With growing financial integration, multinational companies have increasingly shifted profits abroad to reduce their tax payments. Profit shifting is an effective method to lower tax payments: Egger, Eggert, and Winner (2010) find that multinationals pay over 50% less taxes than similar domestic firms in high tax countries. 1 Governments have reacted. With the help of targeted changes to the tax code they have tried to secure their respective tax bases.
One such measure are thin capitalization rules, which aim at reducing profit shifting via internal debt. 2 In the last years, many countries have restricted the deduction of interest payments for tax purposes to a certain percentage of earnings, that is, they have implemented a general “interest cap” (Table 1 in Langenmayr, Haufler, and Bauer 2015). 3 In Italy, for example, interest expenses (net of interest income) can only be deducted if their value is less than 30% of earnings before interest, taxes, depreciation and amortization (EBITDA). Such rules are not restricted to borrowing from affiliates, but comprise all kinds of debt finance. Due to non-discrimination rules, they apply to many or all corporations, even if they are not active internationally.
The benefit of such a broad thin capitalization rule is that it effectively limits profit shifting via debt finance. However, such broadly applicable regulations also have disadvantages. They are badly targeted, as they also apply in cases that have nothing to do with profit shifting. 4 In extreme cases, it is even possible that tax payments accrue under such rules even if the firm makes a loss. 5
As a second example, consider documentation requirements for transfer prices. Transfer pricing is often seen as the main profit shifting channel (Heckemeyer and Overesch 2013). As a countermeasure, many countries require detailed documentation from firms to justify their transfer prices for all international transactions within the firm (Lohse and Riedel 2013; Beer and Loeprick 2014). Preparing these documentations causes substantive administrative costs, especially as many countries do not have materiality thresholds (OECD 2013). Thus, these documentation requirements also affect firms who are active internationally, but do not engage in profit shifting, for example because they are only active in countries with similarly high tax rates. Further costs arise as firms hire consultants or choose inefficient strategies to comply with the regulations. For example, under a thin capitalization rule, firms may abstain from internal debt financing even when it would otherwise be optimal (e.g. for investments by affiliates who face high interest rates), and transfer pricing documentation requirements may deter firms from international expansion.
In this paper, I model such regulations to limit profit shifting, incorporating that they also impose costs on those firms that do not engage in such activities. 6 I use this model to analyze the effects of limiting profit shifting on welfare and on the aggregate sum of profits shifted abroad. Firms in the model are heterogeneous in their productivity and compete under monopolistic competition. Including heterogeneous productivity is crucial to this analysis of limiting profit shifting, as it allows to model that the effects of this specific tax policy differ among firms with different productivity levels.
The key result of the model is that strengthening a limitation on profit shifting does not necessarily lead to less profit being shifted abroad on aggregate. As the costs of such regulations force some firms out of the market, there is less competition, so that the remaining firms become more profitable. It is therefore possible that the absolute amount of profits shifted abroad increases, even though only a smaller percentage of profits can be transferred. Furthermore, additional firms may start to shift profits abroad.
Regulations to limit profit shifting have further effects, besides the ambiguous effect on the amount of profits shifted itself. As such rules force some firms to exit the market, consumers have fewer varieties from which to choose, which implies a welfare loss. The overall welfare effect depends on the market situation: If firms have high market power, it is best if governments do not limit profit shifting possibilities. If firm productivity is very heterogeneously distributed, the government should limit profit shifting, as relatively many firms engage in profit shifting activities to begin with.
Limiting profit shifting is also more likely to be favorable if the costs of profit shifting are relatively low. As such costs have fallen during the last decades due to increasing global integration, this result is in line with the empirical evidence of increased regulation against profit shifting presented above.
This paper is part of the literature that combines models of heterogeneous firm productivity, which are commonly used in international trade theory since Melitz (2003), with the analysis of tax policy. A first part of this literature studies competition for internationally mobile firms (Davies and Eckel 2010; Haufler and Stähler 2013; Baldwin and Okubo 2014). Baldwin and Okubo (2009a) and Bauer, Davies, and Haufler (2014) analyze tax-cut-cum-base-broadening tax reforms, and Pflüger and Suedekum (2013) study entry subsidies in the context of firm heterogeneity. Becker (2013) and Bauer and Langenmayr (2013) consider the interaction between taxes and foreign direct investment. Closest to this paper, Krautheim and Schmidt-Eisenlohr (2011) study profit shifting in a model with monopolistic competition among heterogeneous firms. In their model, the most productive firms shift all of their profits to a tax haven. In contrast, this paper analyzes the case when the government has a second instrument at its disposal, namely regulations that limit profit shifting. Due to such regulations, firms can only partially shift profits abroad.
