Tax-avoidance strategies of American multinationals: an empirical analysis

MANAGERIAL AND DECISION ECONOMICS

Manage. Decis. Econ. 30: 539–549 (2009)

Published online 22 April 2009 in Wiley InterScience

(www.interscience.wiley.com) DOI: 10.1002/mde.1471

Tax-Avoidance Strategies of AmericanMultinationals: An Empirical Analysis

Peter Schwarz�

Sachverstandigenrat zur Begutachtung der Gesamtwirtschaftlichen Entwicklung, Wiesbaden, Germany

This paper analyzes the opportunities of American multinationals to reallocate their profitsinto tax havens. In contrast to previous papers, a comprehensive look on the profit-shifting

process is undertaken by proposing three different tests. Multinationals in high-tax countries

have a lower equity ratio than affiliates in tax havens, indicating that income is shifted by

extensively financing subsidiaries in high-tax countries with debt. Furthermore, the share ofretained earnings is lower in high-tax countries owing to the unattractiveness of tax deferral.

When testing for the outcomes of profit shifting, the results show that the pre-tax profitability

of American multinationals is higher in tax havens. This relationship is consistent with theopportunities of multinationals to shift income outside high-tax jurisdictions. Finally, the

paper shows that profit shifting largely takes place into tax havens, whereas other countries do

not benefit from profit-shifting activities. Copyright r 2009 John Wiley & Sons, Ltd.

INTRODUCTION

One of the parameters multinational enterprises(MNEs) bear in mind when deciding aboutforeign direct investment (FDI) is the tax burdenin a country. By choosing low business taxrates a government can attract foreign MNEs.On the other hand, location decisions are notonly determined by the tax burden. A well-developed infrastructure, the quality of the work-force, and especially the size of the foreign marketare at least as important as taxes (overviews on thedeterminants of FDI are provided by Chakrabarti,2001; De Mooij and Ederveen, 2003). Further-more, real production is less sensitive to taxationbecause an MNE is only ex ante mobile. Once anew plant is built in the foreign country thegovernment gains ex post bargaining powerdue to sunk costs (Doyle and van Wijnbergen,1994; Thomas and Worall, 1994; Janeba, 2000).

Therefore, the decision also for MNEs to relocateproduction is costly, thus making them lesssensitive to taxation.

Nevertheless, the implicit assumption behindthis point of view is that it focuses only on realcapital investments in production facilities. IfMNEs solely want to minimize taxes, they have asecond option available. Different parts of theMNE have alternative elasticities with respect tolocation decisions. Holdings, or more generallythose parts of the MNE with a financing or servicefunction, are more mobile compared with theproduction itself. If an MNE has the opportunityto shift profits from high-tax countries toward taxhavens, real investment decisions should becomeeven more insensitive with regard to taxationbecause profit shifting allows multinationalcompanies to combine the locational advantagesof high-tax regions with the low tax burden of taxhavens. Shifting income between countriesimplicates that the structure of worldwide profitschanges by reporting a higher percentage in taxhavens. Thus, by using affiliates in tax havens anMNE can minimize its worldwide tax burden and

*Correspondence to: Sachverstandigenrat zur Begutachtungder Gesamtwirtschaftlichen Entwicklung, Frankenstraße 20,Wiesbaden 65183, Germany. E-mail: [email protected]

Copyright r 2009 John Wiley & Sons, Ltd.

at the same time can still produce in industrializedcountries.

The aim of this paper is to test whether USmultinationals engage in profit-shifting activities inorder to minimize their tax burden. I expandprevious empirical attempts in several ways: First,either previous studies focused on the outcomes ofprofit shifting or on the instruments an MNE usesto shift profits. For example, Grubert and Mutti(1991), Rousslang (1997), as well as Hines andRice (1994) show that the pre-tax profitability ofUS affiliates is higher in tax havens. This result isconsistent with the profit-shifting behavior. Otherstudies focused instead on the instruments of theprofit-shifting process. Grubert (2003), forexample, shows that profit shifting results largelyfrom the manipulation of transfer prices ofimmaterial goods. An alternative strand of theliterature analyzes profit shifting through the taxdeductibility of interest payments and shows thatMNEs finance their affiliates especially in high-taxcountries extensively with debt (among others,Desai et al., 2004). However, all these studies havein common the fact that they focus only on aspecific aspect of the profit-shifting process.Combining these different approaches, this papertakes a comprehensive look on profit shifting. Theinstruments as well as the outcomes of the profit-shifting process are part of the empirical analysis.

