Taxation and Multinational Firm Behavior: A Critical Survey

The impressive growth and proliferation of multinational firms 1 and of their direct foreign investment 2 over the past two decades have attracted the interest of policymakers. An area that has received particular attention is the effectiveness of tax policy as an incentive or deterrent for major decisions of such firms.3 These decisions affect the long-run welfare of home and host nations, in terms of the levels and the distribution (among consumers, suppliers of factor inputs, governments) of income and product within each country and among countries, as well as their ability to attain short-run goals of balance of payments equilibrium, full employment, and price stability. The importance of the multinational firm’s activities can be surmised, for instance, from the increasing proportion of transactions related to direct investment recorded in the balance of payments of home and host countries.4

Abstract

The impressive growth and proliferation of multinational firms 1 and of their direct foreign investment 2 over the past two decades have attracted the interest of policymakers. An area that has received particular attention is the effectiveness of tax policy as an incentive or deterrent for major decisions of such firms.3 These decisions affect the long-run welfare of home and host nations, in terms of the levels and the distribution (among consumers, suppliers of factor inputs, governments) of income and product within each country and among countries, as well as their ability to attain short-run goals of balance of payments equilibrium, full employment, and price stability. The importance of the multinational firm’s activities can be surmised, for instance, from the increasing proportion of transactions related to direct investment recorded in the balance of payments of home and host countries.4

The impressive growth and proliferation of multinational firms 1 and of their direct foreign investment 2 over the past two decades have attracted the interest of policymakers. An area that has received particular attention is the effectiveness of tax policy as an incentive or deterrent for major decisions of such firms.3 These decisions affect the long-run welfare of home and host nations, in terms of the levels and the distribution (among consumers, suppliers of factor inputs, governments) of income and product within each country and among countries, as well as their ability to attain short-run goals of balance of payments equilibrium, full employment, and price stability. The importance of the multinational firm’s activities can be surmised, for instance, from the increasing proportion of transactions related to direct investment recorded in the balance of payments of home and host countries.4

The policy relevance of the subject at hand and the vast literature (authored by government officials, scholars, lobbyists, and journalists) on it beg for a comprehensive and systematic survey of the tax aspects of the behavior of multinational firms.5 Hence, this paper is intended to synthesize and evaluate the investigation, particularly that of a quantitative nature, undertaken thus far to answer two fundamental questions. Do taxes influence the decisions of the multinational enterprise? If they do, what are the direction and strength of the response of those decisions to tax changes at home or abroad?

The structure of the paper proceeds from the general to the more particular aspects of these questions. Section I, which serves as the analytical backdrop to the remainder of the paper, presents a working definition of the multinational firm and reviews alternative theoretical constructs that have been employed to study the firm’s behavior. Section II describes the actual tax treatment of international direct investment income and remittances in home and host countries. With the theoretical and institutional groundwork already laid, the rest of the paper is devoted to addressing specifically the foregoing questions about the relationship between taxation and the behavior of the firm.

Sections III through V examine the theoretically expected and empirically observed sensitivity of the firm’s key decisions to intercountry differences in tax burdens. The decisions are grouped under three headings: first, investment and finance; second, production and trade; and finally, transfer prices. This breakdown is admittedly artificial—for all these decisions are connected to each other and are predicated on a common company objective 6—yet necessary in order to cope with an otherwise unwieldy presentation. Section VI summarizes the findings and discusses certain implications for tax policy and recommendations for future research.

I. The Theoretical Framework

the multinational firm defined

For analytical purposes, the multinational firm may be viewed as having four distinguishing characteristics: international operations, collective transfer of resources, ownership with control, and cosmopolitan mentality. The most salient characteristic of the multinational firm is that it conducts industrial, commercial, and financial operations across national boundaries.7 It operates through a parent corporation in the home country and through affiliates, in the form of branches (legally, as part of the home-incorporated parent) or subsidiaries (as separate host-incorporated entities), in host countries.8 Functionally, the firm’s operations overseas can be classified according to their relationship to the parent’s activity or stage in the production process. The affiliate may comprise either a horizontal extension, in that it simply duplicates the parent’s activity; forward vertical integration, if its activity goes beyond the parent’s and is closer to the final demand for the product; backward vertical integration, if it antecedes the parent’s processing stage, linking it to the supply of certain basic inputs; or conglomerate diversification, if it cuts across product lines engaging in an activity unrelated to the parent’s main activity.9

The second distinguishing feature of the multinational firm is that it involves a collective transfer of resources between countries.10 It is an international conduit not merely for financial investment flows but also for the transfer of raw materials, semifinished and finished consumer goods, capital goods, labor services, and technological know-how embodied in these inputs or made available separately by way of patents or trademarks. This package of transactions is presumably the result of the investing firm’s choice between such a package and single independent market transactions (i.e., portfolio investment, merchandise trade, rental of labor services, or licensing agreements with unrelated foreign parties). The package tends to confer greater monopoly power than do single transactions.11 Also, it enables the firm to bypass the international marketplace where such transactions occur at arm’s-length prices between unrelated parties.

Third, the multinational firm entails ownership with control over foreign affiliates. This means that the behavior of each entity, at home or abroad, is subject to the firm’s unified control—compatible with a certain degree of decentralized decision making, sometimes deliberately allowed by the firm.12 Portfolio investment is devoid of control;13 likewise, direct investment that involves minority or joint-venture interest by the investor may lack the control element. Thus, only majority-owned affiliates qualify unambiguously for the definition of a multinational firm.14

The fourth and least apparent characteristic is cosmopolitan mentality or outlook.15 The truly multinational enterprise has no preference for investing in any one location, except as determined by expected profitability, risk, or any other objective standard derived from its pecuniary goal.16 In other words, the firm has no special allegiance to any one national jurisdiction, and its investments in a given country are not affected by risk illusion or subjective cultural factors. While it may be difficult to find, in reality, a firm that behaves exactly in this fashion, many firms have acquired an increasingly cosmopolitan outlook over the years owing to closer international contacts through more efficient means of communication and transportation.17

The behavior of the multinational firm, and the role of taxation therein, can be explained with varying degrees of success by two alternative conceptual approaches. The older approach has been developed mostly within the body of traditional international economics. The more recent one is an adaptation of existing microeconomic theories of the domestic firm to segmented output and input markets.

theories of international capital movements

After an early denial of the existence of international factor movements by classical economists, notably Smith and Ricardo, capital mobility gradually became accepted as a fact of life, beginning in the latter part of the nineteenth century, in the writings of Mill, Bagehot, Pigou, and Marshall. However, full recognition did not come about until Ohlin (1933), Nurkse (1933), and Iversen (1936) laid the foundations of the neoclassical theory of capital flows. Essentially, the theory explains foreign investment in terms of each country’s relative factor proportions and the ensuing differential return to capital: capital moves at the margin from the capital-abundant country to the capital-scarce country in response to the difference in marginal rates of return, the capital-poor country having a higher rate than the capital-rich country.

Thus, the neoclassical differential return theory was ready to be cast into static barter general equilibrium models, assuming profit maximization, constant returns to scale, and perfectly competitive markets, with allowance for various policy impediments to international mobility of factors or commodities. In this manner, Mundell (1957) integrated capital flows into the standard two-country, two-factor, two-commodity Heckscher-Ohlin model, while MacDougall (1960) considered foreign investment in the one-commodity model, disregarding trade flows.18 Kemp (1964; 1966), Jones (1967), and Caves (1971) relaxed the Heckscher-Ohlin framework by admitting intercountry differences in the degree of specialization and in technology.19 In order to bring the theory even closer to real-life situations, Hufbauer and Adler (1968), Musgrave (1969; 1975), and Kenen (1972) introduced ad hoc modifications concerning the possible substitution between foreign and domestic investment (or consumption) in host and home countries.20 Most of these studies were conducted in an attempt to analyze the social benefits and costs associated with foreign investment (historically, first British-based and then U. S.-based), and to formulate optimal tax and tariff policies.

