What Do We Know About Base Erosion and Profit Shifting? A Review of the Empirical Literature ITPF/AEI Conference: “Economic Effects of Territorial Taxation” Washington, DC March 31, 2014 Dhammika Dharmapala University of Illinois at Urbana-Champaign

2 Background and Motivation  BEPS initiative  G-20 communiqué, OECD Report (2013)  US reform debate  The magnitude of BEPS is crucial for formulating policy responses  This paper provides a guide to the empirical evidence on the magnitude of BEPS  Highlights how these estimates have changed as new and richer datasets have become available

3 Hines and Rice (1994) Parent (High-tax) Affiliate (Low-tax) Income-shifting: Suppose that the tax rate falls by 1 % point; how much more income will be reported by this affiliate? Semi-elasticity: % change in reported income attributable to a 1 % point change in the tax rate (or tax differential) $ Assume observed pretax income is the sum of:  “True” income  “Shifted” income → attribute unexplained income to BEPS

4 Hines and Rice (1994) Parent (High-tax) Affiliate (Low-tax) Income-shifting: Suppose that the tax rate falls by 1 % point; how much more income will be reported by this affiliate? $ Used aggregate country-level Bureau of Economic Analysis (BEA) data Magnitude: semi-elasticity ≈ 2.25 ( i.e. a 10 % point decrease in the tax rate (e.g. from 35% to 25%) is associated with a 22.5% increase in reported income (e.g. from $100,000 to $122,500))

5 New Affiliate-Level Datasets Confidential Firm-Level Panel Data:  Firm-level BEA data on affiliates of US MNCs  MiDi data on affiliates of German MNCs and German affiliates of non-German MNCs Unconsolidated Panel Datasets (Bureau van Dijk) :  AMADEUS: European affiliates  ORBIS: Global Estimates of the magnitude of BEPS are substantially smaller using these richer and more detailed datasets  Enable researchers to rule out many potential (nontax) alternative explanations

6 Huizinga and Laeven (2008) Parent (High-tax) Affiliate (Low-tax) Income-shifting: Suppose that the tax rate falls by 1 % point; how much more income will be reported by this affiliate? $ Use AMADEUS data for 1999 Magnitude: semi-elasticity ≈ 1.3 i.e. a 10 % point decrease in the tax rate (e.g. from 35% to 25%) is associated with a 13% increase in reported income (e.g. from $100,000 to $113,000)

7 “Consensus” Estimate Parent (High-tax) Affiliate (Low-tax) Income-shifting: Suppose that the tax rate falls by 1 % point; how much more income will be reported by this affiliate? $ Most recent studies (AMADEUS data for ): semi-elasticity of 0.4; BEPS appears to be decreasing over time (Lohse and Riedel, 2013) e.g. AMADEUS data for “Consensus” estimate: semi-elasticity ≈ 0.8 i.e. a 10 % point decrease in the tax rate (e.g. from 35% to 25%) is associated with an 8% increase in reported income (e.g. from $100,000 to $108,000)

8 Other Approaches: Dharmapala and Riedel (2013) Parent (High-tax) Affiliate (Low-tax) Affiliate (High-tax) How do earnings shocks to the parent firm propagate differentially to low-tax and high-tax affiliates? $ Income-shifting: -Tax-motivated? - Other motivations? e.g. internal capital markets, risk-sharing AMADEUS data for Magnitude: 2% of “unexpected” income is shifted to low-tax affiliates, relative to high-tax affiliates

9 Summary A 10% point decrease in a country’s tax rate (e.g. 35% → 25%) → an increase in reported income of: Study%e.g. fromto Hines and Rice (1994) 22.5%$100,000$122,500 Huizinga and Laeven (2008) 13%$100,000$113,000 “Consensus”8%$100,000$108,000 Lohse and Riedel (2013) 4%$100,000$104,000 Are these effects “large” or “small”?

10 Location of US MNCs’ FDI, 2011 Total Assets Net PPE Cap. Exp. SalesNet Income Value Added R&DEmpl. Comp. No. of Empl. All countries ,785 % in Havens “ Ipso facto ” argument for BEPS being large How do we reconcile this with the relatively small estimated (marginal) magnitude of BEPS?

11 Location of US MNCs’ FDI, 2011 Total Assets Net PPE Cap. Exp. SalesNet Income Value Added R&DEmpl. Comp. No. of Empl. All countries ,785 % in Havens % in the Neth Alternatively, this pattern may be attributable to the use of holding companies based in havens, as the fairly similar pattern for the Netherlands suggests

12 Conclusion  It is important that international tax reform and multilateral initiatives are informed by current academic research  An extensive empirical literature seeks to estimate the existence and magnitude of BEPS using a variety of different approaches  The more recent empirical literature:  Uses new and richer sources of data  Finds an estimated magnitude of BEPS that is much smaller than that found in earlier studies