International Taxation and U.S. Businesses | Daniel Garrett

How Does International Taxation Work?

Dan Loney: There has been conversation for some time about the tax structure around international businesses. Daniel Garrett is an assistant professor of finance here at the Wharton School. He has done some research recently into this, especially the potential impact on companies in the United States, and he joins me here in studio.

Let’s start with looking at the basics of international tax structure, because it’s a topic that probably not a lot of people talk about a lot, but it’s obviously a very important one to draw your attention for this research.

Daniel Garrett: In my circles, a lot of people talk about it a lot. A whole lot, in fact. The basic structure of international taxation can have two flavors. The way in which it has been in the U.S. historically has been what we call a worldwide tax system, where we have corporations. You can imagine your large corporations, your Apples and Googles of the world. They operate not just in the U.S. but in many countries around the world, and they make income in many countries around the world.

Historically, the U.S. has said, “We’re going to tax all of your income regardless of where it’s generated.” Another approach is called territorial income taxation, which is to say, instead of taxing Apple’s profits all around the world, we’ll only tax the profits they generate directly in the U.S. Of course, where that gets really tricky is trying to say exactly, when you are a big global company that’s making sales, where are costs allocated, where are revenues allocated, where are the profits allocated. It can be quite a tricky thing to pin down.

Loney: Part of your research was to look at how all of these components potentially impact corporations and domestic workers.

Garrett: Whenever we talk about tax reform, we’re usually thinking about the end goal. Trying to come up with increasing welfare and increasing opportunity for people in the U.S. is usually the political statement that people are making when they’re saying, “We want to lower tax rates, we want to raise tax rates, etc.” What we do in our research is we try to say, “OK, a lot of countries around the world have been moving from worldwide systems, where they’re going to tax all of the profit of the corporations that reside in their jurisdictions, to only taxing the local profits.” What does this do to the way in which firms invest in local communities, and what does that do to the prevalence of local jobs, and that sort of thing? When we cut Apple’s tax rates in Europe, what happens to the number of people Apple is employing in the U.S., and the number of people that are being employed in support roles not just by Apple, but by other companies?

Loney: If you have lower rates overseas, should there be a benefit coming back to the U.S. at some point?

Garrett: The idea is what I’ll describe as a wealth effect or maybe an income effect. We have big multinational corporations in the U.S. Most of the largest corporations in the world are U.S. firms. If the U.S. government can maybe make these firms just a little bit more competitive in foreign jurisdictions, so we’ll say, “You have to pay a 21% tax rate in the U.S., but you can only pay a 12.5% tax rate in other jurisdictions, so you can be really competitive.” The idea is, that’s going to make these U.S. firms bigger. It’s going to make them more competitive. It’s going to make them wealthier. And that’s going to flow down into how many workers they wind up hiring, or how much domestic investment they wind up doing.

That’s what I’ll call a wealth effect. What we’re going to argue in my paper is that there is also a substitution effect. Instead of just saying, “Yes, the U.S. companies get wealthier and so they get bigger, and that has some positive spill-ups for workers,” it’s also that they’re now facing marginal tax costs in different jurisdictions, where doing more business in the U.S. is relatively more expensive and doing more business outside of the U.S. is relatively cheaper.

We’re going to say, “Yes, there is a wealth effect, but there’s also a substitution effect.” We’re going to show, through a particular study of a 1997 regulatory rule, that the substitution effect seems to dominate when we look at the local markets in which these firms operate.

Loney: And that being the check-the-box, as you refer to it in your research?

Garrett: We call it check-the-box. Yes, that’s the common term for this particular accounting rule about what is a subsidiary for tax purposes? We’ll get to that in a second, though.

Check-the-box Regulations and Repatriation Taxes

Loney: When you talk about check-the-box regulations, which goes back to the end of the 20th century, what kind of impact has it had over the last three decades?

Garrett: Check-the-box was a 1997 rule that essentially made profit shifting and tax avoidance for U.S. firms operating outside of the U.S. much easier. What we show is that the firms that benefited most from this new flexibility to engage in profit shifting and tax avoidance in non-U.S. jurisdictions seem to decrease their investment in the U.S. Employment in the places where these firms operate declines in the U.S. We show that, essentially, these firms are appearing to move employment from U.S. operations into foreign operations.

Loney: But this also came full circle, going back to the first Trump administration with the Tax Cuts and Jobs Act and the repatriation holiday in 2017.

Garrett: There was a mandatory repatriation, kind of one time, very low tax on permanently reinvested earnings abroad and unrepatriated earnings by U.S. firms. This happened in 2018. Technically, it was passed in December 2017, so some firms started reporting interactions with this tax in the fourth quarter of 2017. Mostly it happened in 2018 and beyond.