Moreover, because the USA uses the tax creditmethod these tests are only a necessary but not asufficient condition that profit shifting issuccessful. Therefore, we will investigate whetherUS affiliates in low-tax countries retain more oftheir income compared with affiliates in high-taxcountries. Finally, the paper shows that profitshifting is more severe when the tax havens arepart of the empirical analysis.

The paper proceeds as follows: the followingsection gives an overview on the options an MNEhas in minimizing its tax burden and discusseslegal aspects of the US tax system. The nextsection formulates the hypotheses and summarizesthe data sources. The penultimate section presentsthe results of the regressions. Finally, the paperends with a brief conclusion.

STRATEGIES OF INCOME SHIFTING

Although tax rates vary considerably within highlydeveloped countries, tax-minimizing behavior

should be most easily detected when analyzingtax havens. Tax havens are often small countriescharacterized by low personal and corporatetaxation, low banking regulation standards aswell as effective bank secrecy laws, a stablepolitical climate, and the existence of a financialmarket (Palan, 2002, pp. 155–156). The moresuccessful tax havens have signed doubletaxation agreements with some of the developedcountries.1

Although the different parts of an MNE areformally independent, they share in an economicsense the same objectives. Thus, intra-companytransactions can be used to shift profits outsidehigh-tax jurisdictions. When using tax havens, anMNE has different alternatives available. First,one opportunity consists of the manipulation ofthe transfer price for traded goods. Approximately40% of the US trade consists of inter-companytransactions (Clausing, 2003). One strategy is tooverinvoice the transfer price for goods exportedinto high-tax countries, whereas the MNE shouldunderinvoice the price of the traded good whenexporting to affiliates in tax havens. Overinvoicingof exported goods lowers the income of theaffiliate in the high-tax region, while theprofitability of subsidiaries in tax havens rises bysetting low transfer prices. The same relationshipholds for imports with opposite signs.

Nevertheless, an MNE faces constraints whensetting transfer prices. Transfer prices have to accordto the ‘arms-length principle’ (OECD, 1995). Thismeans that the transfer prices for traded goods haveto be set as if the transaction would have beencarried out with a third, independent party.Governments use several methods to constrain taxevasion via the manipulation of transfer prices.Among the different methods, the USA usestransaction-based methods as well as profit-basedmethods. Especially the latter—often applied in thecase of immaterial goods—is an imprecise way toallocate the worldwide profits of the MNE betweenthe USA and the foreign countries. Furthermore, ifthe USA and the foreign country use differentmethods in estimating the ‘true’ or undistortedtransfer price, the MNE bears the risk of doubletaxation. Even if there is no double taxation,alternative methods in different countries may raisecompliance costs due to increasing documentationrequirements (European Commission, 2001).

Another strategy of tax avoidance is to financeaffiliates in high-tax regions with as much debt as

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Copyright r 2009 John Wiley & Sons, Ltd. Manage. Decis. Econ. 30: 539–549 (2009)DOI: 10.1002/mde

possible. Because the interest payment of theaffiliate is deductible from the tax base, the pre-tax profit of the affiliate declines. Thus, an MNEshould use debt instead of equity capital in the caseof high-tax countries. A more complicated buteven more promising option is to finance affiliatesthrough a holding from a third country. Considerthe case of a Japanese affiliate paying interest on aloan to its American parent company. Whereas theinterest payments—due to their deductibility fromthe tax base—reduce the income of the Japaneseaffiliate, the interest receipts raise the income ofthe US parent company. Although the USA taxescorporate profits on a somewhat lower rate thanJapan, little is gained from that transaction. Aslong as the tax burden in the USA is stillconsiderably high, the MNE could take anadditional advantage by choosing to finance theaffiliate through a financing center in a low-taxregion. In that case, the interest receipts would betaxed by the tax rate of the tax haven. A finaloption in reallocating profits is the use of royaltypayments and license fees. Patents as well astrademarks have the advantage of being non-homogeneous goods. Compared with other goods,it is more difficult for the tax administration toinvestigate whether prices are in accordance withthe arms-length principle.

