International Tax Competition and Multinational Corporate Strategy
Saturday, January 24, 2004
Copyright Adam Robinson, 2004. Do not reproduce without prior consent from the author, Adam J. Robinson. Please write for proper footnoting and word format to Adam.Robinson@yale.edu. Also, visit the author's website at www.ajrobinson.blogspot.com
Globalization is the increasing multitude and depth of networks and relationships across boundaries and at great distances. In the last century, improvements in technology have significantly lowered the transaction costs of transportation and communication for firms and individuals, accelerating the pace of globalization. This has caused a compression of economic space that has made capital infinitely more mobile, creating competition for foreign direct investment among states that want to further integrate themselves into the world economy.
Foreign direct investment (FDI) is the private capital flow from a parent firm to a location outside of the parent firm’s home country. Competition for capital in the form of FDI is especially fierce because the evidence is almost unanimous that FDI significantly benefits the country that receives it. Studies have shown that FDI facilitates the transfer and diffusion of technology from foreign to domestic firms and that an educated labor force significantly speeds up this process beyond a certain threshold. Additionally, FDI increases competition within the private sector, creating more efficient and transparent domestic firms.
To become a competitive FDI recipient, governments must improve their efficiency in the eyes of capital-owners, offering upgraded governance in exchange for the tax rate they impose. Competition for FDI has already had significant effects on the world economy. Skeptics argue that this increased “harmful” competition among governments for FDI has spurred a race to the bottom in labor and environmental standards. Additionally, they assert that instead of becoming more efficient, governments just transfer more of an ever-increasing tax burden onto immobile factors such as land and labor. Others argue that competition for FDI has begun a race for better governance, which can then justify a country’s tax rate on capital and ultimately expand its capital tax base.
From the perspective of a multinational firm, choosing where to invest depends on the pivotal relationship between what a country has to offer and its corporate tax rate. Are the services provided and the advantages of the location worth the tax rate charged? Most important to this relationship is the effective corporate statutory tax rate in the home country. But firms can often legally employ transfer pricing strategies at certain parts of the production process where fair market value is difficult to determine, and thereby reduce or avoid its home’s tax regime. Transfer-pricing strategies effectively achieve more bang for the firm’s buck – as the ratio of services to the tax rate actually paid is significantly reduced.
For the purposes of this paper, I will analyze globalization’s effect on tax competition between countries from the multinational firm’s perspective. I will discuss differing tax regimes across countries in detail, elaborating on the advantages of each to the multinational firm. I will use evidence in the form of inflows and outflows of FDI to corroborate my assertions. The multinational’s goal is to tailor a strategy to different countries based on their tax regimes and what the location and services there provide in return for its tax payments.
From the country perspective of attracting FDI, I will analyze what services should be emphasized in terms of government spending in order to justify the corporate tax rate. Education and job training are significant factors (to improve the ratio of labor quality to labor cost), along with political and economic stability, corruption elimination, a strong judiciary and civil service system to enforce contracts and private property, government loans and subsidies to research and development, as well as personal and institutional security for investors and investments. I will expand on a model by Alesina and Rodrik (1994) to show that increased investment on education and job training should reduce taxes on capital in democracies over the long term. I argue, because of the model, that education spending should be looked upon even more favorably by multinational firms, beyond just its labor-enhancing effects.
Finally, throughout this paper I will examine case studies that best exemplify an effective international corporate tax strategy, from both the firm and country perspective. Specifically, I will analyze the cases of Ireland, the United States, India, Austria, and Singapore. To conclude, I will make recommendations for the way tax regimes should be reformed across countries to stimulate investment, equity and efficiency in the long run.
In a global capitalist economic system, a firm cannot be successful without maximizing revenues and minimizing costs. The profit motive, a central tenet to this system, implies that a firm will aggressively cut costs if it is in its long-term growth interests, and taxes are often one of a firm’s biggest costs. “There is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible,” Learned Hand, the most prominent American judge not appointed to the US Supreme Court, once said. “Everybody does so, rich and poor; and all do right, for [in a capitalist system] nobody owes any public duty to pay more than the law demands.” In a capitalist system, if a firm does not minimize its tax burden it will face the consequence of being acquired or out-competed by a firm that does. When the firm expands abroad, it should therefore determine the advantages and disadvantages of different tax regimes. More broadly, it should also determine the importance of the tax regime in relation to other factors before deciding where the firm eventually invests.
The two most significant things multinational firms consider from the tax perspective when deciding where to invest are: the corporate statutory rate (taxes assessed on corporate profits), as well as how countries treat worldwide income in the country (foreign tax regime). The most common foreign tax regime employed by members of the Organization for Economic Co-operation and Development (OECD) grants an allowance of an exemption for all repatriated worldwide profits. Governments provide these exemptions to maximize profits reinvested in their home country from a multinational and their foreign subsidiaries.
If combined with a low tax rate, this reinvestment often generates more tax revenues for the home country in the long run, because it frequently leads to more growth, and profits, which are then taxed. If the country’s statutory tax rate were high, reinvestment in the home country would subject firms headquartered there to high taxes, which may have been the reason the firm chose to invest abroad in the first place. If the corporate statutory rate is high, the firm would invest all profits abroad in a low tax country and then repatriate under the exemption only what is necessary to keep the domestic firm alive, avoiding the higher domestic tax rate. The end result is that from a government standpoint, exemption strategies may only improve revenue if they are employed in conjunction with a low corporate statutory rate.
This exemption strategy remains advantageous because many other countries employ a foreign tax credit regime, in which they attempt to tax worldwide income of multinational corporations based in their country at their own corporate statutory rate. Under a foreign tax credit regime, a tax credit is given (up to a full exemption) for taxes paid to foreign governments. An unfortunate cost of this extra tax revenue is the worldwide profits that, if not for the high corporate tax rate on repatriated income, might have been reinvested in the home country.
Theoretically, from the perspective of the multinational firm, the most tax-competitive country is one that imposes the smallest corporate statutory rate and exempts worldwide income. Under that scenario, a firm could reinvest worldwide profits in its headquarters and allocate money from there to foreign affiliates without worrying about repatriating profits later.
