Ser ciudadano

Our modeling strategy relied on a number of simplifying assumptions. In this section we discuss the robustness of our results when some of these assumptions are relaxed.

We suppose the volume of profit shifted depends on the misreporting of the transfer price for one unit of the service good traded within the firm. A slightly more general approach is employed by Sørensen (2004) and Eggert and Schjelderup (2005) who pre- sume that shifting opportunities additionally depend on investment at the affiliate’s location. Formally, profit shifted by MNE i to country j equals (pj_i −1)kj_i and con- cealment cost becomes Q(pj_i)kj_i. A possible interpretation is that the internally traded number of goods depends on the capital investment in the subsidiary, e.g. one unit of a overhead service is provided for every machine installed at the entity or the quantity of a headquarter’s management service increases with the affiliate’s size. This approach

to transfer pricing implies that investment abroad eases profit shifting in the sense that for given pj_i the volume of shifting increases with kj_i. It can be shown that all our results remain qualitatively unchanged for this more general shifting technology as investment simply amplifies the shifting induced by the distortion of transfer prices.16 Next, there may be concerns that our short-run results hinge on the assumption of equal deductibility parameters while empirical observations suggest considerable cross country heterogeneity in the tax base legislation. For the results of Section 3 to hold, the MNEs’ effective tax rate within the union must be biased towards the tax rate of the low-tax union country (Lemmas 1 and 2). If the deductibility parameters differ across countries, these lemmas may not be true.17 However, it is straightforward to show that deductibility has to be equal for member countries after the formation of the FA- union only. The deductibility parameters may differ between FA and non-FA countries and between SA and FA. In reality, many existing FA unions are characterized by a common definition of the corporate tax base, for example, local and regional business taxation in Germany and Canada. Moreover, the proposal of the European Commission (2001) emphasizes the need for a homogeneous legislation with respect to the tax base definition across EU countries. Therefore, the condition of an equal tax base definition in the FA-union is in line with the planned design of a potential European FA system. Our analysis so far assumed that corporate income taxation follows a pure source principle. If instead the residence principle with a limited tax credit was in operation, our results might not hold.18 Nevertheless, worldwide corporate taxation is to a large 16_{Formal proofs are contained in an earlier draft of this paper (Riedel and Runkel, 2005). Further}

information can be obtained from the authors upon request. The logic of our results will also hold if profit is shifted by a distortion of the MNEs’ debt-equity structure. The reason is that even with this shifting technology the volume shifted depends on the tax rate differential between two countries.

17_{Intuitively, if the low-tax FA country allows fewer deductions, one might think of a situation in}

which the MNEs invest relatively more capital in the high-tax country and the effective tax rate under FA is biased towards the higher national tax rate within the FA union.

18_{For example, consider Propositions 2.1 and 2.2 withτ}c _{< τ}b _{< τ}a_{. Under a SA system with tax} crediting, MNEs a and b do not shift any profit to c since their foreign income is taxed at their

extent consistent with the source principle (e.g. Keen (1993), Haufler and Schjelderup (2000)). A related question which is consistent with the predominance of the exemption principle is whether the EU should combine the introduction of FA with the adoption of other instruments to protect its tax base against outflows to non-participating tax havens. G´erard (2006) discusses a so-called Controlled Foreign Company (CFC) rule which means that profit of an entity in a third country is included in the consolidated tax base. Such a rule resembles worldwide consolidation and preserves our short-run results as MNEs do not shift profit under FA. Alternatively, G´erard (2006) suggests the EU might reject granting exemption to profit from water’s edge countries and apply the tax credit method instead. In this case, our short-run results are equally preserved: We now have to compare a SA-exemption system with a FA system where exemption is applied within the FA union and crediting to countries outside the union. Under SA-exemption, MNEs a and b shift profit to country c. Under the FA system, the union profit of MNEs a and b is again taxed at the effective tax rate. Hence, MNE b’s tax rate differential to country c changes from τb −τc to τ_b −τb. As τ_b −τb always falls short ofτa_−τc_{, shifting of MNEb under the FA system is smaller than shifting of}

MNE a(!) under the SA-exemption system. In addition, MNE areverses its direction of profit shifting as all profit earned within the FA union is taxed at rateτ_awhile upon repatriation profit earned in country c is taxed at the national tax rate τa > τ_a. In sum, total shifting of MNEs a and b to country c declines.

Finally, we suppose fully symmetric countries within the FA union. Under this assumption our analysis shows that replacing SA by FA will increase the union coun- tries’ welfare if the apportionment formula is suitably designed. From tax competition models like e.g. Wilson (1991) it is well known that in case of country asymmetry the smaller country chooses the smaller tax rate and may benefit from tax competition.

home countries’ national tax rate. Under FA with crediting, all profit of MNE ais taxed at rate τa. MNE a therefore still refrains from shifting. But MNE b’s profit in the FA union is taxed at the effective tax rateτb > τb. As profit earned in cis taxed at τb, MNEb starts shifting from the union to countryc. Thus, under crediting FA raises total shifting by MNEsaandbfrom the union to countryc.

Tax harmonization is then not Pareto improving as the small country’s welfare declines. Similar, in case of asymmetric countries the introduction of FA may be beneficial for some union countries but detrimental for others. The optimal formula design under homogenous countries is then different from the design which ensures a strict Pareto improvement in case of asymmetric countries. However, before investigating the con- ditions for a Pareto improvement in the presence of a water’s edge it is important to understand the implications of country asymmetries in the absence of a water’s edge. To the best of our knowledge, such an analysis is missing in the literature so far.19 As a rigorous analysis is beyond the scope of our paper, we have to leave it for future research.

2.6

Conclusion

Many policy-makers and researchers have been skeptic about replacing SA principles by FA. One main objection concerns the necessity to restrict profit consolidation to the local area of a FA union (water’s edge), since FA systems with world wide consolidation rules proved to be politically non-feasible in the past. With the water’s edge regula- tion, profit shifting channels to countries outside the union stay open and thereby may undermine the aim of FA regarding the abolishment of income shifting and the asso- ciated fiscal externalities. Using a three-country model with MNEs, our paper shows that this fear is basically unfounded. On the contrary, for given national tax rates, introducing FA with a water’s edge consolidation is likely to reduce profit shifting to tax havens outside the union. Our paper shows that MNEs tie their shifting decision to the tax rate differential between two countries and that a switch to FA reduces the effective tax rate differential between high-tax FA countries and outside tax havens by more than it increases the effective tax differential between low-tax FA countries and outside tax havens. Under tax competition, the water’s edge causes a fiscal externality 19_{Asymmetric FA is considered by Anand and Sansing (2000) and G´erard (2005, 2006). But their}

that distorts corporate tax rates upward. But this externality is smaller in absolute terms than the profit shifting externality under SA and tends to compensate for other externalities under FA. Therefore, the existence of a water’s edge is likely to be ben- eficial. A numerical simulation of our model suggests that the suitable design of the apportionment formula is important for this positive role of the water’s edge to evolve.