Nama : Ridwan Tri Atmojo (26212325)
Riszki Indra Septian (26212482)
Tax Reforms and Evidence of Transfer Pricing
Deborah
Swenson
2000
BACKGROUND
While tax reforms have generally reduced
corporate tax rates globally, continued international tax differentials are an
enduring feature of the global fiscal environment. In this context,
multinational firms can reduce their worldwide tax payments by shifting income
from highly taxed jurisdictions to more lightly taxed locations. While income
shifting can be accomplished through the reallocation of real activities, it
can also be attained by shifting reported income, as occurs when firms
manipulate their transfer prices on international transactions. While a few
studies have examined transfer pricing directly, there is little evidence or
consensus about the actual level of transfer pricing activities.
Since research on tax incentives and the
behavior of multinational firms typically relies on publicly available data,
data limitations generally force researchers to focus on indirect evidence of
income shifting. Most papers choose
proxies such as reported income, tax payments, and intra-firm exports, and have
found that cross-country and cross-time variations in these variables are
consistent with income shifting incentives. Other work has shown that multinational
firms have changed their real activities such as foreign investment, or altered
their location of debt in response to tax incentives. However, while this line
of research provides evidence from economic aggregates that is consistent with
tax-induced income shifting, this line of research can not determine whether
tax-induced transfer price manipulation played a major role.
This paper turns to individual
product-level data to determine whether transfer-pricing incentives havep layed
a significant and measurable role in the movement of U.S. import product
prices. If firms use transfer prices to manipulate income, reported customs
values should rise and fall with changes in tax incentives. I study the years
1981 to 1988 since they capture a period when the U.S. and many of its trade
partners changed their corporate tax
rates. In general it is difficult to measure the effects of tax reform, since any
year to year variation in aggregate data may be caused by changes in the
underlying macroeconomic environment rather than changes in taxes. In this
study I manage to avoid this problem, because I identify tax effects by
examining fine product-level transfer prices in a framework that controls for
corporate tax incentives, and cross-product tariff variation. The cost of
shifting income out of the U.S. through artificially raised transfer prices
differs across products according to U.S. tariff rates. I utilize these
cross-product tariff differences to distinguish the responsiveness of reported
transfer prices to transfer pricing incentives.
This paper proceeds as follows. In the
next section, I explain how corporate taxes and product tariffs influence
transfer-pricing incentives. I then develop a simple model that shows how
multinational firms select their reported transfer prices based on tariff rates
and tax considerations. In the third section, I use regression analysis to
measure the response of product level prices to tariffs and taxes. In the
fourth section I measure the implied penalties associated with transfer pricing
and describe the economic implications of my results. A brief conclusion
follows.
PURPOSE
for studies the reported transfer prices
for a set of products imported into the U.S. from Canada, France, Germany,
Japan and the U.K. between 1981 to 1988. Tariff variation across products
creates incentives for the underpricing or overpricing of affiliated firm
transactions that may either complement or detract from general tax-induced
income shifting motives.
ANALYSIS
TOOLS
Taxes, Tariffs and Income Shifting
Incentives
The foreign affiliates of multinationals
commonly import goods from their parent firm. These imports arise because the
affiliate acts as a distributor, or because the affiliate imports intermediate
inputs from its foreign parent and assembles them in the host country. The discussion
that follows assumes that firms base their production and sourcing decisions on
market opportunities and relative production costs.
When multinationals set transfer prices
for intra-firm transactions they may seek to maximize their expected world
income by manipulating the reported transfer prices upward or downward. The
direction of manipulation depends on the tax system governing the
multinational, differences in tax rates between the home and affiliate locations,
and any relevant product tariffs. When firms select a transfer price, they must
consider the integrated effect of taxes and tariffs, since Internal Revenue
Code Section 1059A states that the tax cost of imported goods is not to exceed
their customs value. This effectively means that firms are required to select a
single reported price for tax and tariff purposes.