Empirical evidence from 19 OECD countries supports that multinational firms take into account both the corporate statutory rate and the type of tax regime when they choose where to invest. I draw on evidence compiled by Gropp and Kostial (2000) for the IMF, which split countries into exemption regimes and tax credit regimes and measured the sensitivity of FDI to the corporate statutory rate. They tested to see if FDI inflows were significantly positively affected by a low corporate statutory rate while outflows were significantly negatively affected. They further tested to find whether FDI outflows were significantly more sensitive for the exemption group than for the tax credit group of countries. They did this to find whether firms based in exemption countries with high corporate statutory rates experience much more FDI outflow, because the firm can entirely avoid domestic taxes by sending profits abroad and repatriating them later under the exemption. The evidence supported their hypotheses. FDI outflows (inflows) are significantly smaller (larger) for low tax countries even beyond the 1% confidence level. Further, FDI outflows are significantly more sensitive to the corporate statutory rate for exemption countries compared to tax credit countries, to a 1% confidence level.
While other factors were also significant, the corporate statutory rate and tax regime were by far the most significant factors determining FDI inflows and outflows. This evidence was later corroborated by Lehmann (2002), which significantly negatively related the corporate tax rate to returns on foreign equity investments (as opposed to FDI flows). Additionally, the studies concluded that international tax competition exists, and that competition is not just a product of what is normally thought of as low-rate tax havens.
For example, Ireland has a 12.5 % corporate statutory tax rate on both foreign and domestic firms. Marketing itself as the best buy in Europe in terms of services offered (i.e., in terms of legal environment and economic stability) for taxes assessed, Ireland is positioned to become the e-commerce center of Europe. The Economist notes, “The country’s recent economic boom has owed much to low taxes on foreign firms moving there. GDP per capita, which as recently as 1990 was 70% of the EU average, now exceeds Britain’s, and is expected to exceed the EU average by around 2005.” The rise of the Internet and e-commerce will make tax competition an even more relevant factor to where a firm invests, because with e-commerce location-specific advantages and governance are often unnecessary except for the outright physical security of the databases and servers that run the virtual world. Corporations would not and should not be willing to pay much for such limited government services.
These facts make the threat of tax havens far more acute from the standpoint of many governments, because “opaque” tax havens can help to hide assets and prevent them from being taxed. Electronic assets compound this threat because they leave no record in the country from where they came and therefore can easily escape enforcement by that country’s tax regime. There is strong evidence that the threat is already a reality. By 1994, total FDI into tax havens had increased five-fold from a decade before to US$ 200 billion. Even more astounding, in the same year “tax havens accounted for 1.2% of world population and 3% of world GDP, but 26% of the assets and 31% of the net profits of American multinationals (though only 4.3% of their workers).”
This implies the existence of sketchy transfer pricing strategies by these firms that significantly reduce their tax burdens as well as the corporate tax revenues of their home government. Transfer-prices, defined by the OECD as “payments from one part of a multinational enterprise for goods or services provided by another,” are troublesome for tax purposes because they can be distorted in ways that avoid tax regimes and unevenly divide profits among countries. This example should explain why transfers are unique:
"Consider a profitable UK computer group that buys micro-chips from its own subsidiary in Korea: how much the UK parent pays its subsidiary – the transfer price – will determine how much profit the Korean unit reports and how much local tax it pays. If the parent pays below normal local market prices, the Korean unit may appear to be in financial difficulty, even if the group as a whole shows a decent profit margin when the completed computer is sold. UK tax administrators might not grumble as the profit will be reported at their end, but their Korean counterparts will be disappointed not to have much profit to tax on their side of the operation."
Korean companies under foreign ownership often apply for and receive government aid because of how weak their financial situation appears.
Transfer pricing becomes even more significant when one takes into account that 60% of all world trade occurs within multinational firms, indicating a huge potential for profit distortion. If transfer pricing below fair market value were legal, then firms could significantly lower their tax burdens by opening up company affiliates in tax havens and effectively storing profits there. To complete the strategy, these firms could purposely undercapitalize their other foreign affiliates and use these stored profits to recapitalize them.
If transfer pricing below fair market value is illegal in almost all countries, how does one explain 31% of profits of American multinationals being reported in tax havens? Beyond what goes on that is illegal, I believe the reason for it is that fair market value on many of a firm’s goods are almost impossible to determine at certain stages of production. Multinationals sidestep tax regimes by transferring products between affiliates at points in the production chain where the fair market value of the product is more or less arbitrarily determined, or when the value is not in the components or equipment used, but in intangible assets like managerial know-how.
An example of this would be trying to assess the fair market value of half of the assembled components of a car-fender. The market value for such things is no more than their value as raw material, but when combined with the other assembled half they suddenly acquire a much higher value, which translates into profits entirely made in the country where the two halves of the fender were put together. That assembly process might have been much less labor intensive than the assembly of each half-fender, but because the fair market value of the useless half-fender would probably be set at the cost of making it (because knowing how to put the two halves together – or the intangible asset – cannot be taxed by the government), the affiliates making each half barely break even, and might even get a tax refund or government aid. Meanwhile, the profits on the final product are barely taxed, increasing the global income of the multinational corporation and pushing its stock price up, even in the countries where the local subsidiary of the firm incurred a loss. The improved stock price then refinances, or even expands, the whole operation.
The United States has tried to address this increasingly huge revenue loss by threatening severe penalties (including criminal felony prosecution and huge fines) for below fair-market transfer prices between a company in the US and any foreign company with which it has a relationship. All US companies that do have such a relationship (often determined by at least 10% common ownership or control) with a foreign company are required to file US tax form 5471 or 5472 with its tax return. These forms disclose its common ownership or control relationships with other firms. A transfer-price study is also required, verifying that the transfer-price reported by the US firm is fair, ensuring that the correct profit is reported and appropriately taxed by the US government. Additionally, the US, through the OECD, has pursued opaque tax havens, forcing them to become more transparent, and since June 2000 only five tax havens of 41 worldwide remain “uncooperative.”