Figure 1 summarizes the instruments discussedso far. The three instruments have all in commonthat the reported pre-tax profitability should risein tax havens and shrink in countries where theMNE is heavily taxed. For example, if the parentcompany in a high-tax region underinvoices the

price of the exported good, the pre-tax profitabilityof the parent will be low, while the profitability ofthe affiliate increases. Therefore, an empiricalassessment of tax-planning activities can analyzethe outcomes of profit-shifting activities as well. Ifprofit shifting is severe, one should expect that thepre-tax profitability of MNEs is higher in taxhavens.

A test of profit-shifting opportunities isincomplete as long as the sufficient condition isnot fulfilled. The USA uses the tax credit methodin taxing foreign profits. In contrast to countriesusing the exemption method, it is more difficult toevade taxes under a tax credit regime. Under theexemption method, foreign profits are exemptedfrom taxation in the residence country of theinvestor. In contrast, under a tax credit regime, theforeign tax is credited against US tax liabilitywhenever (foreign) profits are returned to the USparent. If profits are repatriated as dividends, theUS tax rate becomes the relevant tax rate. Thus,the specific tax burden will depend on whether acountry uses the tax exemption or the tax creditmethod. Table 1 summarizes the different possibleoutcomes. More specifically, the USA applies thetax credit method with limitation by a per-countrybasis. If the foreign countries’ tax rate is lowerthan the US tax rate, it does not matter whetherthe tax credit method is based on a limitationbasis. Only when the foreign tax burden exceedsthe US tax burden, this distinction becomesimportant, because the amount of foreign taxcredits is limited. Under these circumstances, afirm is in an ‘excess’ position if its available foreigntax credits exceed the US tax liability on its foreignincome. This scenario is shown in column 4 ofTable 1. Under the tax credit method on alimitation basis, the higher of the two tax rates isthe relevant tax rate for the US investor.

Outcomes ofProfit Shifting

Tax Credit Method

Pre-Tax Profitability

Instruments Inter-companyTrade

Allocation ofInterest Payments

Trade inImmaterial Goods

Additional Condition

High Retained Earnings in Tax HavensFor Countries Using the

Figure 1. Tests for profit-shifting activities.

Table 1. Effects of Different Foreign IncomeRules on the Tax Burden

Taxexemptionmethod

Tax creditmethod withoutlimitation

Tax creditmethod withlimitation

Profits USA 100 100 100Profits abroad 50 50 50US tax (40%) 40 60 60Foreign tax (50%) 25 25 25Credit — �25 �20Tax burden 65 60 65

TAX-AVOIDANCE STRATEGIES OF AMERICAN MULTINATIONALS 541


Therefore, if profits are repatriated and the foreigntax rate is lower than the US tax rate, the taxexemption method is more advantageous.

Compared with MNEs from countries using thetax exemption method, it is more difficult for USMNEs to avoid taxation on their foreign profits inthe home country because repatriation comes atthe cost of being taxed under the rules of the USlaw. On the other hand, if the subsidiary reinvestsits profits, the MNE takes advantage of the taxdeferral. Thus, one should expect that profitsshould be repatriated less often when the MNEoperates in tax havens. In that case, the MNEgains from the deferral. By reinvesting profits inthe foreign country, taxation in the USA can becircumvented, because the US tax laws have to beapplied only when profits are repatriated. A highshare of retained earnings in the host countryshould be therefore more often observed in thecase of tax havens.

Two reasons may have counteracting effectscausing a high share of retained earnings in thehost country to be unattractive. First, reinvestingmoney in the foreign country is only an appropriatestrategy if the foreign affiliate is able to earnreasonable profits. If investment opportunities arelimited, the gains from the tax deferral should besmall. Second, the US tax administration overrulesthe opportunity of tax deferral if the foreign profitsconsist of a special sort of income.2 Presently, theprofits of controlled foreign corporations (CFCs),i.e. foreign corporations owned at least by 50% ofAmericans, are immediately taxed when resultinglargely from passive income sources. Theapplication of passive income legislation does notdepend on whether the CFC repatriates profits orreinvests money in the foreign country. Passiveinvestments are, for example, interest receipts orincome from royalty payments. Furthermore,profits are immediately taxed if the income arisesfrom base companies or if the profits are generatedby insuring risks from operations in the USA.Taken together, most income arising from intra-company services or financing bears the risk ofimmediate taxation.3

An MNE can take advantage of the existence oftax havens in various cases. However, the USgovernment has responded to the use of tax havensby adopting several counteracting anti-tax-avoidance rules.4 Therefore, it is an empiricalquestion to judge the opportunities of MNEs inusing tax havens for tax sheltering.

