Contributing Writer: Wyatt Broscious | May, 2024
Background:
Dr. Cody Kallen is an Economist, working at the Board of Governors of the Federal Reserve System in the International Finance division. He graduated with a PhD in Finance and Economics at UW Madison in 2023. His research interests include multinational firms, tax policy, firm and business cycle dynamics, and growth. This interview focuses on his contribution to research about profit shifting, a phenomenon where multinational companies avoid paying taxes by shifting profits between different subsidiaries.
The results of Kallen’s research broadly focus on both firm heterogeneity when it comes to profit shifting, and the macroeconomic implications of profit shifting. Firm heterogeneity can generate important macroeconomic effects and interact with policies in ways that cannot be achieved by models of homogeneous firms. This theme characterizes the research in Kallen’s dissertation.
The views expressed are the economist’s and should not be interpreted as reflecting the views of the Federal Reserve.
Interview:
Question 1: One of the themes in your paper was how profit shifting would increase investment in both high and low-tax countries. Could you elaborate on how profit shifting affects investment decisions in multinationals across different countries?
Cody: Profit shifting allows firms to report some of their profits that are generated in high-tax countries like the US, in lower-taxer countries like Ireland, for example. If you’re shifting half of your profits out to a tax haven, that’s half of those profits that are not being hit by U.S. tax rates. They’re subject to a lower, Irish tax rate instead. These excess profits are then invested in the US, driving more productivity. For the low-tax countries, the story is a little different. Additional productive activity located in Ireland is an indirect result of shifting income there. If you report a billion dollars of profits and you have three employees- tax authorities will be all over that. If you have actual productive activities there, it’s less likely to face scrutiny and you can more easily justify to the IRS. It’s standard to just come up with a single estimate of that parameter, the profit-shifting semi elasticity [1]. The innovation, or contribution, of the paper comes from estimating lots of these semi elasticities across different firms.
Wyatt:
Why do firms need to justify profit shifting to tax authorities?
Cody:
It’s a mix of illegal and legal activity. For example, Microsoft has a bunch of its intellectual property owned by an affiliate in Ireland. Microsoft’s American affiliate pays royalties for the right to use this intellectual property. That shifts profits from the US to Ireland. What’s illegal is to overvalue that intellectual property, as to pay excess royalties. But that’s inherently subjective. Some of them use in-house advisors to calculate this, but a lot of them will pay consultants to conduct what’s called “transfer pricing” for them. But they’re trading off those additional savings and taxes against the risk of being audited, of course.
Question 2: You mentioned constructing a model of profit shifting and investment with different multinational corporations. How did you account for the various tax policies of different countries in this model? What were the challenges?
Cody:
Obviously, tax policies are extremely complex. And so, there are lots of things that I’m not capturing here. It doesn’t capture withholding taxes, which don’t matter so much for the US, but are important in a lot of developing countries. However, I believe a balance was struck so enough differences were captured to make a meaningful addition to past research.
Wyatt:
Are there any kinds of taxes that you would generally want to add in the future?
Cody:
Absolutely. The OECD (Organization for Economic Co-operation and Development) has been pushing two new “pillars” to change international tax law. Pillar one is essentially reapportioning firms’ profits. Firm subsidiaries will no longer be treated as separate entities. Also, each portion of the profit will be taxed by the country where the profit was made. Pillar two is a set of taxes which forces countries to tax big multinational firms at a minimum 15% corporate tax rate. However, there will still be ways to profit shift, such as a research tax credit. This is very reasonable to do in countries like Ireland and Switzerland. However, it will be more difficult to justify in smaller tax havens, like Bermuda, where there really isn’t much research going on.
Question 3: You mention explicitly breaking down your research to look at specific sectors and even specific firms. Did you see any companies or sectors that had a uniquely high amount of profit shifting?
Cody:
The industries that generally are better at profit shifting are pharmaceuticals, computer and computer component manufacturing, electronic and electrical component manufacturing.
One of the most interesting things is beverages. It turns out a lot of the value of these companies is tied up in the recipes, trademarks, or brands. Those are all types of intellectual property. The more intellectual property you have, the more you can rely on that intellectual property to justify profit shifting. There’s also a social benefit of research. That’s largely why we subsidize R&D through a research tax credit in the US, as many countries do. This creates an odd tension as companies are encouraged to conduct R&D, however at the same time the government is working to rein in profit shifting.