US efforts have been rewarded by exposing tax havens and increasing information sharing as well as establishing records of US companies with controlling stakes or common ownership of foreign companies. However, these efforts have still not significantly reduced the disproportionate amount of assets and profits reported offshore. The extent to which this has occurred has caused the US Congress to consider providing a one-year tax holiday in which the worldwide income of US multinationals would be exempted when it is repatriated back into the United States. The New York Times reported that the “Senate Finance Committee voted to include a “repatriation” provision in its tax bill… that would let companies bring up to $400 billion in untaxed foreign profits back into the United States at about one-seventh of the 35 percent corporate tax rate.” While revenues would drop drastically for the year, the reinvestment would hopefully stimulate economic growth and employment and create profits that would be more difficult to export under a future tax code. The proposed tax code changes are entirely a response to the increasingly fierce international tax competition occurring in the recent globalization era.
International tax competition does not, of course, minimize the importance of governance, natural resource endowments and location factors to international corporate strategy. From a government perspective, higher corporate tax rates could be charged to multinationals for the ability to use or access country-specific advantages, such as a large domestic market, relatively cheap labor, or a wealth of natural resources. Additionally, judging by both capital expenditures and FDI flows, corporations have been willing to pay more for things the government provides, such as a high quality labor force relative to cost, trade openness, economic growth prospects, stable inflation and exchange rates, reduced corruption levels, private property protection, a strong, stable legal environment, and democracy. But why are corporations willing to pay a premium for these factors in the form of higher tax rates? And what is the relative importance of these factors to the multinational firm?
The answer to the first question is undoubtedly because either the multinational firm cannot function without the service, or because the improvement to business is more than the cost of the tax. The second question is impossible to answer without reviewing the underlying specific needs if firms and specific country offerings. This is evidenced by the fact that almost every study on the subject offers different levels of relative importance for each factor that determines the destination of FDI.
For instance, India’s most attractive feature is a relatively cheap, qualified labor force. Increasingly, firms are looking to India to outsource their back office and information technology needs. Financial services companies and investment banks like Morgan Stanley, J.P. Morgan and Lehman Brothers are even starting to export research analyst positions there, replacing jobs on Wall Street that cost US$ 150,000 in salary with similarly qualified Indian analysts that cost just US$ 35,000. To show just how cheap qualified labor is in India, consider that the average salary of graduates from India’s top 4 business schools is only US$ 13,226.
India has also become the premier location where firms set up their technical support lines, in the form of call centers. The Wall Street Journal reports “an estimated 150,000 are employed by India's call centers, in jobs that have migrated mainly from the U.S. and Britain.” College graduates (India graduates 1.1 million people annually, though only 5 – 10% speaks English well) feed a need for a 100,000 strong labor force to work in call centers every year. Due to this trend, the Forrester Research of Cambridge, Mass, estimates that the US will lose one million jobs overseas in the next decade, with China, India, the Philippines and Russia expected to gain most of the work.
But why have firms only recently decided to invest heavily in India’s human capital? The country’s work force has been qualified and relatively cheap for some time. One reason is because India’s finance minister, Vijay Kelkar, has been in the process since November of 2002 of overhauling India’s tax code. In the fiscal year 2000-2001, the corporate statutory rate in India was 39.55 %, and after accounting for various tax incentives, for example, foreign banks were taxed on average 35.01 %. Kelkar is trying to push through a reduction of the corporate statutory rate to 30 %, but it seems unlikely that in the 2004 election year any significant changes to the tax code will be passed. Nonetheless, “Foreign investors will be closely following the developments in this area,” says Mukesh Butani, director of global tax advisory services for Ernst & Young in India. He concluded, “The tax administration has been identified as one of the roadblocks to foreign direct investment.”
The opposite is true for countries like Austria, Ireland and Singapore. Investment in Austria is bolstered by a relatively low effective rate of corporate tax (while the statutory tax rate is 34 %, after incentives are factored in the average corporate tax rate is 16.7 %). This is in addition to Austria’s extremely low property taxes, and low road freight toll-costs. Additionally, “the country has a network of more than 30 technology parks designed to provide ‘plug-and-play’ opportunities for companies ranging from start ups to major businesses.” By sacrificing initial tax revenues because of the attractive tax rate, Austria is now reaping the benefits. In 2000, there were about 2500 foreign companies employing approximately 300,000 Austrians, or 10 % of the total work force. Austria’s Trade Commissioner believes that “the country's workforce is a major attraction to many European companies.” Like Austria has, India should continue its efforts to complement its country-specific advantage in labor with an effective tax strategy, in order to lure more foreign direct investment.
Already mentioned, Ireland is another country that developing countries should emulate. In Ireland, “FDI has helped to transform a largely agricultural society into one of the fastest growing economies in Europe with one of the highest per capita GDP.” Supporting my argument, Veldi (2001) notes, “It is generally thought that fiscal incentives are the single most important reason for the recent surge of FDI.” In fact, a competitive tax strategy for over 40 years is primarily responsible for Ireland’s extremely “FDI-friendly image.” Dating back to the 1950s, Ireland had a 15-year (zero) tax holiday on export profits. In 1982, Ireland was forced to change the rate to 10% to be consistent with EU rules. This is in comparison to a standard 50% corporate tax rate that existed in Europe at that time. The result is that “FDI has created jobs in new sectors, raised investment and enhanced overall and local productivity.”
Similarly, Singapore has aggressively promoted FDI with enormous success. Since the implementation of the Pioneer Industries Ordinance of 1959, corporate tax rates on approved firms have been and still are as low as 4 %, provided that the firm raises a minimum level of capital intended for the development of new products. I believe that it is no coincidence that over the same four-decade period, Singapore’s GDP growth rate has averaged 10% annually, and that FDI as a percentage of GDP has risen from 5.3 % in 1965 to 98.4 % in 1998. Employment has also benefited immensely from such a huge FDI influx and attractive corporate tax rate, with foreign firms in 1998 employing 50.5 % of workers in manufacturing, 29.1 % in trade, and 25.7 % in finance. While Singapore is only a city-state in physical size, FDI inflows have turned it into the economic powerhouse of its region.