A different line of literature examines specific policy measures to limit profit shifting. Hong and Smart (2010) consider if the presence of tax havens is desirable from the perspective of high-tax countries. In an extension they consider the case that the high-tax country imposes thin capitalization rules. Haufler and Runkel (2012) focus explicitly on thin capitalization rules, but in contrast to this paper, the firms’ internationalization decision is not endogenous in their model. Instead, they assume that only some firms are active internationally, and firms are otherwise identical.
This paper is structured as follows. The next section introduces the reader to the model and derives a first result on the aggregate amount of profits shifted abroad. Section 3 analyzes the optimization problems of the two countries in more detail. Some numerical simulations in Section 4 clarify the theoretical results. Section 5 concludes.
The model consists of two countries, the “home market” and the “tax haven.” The tax haven is small; all production takes place in the home market. The economy of the home market comprises two sectors. One of them is a numeraire sector that produces a homogeneous good with a single factor (labor) under perfect competition using a technology with constant returns to scale. The final good in this sector is freely traded, its price is normalized to unity. In the second sector, firms with heterogeneous productivity manufacture differentiated goods under monopolistic competition.
7 The cost of production consists of constant, firm-specific marginal costs
The Pareto distribution implies that higher values of
Firms in the differentiated goods sector compete under Dixit–Stiglitz monopolistic competition: Each firm offers a product that is, from the consumers’ point of view, only imperfectly substitutable by other goods. Therefore, firms have some market power. Consumers’ preferences are given by
Maximizing the utility function  subject to the budget constraint, the demand for a particular variety of the differentiated good is given by
Firms facing this demand function maximize their profits. Therefore, they set their prices as a constant mark-up over marginal cost,
The price is higher if the elasticity of substitution is lower, i.e. if firms have more monopoly power.
Thus, pre-tax profits of firms are given by the following equation, with the second equality taking optimal price and quantity decisions into account 10
The most efficient firms (i.e. the firms with the lowest marginal cost
Profits are taxed at a constant marginal rate
In reality, many regulations limit profit shifting. Such regulations have to target the means of profit shifting, i.e. transfer pricing or internal financing structures. Due to limited information, the government cannot fully differentiate between legitimate intra-firm transactions and profit shifting. It thus has to use broader rules that also hinder activities other than profit shifting. 12 A first example is thin capitalization rules, which dictate that only interest expenses of up to a certain fraction of profits can be subtracted from earnings for tax purposes for all firms. On the one hand, this limits the possibilities for profit shifting via debt. On the other hand, it increases all firms’ financing costs, as they have to comply with these rules or face higher tax rates, also if they did not intend to shift profits abroad. A second example is transfer pricing documentation requirements, which apply to all firms that are active internationally, also when they operate only in countries with similar tax rates.
In the model, the government of the home country can impose such regulations, which limit the maximum percentage of profits
Due to the fixed costs of production and profit shifting limitations, not all potential firms are productive enough to be in business. A zero-profit condition determines the cut-off value
Solving this condition for
If the tax rate in the home country or the cost of the limitation on profit shifting is higher, fewer firms are in the market. More firms are active in larger markets (as measured by
Every firm can incur a fixed cost f to shift some of its profits abroad.
15 As the most profitable firms have the most to gain from avoiding taxes, and given that the cost of profit shifting is fixed, only firms with marginal costs below a level
The left-hand side of eq.  represents the case in which the firm pays taxes only in the home country. On the right-hand side, it shifts profits into the tax haven. As the cost of profit shifting, f, is fixed, the firm always shifts as much of its profit abroad as is possible. It is assumed that the cost of profit shifting is not deductible from the firm’s taxable base. 17
Inserting eq.  for the profits, the marginal cost level
Firms with marginal costs under
Lastly, let us consider optimal quantities of the numeraire good
To look at this in more detail, consider the tax base in both countries (i.e. aggregate profits without deducting the burden imposed by the limitation on profit shifting). These are for the home country (
The tax base in the home country, eq. , can be interpreted as the sum of all profits (i.e. the tax base without any profit shifting,
What determines how much profit is shifted abroad on aggregate? The tax base in the tax haven rises if the tax difference between the two countries increases. It falls if firms have higher costs to shift profits (higher f) or if the demand for differentiated goods in the home market is lower (lower
Importantly, it is not always the case that a limitation on profit shifting leads indeed to less profit being shifted abroad on aggregate. Differentiating eq.  with respect to
The first term reflects the effects on the intensive margin, that is, the change in the amount of profit each firm shifts abroad. First, there is a direct effect
(Effectiveness of Limits on Profit Shifting)Stricter limitations on profit shifting do not necessarily lead to less profit shifted abroad on aggregate. Such regulations are only effective if the burden associated with them is relatively small.