To see how taxes and tariffs influence the
firm’s pricing decision, consider the tax linkages between a foreign parent
firm and its U.S. affiliate. The firm can shift taxable income out of the US
and in to its foreign parent country by reporting artificially elevated
transfer prices. If the U.S. tax rate is higher than the tax rate in the home
country, this strategy reduces the firm’s worldwide tax payments since taxable
income is transferred from the U.S. to the lower tax parent country. However,
as the firm uses overstated transfer prices to shift income out of the U.S, it
becomes liable for additional US tariff payments on the incremental elevation of
transfer prices. If the tariff rate is especially high, all tax benefits
associated with shifting may be more than offset by the new tariff payments.
Further, income-shifting costs, penalties, and the fear of detection may all reduce
the degree of transfer price manipulation selected by the firm.
Multinationals that are headquartered in
high tax territorial countries face reverse tax incentives; they may decide to
report artificially low transfer prices as a means of shifting income into the
U.S. This is due to the fact that territorial firms pay taxes on income based
on the location of earnings; income generated at home is taxed exclusively at
home, while foreign earned income is taxed only abroad. As these firms reduce their worldwide tax payments,
they enjoy the added bonus of lowered tariff payments that complement the
strategy. I combine these ideas to
create a simple model that describes how multinational firms set their transfer
prices.
Empirical Evidence of Transfer Pricing
While the transfer-pricing hypothesis is
straightforward, there is little empirical evidence to quantify the economic
importance of this method of income shifting in firm activities. To fill the
void, I study the prices of U.S. imports from Canada, France, Germany, Japan,
and the U.K. since these countries were some of the biggest foreign investors
in the U.S., and their activity created an infrastructure of parent firms and
U.S. affiliates which could manipulate transfer prices. Ideally, I would study
the reported prices for individual firm intra-firm product sales. Since such
data are not available, I am instead studying reported product prices by country.
The sample covers 1981 to 1988 because these years involved frequent tax changes
in the U.S. and abroad and cover years when U.S. tariff rates were changing.13
The fundamental price variable in the data
set is based on U.S. Department of Census trade data collected at the fine
TSUSA product-level. The TSUSA category system, or Tariff Schedule of the
United States Annotated, is used to classify products for tariff purposes – all
products within a particular TSUSA category face the same tariff rate. While
the Census data do not report prices, they do report the annual value of
imports for each TSUSA item by country, and the corresponding annual quantities
of these imports. As a result, I construct reported prices by the formula PR ic
= [(Custom’s Value of Product i imports from country c)/(quantity of product i
imported from country c)].
The identification of transfer pricing is
based on the TPI variable. As is demonstrated in the previous section, the
definition of the TPI is, TPI = (τf-τh)-TARf(1-τf) if the investor is
headquartered in a territorial country, or for investors headquartered in a
residential country whose rate of tax is less than or equal to the U.S.
corporate tax rate. For all other residential investors, the TPI = - TARf. In
sum, the relevant TPI depends on the form of taxation in the multinational’s
home country, and on tax rates in the U.S. and the multinational’s headquarters
location.
Transfer Pricing and Penalties.
Since the benefits of transfer price
manipulation are attenuated by potential costs of shifting, I explored whether
transfer pricing costs and penalties explain the small economic magnitude of
the transfer pricing estimates. To estimate the implicit magnitude of transfer
pricing penalties and costs, I applied nonlinear least squares estimation
techniques to the pricing formulas in section 2 which show that the reported price
for each product, parent country and year (subscripts i, c, and t)
To implement this procedure, I assume that
the price ratio for arm’s length prices piht/pimt is determined by overall
quality differences between countries, and by macroeconomic factors. This
implies that I can proxy the ratio of arm’s length prices for each country pair
with the ratio of arm’s length prices for all products sold. 22 The resulting
estimating equation relates the ratio of reported prices to the average over
all products ratio (by country-year pair), and the tax-tariff-penalty functions
derived in section 2. I use non-linear least squares, since reported prices are
a non-linear function of the tax, tariff and penalty components.