HYPOTHESES AND DATA

The data source for the dependent variables comesfrom the ‘Bureau of Economic Analysis’ (BEA). It isthe most comprehensive source on the activities ofAmerican multinationals and provides detailedfinancial and operating statistics about the affiliatesof American firms. Coverage is close to complete(Desai et al., 2006a). The sample size variessomewhat depending on which hypothesis is tested.However, for roughly 50 countries data during theperiod 1999–2001 are available.5 A complete list ofthe countries is given in the Appendix. With theexception of retained earnings including all affiliates,the analysis will focus on CFCs in foreign countries.Testing for the outcomes of profit shifting requires acomparable denominator existing across thecountries. Previous studies have proposed differentalternatives with respect to scaling pre-tax profits(Grubert and Mutti, 1991; Hines and Rice, 1994;Huizinga and Laeven, 2008). One feasible optionis to scale the profits in the respective country bythe sales of the affiliates. This will be ourpreferred measure of pre-tax profitability in thebasic specification. However, if the allocation ofindustry-specific FDI differs largely across countries,perhaps sales are a less reliable denominator.Alternatively, some studies have also scaled profitsby the equity capital of the affiliates (Grubertand Mutti, 1991). However, equity is measuredsometimes with large errors and is itself anendogenous variable because in high-tax countriesthe affiliate should be financed largely by debtrather than equity. Instead, as a second profitabilityratio, profits will be scaled by total assets in theempirical analysis. Total assets of the affiliates arenot distorted by the tax-planning strategies of anMNE. In the empirical analysis, averages for theperiod 1999–2001 serve as the dependent variable inorder to minimize business cycle effects.

Owing to different views regarding the costsassociated within the profit-shifting process, itremains unclear which tax rate is the relevant onefor the MNE. According to the first view, thenominal rather than the effective tax burden maybe the relevant decision variable of MNEs(Haufler and Schjelderup, 2000). Regarding thisview, MNEs derive in the first stage profits bytaking the impact of depreciation allowancesinto account; in the second stage, the decisionwhere to shift profits is undertaken by comparingthe differences in nominal tax rates. Because

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the costs of profit shifting depend only on thedifference between the true and the distortedtransfer price, this view suggests that real capitalinvestments and profit shifting are completelyindependent of each other. Therefore, thenominal tax rate will serve as the first tax burdenindicator. Data on nominal tax rates is taken fromKPMG Tax Notes and complemented by datafrom the Office of Tax Policy Research.

On the other hand, some authors claim thatreal capital investments and profit shifting are notpure substitutes (Weichenrieder, 1996; Grubert,2003, pp. 224–225). Alternatively, the effective taxrate (ETR) will be included as a second measure ofthe tax burden in the empirical analysis. Incontrast to the nominal tax rate, the ETR takesthe impact of depreciation allowances as well asdifferent rules regarding the carryover of lossesinto account. The ETR is calculated by dividingpaid taxes in the respective country by the pre-taxprofits of the affiliates. Data are provided bythe BEA.

The pre-tax profitability in a country is notonly a function of the opportunity to engage inprofit-shifting activities. If the economy of acountry exhibits large growth, the pre-taxprofitability of the US affiliates should rise.Therefore, the average growth rate during1999–2001 is included to control for differenteconomic climates. Furthermore, the profitabilityin a country should not only depend on profit-shifting activities and the general economicenvironment, it is also a function of country risk.Differences in the profitability across countriesmight therefore simply reflect differences incountry risk. If a company invests in unstablecountries, it will require a higher pre-tax rate ofreturn compared with an engagement in theindustrialized countries. Hence, a politicalinstability indicator measuring the likelihood ofconflicts and violence is used to control fordifferences in country risk. Higher scores indicatethat a country is politically more stable. Data arefrom the World Bank Governance Indicators(Kaufman et al., 2007).

