The effects of multinationals' profit shifting activities on real investments.

INTRODUCTION

Corporate tax rates vary significantly between different countries. Real investment decisions are affected by these international differences in business taxation. Moreover, cross-country profit shifting of multinationals can be observed. Governments attempt to restrict profit-shifting opportunities in order to protect their tax revenues. Then, from a theoretical point of view, consequences for the level of investment in high-taxing countries can be expected, which may also intensify tax competition (see, e.g., Keen, 2001; Peralta, Wauthy and van Ypersele, 2006). This paper aims to provide empirical insight into the interaction between profit-shifting activities and real-investment decisions. Particular attention is paid to the issue of whether the size of multinationals' real investments in high-tax locations is affected by the taxation of shifted profits.

Previous empirical literature confirms that corporate taxation significantly affects business decisions. In particular, the effects of corporate taxation on multinationals' foreign direct investment decisions have been extensively analyzed. This literature confirms significant negative effects of the host country's tax level on the size and the frequency of Foreign Direct Investment (FDI). (1) Furthermore, there is striking evidence that the cross-border shifting of paper profits is associated with international tax rate differentials. (2) Several studies, such as Altshuler and Grubert (2003) and Desai, Foley and Hines (2004), show that financial structures are used to shift profits. Moreover, there is evidence that multinationals' transfer pricing is also tax driven (Clausing, 2003, 2006; Grubert, 2003). The success of such shifting strategies is confirmed by studies that find that the reported profitability of multinationals' affiliates is negatively affected by the level of the local tax rate (see, e.g., Hines and Rice, 1994; Huizinga and Laeven, 2008).

Only very few studies have analyzed both profit-shifting and investment effects. Hines and Rice (1994), Grubert and Slemrod (1998) as well as Desai, Foley and Hines (2006) provide evidence that US investments at typical tax havens are associated with profit shifting. However, empirical studies dealing with the expected corresponding investment effects in high-tax countries are still rare. Grubert (2003) finds that US multinationals whose profit shifting opportunities are higher than average choose locations with either extremely low or extremely high tax levels. The preference for tax havens stems from the need for locations that serve as tax shelters. By contrast, the higher attractiveness of high-tax locations for multinationals can be explained by competitive advantages due to profit-shifting opportunities.

The following study contributes to the understanding of the effects of profit shifting activities on multinationals' investment decisions in high-tax countries. The analysis focuses on effects of profit shifting on investment levels rather than on location decisions. Using data of German multinationals, Buettner, Overesch, Schreiber, and Wamser (2008) confirm that negative investment effects arise if profit shifting is restricted by thin-capitalization rules. Becker and Riedel (2008) analyze several channels through which the tax rate of the parent company's location may affect the affiliate's investment level. In accordance with a profit-shifting effect, they find a positive impact of the tax rate differential between the host country and the parent company's home country on investment levels of affiliates located in several European high- and low-tax countries. Unlike these studies, our analysis is exclusively based on investment data of foreign-controlled affiliates located in one specific high-tax country: Germany. Since Germany has an extremely high tax rate, the focus of this analysis lies on the positive investment effects that can arise from a lower taxation of shifted profits. Furthermore, we consider affiliate-specific asymmetries in profit-shifting incentives in our analysis of investment effects.

A tax rate of a location other than the host country affects the cost of capital if profits are effectively shifted toward that location. Let us, for example, consider a parent company located in Ireland and a subsidiary located in the host country Germany. Without profit-shifting activities, the investment level of the subsidiary is only influenced by the German tax rate. However, a part of the profits of the German affiliate may be shifted to the parent company in Ireland, since the Irish tax rate is significantly below the German tax level. The shifted profit amount is effectively taxed in Ireland. Then, the Irish tax rate has an impact on the cost of capital of the subsidiary in the host country Germany. The gains from profit shifting increase with a rising tax rate differential, in this case between Germany and Ireland. This example suggests that the investment size of a subsidiary in a high-tax country should theoretically increase with a rising tax rate differential if profits are shifted.

The empirical analysis is based on the MiDi (Microdatabase Direct Investment) database, a comprehensive micro-level panel database of virtually all FDI projects in Germany, made available by the German central bank (Deutsche Bundesbank) for research purposes. Germany as a host country of FDI is a matter of particular interest for several reasons. First of all, the German statutory company tax rate is almost the highest in the world. Hence, there are high incentives to shift profits out of Germany. (3) Secondly, Germany is the biggest economy in Europe and an important location for FDI, e.g., of US firms. Finally, due to European directives, profit shifting toward other European countries is not restricted by withholding taxes. The specific advantage for the empirical analysis lies in the very high German tax level. If parts of the profits of affiliates located in Germany are shifted toward their parent companies, one can expect a positive impact of a higher tax rate differential between the host country Germany and the parent company's home country on the investment level of the affiliate in Germany. Our empirical analysis reveals that the investment levels of subsidiaries in high-tax Germany are positively affected by a rising tax rate differential between Germany and the direct owner's home country. Hence, the results suggest that investments in a high-tax country are significantly affected by competitive advantages due to a lower taxation of shifted profits.