# Presentation: 320553

## Taxation and Global Competitiveness

- Mihir A. Desai
- Harvard University and NBER
- President’s Advisory Panel on Federal Tax Reform
- San Francisco, CA
- March 31, 2005

## Outline

- The changing scale and scope of multinational firm activity
- How do multinational firms respond to tax rules?
- What does economics tell us about the efficient way to tax international activities?
- The costs and benefits of the current system
- Appendix:  Selective References

## I. The Rising Importance of Foreign Direct Investment (FDI)

- Increasingly, it is impossible to analyze corporate taxation and its reform without considering international provisions

- Ratio of Outbound FDI to Private Nonresidential Fixed Investment    (for US firms)

## I. The Changing Nature of Multinational Firm Activity

- The older model of multinational firm activity stressed capital flows that duplicated activity to overcome tariffs & transport costs...

## I. The Changing Nature of Multinational Firm Activity (cont.)

- With falling tariffs and transport costs, firms are less likely to duplicate activities around the world - Now, FDI creates integrated production processes that must be highly efficient for very competitive markets

**U.S. MNC**

**Austrian **
**Sub**

- Worldwide customers

- Intermediate
- G&S

**Brazilian**
**Sub**

- “Vertical
- Foreign Direct Investment”

- Intellectual
- Property

## I. The Changing Nature of Multinational Firm Activity (cont.)

- This transformation has several implications...
- Transfer pricing issues loom larger...
- Worldwide frictionless markets create greater pressures for efficiency
- 	Tax costs/advantages more likely to be pivotal
- A good tax regime must ensure that firms can create these networks as efficiently as possible
- New research suggests that FDI stimulates domestic investment

**U.S. MNC**

**Austrian **
**Sub**

- Worldwide customers

- Intellectual
- Property

- Intermediate
- Goods

**Brazilian**
**Sub**

## II. How do multinationals respond to international tax rules? 

- Very actively – and in three distinct ways...
- 1. Avoidance
- Transfer pricing of goods and services – e.g. paper clips
- Financing patterns – e.g. dividend repatriations
- Location of intangible property – e.g. patent transfers
- Consequences: Plenty of resources dedicated to rearranging profits
- Magnitudes: e.g. 10% tax rate difference associated with changed reported profit rates of 2.3%; 13% lower repatriations because of taxes

## II. How do multinationals respond to international tax rules? (cont.)

- 2. Ownership patterns
- Joint ventures
- Expatriations
- Mergers and acquisitions
- Consequences: Who owns what (and in what form) shaped by tax rules
- Magnitudes: e.g. Joint ventures by U.S. companies fell in response to 1986 tax law changes, firms changing nationality

## II. How do multinationals respond to international tax rules? (cont.)

- 3. Investment
- Across countries
- Between home and abroad
- Consequences: Where and how much firms invest is shaped by tax incentives
- Magnitudes: e.g. 10 percent differences in tax rates associated with 10 percent differences in investment

## III. What does economic theory tell us about the efficient way to tax foreign activities? 

**Double****taxation**

**Taxation in host ****countries only**

- Exemptionof foreignincome

- Full taxation with full credits for
- foreign taxes
- paid

- Full taxationwith no relief for
- foreign taxes
- paid

**Not done as countries **
**would be subsidizing other**
**tax systems**

**Several countries **
**explicitly or effectively **
**do this**

**No one does this**

**The spectrum of choices for taxing multinational firms...**

## III. What does economic theory tell us about the efficient way to tax foreign activities? (cont.)

**Double****taxation**

**Taxation in host ****countries only**

- Exemptionof foreignincome

- Full taxation with full credits for
- foreign taxes
- paid

- Full taxationwith no relief

**What do we do?**
- Full taxation with *partial* credits but with *deferral* and with complex *allocation* rules – one of the more costly and complex regimes in the world

**Which way have we been heading?**
*Toward exemption*: e.g. repatriation tax holiday...
*Away from exemption*: e.g. restrictions on deferral, tougher allocation rules
*In circles...*

## III. What does economic theory tell us about the efficient way to tax foreign activities? (cont.)

**Double****taxation**

**Taxation in host ****countries only**

- Exemptionof foreignincome

- Full taxation with full credits for
- foreign taxes
- paid

- Full taxationwith no relief

**Efficient** if FDI represents
- flows of capital between
- countries ...
**Why?** Tax rules should leave
- these flows undisturbed and
- full credits do this

**Efficient** if FDI represents
- better owners owning what
- they should...
**Why?** Tax rules should leave
- ownership patterns
- undisturbed and exemption
- does this

**Highly distortionary**

## IV. The costs and benefits of the current system

*Costs of the current system*
- Desai & Hines (2004) estimate very large efficiency costs relative to an exemption system (because firms are so responsive) creating a large ratio of efficiency costs to revenues
- Compliance costs are also enormous
- American firms compete with firms not facing these costs...