This result is driven by the market exit of some small firms, which occurs because of the compliance costs associated with regulations limiting profit shifting. To gauge the likelihood that such costs force some firms out of the market, let us consider some real-world numbers: In a survey of mid-sized US firms, Slemrod and Venkatesh (2002) find average tax compliance costs of $243,942. In a different sample, Blumenthal and Slemrod (1995) show that about 40% of compliance costs arise due to regulations concerning foreign-source income and are thus directly related to measures against profit shifting. There is also evidence that corporate tax compliance costs fall disproportionally on small firms (Sandford et al. 1989; Slemrod and Venkatesh 2002). For example, even the smallest firms in Slemrod and Venkatesh (2002) sample (firms with less than $5 million assets) report compliance costs of $105,467. Considering even smaller firms (less than 250 employees), Foreman-Peck, Makepeace, and Morgan (2006) find that tax compliance costs bear most heavily on the profitability of the smallest firms. In total, it is plausible that measures against profit shifting force some firms out of the market.
A numerical simulation in Section 4 will shed some more light on this result. First, however, I derive and discuss the conditions that determine the optimal tax rates and limitation on profit shifting in the following section.
3 Optimal Tax Policies
3.1 Optimization of the Tax Haven
The tax haven sets its tax rate
Solving eq.  yields the tax haven’s best response function,
The tax haven reacts to stricter limitations on profit shifting (lower
3.2 Optimization of the Home Country
The home country can decide about two policy instruments, the tax rate and the degree to which it restricts profit shifting. The government employs both instruments in a way that maximizes social welfare. The revenue raised from corporate taxation is used to finance the public good,
Note that income I consists of labor income L and (after-tax) profit income. The fixed costs of profit shifting, f, are paid by all
The first-order conditions for the optimal limitation on profit shifting and the optimal tax rate are
Due to the analytical complexity of the model, these first-order conditions cannot be solved explicitly for
First, to interpret the effects of such a regulation better, eq.  can be rewritten as
The first term of eq.  captures the effect that limiting profit shifting has on consumption. This term is always positive, showing that stricter regulations (lower
The main advantage of a regulation that limits profit shifting is supposedly that less profits are shifted abroad. The change in the volume of profits shifted has two effects, which are captured in the second term of eq. . First, stricter profit shifting rules increase tax revenues in the home country. Second, less income is lost to tax payments in the tax haven (from the home country’s point of view, taxes paid on profits in the tax haven are a pure loss, as they neither generate tax revenue nor profit income). Moreover, as shown by the third term of eq. , if fewer firms shift profits, less profit income is lost due to the fixed cost f, which firms incur to shift profits. Note, however, that it is not clear whether such a rule really leads to less profits being shifted abroad (see Proposition 1).
The fourth term of eq.  reflects that as fewer firms are in the economy, fewer firms incur the fixed costs of production, c. As this cost is tax deductible, this also has implications for tax revenue. Lastly, the strictness of regulations influences the severity of the burden that is associated with such a limitation on profit shifting. First, lowering
(Welfare effects of regulations to limit profit shifting)The welfare effects of strengthening a limitation on profit shifting are ambiguous and given by eq. . Besides the positive effect of keeping profits in the country, such a regulation has further effects due to the market exit of some firms. This decreases competition and makes consumers worse off as they have fewer varieties from which to choose, but may increase tax revenue (see Proposition 1).
Next, let us consider the effects of a change of the tax rate in the home country,
The first term again captures the effect on consumption: If the tax rate is higher, it is more difficult to be profitable enough to stay in the market despite the excess burden of regulations to limit profit shifting. Thus, a higher tax rate implies fewer varieties in the market, thereby decreasing welfare. The second term captures the effect of a tax rate increase on tax revenues. First, there is a direct effect: For a given tax base, a higher tax rate implies higher revenues. 20 However, there is also a negative indirect effect, as the tax base decreases because the higher tax rate leads to more profit shifting. The additional profit shifting also implies that income is “lost” in the tax haven, because more profits are taxed there. This effect is represented by the third summand of eq. . As more firms incur the fixed costs of profit shifting, income is further reduces, as the fourth term shows. Lastly, there also is a positive effect of market exit due to higher tax rates: As fewer firms are active, the dead weight loss of the limitation on profit shifting affects fewer firms and fewer firms have to pay the fixed costs of production.