Economists long ago realized that differences in rates of return provide only a partial explanation of international capital flows. Nurkse (1933), for example, indicated that investors weigh not only relative rates of return but also relative degrees of risk associated with alternative investment opportunities. But as the primary concern was with the effects of capital flows rather than with the motives for foreign investment, the neoclassical theory assumed a riskless world. It was only some time after the advent of the portfolio selection theory developed by Tobin (1958) and Markowitz (1959) that risk and uncertainty were formally introduced in the analysis of international capital flows. The portfolio theory, adapted to direct investment by Stevens (1969 b) and Prachowny (1972),21 states that capital movements are a function of the expected value of returns on investments in different countries balanced against the variance (and covariance) of these returns, given maximization of utility by risk-averse investors. Thus, investment moves to locations with relatively high anticipated return and low variance in the return.22

A convenient way of evaluating the neoclassical and portfolio theories is from the standpoint of our working definition of the multinational firm. While both theories can accommodate without difficulty the characteristics of international operations and cosmopolitan outlook, neither provides an explicit treatment of collective transfer of resources and control (or of the monopolistic market structure and intrafirm pricing issue implied by these characteristics). A major problem is the barter nature of these theories; in them, financial and real capital flows are indistinguishable from each other.

From the point of view of empirical performance, both theories are inadequate. Differential returns have failed to explain international investment flows, especially because of the specification of observed average returns, instead of unobservable expected marginal returns, as independent variables. Moreover, the assumption of investment in assets that are riskless or equally risky is often unrealistic.23 Although in this sense the mean-variance approach is an improvement over the differential-return explanation, it is also plagued by measurement difficulties when estimated on direct foreign investment.24 Notwithstanding the inability of these theories to account for international direct investment behavior, neoclassical general equilibrium models can offer valuable insights into the macroeconomic consequences of direct investment.25

theories of the firm

Much of the contemporary literature on the multinational firm is indebted to partial equilibrium theories of the domestic firm. These may be classified under three major headings contingent on the firm’s objective function: profit maximization, size or growth maximization, and various forms of nonmaximization (i.e., the so-called behavioral or satisficing theory).26

Under profit maximization, the obvious goal is to maximize the firm’s present value or discounted global net worth, or, as a static first approximation, to maximize its current net earnings. A distinct advantage of this neoclassical partial equilibrium approach over its general equilibrium counterpart (the differential return version) is that it permits derivation of the decisions of the firm, such as the levels of output and investment and, with certain qualifications, the financial structure, as a function of certain exogenous variables (e.g., commodity demand, factor costs). Further, the standard profit-maximizing model can be modified explicitly as to diverse technologies, market structures, and sources of finance.

Following the lead by Hymer (1960),27 profit maximization was adopted with some variations in a number of studies of the multinational firm. Examples of studies in the neoclassical tradition include Morley (1966), Stevens (1969 a; 1972), Kopits (1971; 1972 a), Kwack (1972), and Boatwright and Renton (1975)28 in explaining plant and equipment expenditures and/or direct investment flows, and Johnson (1970), Horst (1971), Adler and Stevens (1974 a; 1974 b), and Vaitsos (1974) in explaining the firm’s production, trade, and pricing decisions.

With the evolution of the large widely held corporation, Gordon (1945), Baumol (1959), and Marris (1964) questioned the profit-maximizing objective. They argued that, instead, the firm’s goal has become the utility of managers, expressed by the size of the firm, maximization of which confers on them power, prestige, and higher monetary rewards. Size maximization, however, is subject to a profit constraint, determined by the reduction in the firm’s net worth tolerated by stockholders. Along similar lines, Behrman (1969) and Hymer and Rowthorn (1970) suggested that the multinational firm seeks to maximize the size or growth of its global operations. The solution for the desired level of investment, output, or other decision variables obtained in such a model is often not too different from that derived from profit maximization.29

The third school of thought, inspired originally by Simon (1957), views the firm as a nonmaximizing entity, to be studied in terms of observed behavior rather than an objective function specified ex ante. The behavioral theory contends that the firm operates according to rules of thumb, established through interpersonal conflict and compromise within the firm, and in response to specific environmental stimuli. Grouped under this approach we find several hypotheses that do not necessarily claim irrational behavior, incompatible with the profit motive. Rather, they interpret the firm’s decision-making process as being aimed at tangible surrogate goals, easily understood by corporate personnel at various operational levels.

The oldest behavioral explanation of direct foreign investment, popularized by Barlow and Wender (1955, Ch. 11), is the so-called gambler’s earnings hypothesis.30 They viewed the foreign investor as a gambler who bets money at the racetrack. Each time he wins, he reinvests one half of his winnings and keeps the other half. In a more sophisticated model, Aharoni (1966) enumerated certain internal and external initiating forces (e.g., drive of a top executive) that, accompanied by auxiliary forces and followed by a process of investigation and commitment, determine direct foreign investment. Unlike the Barlow-Wender and Aharoni models, which have no counterpart in the literature on the domestic firm, the stable payout hypothesis has been borrowed from Lintner (1956) by Zenoff (1966), Moose (1968), and Mauer and Scaperlanda (1972). Applied to the multinational firm, this hypothesis states that the repatriation of earnings from affiliates is a function of current earnings and past remittances.

Many direct investment models resemble at least two, if not all three, theories of the firm. According to Penrose (1956), the firm maximizes growth while allowing a large degree of independence to foreign subsidiaries. Vernon (1966; 1971, Ch. 3) saw direct investment as the result of the development of a product: the firm invests abroad when it perceives a higher marginal cost of exporting its product to a given country than of producing it there, and fears the entry of a competitor in that market. Robbins and Stobaugh (1973, Ch. 3) integrated maximizing with nonmaximizing theories in an explanation of the financial decision making of the multinational firm. They argued that, broadly speaking, the objective is always to maximize profits, although actual behavior depends on the size of the firm.

On the whole, the theories of the firm are consistent with our working definition of the multinational firm. But, ideally, the moment of truth of any theory lies in empirical testing. Unfortunately, it is difficult to compare the performance of the foregoing models because they have been tested on different types of data and with different research methods. The maximizing models lend themselves more to statistical estimation on quantitative data, while nonmaximizing models can be checked only against information collected through surveys (questionnaires or interviews), case studies, or anecdotes.

If our criterion for evaluation is (besides analytical rigor) successful testing on alternative data sets, the standard neoclassical theory, with some qualifications, stands up as the single most powerful explanation of the behavior of multinational firms.31 Nevertheless, sales maximization has not been refuted. In fact, much of the reported evidence can be construed as providing support for either optimization theory. In comparison, the performance of the behavioral models, despite their realistic appearance, is uneven at best. Some of them have been corroborated on a limited but objective sample of observations (e.g., the product cycle hypothesis),32 while others have never been subjected to any impartial test (e.g., Aharoni’s model) or have failed such tests (e.g., the stable payout hypothesis).33

In short, the current state of economic analysis reveals that the neoclassical partial equilibrium theory of the firm (preferably qualified by a monopolistic market structure and generalized to include risk minimization) offers the most robust representation of the behavior of multinational firms.34 Moreover, as shown later, this approach is the most convenient operational construct for measuring the impact of taxation on the decisions of multinational enterprises.