No matter what the primary factor is in determining where a multinational firm invests, as outlined in the case studies above, the country’s tax regime always plays a unique role. This is because after assessing the country-specific advantages of investment, the firm must always ask whether the benefits outweigh the tax costs. Drawing on these case studies and the preceding analysis, I will now speculate on corporate and country tax strategy in the long term. I will argue that a country can prosper in terms of increasing its inflow of FDI by filling what I will call the “intangible” niche. Finally, I will ask what countries might do in the long term to move toward this ideal.
When multi-nationalizing production, the firm should always assess what its specific needs from a government are at every separable point where value is added in the production chain. If a part of production does not require any sort of country-specific advantage, the firm should choose to produce in a country with a low tax rate. This is important from a firm perspective so that it can export the maximum “intangible value” of a product to a low tax country. Oftentimes, this just means exporting the managerial model or trade secrets of a firm to its foreign branch. That way, when the unfinished product arrives in the low tax country, it will be worth little on the open market compared to what it soon will be worth when the firm adds the “intangible value” ingredient.
The half-fender example mentioned earlier would help to explain the intangible value concept if most of the value (from which the profits come) of the completed fender were derived from the special, confidential, firm-specific way in which the halves of the fender were combined. In a more realistic example, Nike could separate the manufacturing of their shoes and the stamping of the Nike “swoosh” into different countries. Nike could transfer the generic shoe produced by factories in countries with a lot of cheap labor at fair market value to a low tax country, where it would then stamp on the swoosh, which contains the “intangible value” to which I have referred. Then Nike could sell the product from the affiliate in the low tax country for significantly more than they paid for the generic shoe, the profits of which would be subject to the lower tax rate.
This corporate tax strategy could work for all producers in which most of the intangible value of their product lies in a removable brand name. That is an example of just one way in which corporate investment decisions might be affected by a legal transfer pricing strategy.
If administering a brand name or a secret ingredient to a product is complicated (which with increasingly sophisticated technology it often is), this strategy may require significant job training, research and development by the company in the low tax country. A company might be willing to produce in a higher tax jurisdiction if there were government money allocated to subsidizing research and development, or a highly skilled, versatile work force that a company could use instead of having to train people with no technical background. Certain countries could fill this niche by offering a moderate corporate statutory rate and significant incentives to companies that would help reduce startup costs. Countries like Ireland and Bermuda have already begun to market themselves as exactly filling this niche. In fact, Ireland spends over US$ 170 million each year in grants to foreign direct investors, mostly to startup companies. These countries benefit from a broader corporate tax base and improved human capital from firm transfers of technology. Insofar as this technology diffuses into the domestic sector, domestic firm global competitiveness improves as well.
From the country perspective, on an even longer-term basis, governments could market high education spending to firms as an appropriate justification for their tax rate. As stated, a strong education system creates a high-skill, versatile labor force that could be useful to any company. Additionally, in democracies there is reason to believe that a highly-skilled population would vote in more pro-growth policies and eventually a lower tax rate.
This is true because citizens vote to maximize their welfare, and not necessarily to maximize economic growth rates. While often these two things go hand in hand, many times government redistribution policies cause capital to be taxed in such a way that reduces overall economic growth. This is logical from a government view insofar as it aids efforts to reduce the systemic problem of income inequality in society. If a society is very unequal in terms of capital (capital-owners almost always have the highest incomes), then to win elections the government should redistribute some of this income to increase the welfare of the majority – at the expense of the growth rate. The only way the electorate would vote in growth-maximizing policies is if they increase the welfare of the majority. This could indeed happen if everyone had equal and fair access to capital and education. Only through equality of opportunity can a majority of people improve their human capital to a point that a redistribution tax on capital would hurt the majority more than it would help it.
It makes sense, then, for both corporations and countries to invest heavily in improving education. From the country view, education provides a skilled, versatile labor force and in the long term less societal inequality, more economic growth and a lower tax rate, which they can advertise to firms in order to attract more foreign direct investment. From the firm perspective, education will improve profits in a country through lower tax rates and the country-specific advantage of an especially qualified labor force.
This idea was first demonstrated in a model created by Alesina and Rodrik (1994), in which they showed that income inequality in a country theoretically increases taxation and reduces economic growth. Their empirical results substantiated the model. Their investigation gives multinational firms and countries a common ground from which to build common development strategies. In the future, governments might want to make lower tax rates contingent on corporations investing in the further education and job training of their workers.
To conclude, this paper has focused on the effect of increased capital mobility on tax competition between countries for FDI, and how that subsequent competition has affected international corporate development and tax strategy. Studies have shown that corporate investment abroad depends most significantly on the rates at which the country plans to tax returns on that investment. Other factors, such as a cheap, high-skill labor force were also shown to significantly affect the firm’s decision of where to invest abroad, but the case studies I analyzed indicate that country-specific advantages best attract investment when they are also complemented with a moderate tax rate and incentives to make initial investments. Finally, I examined and explained the international transfer pricing system, as well as corporate strategies to utilize such a system to minimize its tax burden.
The reality of the situation is that the transfer pricing system currently in use is vastly inefficient from both country and firm perspectives. Firms end up paying astronomical amounts for accountants and economists to assess the fair market value of unfinished goods for which there is no market, and country tax administrators spend more and more of every dollar they collect hopelessly trying to keep up with the ways firms reallocate their resources to minimize their tax burdens – legally – which inaccurately assumes unlawful tax evaders do not exist. There must be a better way.
To fix these efficiency problems before the Internet exacerbates the situation, I believe the current transfer pricing system must soon be completely overhauled in favor of a “unitary tax.” This tax would involve “taking a firm’s total profits and allocating different slices of that total on the basis of a formula that reflects the firm’s relative economic presence in that country.” This would stop tax havens from “sucking out” revenues from the countries where the real value is added to the product, or would cause multinationals to actually reallocate some of their business to low tax countries, as has already been seen in the cases of Ireland, Austria and Singapore. This would preserve the competition for investment currently occurring under the transfer pricing system, but countries would more fairly receive tax revenues for the services and incentives they provide.
