Multinationals' Sensitivity to Tax Rules
As investors from foreign tax credit countries are able to mitigate or avoid repatriation taxes, the floor on tax competition is lowered or removed.
Changes in the way multinational firms structure their operations abroad have made low tax rates increasingly important to a country's ability to attract foreign capital. This trend is particularly significant for European countries, where 10 percent higher tax rates are associated with 7.7 percent less foreign direct investment (FDI). In Chains of Ownership, Regional Tax Competition, and Foreign Direct Investment (NBER Working Paper No. 9224), authors Mihir Desai, C. Fritz Foley, and James Hines Jr. explore this phenomenon by analyzing how investment decisions by U.S.- based multinational firms are influenced by the growing tendency to employ "chains of ownership." This form of indirect ownership allows firms to defer paying American taxes on income earned by their foreign affiliates.
The authors note that in the past, U.S. firms were less sensitive to tax rates in countries where they operated. That's because whatever they paid out in foreign taxes could be used as credits to offset their U.S. tax liabilities. For example, the U.S. corporate tax rate is 35 percent. So if an American corporation earned $100 in a country with a 10 percent tax rate, it would pay $10 to the foreign government and then use that as a credit to reduce what would be a $35 U.S. tax liability to $25. Unless foreign tax rates exceed 35 percent, or firms can defer triggering U.S. taxes, the existence of the credit made the host country tax rate less pivotal for investment decisions.
What if a U.S. company could defer paying domestic taxes on its foreign earnings? Desai, Foley, and Hines assert that U.S-based multinational firms are increasingly adept at doing just that, a feat they accomplish by structuring complex business relationships in which foreign affiliates are "owned indirectly through other affiliates rather than directly" by the U.S. parent company. Through these arrangements American firms defer paying "repatriation taxes" on their earnings abroad and, consequently, the foreign or "host" country's tax assessment becomes a more important factor in attracting investment. It is no longer simply used as a credit to offset what is now a less-important American tax liability. Instead, it stands out as something that directly affects a firm's bottom line much as is the case under so-called exemption regimes of taxing international income.
"As investors from foreign tax credit countries are able to mitigate or avoid repatriation taxes, the floor on tax competition is lowered or removed," the authors state. They assert that "if the recent trend of rising indirect ownership continues" -- both among American firms and among multinationals from countries with similar tax laws -- "then capital-importing countries are likely to feel growing pressure to reduce any source-based taxes they impose on foreign investment... Lower tax rates will in turn encourage American firms (and others) to accelerate their use of indirect ownership structures for their foreign investments," they add. Additionally, the results shed light on the sensitivity of investment from countries that employ exemption systems as U.S. firms are effectively able to mimic the position of exemption countries.
Desai, Foley, and Hines believe the effect could be particularly pronounced in Europe, where they find that European affiliates of American companies are more likely than others to be indirectly held and foreign investments seem to be much more sensitive to taxes than elsewhere. For example, as was noted previously, a 10 percent difference in tax rates among European Countries was associated with a 7.7 percent reduction in investment, while outside of Europe, a 10 percent difference was associated with only a 2.3 percent reduction in investments.
One reason for the disparity, according to these economists, is that "the effects of integration brought about by the European Union have intensified competitive pressures within Europe" to reduce taxes incurred by foreign companies. Desai, Foley, and Hines caution that "partial European economic integration, without coordination of tax policies" may intensify the tendency of European countries to compete for foreign investment via lowered tax rates.
-- Matthew Davis