Conclusion
This paper studies the reported transfer
prices for a set of products imported into the U.S. from Canada, France,
Germany, Japan and the U.K. between 1981 to 1988. Tariff variation across
products creates incentives for the underpricing or overpricing of affiliated
firm transactions that may either complement or detract from general
tax-induced income shifting motives. In my examination of the data I discover
that reported prices rise when the combined effect of taxes and tariffs
provides an incentive for firms to overstate their prices. While the results are
statistically significant, they are economically small, implying that a 5% decline
in foreign tax rates causes the reported price of affiliated firm imports to
rise by 0.024%. Because transfer price manipulation is predicated on the actual
flows of goods among countries, this method of moving income may be more costly
than other methods of income shifting. While the manipulation of intra-firm
trade transfer prices represents one potential avenue for income shifting, my
evidence from trade transaction prices suggests that the manipulation of
product transfer prices is not generally responsible for large movements in reported
income.
Evaluating International Tax Reform
INTRODUCTION
Much of the current structure of U.S.
taxation of foreign income dates to the early 1960s, and, remarkably, so too
does much of current thinking on the desirability of taxing foreign income. The
U.S. regime of taxing foreign subsidiaries of American multinational
corporations was put in place in 1962, and despite numerous modifications in
subsequent years, the system used by the United States to tax foreign income
has been broadly unchanged since the early 1960s. American individuals and
American corporations owe tax to the U.S. government on their worldwide
incomes, but are entitled to claim credits for income taxes paid to foreign
governments. Taxpayers are permitted to defer U.S. taxation of unrepatriated
foreign income earned by separately–incorporated foreign subsidiaries, though
this deferral is limited. Every political season in the United States brings
new issues and controversies, typically including tax legislation that has
foreign provisions. Proposed U.S. legislation in 2003 illustrates this trend,
with three major legislative initiatives directed at those inclined to change
the taxation of foreign income. This flurry of interest reflects not only the
importance of international taxation to modern economies and the unsettled
nature of the U.S. tax treatment of foreign income, Evaluating International
Tax Reform Mihir A. Desai Business School, Harvard University, Boston, MA 02163
and NBER, Cambridge, MA 02138 James R. Hines Jr. Business School, University of
Michigan, Ann Arbor, MI 48109-1234 and NBER, Cambridge, MA 02138 NATIONAL TAX
JOURNAL 488 but also fundamental uncertainty over what constitute desirable
attributes of systems of taxing foreign income. Economic theory offers three
benchmarks for assessing the desirability of tax systems and reforms. The
concepts of “capital export neutrality” (CEN) and “capital import neutrality”
(CIN), introduced by Richman (1963), and which she refined in Musgrave (1969),
are mainstays of the welfare analysis of international tax reform. These
principles characterize tax systems directed at maximizing global welfare,
while “national neutrality” (NN) is characteristic of home–country tax systems
directed at maximizing home–country welfare. The purpose of this paper is to
describe new methods of evaluating the desirability of taxing foreign income,
and to use these methods to consider current U.S. international tax reform
proposals. The analysis introduces capital ownership neutrality (CON), the
principle that world welfare is maximized if the identities of capital owners
are unaffected by tax rate differences, and national ownership neutrality
(NON), the principle that national welfare is maximized by exempting foreign
income from taxation. The second section of the paper motivates the emphasis on
ownership that is central to CON and NON and that is missing from standard
welfare frameworks. The third section describes CON and NON, drawing attention
to the very small change in assumptions that distinguishes them from standard
welfare benchmarks. The fourth section evaluates current international tax
reform proposals according to these alternative welfare frameworks. The fifth
section is the conclusion.