II. Tax Treatment of the Multinational Firm

The study of the impact of taxes on the behavior of the multinational firm requires an understanding of the tax treatment of income and remittances from direct foreign investment. As the firm operates under several national jurisdictions, the tax liability on its earnings is determined by the interplay between the tax systems of home and host countries.

Although the host country has priority in taxing earnings of foreign affiliates by imposing a corporate income tax (at national and local government levels) and withholding taxes on the repatriation of profits and other intrafirm remittances, the home country establishes the ultimate tax burden on such earnings.35 The home government can choose to alleviate, leave unchanged, or exacerbate the tax burden on foreign-source income. As shown in Table 1, all the major home countries (with more than US$1 billion direct investment abroad in 1967) seek to neutralize the tax on direct investment income by adopting methods that fall between current taxation at the home tax rate with full credit for host taxes on income and remittances, and complete exemption from the home tax. These two methods correspond, respectively, to the standards of capital-export tax neutrality, defined in reference to the location of the investor (the parent), in the home country, and capital-import neutrality, defined with respect to the location of the investment (the affiliate), in the host country. Under the first standard, all investors that reside in a given country are subject to a uniform tax rate on investment income, regardless of the site of the investment; the second standard requires all investment income that arises in a given country to be taxed at a uniform rate, regardless of the residence of the investor.36

Table 1.

Major Home Countries: Taxation of Corporate Direct Investment Income and Remittances

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Sources: United Nations (1973 b), Chown (1974), and various official and unofficial sources.

After deducting foreign taxes, 75 per cent is exempt from corporate tax.

Exemption is sometimes accorded by treaty.

Subsidiary dividends, after deducting foreign taxes, are subject to 10 per cent précompte mobilier; 90 per cent to 95 per cent of the remaining income is exempt from corporate tax.

Of grossed-up dividends, 95 per cent is exempt from corporate tax.

Entire income is exempt from business profits tax, but corporate tax applies to income, after deducting foreign income tax (withholding tax is credited).

In principle, foreign-source income is subject to taxation; in practice, exemption with progression is granted on foreign income that has been taxed abroad.

In principle, foreign-source income is subject to taxation; in practice, only net worth tax is applied.

Dividends from less developed host countries are taxed after deducting and crediting the foreign income tax. Constructive dividends from certain tax-haven income are subject to tax.

The most common approach, followed by the Federal Republic of Germany, Japan, Sweden, the United Kingdom, and the United States, is a mixed one, whereby the domestic tax is payable currently on foreign branch income and is deferred until repatriation on foreign subsidiary income (in the form of dividends) and payments (interest, royalties, or other intrafirm charges). In either case, host taxes on income and remittances may be credited against the home tax, the credit being limited by the home tax or host tax, whichever is lower.37 The ceiling on the foreign tax credit is generally computed by host country, by affiliate, and/or by type of income or remittance. In the United States, under the overall limitation, the firm may elect to average foreign income and taxes from all sources; in addition, unused credits may be carried backward to earlier taxable years and forward to future years to offset the home tax liability on foreign-source income. The overall limitation and carryover provisions bring the tax system close to capital-export neutrality. In countries that provide a credit, taxpayers may, as an alternative, deduct foreign taxes from global income (advantageous in the event of foreign affiliate losses).

Several home countries, notably France, exempt fully or partially direct investment income and remittances from domestic taxes. Others, like Belgium and Italy, offer exemption from certain taxes, or on a portion of foreign income, allowing deduction of foreign taxes when calculating the home tax liability on the nonexempt portion. A few home countries, such as the Federal Republic of Germany and Sweden, exempt foreign-source income under bilateral treaties for the avoidance of double taxation, mainly with less developed host countries.

The host country taxes the affiliate’s profits usually at the same rate as any other company established within its borders, thus achieving capital-import neutrality (in the absence of home taxation). But the withholding taxes imposed on subsidiary dividends (on top of the income tax) and on other deductible remittances constitute discriminatory departures from capital-import neutrality.38 Another discriminatory practice exists in some host countries where branch profits are taxed at a rate in excess of the normal corporate rate. Table 2 lists the tax rates on corporate direct investment income and remittances in host countries in 1968.39

Table 2.

Host Countries: Tax Rates on Corporate Direct Investment Income and Remittances, 1968

(In per cent of taxable income or remittance)

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Sources: Devlin and Cutler (1969), Organization for Economic Cooperation and Development (OECD) (1972), Kyrouz (1975), U.S. Treasury Department (in preparation), and various official and unofficial sources.

Taxes paid as a percentage of positive earnings and profits (defined for U.S. tax purposes) of U.S. controlled foreign corporations.

Rates accorded in tax treaty with the United States, if applicable. Most common treaty rates are shown for the United States.

Includes petroleum refining.

Value of direct investment by countries that are members of the Development Assistance Committee of the OECD. Actual totals are shown for Canada and the United States.

Included in national tax rate.

US$50 million or less.

Income from metal or petroleum extraction is subject to different tax rates.

The discrepancy between statutory and realized income tax rates40 reflects primarily the effect of intercountry differences in capital cost recovery allowances and of reduced tax rates, exemption, or outright subsidies granted for particular activities or regions. Also, realized tax rates are determined by the actual payout of affiliate earnings in host countries that provide a split rate on retained versus distributed corporate profits.41

Withholding tax rates are applied uniformly to a common tax base, namely, the amount of the remittance, so that statutory rates are equivalent to realized rates. In developed host countries, the tax rate on dividends is generally heavier than on industrial royalties or interest. The opposite is true in certain developing countries where royalties, interest, and other intrafirm service charges are being treated increasingly as repatriation of income and are subject to ordinary corporate tax under presumptive profit rules. In either case, the overall host tax rate on dividends (i.e., the withholding tax plus the underlying income tax) usually exceeds the host rate on interest, royalties, or service charges.

A number of relatively small countries, known as tax havens, exempt either all income (even when it arises within their own boundaries) or foreign-source income channeled through them.42 The Bahamas and Bermuda, for example, belong to the first category in that they provide exemption on all corporate earnings. In the second category there are two types of tax haven. Some countries, like Panama and Liberia, do not tax income from activities undertaken outside their territory, such as sales or shipping, regardless of the company’s place of incorporation. Others, like Luxembourg, give full exemption to foreign income flowing through holding companies. The Netherlands and Switzerland also exempt holding companies but impose withholding taxes on their remittances overseas.

The multinational firm can benefit substantially from the tax deferral mechanism by accumulating income in subsidiaries engaged in certain passive operations 43 out of tax-haven host countries—with the primary purpose of avoiding taxes—on behalf of the rest of the firm, which carries on normal productive activities through the parent and affiliates established elsewhere. However, among home countries, the United States has reduced this advantage by taxing on a current basis a large portion of such income of controlled foreign corporations.44

The general tax policies toward the multinational enterprise that have just been outlined are somewhat modified by a network of bilateral tax treaties. A major feature of these treaties is the principle of nondiscrimination, whereby each contracting country (in its capacity as host country) limits the tax liability on foreign affiliate income to the rate imposed on the income of native firms, and grants a reduction in (or exemption from) withholding taxes on remittances to the other contracting (home) country. (Table 2 reflects treaty rates normally accorded to U. S. direct investment, where applicable.) A companion treaty provision is home relief from double taxation in the form of credit or exemption—already extended unilaterally by the largest home countries, as shown in Table 1.

