How do taxes affect the location of debt and profit?

Research Highlight 2007

Differences in corporation tax rates between countries clearly create incentives for multinational companies to move taxable income to lower-taxed countries. But the economic significance of this is not well documented. This project attempts to quantify these effects using unconsolidated accounting data for a large number of companies for many countries. It investigates how the use of debt, and how rates of profit, depend on differences in tax rates and other factors.

A theoretical model predicts that if profit shifting is important, then post-tax profitability will be lower when the tax rate is higher. The prediction for pre-tax profitability is ambiguous, but if profit shifting is not too costly the same should also be true of pre-tax profit. We attempt to identify the effects of the host country tax rate on the pre- and post-tax profitability of foreign subsidiaries of French, German and British multinationals. Preliminary results suggest that a higher tax rate has a significantly negative effect on both the pre-tax and post-tax rates of profit.

Stephen Bond, Michael Devereux and Socrates Mokkas