Overall, as globalization increasingly allows labor to join capital as a mobile taxpaying factor of production, there will be added pressure on governments to deliver their services more efficiently. Better education should hopefully stimulate voters to choose pro-growth policies that drive the innovations that will make labor become mobile, propelling the world economy and making it more equitable and efficient.
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Globalization is the increasing multitude and depth of networks and relationships across boundaries and at great distances. In the last century, improvements in technology have significantly lowered the transaction costs of transportation and communication for firms and individuals, accelerating the pace of globalization. This has caused a compression of economic space that has made capital infinitely more mobile, creating competition for foreign direct investment among states that want to further integrate themselves into the world economy.
Foreign direct investment (FDI) is the private capital flow from a parent firm to a location outside of the parent firm’s home country. Competition for capital in the form of FDI is especially fierce because the evidence is almost unanimous that FDI significantly benefits the country that receives it. Studies have shown that FDI facilitates the transfer and diffusion of technology from foreign to domestic firms and that an educated labor force significantly speeds up this process beyond a certain threshold. Additionally, FDI increases competition within the private sector, creating more efficient and transparent domestic firms.
To become a competitive FDI recipient, governments must improve their efficiency in the eyes of capital-owners, offering upgraded governance in exchange for the tax rate they impose. Competition for FDI has already had significant effects on the world economy. Skeptics argue that this increased “harmful” competition among governments for FDI has spurred a race to the bottom in labor and environmental standards. Additionally, they assert that instead of becoming more efficient, governments just transfer more of an ever-increasing tax burden onto immobile factors such as land and labor. Others argue that competition for FDI has begun a race for better governance, which can then justify a country’s tax rate on capital and ultimately expand its capital tax base.
From the perspective of a multinational firm, choosing where to invest depends on the pivotal relationship between what a country has to offer and its corporate tax rate. Are the services provided and the advantages of the location worth the tax rate charged? Most important to this relationship is the effective corporate statutory tax rate in the home country. But firms can often legally employ transfer pricing strategies at certain parts of the production process where fair market value is difficult to determine, and thereby reduce or avoid its home’s tax regime. Transfer-pricing strategies effectively achieve more bang for the firm’s buck – as the ratio of services to the tax rate actually paid is significantly reduced.
For the purposes of this paper, I will analyze globalization’s effect on tax competition between countries from the multinational firm’s perspective. I will discuss differing tax regimes across countries in detail, elaborating on the advantages of each to the multinational firm. I will use evidence in the form of inflows and outflows of FDI to corroborate my assertions. The multinational’s goal is to tailor a strategy to different countries based on their tax regimes and what the location and services there provide in return for its tax payments.
From the country perspective of attracting FDI, I will analyze what services should be emphasized in terms of government spending in order to justify the corporate tax rate. Education and job training are significant factors (to improve the ratio of labor quality to labor cost), along with political and economic stability, corruption elimination, a strong judiciary and civil service system to enforce contracts and private property, government loans and subsidies to research and development, as well as personal and institutional security for investors and investments. I will expand on a model by Alesina and Rodrik (1994) to show that increased investment on education and job training should reduce taxes on capital in democracies over the long term. I argue, because of the model, that education spending should be looked upon even more favorably by multinational firms, beyond just its labor-enhancing effects.
Finally, throughout this paper I will examine case studies that best exemplify an effective international corporate tax strategy, from both the firm and country perspective. Specifically, I will analyze the cases of Ireland, the United States, India, Austria, and Singapore. To conclude, I will make recommendations for the way tax regimes should be reformed across countries to stimulate investment, equity and efficiency in the long run.
In a global capitalist economic system, a firm cannot be successful without maximizing revenues and minimizing costs. The profit motive, a central tenet to this system, implies that a firm will aggressively cut costs if it is in its long-term growth interests, and taxes are often one of a firm’s biggest costs. “There is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible,” Learned Hand, the most prominent American judge not appointed to the US Supreme Court, once said. “Everybody does so, rich and poor; and all do right, for [in a capitalist system] nobody owes any public duty to pay more than the law demands.” In a capitalist system, if a firm does not minimize its tax burden it will face the consequence of being acquired or out-competed by a firm that does. When the firm expands abroad, it should therefore determine the advantages and disadvantages of different tax regimes. More broadly, it should also determine the importance of the tax regime in relation to other factors before deciding where the firm eventually invests.
The two most significant things multinational firms consider from the tax perspective when deciding where to invest are: the corporate statutory rate (taxes assessed on corporate profits), as well as how countries treat worldwide income in the country (foreign tax regime). The most common foreign tax regime employed by members of the Organization for Economic Co-operation and Development (OECD) grants an allowance of an exemption for all repatriated worldwide profits. Governments provide these exemptions to maximize profits reinvested in their home country from a multinational and their foreign subsidiaries.
If combined with a low tax rate, this reinvestment often generates more tax revenues for the home country in the long run, because it frequently leads to more growth, and profits, which are then taxed. If the country’s statutory tax rate were high, reinvestment in the home country would subject firms headquartered there to high taxes, which may have been the reason the firm chose to invest abroad in the first place. If the corporate statutory rate is high, the firm would invest all profits abroad in a low tax country and then repatriate under the exemption only what is necessary to keep the domestic firm alive, avoiding the higher domestic tax rate. The end result is that from a government standpoint, exemption strategies may only improve revenue if they are employed in conjunction with a low corporate statutory rate.
This exemption strategy remains advantageous because many other countries employ a foreign tax credit regime, in which they attempt to tax worldwide income of multinational corporations based in their country at their own corporate statutory rate. Under a foreign tax credit regime, a tax credit is given (up to a full exemption) for taxes paid to foreign governments. An unfortunate cost of this extra tax revenue is the worldwide profits that, if not for the high corporate tax rate on repatriated income, might have been reinvested in the home country.
Theoretically, from the perspective of the multinational firm, the most tax-competitive country is one that imposes the smallest corporate statutory rate and exempts worldwide income. Under that scenario, a firm could reinvest worldwide profits in its headquarters and allocate money from there to foreign affiliates without worrying about repatriating profits later.