THE IMPORTANCE OF OWNERSHIP TO THE WELFARE
ANALYSIS OF FDI
It
is common practice in analyzing the desirability of international tax rules to
posit that foreign investments by multinational firms from different countries
are equally productive. In contrast, CON and NON put differences between owners
at the center of the welfare analysis of international tax rules. In order to
consider the appropriate role of ownership in evaluating international tax
rules, this section considers evidence on the role of ownership in determining
patterns of foreign direct investment (FDI) and on the effects of tax rules on
ownership.
Ownership and FDI
Since Hymer (1976), the literature on
foreign direct investment starts from the observation that FDI is driven by the
needs of firms in markets, and therefore represents something much more than
the transfer of net savings between countries. Caves (1996), who offers an
excellent survey of this literature, notes that the intuition that
multinational firms are merely conduits for capital to arbitrage differences in
rates of return between countries has been found to be “neither satisfying
theoretically nor confirmed empirically” (p. 26).In its place, economic models
of multinational behavior have emphasized a transaction–cost approach whereby
multinational firms emerge because of the advantages conferred by joint
ownership of assets across locations. These advantages are understood to stem
from proprietary assets that are best exploited under common ownership. The
most common manifestation of this framework for explaining foreign direct
investment in the international business literature—Dunning’s eclectic
paradigm—emphasizes how ownership, localization, and internalization (OLI) are
the fundamental determinants of foreign direct investment.1 Specifically,
multinational firms are thought to engage in foreign direct investment when
ownership confers
specific advantages relative to arms–length relationships, so activities are
most profitably undertaken within the firm. An obvious implication of this
approach is that multinational firms differ in the proprietary assets (e.g.,
brands, production processes, patents) they can exploit and that these
differences are critical to understanding the patterns of FDI and the productivity
of these firms.2 In addition to differences in business practices contributing
to the possible importance of ownership, scholars are paying increasing
attention to differences in institutions (e.g., legal regimes) and the ways in
which these variables can influence firm outcomes. These country–level
differences would provide another reason to expect ownership to be associated
with different patterns of FDI and the productivity of that investment.3 The
modern property rights approach to the theory of the firm, as developed in
Grossman and Hart (1986) and Hart and Moore (1990), suggests that the
prevalence of incomplete contracts provides a rationale for particular
configurations of ownership arrangements. The ability to exercise power through
residual rights when contracts are unable to prespecify outcomes provides an
economic rationale for when ownership is important. Such settings are
particularly likely to characterize multinational firms investing abroad.
Desai, Foley, and Hines (forthcoming) analyze the changing ownership decisions
of multinational firms, finding that globalization has made firms more
reluctant to share ownership of foreign affiliates, given the higher returns to
coordinated transactions inside firms. The costs and benefits of ownership
appear to be central, and increasingly so, to the choice between investing in a
country and serving the same market with arm’s–length transactions. It is
useful to consider the importance of ownership with reference to a specific
example. Consider the establishment of an automotive manufacturing plant in a
large emerging market. Why might the productivity of this plant differ
depending on whether a local or multinational firm owns it? One can easily
imagine that the multinational firm may be more productive given the ability to
extend a global brand or to transplant proven production processes to the
emerging market. Similarly, the ability to integrate this plant within a
worldwide production process or to use expatriates with related experience in similar
markets could also have important productivity consequences. Finally, the
ability to use incentive contracts tied to equity where minority shareholders
have protections could similarly lead to productivity differences. While this
example emphasizes a productivity advantage for the multinational firm, the
more general point is that ownership is likely to be associated with
significant productivity differences. Recent evidence illustrates the degree to
which foreign direct investment represents transfers of ownership rights rather
than reallocations of property, plant, and equipment between countries. Table 1
categorizes foreign direct investment into the United States, as reported by
Anderson (2002), as either the establishment of new entities or the acquisition
of preexisting entities. These figures suggest that the vast majority of FDI in
the United States over the last decade represents transfers of ownership rights
rather than greenfield
Taxation and Ownership of FDI
Do taxes influence the level and ownership
of FDI? Home–country taxation has the potential to affect the ownership of
foreign assets by changing after–tax returns and thereby inducing the
substitution of one investment for another. As a general matter, investors from
countries that exempt foreign income from taxation have the most to gain from
locating their foreign investments in low–tax countries, since such investors
benefit in full from any foreign tax savings. Investors from countries (such as
the United States) that tax foreign profits while providing foreign tax credits
may benefit very little (in some cases not at all) from lower foreign tax
rates, since foreign tax savings are offset by higher home–country taxation.