These various effects allow no clear conclusion whether limiting profit shifting is desirable, given that it imposes costs on all firms. To see the effects of such a limitation more clearly, the next section looks at some numerical simulations of the modeled economy.
4 Numerical Analysis
4.1 Simulation of Proposition 1
The theoretical model has shown that it is not clear that a regulation that limits profit shifting always succeeds in its aim of decreasing the amount of profits that is shifted to a tax haven (see Proposition 1). In the following, numerical simulations will illustrate this. Their results are shown in Figure 1.
The graphs clarify how the tax policy of the home country affects the aggregate amount of profits shifted abroad. It compares the aggregate value of profits shifted abroad in the case with a limitation on profit shifting (dark plane) and without such a limitation (light plane). The optimal response of the tax haven (i.e. the optimal
On the two axes with the independent variables are
The graphs clarify that only for some combinations of
4.2 Simulation of Proposition 2
Lastly, let us consider the welfare effects, which were described in Section 3 and summarized in Proposition 2. A numerical analysis of the model confirms that it is not always optimal to limit profit shifting if this entail costs for all firms.
However, the simulations also show that if a limitation is welfare-increasing at all, then the government should set is as strict as possible, i.e. set
It depends on the characteristics of the economy (i.e. on parameters) whether a country chooses to prohibit profit shifting or not. Figures 2 and 3 show how market and firm characteristics influence whether profit shifting should be barred.
Figure 2 summarizes the results of simulations comparing welfare without a limitation on profit shifting (i.e.
Profit shifting should not be limited with a regulation that imposes costs on all firms if there are relatively many firms in a relatively uncompetitive market. If the elasticity of substitution is low, then it is more important for consumers to have as many firms in the market as possible. Hence, the utility loss of losing additional varieties is higher. In contrast to what might be the first intuition, this effect is stronger when many firms are in the market (low fixed costs c), because the additional fixed costs of limiting profit shifting become more important when other fixed costs are low.
A further interesting aspect is the interplay of the different firm characteristics, namely fixed costs c and the costs of profit shifting, f, which is depicted in Figure 3. It is intuitive that the benefit from limiting profit shifting is smaller if few firms shift profits due to high costs f, especially because the burden imposed by regulation to hinder this falls on all firms. However, high fixed costs c make it more likely that profit shifting should be limited. If fixed costs are high, the market consists mainly of highly profitable firms, which are more likely to shift profits abroad, thus increasing the benefit of limiting profit shifting.
The degree of firm heterogeneity also influences whether profit shifting should be prohibited or not. Heterogeneity is measured by
This article has analyzed the various effects and welfare implications of limiting profit shifting. It points out that regulations that aim to limit profit shifting may curb competition by forcing some firms out of the market. By rendering the remaining firms more profitable, it is possible that more profits are shifted abroad on aggregate after the introduction of a regulation that is supposed to prohibit or limit profit shifting.
In the introduction it was mentioned that such measures, e.g. thin capitalization rules, have increasingly been introduced or strengthened during the last years. The model also offers explanations for this by clarifying the effect of different parameters on the likelihood that limiting profit shifting increases welfare. It becomes clear that lower costs of profit shifting, which may have resulted from increasing financial integration, make limiting profit shifting more beneficial.
The author would like to thank Carsten Eckel, Clemens Fuest, Andreas Haufler, Sebastian Krautheim, seminar and conference participants in Munich and Uppsala and two anonymous referees for helpful comments and suggestions.
Table 1 states some results of numerical simulations of the model. The fixed parameters are
Results of the numerical simulation.
It becomes clear that is always either optimal not to limit profit shifting at all (
The graphs clarify that it is not always welfare increasing to introduce a limitation on profit shifting: In the graph on the left, welfare with such a limitation is always lower than in the benchmark case where profit shifting is not limited. If such a rule should be introduced, it is optimal to set it as strict as possible (that is, at the left side of the graph).
Welfare is depicted for different values of the elasticity of substitution,
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There are several empirical analyses of thin capitalization rules confirming that such rules indeed have a significant effect on firms’ decisions. Buettner et al. (2012) find that thin capitalization rules decrease the use of internal debt, but result in higher external debt. Buslei and Simmler (2012) find an effect on leverage, but not on investment. Blouin et al. (2014) show that such rules reduce a firm’s aggregate interest expenses. Weichenrieder and Windischbauer (2008) and Overesch and Wamser (2010) reach similar conclusions.
This is the case especially in the European Union, where the European Court of Justice ruled against measures targeted specifically at multinational firms (Lankhorst-Hohorst-decision, 12 December 2002; CELEX-No. 62000CJ0324).