In some treaties, relief is provided not only for foreign taxes actually paid but also for foreign taxes spared by a contracting less developed host country under tax holidays available in so-called pioneer industries.45 All major home countries, except for the United States, are willing to enter treaties that include tax-sparing agreements. Because of the reluctance of both sides to reach a compromise on the tax-sparing issue, the United States is signatory to very few tax treaties with developing countries. Overall, a lack of mutuality of interests between industrial countries (which are primarily capital exporters) and developing countries (predominantly capital importers) has resulted in only a limited number of treaties between them.46

Table 2 reveals substantial variance of tax rates on foreign affiliate income and remittances. But, as mentioned earlier, host rates are to be considered jointly with the home tax system. By themselves, differences between host and home tax rates do not influence the firm’s decisions; the effect of such differences is contingent on the home country’s policy toward foreign-source income in terms of the timing of the home tax (current or deferred) and of the method of relief from double taxation (exemption, credit, or deduction). Tax rate differentials are effective under capital-import neutrality, which may hold if the home country exempts foreign income or if it provides tax deferral along with the credit.47 In contrast, current taxation coupled with the credit offsets the influence of the differentials on the firm’s behavior, that is, brings about capital-export neutrality.48

In view of the skewed distribution of direct foreign investment, most studies dealing with the role of taxes in the activities of the multinational firm have focused on U. S. direct investment (which acounts for more than one half of the total, as shown in Table 1). The specific object of inquiry has been horizontal, vertical, and diversified investment, mainly in manufacturing (including petroleum refining), conducted in the form of foreign subsidiaries.49 As these subsidiaries are eligible for tax deferral on their earnings, they are exposed to the observed tax rate differentials. Backward vertical investment in extractive industries, undertaken principally through foreign branches, has fallen outside the scope of research concerned with the tax effect because capital-export neutral taxation (current tax plus credit) is approximated in this sector.50

III. Effects on Investment and Finance

the differential return and portfolio approaches

In the primitive setting of the neoclassical theory of international capital flows, direct foreign investment is envisaged as a function of after-tax marginal rates of return in home and host countries. Thus, taxation affects the direct investment flow (that is, net capital outflow to the affiliate plus retained subsidiary earnings) through the rates of return. Despite its numerous shortcomings, discussed earlier, this theory still has adherents among students of the role of taxes in foreign investment.

In a recent adaptation of the differential return approach, Snoy (1975, Chs. 26 and 27) recognized the difficulties in measuring rates of return, as well as the desirability of testing independently the tax impact; hence, he hypothesized that the direct investment flow is determined by the growth rate of manufacturing production (as a proxy for the expected rate of return) and the tax rate in the host country. Ordinary least-squares regressions were applied to 1966–69 cross-sectional data on direct investment by the United States, the United Kingdom, the Federal Republic of Germany, France, and Belgium in 14 European countries, quantifying the dependent variable in three alternative forms. Two variants of realized host tax rates were employed: one relating to foreign subsidiaries’ income taxes deemed paid by U. S. parent companies, and the other comprised of withholding taxes on all subsidiary remittances and foreign branch income taxes paid or accrued by U. S. parents.51

The overall performance of the equations was quite weak. The coefficient of the growth variable was insignificant in nearly all instances, yet that of the tax variable displayed some significance. U. S. direct investment flows, deflated by manufacturing investment in the host country, appear to be related to the host tax rate on subsidiary income, whereas similarly deflated investment flows from the United Kingdom and the Federal Republic of Germany seem responsive to the host rate on subsidiary remittances and branch income. Although the latter relationship might be dismissed as being spurious, it could be argued in behavioral terms that the firm’s direct investment decision is more sensitive to taxes paid directly by the parent than to the host tax burden incurred indirectly on subsidiary earnings.52

The work of Mellors (1973) highlights the need to include risk, besides the differential return, as a determinant of direct investment abroad. By means of a portfolio model, Mellors examined the effect of taxation on the distribution of direct investment by a sample of British companies in seven developing countries. He calculated the expected returns and the standard deviation of returns associated with the actual distribution of this investment, and compared them with the expected returns and the standard deviation of returns of an optimal distribution.53 For the majority of firms in the sample, it was found that the actual investment portfolio was closer to the optimal portfolio when the mean and standard deviation of returns were measured after host taxes rather than before. Although these calculations show that relative riskiness of investment in various locations should be taken into account in estimating the tax effect, neglect of the risk factor is not likely to produce a serious distortion in Snoy’s analysis, based on observations drawn from a fairly homogeneous sample.

The elasticity of direct investment with respect to the host tax rate implied by Snoy’s significant coefficients are shown in Table 3. With the exception of the British elasticity (of an absolute value of over 20) they fall surprisingly within range of other comparable estimates in that table. Unfortunately, elasticities cannot be computed from the analysis by Mellors.

Table 3.

Summary of Estimates of the Response of Multinational Firms to Taxation

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Excluding transfer pricing. (See Table 4.)

Manufacturing industries, unless otherwise indicated.

Estimate has incorrect sign, or is statistically insignificant, or both.

Fixed investment, change in inventories, change in receivables, change in other assets, dividends, flow of funds from the home country, flow of funds from abroad.

Not estimated.

Dependent variable deflated by the level of earnings after host income tax.

Dependent variable deflated by fixed investment in host country manufacturing.

Elasticity with respect to withholding and branch income tax rates.

Chemical industry only.

the profit-maximization approach

The profit-maximizing firm’s demand for factor inputs is determined by equilibrium conditions linking the marginal revenue product of each factor to its price. According to the neoclassical theory of the firm,54 the demand for fixed and current assets of the parent and each foreign affiliate, as well as the value of the derived demand for direct investment in that affiliate, obtain from such marginal conditions in their respective locations—given by the production function, commodity demand, price of capital goods, and cost of finance. As the firm pursues worldwide maximization, the relationship between the marginal productivity conditions of the parent and the affiliate, qualified by differences in tax burdens, establishes the desired financial flow across frontiers. However, taxation plays a role in determining not only the overall intrafirm financial flow but also the composition of that flow, that is, the outflow of equity and debt from the parent to the subsidiary, as well as the returning remittances in the form of dividends, interest, and various head office charges. Further, the optimal level and mix of internal flows are to be solved jointly with the level of external borrowing at home and abroad.

Specifically, one may assume for convenience competitive product and factor markets, and production functions that exhibit unitary elasticity of factor substitution,55 whereby the foreign affiliate’s equilibrium stock of assets depends directly on the value of output and inversely on the rental or imputed cost of capital, which includes the tax variable. Real investment expenditures adjust with a lag to past changes in the desired capital stock.56 Similarly, the direct investment flow is a function of changes in the desired stock of assets. Yet, unlike the determination of real investment, the causal link between changes in the equilibrium stock of affiliate assets and changes in the firm’s financial claims on those assets, or direct investment, depends on its access to outside funds. Presumably, the more levered the firm, the weaker is the link. But what determines the firm’s leverage? While most authors have tackled this thorny question 57 by assuming (on behavioral grounds) either full reliance on internal funds 58 or external financing at increasing interest cost,59 others have opted for the theoretically less objectionable approach of incorporating minimization of foreign exchange risks (represented by the variance of profits or of rental costs), along with profit maximization, within the firm’s utility function.60

As indicated, the impact of income taxation on the level of real investment of foreign subsidiaries and on the ensuing flow of direct investment is to be felt through the rental price of capital. With tax deferral or exemption in the home country, a rise in the home tax rate is expected to increase subsidiary investment and reduce parent investment, whereas an increase in the host tax rate would result in a fall in subsidiary investment and a rise in parent investment. The form of the tax effect, under the U. S. credit-cum-deferral system, has been derived by Kopits (1971, Ch. 3). But, owing to data limitations, he investigated the tax impact on only one—although major—component of intrafirm financial flows, namely, the repatriation of subsidiary earnings. On the basis of the neoclassical theory, he postulated that subsidiary dividends are determined residually by the demand for and supply of investible internal funds, represented, respectively, by changes in the value of the equilibrium capital stock and by after-tax earnings.61 Thus, a rise in the home tax rate would depress dividend remittances through the rental cost of capital, while a rise in the host rate would have a dual effect on dividends: an increase, through the cost of capital, and a fall, through the level of earnings.62