These relative tax incentives therefore create incentives for investors from
countries that exempt foreign income from taxation to concentrate their
investments in low–tax countries, while investors from countries that tax
foreign income while providing foreign tax credits have incentives to
concentrate investments in high–tax countries. There is considerable evidence
that patterns of foreign investment respond to incentives created by
home–country tax regimes. Hines (1996) compares the location of investment in
the United States by foreign investors whose home governments grant foreign tax
credits for federal and state income taxes with the location of investment by
those whose home governments do not tax income earned in the United States.
Investors who can claim credits against their home–country tax liabilities for state
income taxes paid in the United States should be much less likely than others
to avoid high–tax states, and the behavior of foreign investors is consistent
with this incentive. Hines (2001) compares the distribution of Japanese and
American FDI around the world, finding Japanese investment to be concentrated
in countries with whom Japan has “tax sparing” agreements that reduce home
country taxation of foreign income. Recent empirical work indicates the extent
to which ownership decisions of U.S. multinationals are affected by tax
incentives. Desai and Hines (1999) measure the extent to which American firms
shifted away from international joint ventures in response to the higher tax
costs created by separate “basket” provisions of the Tax Reform Act of 1986.5
Altshuler and Grubert (2003) and Desai, Foley, and Hines (2003) demonstrate
that American multinational firms increasingly use “chains of ownership” for
their foreign affiliates, including intermediate ownership by affiliates
located in countries that exempt foreign income from taxation, to facilitate
deferral of home country taxation. The National Foreign Trade Council (1999)
argues—through case study examples of the foreign flag shipping, life
insurance, and oil and gas pipeline industries—that tax rules have altered the
positioning of U.S. firms relative to multinationals from different countries
leading to changes in ownership patterns within these industries. And Desai and
Hines (2002) analyze dramatic ownership reversals in which U.S. multinational
firms expatriate by inverting their corporate structure, reconfiguring their
ownership as foreign corporations in order to reduce the burden imposed by U.S.
tax rules. These and other cases indicate that ownership
CONCLUSION
The welfare principles that underlie the
U.S. taxation of foreign income rely on the premise that direct investment
abroad by American firms reduces the level of investment in the United States,
since foreign competitors are assumed not to react to new investments by
Americans. It follows from this premise that the opportunity cost of investment
abroad includes foregone domestic economic activity and tax revenue, so
national welfare is maximized by taxing the foreign incomes of American
companies, whereas global welfare is maximized by providing foreign tax
credits. If, instead, direct investment abroad by American companies triggers
additional investment in the United States by foreign companies, which is
likely in a globally competitive market, then entirely different prescriptions
follow. National welfare is then maximized by exempting foreign income from
taxation (NON), and global welfare is maximized by harmonizing the taxation of
foreign income among capital– exporting countries (CON). It is tempting to
think of international tax differences as influencing the location of economic
activity rather than determining the ownership of assets around the world. In
fact tax systems do both, but given the central importance of ownership to the
nature of multinational firms, there is good reason to be particularly
concerned about the potential for economic inefficiency due to distortions to
ownership patterns. Tax systems that satisfy CON ensure that the identities of
capital owners are unaffected by tax rate differences, thereby permitting the
market to allocate ownership rights to where they are most productive. Proposed
and pending international tax reforms in the United States have the potential
to affect national and global welfare. In order to evaluate these tax reforms
properly, it is necessary to consider their implications for patterns of
capital ownership throughout the world.