For example, the Italian thin capitalization rule applies also if a group is only active nationally, and debt mostly stems from bank financing. There is no exemption threshold, i.e. it applies to all firms, regardless of their size.
Homburg (2007) gives the following example for the German interest cap, which is very similar to the Italian rule: Consider a corporation making a loss of 20 million euros, with net interest expenses of 60 million and 10 million euros of depreciation allowances. The interest limits deductible interest expenses to 15 million euros, resulting in a taxable profit of 25 million (implying a tax payment of about 7.5 million despite making a loss). In line with this example, the empirical analysis of Dreßler and Scheuering (2012) finds an especially strong negative effect of the interest cap on leverage for low-profitability firms. Note, though, that in contrast to the Italian rule, the German interest cap has an exemption limit and always allows deduction of interest up to 3 million (since 2008). Possibly this exemption limit was introduced to avoid exactly the negative implications pointed out in this paper.
In some contexts, governments can employ controlled foreign corporation (CFC) rules to hinder profit shifting. Such rules are less likely to impose costs on firms that do not shift profits. However, such rules cannot be used within the European Union, as they are not in line with the freedom of establishment (Cadbury Schweppes case, C-196/04; see Weichenrieder and Ruf (2013) for details).
To focus on profit shifting, it is assumed that there is no trade in the differentiated goods sector. This is common in the literature, see, e.g. Krautheim and Schmidt-Eisenlohr (2011).
The Pareto distribution is a good approximation of the empirically observed distribution of firm sizes (see Axtell, 2001). As marginal costs determine firm size in monopolistic competition models, the observed distribution of firm size can be used to approximate the distribution of marginal costs.
With a lower value of the parameter
In line with the previous literature, I assume that
As the tax haven has no firms of its own, it collects tax revenue only if it sets a lower tax rate than the home market. Otherwise, no firm would be willing to shift profits.
In EU countries, non-discrimination laws even prohibit regulations that affect only internationally active firms.
When interpreting the limitation of profit shifting as the strictness of transfer pricing documentation requirements, the model should be seen as capturing all firms that are active internationally. Even among these firms, only a part actually shifts profits (Desai, Foley, and Hines 2006). An alternative interpretation is that firms abstain from (otherwise profitable) international activities due to these regulations.
Real-world tax compliance costs are, of course, not constant across all firms. This simplifying assumption keeps the model tractable. However, the mechanism behind the main results in this paper only requires that there are some fixed costs complying with such regulations. Moreover, survey evidence finds that tax compliance costs change only slowly with firm size: US firms with assets below $5 m have average tax compliance costs of $105,467, relatively similar to the compliance costs ($149,876) of those firms with assets of $50–100 m (Slemrod and Venkatesh 2002).
I assume that fixed costs are such that not all firms engage in profit shifting, so that the least productive firm in the market (i.e. the firm with marginal costs of
The tax-deductible fixed cost of production, c, is always deducted in the home country. Due to the higher tax rate there, this is optimal for the firm.
The assumption of no deductibility is justified if the costs of profit shifting lie in distortions or soft costs (such as language barriers or an inability to effectively monitor employees) that arise because an investment (e.g. a sales and distribution office) is undertaken in a tax haven instead of in a high-tax country. It is also common in the literature with heterogeneous firms, see, e.g. Krautheim and Schmidt-Eisenlohr (2011). An alternative assumption would be that these costs are deductible in the tax haven, which would not change the analysis qualitatively.
Again, two counteracting effects are at work on the extensive margin, as can be seen by inspection of eq. . A stricter regulation makes profit shifting less attractive per se, but the increase in profits (due to less competition, i.e. a higher price index P) may change that.
As the CES price index reflects the price of the optimized consumption bundle, it unambiguously falls when fewer varieties are available, even though these varieties were the most expensive in the market.
Increasing the tax rate implies that the additional revenue comes from the firms, whereas stricter profit shifting regulations imply that additional revenue partially comes at the expense of the tax haven. This makes limiting profit shifting more attractive than raising the tax rate, everything else equal (for a similar argument, see p. 154 in Mintz and Weichenrieder 2010). I thank an anonymous referee for pointing out this aspect.
A prohibition of all profit shifting possibilities is not what we observe in reality. Note, however, that in the model it is actually feasible to deter all profit shifting, which is hardly the case in reality. It should hence be interpreted as the government limiting profit shifting as much as it can, while in the other alternative the government chooses not to limit profit shifting at all.
A low level of firm heterogeneity in this sense would be the case if there are many firms with similar (low) productivity levels and only very few highly productive firms.