Empirical evidence from 19 OECD countries supports that multinational firms take into account both the corporate statutory rate and the type of tax regime when they choose where to invest. I draw on evidence compiled by Gropp and Kostial (2000) for the IMF, which split countries into exemption regimes and tax credit regimes and measured the sensitivity of FDI to the corporate statutory rate. They tested to see if FDI inflows were significantly positively affected by a low corporate statutory rate while outflows were significantly negatively affected. They further tested to find whether FDI outflows were significantly more sensitive for the exemption group than for the tax credit group of countries. They did this to find whether firms based in exemption countries with high corporate statutory rates experience much more FDI outflow, because the firm can entirely avoid domestic taxes by sending profits abroad and repatriating them later under the exemption. The evidence supported their hypotheses. FDI outflows (inflows) are significantly smaller (larger) for low tax countries even beyond the 1% confidence level. Further, FDI outflows are significantly more sensitive to the corporate statutory rate for exemption countries compared to tax credit countries, to a 1% confidence level.
While other factors were also significant, the corporate statutory rate and tax regime were by far the most significant factors determining FDI inflows and outflows. This evidence was later corroborated by Lehmann (2002), which significantly negatively related the corporate tax rate to returns on foreign equity investments (as opposed to FDI flows). Additionally, the studies concluded that international tax competition exists, and that competition is not just a product of what is normally thought of as low-rate tax havens.
For example, Ireland has a 12.5 % corporate statutory tax rate on both foreign and domestic firms. Marketing itself as the best buy in Europe in terms of services offered (i.e., in terms of legal environment and economic stability) for taxes assessed, Ireland is positioned to become the e-commerce center of Europe. The Economist notes, “The country’s recent economic boom has owed much to low taxes on foreign firms moving there. GDP per capita, which as recently as 1990 was 70% of the EU average, now exceeds Britain’s, and is expected to exceed the EU average by around 2005.” The rise of the Internet and e-commerce will make tax competition an even more relevant factor to where a firm invests, because with e-commerce location-specific advantages and governance are often unnecessary except for the outright physical security of the databases and servers that run the virtual world. Corporations would not and should not be willing to pay much for such limited government services.
These facts make the threat of tax havens far more acute from the standpoint of many governments, because “opaque” tax havens can help to hide assets and prevent them from being taxed. Electronic assets compound this threat because they leave no record in the country from where they came and therefore can easily escape enforcement by that country’s tax regime. There is strong evidence that the threat is already a reality. By 1994, total FDI into tax havens had increased five-fold from a decade before to US$ 200 billion. Even more astounding, in the same year “tax havens accounted for 1.2% of world population and 3% of world GDP, but 26% of the assets and 31% of the net profits of American multinationals (though only 4.3% of their workers).”
This implies the existence of sketchy transfer pricing strategies by these firms that significantly reduce their tax burdens as well as the corporate tax revenues of their home government. Transfer-prices, defined by the OECD as “payments from one part of a multinational enterprise for goods or services provided by another,” are troublesome for tax purposes because they can be distorted in ways that avoid tax regimes and unevenly divide profits among countries. This example should explain why transfers are unique:
"Consider a profitable UK computer group that buys micro-chips from its own subsidiary in Korea: how much the UK parent pays its subsidiary – the transfer price – will determine how much profit the Korean unit reports and how much local tax it pays. If the parent pays below normal local market prices, the Korean unit may appear to be in financial difficulty, even if the group as a whole shows a decent profit margin when the completed computer is sold. UK tax administrators might not grumble as the profit will be reported at their end, but their Korean counterparts will be disappointed not to have much profit to tax on their side of the operation."
Korean companies under foreign ownership often apply for and receive government aid because of how weak their financial situation appears.
Transfer pricing becomes even more significant when one takes into account that 60% of all world trade occurs within multinational firms, indicating a huge potential for profit distortion. If transfer pricing below fair market value were legal, then firms could significantly lower their tax burdens by opening up company affiliates in tax havens and effectively storing profits there. To complete the strategy, these firms could purposely undercapitalize their other foreign affiliates and use these stored profits to recapitalize them.
If transfer pricing below fair market value is illegal in almost all countries, how does one explain 31% of profits of American multinationals being reported in tax havens? Beyond what goes on that is illegal, I believe the reason for it is that fair market value on many of a firm’s goods are almost impossible to determine at certain stages of production. Multinationals sidestep tax regimes by transferring products between affiliates at points in the production chain where the fair market value of the product is more or less arbitrarily determined, or when the value is not in the components or equipment used, but in intangible assets like managerial know-how.
An example of this would be trying to assess the fair market value of half of the assembled components of a car-fender. The market value for such things is no more than their value as raw material, but when combined with the other assembled half they suddenly acquire a much higher value, which translates into profits entirely made in the country where the two halves of the fender were put together. That assembly process might have been much less labor intensive than the assembly of each half-fender, but because the fair market value of the useless half-fender would probably be set at the cost of making it (because knowing how to put the two halves together – or the intangible asset – cannot be taxed by the government), the affiliates making each half barely break even, and might even get a tax refund or government aid. Meanwhile, the profits on the final product are barely taxed, increasing the global income of the multinational corporation and pushing its stock price up, even in the countries where the local subsidiary of the firm incurred a loss. The improved stock price then refinances, or even expands, the whole operation.
The United States has tried to address this increasingly huge revenue loss by threatening severe penalties (including criminal felony prosecution and huge fines) for below fair-market transfer prices between a company in the US and any foreign company with which it has a relationship. All US companies that do have such a relationship (often determined by at least 10% common ownership or control) with a foreign company are required to file US tax form 5471 or 5472 with its tax return. These forms disclose its common ownership or control relationships with other firms. A transfer-price study is also required, verifying that the transfer-price reported by the US firm is fair, ensuring that the correct profit is reported and appropriately taxed by the US government. Additionally, the US, through the OECD, has pursued opaque tax havens, forcing them to become more transparent, and since June 2000 only five tax havens of 41 worldwide remain “uncooperative.”