Turning to the instruments of the profit-shifting process, it will be investigated whetherUS MNEs use an appropriate financial structureto shift profits toward tax havens. One optionto analyze tax-planning strategies is the equityratio of the affiliate. Because the affiliatecan be financed by equity or debt, the equity

ratio is defined as:

EquityCapital=EquityCapitalþDebt ð1Þ

The equity ratio of the affiliate considers the USparent as well as other investors such as, forexample, financing centers in third countries.Thus, the indicator includes all persons fromwhich the affiliate receives capital. Large equityinjections benefit MNEs in countries with low taxrates, whereas the amount of debt financing shouldincrease in countries with high tax rates. In high-tax countries, the subsidiary can deduct interestpayments from the tax base. A negative signbetween the tax burden indicators and the equityratio is therefore expected. In addition, the banklending rate of the respective country is included tocontrol for differences in lending conditions acrosscountries. High interest rates should negativelyaffect the demand for debt. Furthermore, thepolitical risk of a country should exhibit asignificant effect on financing decisions. Inpolitically unstable countries, the affiliate shouldbe financed largely via debt because fullexpropriation can be hedged by paying interestto the US parent. Therefore, a positiverelationship between country risk and the equityratio is expected.

Successful profit shifting requires that theincome of the affiliate is reinvested in the foreigncountry. Otherwise, the tax laws of the USA haveto be applied. Therefore, the relationship betweenthe tax burden and the retained earnings should benegative. Similar to the case of the profitabilityratio, the share of reinvested earnings is alsoaffected by the political stability of the countryand its growth rate. In more stable and faster-growing economies, a higher amount of incomeshould be reinvested due to sound investmentopportunities.

The functional relationship between thedifferent dependent variables and the tax burdenindicators is unclear. Intuition suggests that anonlinear relationship may be apparent becauseprofits should be largely allocated toward taxhavens. On the other hand, a linear relationshipmay also be plausible. Results, when the taxindicators appear in logs as well as a linearrelationship, are reported in the empirical section.

Table 2 summarizes the data sources and theexpected relationship between the variables.Regarding tax rate setting, the tax competitionliterature assumes that political decision makers



respond to the forces of globalization by cuttingtaxes (Zodrow and Mieszkowski, 1986;Bucovetsky, 1991; Wilson, 1991). If politiciansreact to increasing capital mobility, therelationship between the tax burden indicatorsand the dependent variables might be endogenous.Following previous empirical studies, I will use inthe empirical analysis the logarithm of countrysize as an instrument (Hines and Rice, 1994;Huizinga and Laeven, 2008). Recent empiricalwork focusing on tax competition between highlydeveloped countries suggests that especiallysmall countries set low tax rates (Winner, 2005).The correlation coefficient with the tax rateindicators is also very high.6 For this reason, thelogarithm of country size seems to be a validinstrument. However, when testing whether thedifferent tax burden indicators are endogenous,the Hausman (1978) Test rejects an endogenousrelationship in many cases.7 The results in thefollowing section focus on the tax burdenindicators and show the logarithm of countrysize as a sensitivity check.

RESULTS

Table 3 provides some descriptive statistics on thedependent and independent variables. Thecountries have been classified into tax havensand non-tax havens.8 Although tax havens differwidely in their economic and social characteristics,the US affiliates are more profitable in theseterritories. Furthermore, a larger share of incomeis retained in tax havens. Regarding the equityratio, the descriptive statistics are less conclusive.The equity ratio in tax havens is only slightlyhigher compared with non-tax havens. Whenlooking on the tax burden indicators, we see thatthe tax burden in tax havens is very low. Finally, inboth cases the ETR is lower than the nominal taxrate, because the ETR takes the tax base intoaccount. To sum up, the first descriptiveimpression indicates that profit shifting mayserve as an explanation for the observedempirical pattern.

Table 4 gives the results for the profitabilityequation. Columns 1–4 present the estimates for

Table 2. Data Sources and Expected Relationship

Variable Data source Expected relationship

Pre-tax profitability Bureau of Economic Analysis Dependent variableEquity ratio Bureau of Economic Analysis Dependent variableRetained earnings/stocks Bureau of Economic Analysis Dependent variableNominal tax rate including local taxes KPMG Tax Notes; Office of Tax Policy Research Profitability: �

Equity ratio: �ETR Bureau of Economic Analysis Retained earnings: �Political risk World Bank Governance Indicators Profitability: �

Equity ratio: 1Retained earnings: 1

GDP growth IMF Financial Statistics Profitability: 1Retained earnings: 1

Lending rate IMF Financial Statistics Equity ratio: 1

Table 3. Descriptive Statistics

Tax havens Non-tax havens

Mean Standard deviation Mean Standard deviation

Profit/Sales 0.264 0.181 0.102 0.102Profit/Assets 0.090 0.048 0.065 0.037Equity ratio 0.416 0.144 0.388 0.112Retained earnings share 0.078 0.035 0.041 0.042Political risk 1.03 0.47 0.465 0.933Nominal tax rate 0.162 0.138 0.323 0.083ETR 0.075 0.049 0.317 0.141Population 2.47 2.72 90.2 217.2