Kopits (1971; 1972 a) estimated the dividend equation by way of weighted least-squares regressions on cross-sectional data for 1962 relating to U. S. controlled foreign subsidiaries, aggregated by host country. The tax effect, transmitted primarily through the rental cost of capital, was confirmed for manufacturing subsidiaries established in developed host countries. In addition to the statistically significant dividend response to average realized home and host tax rates, there was also strong response to the split rate system provided in certain host countries (Belgium, the Federal Republic of Germany, and Japan).63 By implication, the size of the elasticities of dividend remittances, in Table 3, suggests that taxation is a powerful tool in influencing direct investment flows to industrial countries.64

As for less developed host countries, the level of net earnings exhibits a significant influence on U. S. subsidiary payout, indicating that changes in the host tax rate have a moderately negative effect on dividends; 65 in contrast, the effect of taxation through the cost of capital is insignificant. The failure of changes in the equilibrium capital stock to explain subsidiary dividend remittances from developing countries may be attributed to the pronounced degree of risk and uncertainty in many of these countries and to the consequently heavier local borrowing by subsidiaries—ignored by the model.66

In an attempt to explain retained subsidiary earnings, Ness (1973) formulated a model broadly consistent with profit maximization and risk minimization. According to the model, specified at the host country level, the retention rate is a function of the ratio of direct investment to gross national product, changes in the foreign exchange rate (i.e., devaluations of the host currency), and the opportunity cost of internal funds. Although the role of the first independent variable may be questioned, the specification of the effect of home and host tax rates within the opportunity cost of funds is almost identical to the tax effect incorporated in the rental cost of capital. Upon applying ordinary least squares to average 1969–71 cross-sectional observations on U. S. manufacturing direct investment in 19 major host countries, Ness found that taxation does affect the retention rate: an increment in the home tax rate leads to a rise in retained earnings, whereas a hike in the host rate reduces retentions. Further, the evidence indicated that U. S. foreign subsidiaries in manufacturing make use of excess foreign tax credits, by electing the overall limitation rather than the per-country limitation. The resulting elasticity of retentions with respect to each tax rate, reported in Table 3, seems rather low.67

In an earlier work, Moose (1968, Ch. 4) also tried to ascertain the impact of the difference between (and the ratio of) tax rates on repatriated and retained earnings on the retention behavior of U. S. manufacturing subsidiaries. Other explanatory variables included the level of earnings and the growth rate of sales. The hypothesized relationship was estimated with weighted least-squares regressions on 13 annual cross-sectional samples of 14 host country observations. Apparently owing to the lack of discrimination between investments in developed and less developed countries (either by truncating the sample, or by including an adequate independent variable, such as exchange rate changes) and to other measurement problems,68 the equations failed to verify the effect of taxation.

A shortcoming common to the foregoing studies is the analysis of foreign subsidiary dividends, or retained earnings, in isolation. Such an approach may present an oversimplified picture of the multinational firm’s investment and financial decisions, with narrower policy implications.69 The model built by Ladenson (1972) constitutes an improvement in this respect, in that it attempts to explain seven uses and sources of funds of foreign affiliates: fixed investment expenditures, change in inventories, change in receivables, change in other assets, dividends, funds from the home country, and funds raised abroad—all constrained by the affiliates’ cash flow. In a set of seven reduced form equations, each flow of funds is specified as a function of three exogenous variables, lagged values of the endogenous variables, and current cash flow. The three exogenous variables, which stand for the desired current value of each control variable, are as follows: the level of affiliate sales, the difference between home and host tax rates, and the difference between home and host country central bank discount rates.

Notwithstanding the virtues of its conceptual framework (focusing on the interdependence among competing decisions and the dynamic adjustment to the equilibrium levels of those decisions), the model is left open to criticism with regard to the specification of the exogenous variables and, more seriously, to the measurement of the underlying data. Each equation was estimated by ordinary least squares on annual data for 1957–65 on U. S. direct investment pooled across major geographic regions (Canada, Latin America, Europe, and the rest of the world). Contrary to a priori expectations, the structural coefficient of the tax rate differential in the dividend equation is positive (although in nearly all other equations the expected positive sign obtains). Estimation of the reduced form parameters precludes calculation of the significance of the tax variable’s coefficients. In any event, the failure of the model to corroborate the effect of taxation (at least on subsidiary dividends) is no surprise, given the regional aggregation of statutory host tax rates.

The most recent and perhaps most comprehensive theoretical analysis of the tax impact on the gamut of investment and financial decisions of the multinational firm has been developed by Horst (forthcoming).70 In his model, the firm has three control variables at its disposal: investment in parent assets, investment in subsidiary assets, and net capital outflow from the parent to the foreign subsidiary. The optimal level of each variable is derived from the objective function (the firm’s consolidated global after-tax earnings), in line with neoclassical theory. Thus, they are affected by the equilibrium between the marginal cost of capital at home and abroad, qualified by relative tax rates according to the deferral-cum-credit mechanism. Horst made changes in the standard formulation by specifying explicitly the mix of intrafirm equity and debt within the net capital outflow, thereby distinguishing between the taxation of subsidiary income and of deductible interest remittances. Also, he explicitly introduced the availability of excess foreign tax credits to the firm under the credit limitation.

However, in order to make the model operational, two shortcuts were taken regarding the determination of other decision variables. Retained subsidiary earnings (and dividends) are assumed to bear a constant relationship to after-tax earnings, without regard to the level of desired capital formation. Further, the level of external borrowing is determined in the model by the firm’s excess demand for finance, that is, the gap between its internal uses (desired investment outlays) and sources of funds (retained earnings and net capital outflow), and by upward-sloping curves for the supply of outside funds.

Horst used his model to estimate the probable effect of eliminating the tax deferral and the credit in 1974. The basis for the calculations is a set of parameter estimates relating to U. S. manufacturing direct investment, compiled from other studies, at the highest level of aggregation—with no breakdown by host country or group of countries. Nevertheless, despite the impossibility of gauging their statistical strength or relevance to particular host countries (although applicable mainly to developed countries), Horst’s estimates seem reasonable, as revealed by the implicit arc elasticities shown in Table 3.71 Specifically, he found that a given percentage tax increment on subsidiary earnings would produce more than six times as large a percentage reduction in net capital outflow, but only a minimal change in real investment spending at home and abroad.

IV. Effects on Production and Trade

From the neoclassical theory of the firm, it is well known that the firm seeks to equilibrate the revenue and the cost associated with the last unit of output produced. For the firm that operates in several markets segmented by national jurisdictions, the level of production is contingent on the relationship between marginal revenue and marginal cost in each location (determined by commodity demand, technology, and factor supply conditions), while the level and direction of intrafirm trade between any two locations are determined by relative marginal costs, adjusted for tariffs, export subsidies, and tax rate differentials—assuming tax deferral or exemption on foreign-source income in the home country.

Using a one-commodity, two-country model, Horst (1971) demonstrated that with increasing costs the firm (facing, as a monopolistic competitor, downward-sloping demand curves at home and abroad) would want to pursue a mixed strategy: produce in both countries and conduct intrafirm trade on the basis of comparative costs. Under constant or declining costs, the firm would choose only two of these three alternatives (never mixing imports and local production in supplying a market). Further, in the decreasing-cost case, this choice is determined by the relative size of each market rather than by real cost considerations.