## IV. The costs and benefits of the current system (cont.)

*Costs of going to exemption*
- Could exemption lead toward more outbound FDI? Altshuler & Grubert (2001) suggest there may be little locational response
- Even if it did, would this necessarily be a bad thing?
- Could it lead to erosion of corporate tax revenues?
- Some of this is happening already...all depends on allocation rules

## IV. The costs and benefits of the current system (cont.)

- Returning to the President’s criteria for reform:
*Simplicity* - The current system is extremely complex - exemption could be simpler but depends critically on allocation rules
*Fairness* - Complex system with costly avoidance opportunities tilt the playing field toward larger firms AND U.S. firms compete with global firms with less costly regimes
*Growth* - Enhancing the competitiveness of U.S. firms helps at home AND current rules have large efficiency costs

## Conclusions

- International tax rules are central to the operation of the corporate tax
- Multinational firms are highly sensitive to these rules on several margins – avoidance, ownership and investment
- Multinational firms should not be viewed as a threat to the domestic economy and reform should reflect their competitive environment
- The efficient design of tax rules should emphasize the minimization of distortions to ownership patterns – this suggests lighter taxation of foreign activities
- Overall, the current system is extremely distortionary and, consequently, costly

## Appendix: Selective References on Various Topics

***Changing nature of multinational firm activities***
- Caves, Richard E.  *Multinational Enterprise and Economic Analysis*.  Cambridge, U.K.: Cambridge University Press, 1996.
- Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr. (2004) “The Costs of Shared Ownership: Evidence from International Joint Ventures.” *Journal of Financial Economics* 73:323-374.
- Feenstra, Robert C. (1998) “Integration of Trade and Disintegration of Production in the Global Economy,” *Journal of Economic Perspectives*, 31-50.
***Behavioral responses to international tax rules***
- Altshuler, Rosanne and Harry Grubert.  “Repatriation Taxes, Repatriation Strategies and Multinational Financial Policy.”  *Journal of Public Economics* 87 No. 1 (January, 2003): 73-107.
- Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr. (2001) “Repatriation Taxes and Dividend Distortions.” *National Tax Journal* 54: 829-851.
- Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr. (2004) “Economic Effects of Regional Tax Havens.” NBER Working Paper #10806.
- Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr. (2004)  “A Multinational Perspective on Capital Structure and Internal Capital Markets.”*Journal of Finance 59:6 (December 2004): 2451-2488* .
- Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr. (2004)  “Foreign Direct Investment in a World of Multiple Taxes.” *Journal of Public Economics*, 88:12, 2727-2744 .

## Desai, Mihir A. and James R. Hines Jr. (1999) “‘Basket’ Cases: Tax Incentives and International Joint Venture Participation by American Multinational Firms.” Journal of Public Economics 71:379-402. 
Desai, Mihir A. and James R. Hines Jr. "Expectations and Expatriations:  Tracing the Causes and Consequences of Corporate Inversions."  National Tax Journal 55 No. 3 (September, 2002): 409-440.
Hines, James R., Jr. (1999) “Lessons from Behavioral Responses to International Taxation.”  National Tax Journal 52: 305-322.
Efficient taxation of international activities
Desai, Mihir A. and James R. Hines Jr. (2003) “Evaluating International Tax Reform.” National Tax Journal 56:487-502
Gordon, Roger H. and James R. Hines Jr. (2002) “International Taxation.”  In Alan J. Auerbach and Martin Feldstein, eds. Handbook of Public Economics, vol. 4 (Amsterdam: North-Holland) 1935-1995. 
Transitioning to an exemption system
Altshuler, Rosanne and Harry Grubert (2001).  “Where Will They Go If We Go Territorial? Dividend Exemption and the Location Decisions of U.S. Multinational Enterprises,” National Tax Journal 54:787-809. 
Desai, Mihir A., and James R. Hines Jr. (2004) “Old Rules and New Realities: Corporate Tax Policy in a Global Setting.” National Tax Journal 57: 937-960.
Grubert, Harry and John Mutti. (2001) Taxing International Business Income: Dividend Exemption versus the Current System (Washington D.C.: American Enterprise Institute).

- Desai, Mihir A. and James R. Hines Jr. "Expectations and Expatriations:  Tracing the Causes and Consequences of Corporate Inversions."  *National Tax Journal* 55 No. 3 (September, 2002): 409-440.
- Hines, James R., Jr. (1999) “Lessons from Behavioral Responses to International Taxation.”  National Tax Journal 52: 305-322.
***Efficient taxation of international activities***
- Desai, Mihir A. and James R. Hines Jr. (2003) “Evaluating International Tax Reform.” *National Tax Journal *56:487-502
- Gordon, Roger H. and James R. Hines Jr. (2002) “International Taxation.”  In Alan J. Auerbach and Martin Feldstein, eds. *Handbook of Public Economics*, vol. 4 (Amsterdam: North-Holland) 1935-1995.
***Transitioning to an exemption system***
- Altshuler, Rosanne and Harry Grubert (2001).  “Where Will They Go If We Go Territorial? Dividend Exemption and the Location Decisions of U.S. Multinational Enterprises,” *National Tax Journal* 54:787-809.
- Desai, Mihir A., and James R. Hines Jr. (2004) “Old Rules and New Realities: Corporate Tax Policy in a Global Setting.” *National Tax Journal* 57: 937-960.
- Grubert, Harry and John Mutti. (2001) *Taxing International Business Income: Dividend Exemption versus the Current System* (Washington D.C.: American Enterprise Institute).

- Appendix: *Selective* References on Various Topics (cont.)