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the statutory tax rate and ETR, whereas in column5 the logarithm of the population of the country isused as an instrument. Columns 6 and 7 reportresults when profits are scaled by assets rather thanby sales. The tax burden indicators as well as theinstrument perform quite well. The semi-logarithmic relationship between the tax rate andthe profitability fits the data somewhat better,although under the linear model the coefficientsare also significant. The allocation of profitsbetween countries seems to be nonlinear, becausea high share of income is deployed in tax havens.When profits are scaled by assets, the overallexplanatory power weakens somewhat. However,both tax burden indicators are still significantat the 5% level.9 Regarding the impact ofpolitical instability and the countries’ growthperformance, the results are less conclusive. Bothindicators exhibit most times the right sign,although they are only significant, when scalingprofits by assets.

Regardless of the profitability indicators or taxrates used, the tax burden has a strong negativeimpact on the pre-tax profitability of the USaffiliates in foreign countries. Furthermore, theresults do not change when the logarithm of thepopulation is used as an instrument. Takingtogether, there seems to be strong evidence thatthe pre-tax profitability of American MNEs abroadis negatively related to the tax burden in therespective country. This strongly contradicts thestandard tax competition model, which concludes

that the net return of capital is equalized acrosscountries (Zodrow and Mieszkowski, 1986).Instead, the results confirm a view, which isconsistent with profit-shifting behavior of the USmultinationals. Regarding the outcome of theprofit-shifting process, there is strong evidence thatthe US MNEs use tax-planning strategies to avoidtaxation in high-tax countries.

The empirical evidence so far is of indirectnature. A more direct test of profit shifting can beundertaken by focusing on the instruments MNEsuse to shift profits. Table 5 gives the results whenthe equity ratio serves as the dependent variable.In countries with high interest rates, the incentiveto finance affiliates via debt is weakened. A 1%point rise in the interest rate increases the share ofequity financing by roughly 0.4% points. Turningto the tax burden indicators, we see that MNEshave a lower equity ratio in countries with a hightax burden. For example, when using thelogarithm of the statutory tax rate, the resultssuggest that an increase of 1% in the statutory taxrate reduces the share of equity by 3.4% points.Affiliates of American companies in high-taxcountries are financed to a larger degree withdebt. Thus, the results suggest that the financialstructure of foreign affiliates is implemented in away to reduce taxes.

Turning to our last hypothesis, i.e. that moreincome is retained in tax havens than in countrieswith high tax rates, Table 6 provides the results.The coefficients on the tax variables are

Table 4. Determinants of US MNEs Pre-tax Profitability

1 2 3 4 5 6 7Denominator Sales Sales Sales Sales Sales Assets Assets

GDP-growth �0.44 �0.27 �0.24 �0.17 0.76 0.63 0.61�0.53 �0.38 �0.28 �0.25 0.97 2.18�� 2.21��

Political risk 0.01 0.01 �0.01 �0.02 �0.03 �0.01 �0.020.60 0.44 �0.56 �1.18 �1.61 �1.72� �2.47��

NomTax �0.64�4.64��

NomTax log �0.09 �0.013�6.43�� 2.34��

ETR �0.42�3.49��

ETR log �0.13 �0.017�6.25�� 2.44��

Population log �0.04�5.75��

No. obs. 51 51 51 51 50 50 51Adj. R2 27.7 43.9 16.4 42.5 38.8 16.7 17.3

Notes: t-Statistics below coefficients. �, ��, ��means significance on the 10, 5 and 1% level.



mainly significant throughout the differentspecifications. In contrast to the regression wherethe pre-tax profitability serves as the dependentvariable, there is some evidence that a linearrelationship between the tax burden indicators andthe retained earnings fits the data somewhat better.For example, the linear specification of the ETRsuggests that a 10% point increase in the ETRcorresponds with a reduction of retained earningsas a share of total FDI stocks by roughly 0.9%points.