Wyatt:
Why has profit shifting increased in past decades?
Cody:
There are two regulation-based reasons I can think of. In 1997, the check-the-box regulation that was intended to make it easier for firms to classify themselves unintentionally opened the door for American multinationals to shift profits around. Another is probably the 2004 repatriation holiday. Previously, if you were shifting your profits to Ireland, you had to stash them there. And if you ever brought them back to the US, you’d have to pay a tax penalty. The dividend holiday essentially let them bring it back and pay much lower penalty rates. This makes it more reasonable for firms to justify profit shifting, given the possibility of another repatriation holiday. Also, we have seen an emergence of large high-profit firms that we haven’t really seen before, especially those who engage in high R&D. This enables more profit shifting.
Question 4: Your research is about how companies move their profits to different countries to pay less tax. This seems to create a pattern where the companies choose to invest in some countries over others. Can you explain this decision-making process?
Cody:
Essentially, the key idea is that it creates a complementarity effect in capital between high-tax and low-tax countries.
Suppose we have a positive production shock in Germany. The firm then wants to shift more profits out of Germany and into Ireland. Then, it increased its production in Ireland as well. The reason for this is that increased profits in Ireland is more likely to trigger the attention of other tax authorities. That raises the effective cost of shifting profits into Ireland overall, including shifting profits from France to Ireland.
The flip side of this is that it also decreases its production in France. That’s the substitutability effect. It creates a kind of interesting dynamic where Germany isn’t with Ireland – it’s competing with France. This leads to some interesting implications for the spillovers of business cycle shocks as well.
Question 5: You explore the equilibrium implications of profit shifting in a dynamic multi-country general equilibrium model. Can you discuss the broader macroeconomic implications such as the impact on worldwide GDP, consumption, and the specific effects on the US?
Cody:
The effects of ending profit shifting, as a percent change from the baseline economy, can be seen in Table 13. If you look at the general equilibrium part, what we get in the US is a small decrease in capital, including foreign-owned capital, and a very small decrease in US GDP.
Now, to trade off for this, we get corporate income tax revenue and somewhat lower US consumption. However, to really capture general equilibrium effects, I think it’s helpful to look at the tax havens.
If you look at that table, in the tax havens, there’s about a 10% drop in foreign-owned capital. Essentially, without profit shifting, companies like Apple, 3M, and Microsoft don’t really have much interest in doing business and tax havens.
And so, they reduce their investment. But one important general equilibrium effect is called crowding out. Namely, if Apple and others start producing in Ireland, it will raise the price of all the inputs that they use, including labor and capital, and so it reduces the investment of other local Irish companies.
And it turns out that in equilibrium, crowding out is quite strong. And so even though there’s a 10% drop in foreign-owned capital, capital owned by multinationals, and tax havens, there’s almost no change in the total capital stock in the tax havens. But there’s still about a 6% drop in GDP in the tax havens.
This is called misallocation. When all those multinationals have stopped investing in Ireland, in equilibrium, we have a decrease in multinational-owned capital and an increase in capital owned by the local firms. But the local firms are way less productive than those multinational firms. And so that reallocation of capital from big, productive multinationals to the smaller Irish companies is inefficient, leading to a big drop in GDP.
Conclusion
This interview with Cody Kallen, a PhD Economist at the Board of Governors, provides deep insights into the complexities and ramifications of profit shifting by multinational companies. Kallen’s expertise, particularly in multinational firms’ tax policy and investment dynamics, shed light on the nuanced ways profit shifting affects investment decisions across different tax jurisdictions. His analysis of new OECD tax policies, implications on investment strategies, and macroeconomic impacts offers a comprehensive understanding of the subject. This interview not only highlights the intricate interplay between corporate strategies and international tax laws but also underscores the ongoing challenges in global financial regulation and policymaking.
REFERENCE
Kallen, C. F. (2023) Essays in Business and Macroeconomics (Publication No. 30491547) [Doctoral dissertation, University of Wisconsin – Madison]. Proquest Dissertations and Theses Database.