US efforts have been rewarded by exposing tax havens and increasing information sharing as well as establishing records of US companies with controlling stakes or common ownership of foreign companies. However, these efforts have still not significantly reduced the disproportionate amount of assets and profits reported offshore. The extent to which this has occurred has caused the US Congress to consider providing a one-year tax holiday in which the worldwide income of US multinationals would be exempted when it is repatriated back into the United States. The New York Times reported that the “Senate Finance Committee voted to include a “repatriation” provision in its tax bill… that would let companies bring up to $400 billion in untaxed foreign profits back into the United States at about one-seventh of the 35 percent corporate tax rate.” While revenues would drop drastically for the year, the reinvestment would hopefully stimulate economic growth and employment and create profits that would be more difficult to export under a future tax code. The proposed tax code changes are entirely a response to the increasingly fierce international tax competition occurring in the recent globalization era.
International tax competition does not, of course, minimize the importance of governance, natural resource endowments and location factors to international corporate strategy. From a government perspective, higher corporate tax rates could be charged to multinationals for the ability to use or access country-specific advantages, such as a large domestic market, relatively cheap labor, or a wealth of natural resources. Additionally, judging by both capital expenditures and FDI flows, corporations have been willing to pay more for things the government provides, such as a high quality labor force relative to cost, trade openness, economic growth prospects, stable inflation and exchange rates, reduced corruption levels, private property protection, a strong, stable legal environment, and democracy. But why are corporations willing to pay a premium for these factors in the form of higher tax rates? And what is the relative importance of these factors to the multinational firm?
The answer to the first question is undoubtedly because either the multinational firm cannot function without the service, or because the improvement to business is more than the cost of the tax. The second question is impossible to answer without reviewing the underlying specific needs if firms and specific country offerings. This is evidenced by the fact that almost every study on the subject offers different levels of relative importance for each factor that determines the destination of FDI.
For instance, India’s most attractive feature is a relatively cheap, qualified labor force. Increasingly, firms are looking to India to outsource their back office and information technology needs. Financial services companies and investment banks like Morgan Stanley, J.P. Morgan and Lehman Brothers are even starting to export research analyst positions there, replacing jobs on Wall Street that cost US$ 150,000 in salary with similarly qualified Indian analysts that cost just US$ 35,000. To show just how cheap qualified labor is in India, consider that the average salary of graduates from India’s top 4 business schools is only US$ 13,226.
India has also become the premier location where firms set up their technical support lines, in the form of call centers. The Wall Street Journal reports “an estimated 150,000 are employed by India's call centers, in jobs that have migrated mainly from the U.S. and Britain.” College graduates (India graduates 1.1 million people annually, though only 5 – 10% speaks English well) feed a need for a 100,000 strong labor force to work in call centers every year. Due to this trend, the Forrester Research of Cambridge, Mass, estimates that the US will lose one million jobs overseas in the next decade, with China, India, the Philippines and Russia expected to gain most of the work.
But why have firms only recently decided to invest heavily in India’s human capital? The country’s work force has been qualified and relatively cheap for some time. One reason is because India’s finance minister, Vijay Kelkar, has been in the process since November of 2002 of overhauling India’s tax code. In the fiscal year 2000-2001, the corporate statutory rate in India was 39.55 %, and after accounting for various tax incentives, for example, foreign banks were taxed on average 35.01 %. Kelkar is trying to push through a reduction of the corporate statutory rate to 30 %, but it seems unlikely that in the 2004 election year any significant changes to the tax code will be passed. Nonetheless, “Foreign investors will be closely following the developments in this area,” says Mukesh Butani, director of global tax advisory services for Ernst & Young in India. He concluded, “The tax administration has been identified as one of the roadblocks to foreign direct investment.”
The opposite is true for countries like Austria, Ireland and Singapore. Investment in Austria is bolstered by a relatively low effective rate of corporate tax (while the statutory tax rate is 34 %, after incentives are factored in the average corporate tax rate is 16.7 %). This is in addition to Austria’s extremely low property taxes, and low road freight toll-costs. Additionally, “the country has a network of more than 30 technology parks designed to provide ‘plug-and-play’ opportunities for companies ranging from start ups to major businesses.” By sacrificing initial tax revenues because of the attractive tax rate, Austria is now reaping the benefits. In 2000, there were about 2500 foreign companies employing approximately 300,000 Austrians, or 10 % of the total work force. Austria’s Trade Commissioner believes that “the country's workforce is a major attraction to many European companies.” Like Austria has, India should continue its efforts to complement its country-specific advantage in labor with an effective tax strategy, in order to lure more foreign direct investment.
Already mentioned, Ireland is another country that developing countries should emulate. In Ireland, “FDI has helped to transform a largely agricultural society into one of the fastest growing economies in Europe with one of the highest per capita GDP.” Supporting my argument, Veldi (2001) notes, “It is generally thought that fiscal incentives are the single most important reason for the recent surge of FDI.” In fact, a competitive tax strategy for over 40 years is primarily responsible for Ireland’s extremely “FDI-friendly image.” Dating back to the 1950s, Ireland had a 15-year (zero) tax holiday on export profits. In 1982, Ireland was forced to change the rate to 10% to be consistent with EU rules. This is in comparison to a standard 50% corporate tax rate that existed in Europe at that time. The result is that “FDI has created jobs in new sectors, raised investment and enhanced overall and local productivity.”
Similarly, Singapore has aggressively promoted FDI with enormous success. Since the implementation of the Pioneer Industries Ordinance of 1959, corporate tax rates on approved firms have been and still are as low as 4 %, provided that the firm raises a minimum level of capital intended for the development of new products. I believe that it is no coincidence that over the same four-decade period, Singapore’s GDP growth rate has averaged 10% annually, and that FDI as a percentage of GDP has risen from 5.3 % in 1965 to 98.4 % in 1998. Employment has also benefited immensely from such a huge FDI influx and attractive corporate tax rate, with foreign firms in 1998 employing 50.5 % of workers in manufacturing, 29.1 % in trade, and 25.7 % in finance. While Singapore is only a city-state in physical size, FDI inflows have turned it into the economic powerhouse of its region.
