by foreign shareholders. Thus, taxes on the MNCs that those shareholders bear economically are likely to transfer wealth from foreign individuals to the domestic Treasury. Second, the extent to which the MNCs are earning global rents raises one’s confidence that their shareholders will bear the MNC taxes economically – a prospect that might be dim indeed if the MNC was merely earning normal returns that it could also earn elsewhere. So the presence of rents, and the country’s capacity to reach them, not just the marginal local returns to real investment, is crucial to this conclusion.

Once one is actually losing revenue from TPR, things don’t look so great from it. But this is easy to understand in the framework where we think of TPR as akin to increasing property-based FA. So the lesson for me is to find other ways of getting at rents. As my DST-et-al paper discusses (and thus, as will be a center stage issue at next week’s NYU Tax Policy Colloquium), this inquiry might lead one in very different directions. It requires that one think further about such options as (1) sales-based FA and its more sophisticated sibling, residual profit allocation, and (2) novel tax instruments such as digital service taxes or diverted profits taxes.