Furthermore, high growth rates in therespective country as well as a sound politicalclimate encourage earnings to be retained since the

reinvestment opportunities rise under stableeconomic and political conditions. Nevertheless,the political instability indicator is only weaklysignificant. This is somewhat surprising becauseone option to revise a (wrong) decision is toreinvest less money in the respective country.Instead, regarding the countries’ economicperformance a downsizing of FDI by payingmore dividends to the US parent becomes aless attractive strategy in more economicallystable countries. All in all the degree to whichearnings are retained follows economic and—toa lesser extent—political considerations. Taxes,however, play a significant role since the

Table 5. Results Equity Ratio

1 2 3 4 5

Lending rate 0.40 0.41 0.47 0.47 0.372.28�� 2.34�� 2.47�� 2.65�� 1.98�

Political risk �0.02 �0.02 �0.02 �0.03 �0.03�0.83 �0.83 �1.05 �1.33 �1.33

NomTax �0.31�2.37��

NomTax log �0.034�2.29��

ETR �0.29�2.67��

ETR log �0.072�3.73��

Population log �0.019�2.44��

No. obs. 53 53 51 51 52Adj. R2 20.5 19.9 18.4 27.4 17.4

Notes: For notes, see Table 4.

Table 6. Determinants of Retained Earnings

1 2 3 4 5

GDP-growth 0.67 0.72 0.56 0.62 0.782.59�� 2.77�� 2.03�� 2.22�� 2.98��

Political risk 0.01 0.01 0.01 0.01 0.011.44 1.35 0.73 0.89 0.70

NomTax �0.09�1.91�

NomTax log �0.009�1.61

ETR �0.09�2.47��

ETR log �0.014�1.93�

Population log �0.01�1.86�

No. obs. 52 52 52 52 52Adj. R2 22.5 20.9 23.4 19.9 22.6

Notes: For notes see, Table 4.

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advantage of tax deferral is strongest in low-taxcountries.

One interesting extension is to analyze whetherthe results remain stable when the tax havens areno more part of the analysis. When excluding thetax havens, one can investigate whether profitshifting is also existent in the case of non-taxhavens. Table 7 presents the results when the taxhavens are excluded from the analysis. As can beseen, the nominal tax rate and the instrument arenow insignificant, whereas the ETR is stillnegatively related to the different dependentvariables. However, with the exception of theprofitability equation, the significance of the ETRhas lowered too compared with the benchmarkresults in Tables 4–6. Thus, one has to concludethat the impact of taxation—regardless of the taxburden indicator—is less apparent when excluding

the tax havens from the empirical analysis. Thisdoes not mean that the forces of tax competitionare not at work in the case of non-tax havens (foran overview of tax-motivated FDI: De Mooij andEderveen, 2003). Instead, for these countries, taxcompetition takes primarily the form ofcompetition about real capital investments,whereas tax havens seem to gain largely fromprofit-shifting activities of American MNEs.

In this section, three different tests for income-shifting activities have been proposed. The USaffiliates engaging in countries with a high taxburden share a lower pre-tax profitabilitycompared with affiliates operating in tax havens.This result is irrespective of the tax burdenindicator, a possible endogenous relationship,and different concepts of the denominator ofpre-tax profits. When turning to the instruments

Table 7. Results without Tax Havens

1 2 3 4 5 6Dependent variable Profit/Assets Profit/Assets Profit/Assets Profit/Sales Profit/Sales Equity ratio

GDP-growth 0.78 0.75 1.02 0.34 1.042.56�� 2.90�� 3.12�� 0.49 1.22

Lending rate 0.512.93��

Political risk �0.02 �0.02 �0.02 �0.01 �0.02 �0.01�2.45�� 3.65�� 3.34�� 0.82 �1.03 �0.56

NomTax log 0.028 �0.0871.29 �1.40

ETR log �0.040 �0.071�3.54�� 2.52��

Population �0.01 �0.018Log �2.61�� 1.65No. obs. 40 40 40 41 41 42Adj. R2 16.6 35.4 24.9 8.5 1.1 26.0

1 2 3 4 5 6Equity ratio Equity ratio Share retained

earningsShare retainedearnings

Share retainedearnings

Share retainedearnings

GDP-growth 0.66 0.67 0.52 0.812.15�� 2.18�� 1.55 2.39��

Lending rate 0.57 0.513.51�� 2.89��

Political risk �0.03 �0.02 0.01 0.01 0.00 0.00�1.41 �1.15 1.18 1.18 0.62 0.25

NomTax �0.08�0.85

NomTax log �0.023�0.93

ETR log �0.105 �0.026�2.99�� 1.89�

Population �0.015 �0.01Log �1.26 �1.32No. obs. 40 42 42 42 41 42Adj. R2 36.7 25.1 11.2 11.5 13.2 12.2

Notes: For notes, see Table 4.



of the profit-shifting process, the analysis hasshown that affiliates in tax havens have a higherequity ratio. Finally, a higher share of income isretained in tax havens due to the gains of taxdeferral because otherwise the MNE is liable toUS taxation. To sum up, the results stronglysuggest that US MNEs use foreign tax havens fortax sheltering.