No matter what the primary factor is in determining where a multinational firm invests, as outlined in the case studies above, the country’s tax regime always plays a unique role. This is because after assessing the country-specific advantages of investment, the firm must always ask whether the benefits outweigh the tax costs. Drawing on these case studies and the preceding analysis, I will now speculate on corporate and country tax strategy in the long term. I will argue that a country can prosper in terms of increasing its inflow of FDI by filling what I will call the “intangible” niche. Finally, I will ask what countries might do in the long term to move toward this ideal.
When multi-nationalizing production, the firm should always assess what its specific needs from a government are at every separable point where value is added in the production chain. If a part of production does not require any sort of country-specific advantage, the firm should choose to produce in a country with a low tax rate. This is important from a firm perspective so that it can export the maximum “intangible value” of a product to a low tax country. Oftentimes, this just means exporting the managerial model or trade secrets of a firm to its foreign branch. That way, when the unfinished product arrives in the low tax country, it will be worth little on the open market compared to what it soon will be worth when the firm adds the “intangible value” ingredient.
The half-fender example mentioned earlier would help to explain the intangible value concept if most of the value (from which the profits come) of the completed fender were derived from the special, confidential, firm-specific way in which the halves of the fender were combined. In a more realistic example, Nike could separate the manufacturing of their shoes and the stamping of the Nike “swoosh” into different countries. Nike could transfer the generic shoe produced by factories in countries with a lot of cheap labor at fair market value to a low tax country, where it would then stamp on the swoosh, which contains the “intangible value” to which I have referred. Then Nike could sell the product from the affiliate in the low tax country for significantly more than they paid for the generic shoe, the profits of which would be subject to the lower tax rate.
This corporate tax strategy could work for all producers in which most of the intangible value of their product lies in a removable brand name. That is an example of just one way in which corporate investment decisions might be affected by a legal transfer pricing strategy.
If administering a brand name or a secret ingredient to a product is complicated (which with increasingly sophisticated technology it often is), this strategy may require significant job training, research and development by the company in the low tax country. A company might be willing to produce in a higher tax jurisdiction if there were government money allocated to subsidizing research and development, or a highly skilled, versatile work force that a company could use instead of having to train people with no technical background. Certain countries could fill this niche by offering a moderate corporate statutory rate and significant incentives to companies that would help reduce startup costs. Countries like Ireland and Bermuda have already begun to market themselves as exactly filling this niche. In fact, Ireland spends over US$ 170 million each year in grants to foreign direct investors, mostly to startup companies. These countries benefit from a broader corporate tax base and improved human capital from firm transfers of technology. Insofar as this technology diffuses into the domestic sector, domestic firm global competitiveness improves as well.
From the country perspective, on an even longer-term basis, governments could market high education spending to firms as an appropriate justification for their tax rate. As stated, a strong education system creates a high-skill, versatile labor force that could be useful to any company. Additionally, in democracies there is reason to believe that a highly-skilled population would vote in more pro-growth policies and eventually a lower tax rate.
This is true because citizens vote to maximize their welfare, and not necessarily to maximize economic growth rates. While often these two things go hand in hand, many times government redistribution policies cause capital to be taxed in such a way that reduces overall economic growth. This is logical from a government view insofar as it aids efforts to reduce the systemic problem of income inequality in society. If a society is very unequal in terms of capital (capital-owners almost always have the highest incomes), then to win elections the government should redistribute some of this income to increase the welfare of the majority – at the expense of the growth rate. The only way the electorate would vote in growth-maximizing policies is if they increase the welfare of the majority. This could indeed happen if everyone had equal and fair access to capital and education. Only through equality of opportunity can a majority of people improve their human capital to a point that a redistribution tax on capital would hurt the majority more than it would help it.
It makes sense, then, for both corporations and countries to invest heavily in improving education. From the country view, education provides a skilled, versatile labor force and in the long term less societal inequality, more economic growth and a lower tax rate, which they can advertise to firms in order to attract more foreign direct investment. From the firm perspective, education will improve profits in a country through lower tax rates and the country-specific advantage of an especially qualified labor force.
This idea was first demonstrated in a model created by Alesina and Rodrik (1994), in which they showed that income inequality in a country theoretically increases taxation and reduces economic growth. Their empirical results substantiated the model. Their investigation gives multinational firms and countries a common ground from which to build common development strategies. In the future, governments might want to make lower tax rates contingent on corporations investing in the further education and job training of their workers.
To conclude, this paper has focused on the effect of increased capital mobility on tax competition between countries for FDI, and how that subsequent competition has affected international corporate development and tax strategy. Studies have shown that corporate investment abroad depends most significantly on the rates at which the country plans to tax returns on that investment. Other factors, such as a cheap, high-skill labor force were also shown to significantly affect the firm’s decision of where to invest abroad, but the case studies I analyzed indicate that country-specific advantages best attract investment when they are also complemented with a moderate tax rate and incentives to make initial investments. Finally, I examined and explained the international transfer pricing system, as well as corporate strategies to utilize such a system to minimize its tax burden.
The reality of the situation is that the transfer pricing system currently in use is vastly inefficient from both country and firm perspectives. Firms end up paying astronomical amounts for accountants and economists to assess the fair market value of unfinished goods for which there is no market, and country tax administrators spend more and more of every dollar they collect hopelessly trying to keep up with the ways firms reallocate their resources to minimize their tax burdens – legally – which inaccurately assumes unlawful tax evaders do not exist. There must be a better way.
To fix these efficiency problems before the Internet exacerbates the situation, I believe the current transfer pricing system must soon be completely overhauled in favor of a “unitary tax.” This tax would involve “taking a firm’s total profits and allocating different slices of that total on the basis of a formula that reflects the firm’s relative economic presence in that country.” This would stop tax havens from “sucking out” revenues from the countries where the real value is added to the product, or would cause multinationals to actually reallocate some of their business to low tax countries, as has already been seen in the cases of Ireland, Austria and Singapore. This would preserve the competition for investment currently occurring under the transfer pricing system, but countries would more fairly receive tax revenues for the services and incentives they provide.
Overall, as globalization increasingly allows labor to join capital as a mobile taxpaying factor of production, there will be added pressure on governments to deliver their services more efficiently. Better education should hopefully stimulate voters to choose pro-growth policies that drive the innovations that will make labor become mobile, propelling the world economy and making it more equitable and efficient.
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