In this context, the firm’s decision to produce and/or export overseas 72 can be affected, inter alia, by the difference between the host and home income tax rates.73 An increase in the tax rate differential (owing to a rise in the host tax rate, or a fall in the home rate, or both) leads to increased exports from the parent to the subsidiary and reduced subsidiary output, provided that the differential exceeds the height of the host country’s ad valorem tariff (plus transport costs) minus the home country’s ad valorem export subsidy. If, on the other hand, the tariff less subsidy exceeds the tax differential, the latter is rendered impotent with respect to production and trade.74

Adler and Stevens (1974 a; 1974 b) expanded the model by incorporating four partially substitutable commodities sold in the host market: imports from the parent, local production by the subsidiary, local production by native firms, and imports from third-country firms. Given product differentiation across countries, the profit-maximizing equilibrium always yields a mixed strategy for the multinational firm, regardless of the shape of its cost curves. In an empirical application, Adler and Stevens estimated the impact of a marginal change in selected exogenous variables (the exchange rate, the host tariff rate, the host tax rate, and the cost of capital) on the levels of output and imports of each commodity. The simulation was performed with respect to the chemical and electrical machinery industries in three host countries, namely, Canada, the Federal Republic of Germany, and Japan. On the basis of direct estimates of production functions, which display constant costs, and of assumed values for own and cross elasticities of demand, they calculated the change in imports (i.e., parent exports) and local production by U. S.-owned subsidiaries in response to an increment of 1 percentage point in the host income tax rate in 1966. The marginal response estimates in the chemical industry are translated into elasticities in Table 3.75 Although the elasticities display appropriate signs, their magnitudes are spread over a wide range—with rather outlandish estimates for Japan.76 The elasticity values are particularly sensitive to assumptions about the degree of substitutability among the four products sold in the host market.77

In light of evidence reported elsewhere 78 revealing that substitution between U. S. exports and foreign subsidiary sales in manufacturing activities may be outweighed by complementarities in ancillary nonmanufacturing activities (distribution, marketing, etc.), the Adler-Stevens elasticities in Table 3 appear to be overestimates, particularly for Japan. In any event, these findings await further statistical testing before any judgment can be passed upon their validity.

V. Effects on Transfer Prices

As a vehicle for package transactions across country boundaries, the multinational firm may be free to arbitrarily set the price on the transfer of each component of the package (a factor input or a finished or semifinished product) between the parent and a foreign affiliate, or between any two affiliates. As a result, transfer prices could differ from arm’s-length prices charged on comparable open market transactions between unrelated parties.79 There are a number of possible reasons why the firm would want to deviate from arm’s-length pricing, based on profit maximization or risk minimization.

Under the profit-maximizing goal, the firm has fiscal and nonfiscal incentives to engage in discretionary transfer pricing practices. As shown by Horst (1971), a major fiscal incentive is comprised jointly of tax rate differentials, ad valorem tariffs, and export subsidies on intrafirm merchandise trade. The firm will find it worthwhile to underprice parent exports to the foreign subsidiary if the host tariff rate (less the home subsidy rate) is larger than the tax advantage of declaring profits at home (represented by the difference between the host and the home tax rates), and to overprice them if the former is smaller than the latter. A symmetrical incentive holds for transfer pricing of parent imports from the subsidiary.

Transfer prices of intangible services (i.e., royalties, fees, interest paid on technology transfers, managerial and engineering services, and loans, respectively) can also be determined by the tax differential. Kopits (1976 b) and Horst (forthcoming) have specified the manner in which the tax-minimizing firm will attempt to balance such service payments and dividends so as to make full use of the foreign tax credit and to pay not more than the home tax rate on foreign subsidiary income and remittances. The firm will try to utilize any excess credits (for host income and withholding tax payments) generated by dividends to offset the net home tax (determined by the differential between the home income tax rate and the host withholding rate) on royalties or related remittances. The incentive to substitute dividends for alternative remittances applies, of course, regardless of the limitation method; but under the overall limitation, the possibilities for substitution are greater.80

Another tax incentive, germane to transfer prices of both goods and services, has been mentioned by Vaitsos (1974). He contended that the firm is prone to overprice parent exports to foreign subsidiaries because taxable profits thus shifted to the parent are offset by the latter’s losses from expensing certain fixed outlays (such as research and development expenditures) undertaken on behalf of the entire firm. This tax incentive does not arise from tax rate differentials; rather, it operates as long as the host tax rate is positive. The argument is rarely applicable, as few established multinational companies would expect to incur such parent losses indefinitely, that is, beyond the period allowed for the carry-over of losses for tax purposes.

A different kind of tax-related departure from arm’s-length prices arises from governmental compulsion rather than from the firm’s tax-minimizing behavior. The most notorious case in point is the posted-price method used in host countries for calculating taxable income of affiliates from the extraction of raw materials (mineral and agricultural products).81 The resulting tax is in essence a production tax. Analogous institutionalized transfer prices apply also to manufacturing operations where host countries fully or partially disallow the deductibility of the affiliate’s payment of intrafirm interest and royalties (shown in Table 2), and, perhaps to a lesser extent, where home or host countries enforce crude proxies for arm’s-length prices in determining the taxable income of the parent or the subsidiary under their respective jurisdictions.82

There are a number of nonfiscal determinants of transfer prices that are worth enumerating.83 The profit-maximizing firm may be inclined to overprice parent exports to foreign subsidiaries to circumvent foreign exchange restrictions in the host country (or underprice them to avoid home restrictions) in the form of quantitative limits or less favorable exchange rates on outgoing remittances.84 The presence of local minority shareholders in the subsidiary could induce the repatriation of funds to the parent through transfer prices, so as to reduce these shareholders’ share in the profits. The firm may want to fend off potentially adverse reaction of the host government or local interest groups to large declared subsidiary profits by inflating the subsidiary’s transfer price payments. A similar incentive exists if the host country’s rate of protection or local price controls on the subsidiary’s output are keyed to its cost of production (including payments for intrafirm imports). Also, in anticipation of a pending devaluation, imposition of exchange restrictions, or outright nationalization, the subsidiary will tend to channel funds out of the host country inconspicuously via transfer prices.

Contrary to the arguments for discretionary transfer pricing schemes, it is often said that the firm acts as a group of unrelated parties by setting arm’s-length prices in intrafirm transactions, for internal incentive and information purposes. According to this view (emanating from the behavioral theory of the firm and promoted by company spokesmen), open market prices are charged internally because the firm evaluates each foreign affiliate on the basis of its individual profit performance, that is, as a separate profit center—assuming decentralized decision making.85 Another possible reason why the firm might not adopt discretionary transfer prices is the enforcement of arm’s-length pricing guidelines by tax and customs authorities in home and host countries. Neither of these constraints is likely to be effective in forestalling the firm’s inclination to fix transfer prices in response to global optimization. The profit-center argument is suspect in light of its conflict with the firm’s profit-maximizing goal; as to the enforcement of arm’s-length prices, this is admittedly lacking in most countries.86

Thus, the transfer pricing issue is an eminently empirical one. Unfortunately, apart from a few celebrated court cases,87 there is little quantitative information on transfer prices charged by multinational enterprises, and there is even less evidence about the influence (or lack of it) of tax rate differentials on those prices. The studies by Lall (1973) and Vaitsos (1974) contain the only direct statistical evidence on transfer prices, summarized in Table 4. They documented the overpricing of foreign-owned subsidiary imports prevalent in Colombia in the pharmaceutical, rubber, and electronics industries. Lall found a particularly high incidence of overpricing by pharmaceutical subsidiaries, with a weighted average of overpricing ranging from 33 per cent to more than 300 per cent of international market prices, during the years 1966–70. Similarly, Vaitsos reported overpricing of pharmaceutical products averaging 155 per cent in 1968. The overriding determinant of these practices was probably the quantitative ceiling on profit repatriation. But as several Colombian subsidiaries made their purchases through subsidiaries located in a tax-haven jurisdiction (Panama), and as the Colombian rate of protection on pharmaceutical imports was almost nil,88 the fiscal incentive may have been operational, too.