CONCLUSION

This paper has emphasized that globalizationbenefits American MNEs by enabling them toshift profits outside the USA as well as their highlytaxed European subsidiaries. MNEs are moreprofitable in tax havens; they retain more incomein them and they finance their subsidiaries in high-tax countries by a larger extent with debt.Furthermore, the empirical evidence indicatesthat profit shifting can be extensively observedwhen tax havens are part of the empirical analysis.Competition about ‘paper profits’ benefit especiallytax havens; instead the relationship is weaker whenexcluding the tax havens from the sample. Thus,the allocation of profits seems to take place largelyin countries with tax rates below 10%.

Given these results, defensive anti-tax-avoidance measures proposed by the USA seemto be highly ineffective at the current stage. Oneoption to cope with this problem would be toeliminate tax deferral opportunities. Presently,tax deferral is restricted to active income;when one forbids tax deferral completely, profitshifting can be effectively eliminated because everyincome earned abroad is then immediately liable toUS tax.

Although, it was shown that MNEs use taxhavens for profit shifting, the overall welfare effecton the US remains unclear because tax havens mayalso offer large gains. For example, tax havensmight be used as a substitute for export subsidies,since the latter is forbidden by the WTO. Thus, theexistence of tax havens might promote thecompetitiveness of US MNEs in the worldmarket. Furthermore, the high profitability ofcompanies operating in tax havens may alsoencourage more investment in the USA (Desaiet al., 2006b). It is unclear whether the potentialgains from the existence of tax havens outweighthe revenue losses. This would be an interestingissue for future research.

APPENDIX A: COUNTRY LIST

Canada Dominican RepublicAustria UK Caribbean IslandsBelgium BermudaCzech Republic EgyptDenmark South AfricaFinland IsraelFrance Saudi ArabiaGermany AustraliaGreece ChinaHungary Hong KongIreland IndiaItaly IndonesiaLuxembourg JapanNetherlands South KoreaNorway MalaysiaPoland New ZealandPortugal PhilippineSpain SingaporeSweden TaiwanSwitzerland ThailandTurkey PeruUK VenezuelaArgentina Costa RicaBrazil HondurasChile MexicoColombia PanamaEcuador Barbados

NOTES

1. Switzerland has ratified double taxation agreementswith almost all countries from the OECD area. Inaddition, smaller tax havens are sometimes able tosign a tax treaty (for example, Liechtenstein withAustria, Barbados with the USA, or the NetherlandsAntilles with the Netherlands).

2. This sort of income is often referred to as passiveincome or ‘subpart F income’. All sorts of passiveincome are described in detail in the Internal RevenueCode Section 952.

3. However, immediate taxation can be circumventedunder the US law if the passive income is reinvestedin active investment projects.

4. The USA was one of the first countries to introduceunilateral anti-avoidance legislation in the beginningof the 1960s (Rixen, 2007). A recent study by Ernstand Young (2005, pp. 23–24) shows that manydeveloped countries have followed the US approach.

5. The selection of countries depends on the availabilityof data. The analysis in the following section focuseson all non-bank affiliates. If more disaggregated dataare used, for example, by analyzing affiliates from themanufacturing or service sector, the results are similar.

6. It is 0.59 in the case of the ETR and 0.71 for thenominal tax rate.

7. The results of these tests are available upon request.8. Countries identified as tax havens are the same as

those in Hines and Rice (1994) and include thefollowing territories: Ireland, Luxembourg,

P. SCHWARZ548


Switzerland, Malaysia, Singapore, Hong Kong,Bermuda, Barbados, Dominican Republic, UKCarribean Islands, and Panama.

9. The results remain stable when the tax rates appearlinearly in the equation. Results are suppressed forspace reasons and are available upon request.

DISCLAIMER

The views expressed in the paper do not necessarilycoincide with those of the Sachverstandigenrat.

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Tax-avoidance strategies of American multinationals: an empirical analysis

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