Table 4.

Summary of Estimates of Discretionary Transfer Prices Within Multinational Firms

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Percentage deviation from arm’s-length price is defined as the difference between the transfer price and the open market price, divided by the latter (and normalized by 100).

All industries, unless otherwise indicated.

Not estimated.

Estimate is not statistically significant.

Manufacturing industries.

Extreme observations.

Pharmaceutical products.

Exports from companies (mainly affiliates) located in ten Latin American countries.

The U. S. Treasury Department (1973) published data on a sizable reallocation of taxable foreign-source income of U. S. parents by examining revenue agents in 1968 and 1969 on the basis of arm’s-length pricing rules.89 But the amounts reallocated under these rules, reported in Table 4, must be interpreted with caution. To the extent that only a portion of the reallocations was made under the uncontrolled sales price or the resale price methods, while the remaining cases were subject to ad hoc guidelines, the figures constitute mere approximations of the incidence of tax-minimizing transfer prices. In addition, nearly one half of the reallocations can be still contested by the taxpayers. However, an obvious source of understatement is that a limited number of firms were selected for examination.90

Unlike the preceding works, Ness (1973), Müller and Morgenstern (1974 a; 1974 b), and Kopits (1976 b) attempted to estimate indirectly the extent of discretionary transfer pricing schemes through least-squares estimation. Ness sought to explain the rate of return (the ratio of after-tax earnings to book value of direct investment) of U. S. manufacturing affiliates for the years 1969–71 as a function of the independent variables specified in the retained earnings equation,91 and of two additional ones: the host country’s real economic growth rate and the number of coups d’etat during the years 1965–71. His rationale was that the firm’s profit rate in each host country is determined not only by actual investment opportunities in that location but also by its ability to shift profits through transfer prices to stable low-tax host countries. Although the overall fit is satisfactory, the evidence on transfer pricing is mixed. The profit rate seems to reflect both the necessary risk premium in politically unstable host countries and the depressing effect of devaluations (presumably through transfer pricing manipulations). The coefficient of the tax variable (incorporated in the opportunity cost of internal funds) is insignificant but displays the expected sign, suggesting that the multinational firm may attempt to accumulate profits in low-tax jurisdictions via transfer prices. At any rate, there is no way of telling whether the weakness of the tax factor is due to internal or external inhibitions of the firm to engage in transfer pricing schemes, or simply to measurement difficulties.92

In several respects the work of Müller and Morgenstern (1974 a; 1974 b) is even less conclusive. They hypothesized that the value of exports by Latin American companies (which include parents and affiliates) depends on the value of their total sales, their sales/employment ratio, and several attributes quantified as dummy variables. These dummies include the industrial activity, degree of foreign ownership, country of export origin, and the most frequently used buyer/seller relationship (whether internal or external). The authors interpreted a barely significant negative coefficient of the buyer/seller dummy in the regression for exports to Latin America in 1969 as evidence of underpricing of intrafirm exports within that region, as shown in Table 4. (Strangely enough, the same coefficient is insignificant concerning exports to the rest of the world.) Müller and Morgenstern conjectured that, inter alia, tax rate differentials could play a role in underpricing exports. Nevertheless, even if one were to accept the supposition that the buyer/seller dummy captures variations in export prices rather than in export quantities,93 the incentive for underpricing intrafirm exports with Latin American destination alone remains ambiguous at best.

Kopits (1976 b) investigated the determination of royalties remitted by manufacturing subsidiaries to U. S. parents in payment for the transfer of intangibles (patents, know-how, or trademarks). He formulated a model in which royalties are a function of subsidiary sales, the excess foreign tax credit generated by subsidiary dividends from high-tax host countries, and foreign exchange restrictions. Weighted least-squares regressions on cross-sectional data for 1968, broken down by host country and industry, provide support for the hypothesis, particularly with regard to developed host countries. With the industry effect isolated, by truncating the intercept and the sales variable, it was found that the larger the excess of the host tax rate (income plus dividend withholding taxes) over the home rate, the greater is the firm’s propensity to inflate subsidiary royalties (if deductible in the host country) and to reduce dividends. If the firm fully employs the excess credit on dividends to offset the net home tax liability on the royalty, its average tax rate is equivalent to the home rate. Estimates of average deviations from tax-invariant royalties, derived from the regression results, are given in Table 4.

Although Kopits’s estimates of transfer pricing manipulation can be traced unambiguously to the tax factor, they cannot be checked against actual prices—a shortcoming shared with Ness and Müller and Morgenstern. On the whole, then, some progress has been made in ascertaining the extent of tax-induced transfer pricing practices, but much more empirical research in this area lies ahead. This, however, is contingent on further availability of reliable quantitative data.

VI. Summary and Conclusions

This paper surveys the body of knowledge about the effects of taxation on the principal decisions of multinational enterprises. It begins with a working definition of the multinational firm and a comparison of various theoretical explanations of its behavior. This is followed by a description of existing tax provisions regarding income and remittances from direct foreign investment. Then, the paper presents and evaluates the studies dealing with the connection between taxes and each major decision of the firm.

The multinational firm is defined as having four distinguishing properties: international operations, collective flow of resources, ownership with control, and cosmopolitan outlook. The existing explanations of the firm’s behavior follow two theoretical strains. The first encompasses the theories of international capital movements, namely, the differential return and the portfolio selection approaches. The second consists for the most part of adaptations of microtheories of the domestic firm, based on profit maximization, size maximization, and nonmaximization. Of all the theories examined, the neoclassical profit-maximization theory is the most amenable to ascertain the role of taxation in the decisions of the multinational firm.

The tax variable can be expressed by differences between host and home tax rates that prevail because of the manner in which home countries ease double taxation on most direct investment income and remittances (through the combination of home tax deferral and foreign tax credit, or simply exemption). Tax rate differentials are generally detected for overseas manufacturing subsidiaries of U. S.-based multinational companies, which consequently (and given their magnitude) have become the prime target of quantitative research.

The literature on the impact of taxation proper, drawing chiefly on the neoclassical partial equilibrium theory, reveals a somewhat uneven record. Given the inherent complexity of the multinational firm’s decisions (including their interconnections) as well as limitations of data, some of the works provide a stronger theoretical analysis, while others make use of more reliable data or of more sophisticated estimation techniques—but none combines all these qualities. As the research undertaken has been complementary rather than competitive, there is relatively little room for comparing the results obtained by various authors on a one-to-one basis.

Nevertheless, the overall picture that emerges corroborates the effectiveness of tax rate differentials. The size and statistical significance of the relevant elasticity estimates confirm the impact of taxes on the flow of direct investment (net capital outflow plus retained subsidiary earnings) and the repatriation of subsidiary earnings in the manufacturing sector. Evidence concerning the effect on other financial flows, fixed investment, production, and trade is less conclusive. Discretionary transfer pricing practices have been documented, but the influence of taxation thereon has been statistically verified only in transactions in intangibles. (All empirical findings are summarized in Tables 3 and 4.)

policy implications

Perhaps the most straightforward implication of these findings is that the effect of any change in home or host tax policy on government revenues (or, for that matter, on any other economic aggregate) must be estimated by taking into account the ensuing impact on the behavior of the firm. This, of course, invalidates the traditional approach (followed not only in the foreign tax area) of measuring revenue effects through a simple recomputation of available tax return information under the proposed tax change—assuming implicitly zero elasticities of the decision variables with respect to taxation.94 But the formulation of tax policy entails more than just weighing revenue consequences. It is in the broader scope of long-run allocative and distributional effects (likewise felt through changes in the firm’s decisions) on home and host countries that various tax reform proposals must ultimately be evaluated.95

The existing tax rate differentials on direct investment income and remittances, as well as the estimated sensitivity of direct investment flows to such differentials, imply that there is more than negligible tax-induced inefficiency in the allocation of resources among countries.96 Hence, international harmonization of corporate income taxation would bring about an improvement in world welfare.97 Alternatively, the latter could be achieved if each home country were to adopt unilaterally a tax policy of capital-export neutrality, by current taxation (at the ordinary domestic rate) of foreign-source income with a full credit for all host taxes on that income (including a refund for any excess of the host tax over the home tax liability).98 When confronting such a home tax policy, the host country may impose the tax rate it wishes, on the basis of revenue considerations alone. But as a matter of international goodwill, it should extend nondiscriminatory tax treatment to all corporate income (including elimination of the withholding tax on remittances). This leads to what might be regarded as the most important question concerning tax neutrality—namely, who should pay for it? Strictly speaking, that question belongs to considerations of intercountry equity, discussed later.

However, instead of being concerned about global welfare, each country may want to pursue its national interest, regardless of repercussions on the rest of the world. Consistent with this goal, tax policy is to be predicated solely on the effects of direct investment on the country’s economy—its national productivity, terms of trade, and income distribution.99 Ordinarily, for the home country, this means current taxation of foreign-source income and deduction of foreign taxes; for the host country, a discriminatory tax dependent on the home tax treatment 100 and on the trade-off between potential revenue gains and nontax benefits.101 In this respect, the present survey has a special implication for host countries endowed with a relatively risky investment environment. Where risk is likely to overwhelm the role of tax rate differentials in the firm’s decisions, host countries (particularly less developed ones) would want to refrain from offering generous tax concessions;102 instead, they should attempt to raise badly needed tax revenues 103 from direct investment from abroad (that they may acquire regardless of the tax factor) over the short run, and to stabilize the overall investment climate over the long run.

Host governments, particularly in developing countries, have become alarmed about the monopoly power of the multinational firm derived from package transactions.104 As a result, these governments often contemplate the use of fiscal tools (as part of their foreign investment codes) to break up the package and to encourage substitute open market transactions (purchase of patents, capital goods, and technical services, as well as borrowing funds) between locally owned companies and unrelated foreign suppliers, thereby hoping to maximize the benefits commonly associated with incoming direct foreign investment. Here again, measurement of the firm’s response to taxation is an essential ingredient to policy formulation. Yet it should be borne in mind that antitrust regulation is the first-best policy to counteract restrictive business practices, whereas taxation is merely a second-best alternative.

In lieu of international or national efficiency, tax policy toward the multinational firm may be dictated by intercountry equity considerations. These involve allocation of the firm’s tax base among the countries where it operates on the basis of value judgments as to each country’s fair revenue share.105 Under the intercountry equity concept (implementation of which would require broad international consensus), the tax base may be defined and allocated in terms of a number of alternative criteria other than income: factor location, benefit from public services, developmental needs, etc. Adoption of any such criterion would relegate the issue of effectiveness of taxation in influencing behavior to a position of secondary importance, or make it altogether unimportant.

The observed tax impact on the firm’s decisions is also of interest to the extent that it is felt in the home and host countries’ balance of payments,106 employment, and price level;107 from the estimated size of the impact, policymakers may infer the magnitude of the necessary compensatory adjustment over the short run. However, unlike the efficiency or equity objectives, short-run goals should not be pursued through changes in the taxation of direct investment income and remittances. Other more suitable instruments should be employed for this purpose: exchange rate policy, adjustment assistance programs, and overall fiscal and monetary policies.108

The issue of transfer prices merits separate consideration in that it involves tax administration and enforcement rather than the formulation of tax policy. The accumulated quantitative evidence confirms allegations of intrafirm pricing abuses—with immediate repercussions on the balance of payments and government revenues of home and host countries. However, with the exception of transactions in intangibles, the role of taxation in transfer pricing practices has not been empirically ascertained. Nevertheless, the multiple causality behind discretionary transfer prices underscores the need for implementation of reasonable arm’s-length pricing standards jointly by tax and customs authorities in each country, as well as for cooperation (mostly by sharing information) among governments at an international level.109 This need arises with any given tax policy goal, except upon application of intercountry equity criteria, which for the most part would obviate the adoption of arm’s-length prices.110

In general, the various estimates of the response of multinational firm behavior to tax changes must be interpreted carefully for at least two reasons. In the first place, as most estimates were obtained from cross-sectional data (or from computation of equilibrium values), the resultant elasticities of the firm’s decisions with respect to the tax variable reflect the average long-run response (weighted by the quantitative importance of each observation in the underlying sample) to a tax increment; that is, they measure the ensuing change in the decision variable to a new equilibrium value.111 The second caveat is that the elasticities portray the sensitivity of behavior to variations in the tax rate at the margin. It is, therefore, hazardous to generalize the point elasticities given in Table 3 for calculating the impact of a quantum tax change, such as, for example, repeal of the credit and the deferral in the home country.112 The latter is likely to have much more drastic consequences on the firm’s decisions than envisaged by the elasticity estimates.113 This shortcoming, present in any marginal analysis, is compounded by a variety of potential reaction functions of host governments in the event of tax reform in a major home country.114

the direction of future research

From the foregoing survey it follows that future investigation of the influence of taxation on the behavior of the multinational firm should proceed on three fronts—assuming that the purpose of the research is to bring about more efficient policymaking in this area. First, on the theoretical front, the key decision variables of the firm should be fully integrated to capture the interrelationships among them, possibly within the context of a twin optimizing behavior (i.e., profit maximization and risk minimization). Specifically, financial and real control variables must be linked to permit measurement of the impact of tax changes on both sets of variables simultaneously. In addition, tax-induced transfer prices should be identified and measured in all intrafirm transactions. To this end, it is essential to take into account the complete institutional setting in which parent and affiliates operate (including the presence of nontax policy tools, such as exchange controls, codes of conduct, investment guarantees, tariffs, nontariff barriers, domestic price controls).

Second, much progress remains to be made in the compilation of adequate statistical data.115 The coverage and periodicity of the information already being gathered by governments and international organizations should be improved: data should be disaggregated by home and host country, by industrial activity of the affiliate,116 and by percentage and tier of ownership, and should be collected on a quarterly basis. Data on transfer prices, which at present are practically unavailable, should be compiled on major product and service categories. Further, information on effective tax rates 117 is still lacking, so that average realized rates remain as the most acceptable proxy.

The third front, which to a large degree presupposes headway in the preceding two, relates to empirical estimation. The usefulness of econometric and other quantitative methods has already been proved in analyzing the tax impact. Estimation on pooled cross-sectional (preferably at the affiliate level) and time-series (quarterly) data should be undertaken to determine the time path of the response of each decision variable to marginal tax changes. A more ambitious task would be to dynamically simulate the firm’s reaction to major changes in home or host tax policies.

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