What we look at is actually an earlier version of a repatriation holiday, which was in 2004 as part of the American Job Creation Act, ACA, which also gave an optional lowering of repatriation taxes for earnings that were housed in corporations outside of the U.S. So, they would get to lower their repatriation tax cost by 85% percent if they repatriated. What happened in 2004 is most firms didn’t repatriate. Many firms did repatriate. And they brought back about $300 billion in 2004, which is much less than the most recent bunch of repatriations.

Loney: When you have a situation where you have check-the-box regulations and a repatriation holiday in the mix, does that double the impact that you see coming back against workers here in the U.S.?

Garrett: We think of these as two separate but very much interacting rules. Check-the-box says, “You can engage in profit shifting as long as you do it outside of the U.S.” Repatriation holiday says, “Those profits you shifted outside of the U.S., now when you want to bring them back to the U.S, they’re a little bit cheaper.”

We think that lowering the tax rates should change the marginal cost of operating in different places, but lowering the repatriation costs should allow us to now move all this cash that we’ve built up overseas and bring it back into the U.S., potentially. Those are two very related ideas, but different mechanisms that the government has at their disposal in order to raise these taxes.

Loney: How much focus is this starting to draw right now?

Garrett: Oh, it’s drawing a lot. I think it’s drawing probably a little bit less than it did in the first round of TCJA, in that most of the mandatory repatriations have already happened, so we have a lot less cash built up overseas. I think a lot of what we’re going to be talking about is this marginal tax rate of U.S. versus non-U.S. jurisdictions, and maybe trying to make that gap a little bit smaller. I think that’s where I see a lot of the focus, not so much on the repatriation taxes and the repatriation holidays.

In my research, we do find that the repatriation holiday has very little impact on domestic markets, whereas check-the-box and lowering foreign effective tax rates does seem to have a material impact on domestic markets, with lower foreign taxes being associated with lower domestic employment.

How International Taxes Impact U.S. Business Operations

Loney: In doing this research, was there anything that surprised you?

Garrett: Let me point out two things that I think are really interesting. In this research, one of the things we’re able to do that I think is really cool is we can tie publicly traded U.S. firms to their global footprint of where they operate in the U.S., and we can show that, of course, they don’t operate everywhere in the U.S. Most places in the U.S. have large, publicly traded firms, but they’re geographic clusters where they operate a lot. These clusters, starting around 1997 and going through 2006, had pretty substantial declines in employment relative to places where these firms didn’t exist. I think that’s an interesting, stylized fact that no one has ever really shown before that we’re able to show with a bunch of statistical rigor.

The second thing that I think is really interesting, that went against what my intuition was, is that most of the foreign employment growth of U.S. firms during this period was not in developing markets. It was not in China or Brazil. It was actually in the Eurozone, which is commonly thought of as a very high tax place. But U.S. firms who are benefiting from check-the-box are able to pay very low tax rates while they’re operating in the Eurozone. I was very surprised when I started looking through the data on where U.S. multinational firms have non-U.S. employment.

Loney: One of the other things you noted in your paper is the impact of the scale and size of the company in terms of this process.

Garrett: There’s another strand of literature that we’re speaking to about the nature of organizational complexity. I told you check-the-box allowed profit shifting. Of course, a lot of the profit shifting that was done required very large and complex structures, such that firms that have more subsidiaries in more places.

One of the famous styles of subsidiary organization that allowed profit shifting is called the “double Irish Dutch sandwich” that required having at least two subsidiaries in Ireland and one in the Netherlands. Lots of very large firms got very large and very complex around this time. Now, assigning causality to tax law versus other maybe regulatory ways in which firms want to move their costs and revenues — there could be other things moving on that we’re not able to kind of rule out everything. But we do think that these tax laws are part of what is driving a lot of this increasing complexity.

Loney: But there’s a dynamic of how some of these countries have changed, how they operate their tax law. Ireland is one of them that’s really been focused on a lot in the last few decades, and really has brought a lot of this conversation and this tumult to the forefront, hasn’t it?

Garrett: Yeah, Ireland is a big one. There are lots what the literature will refer to as tax havens. We do think Ireland is a particularly big part of the story that we are measuring insofar that the U.S. multinational firms at this period were really increasing their employment in Europe a lot. I don’t know if I have too much to say about the specific countries that were doing it, but there have been a bunch of regime changes. The double Irish was actually wound down in the last few years. There are all sorts of changes in which countries are vying for getting U.S. subsidiaries to be formed in their jurisdictions and that sort of thing.

It’s really hard. I’ll say that there’s a lot of research into exactly which foreign jurisdictions are doing exactly what activities and how that’s impacting U.S. multinational work. We’re looking at the U.S. side of how is the U.S. allowing or disallowing using those sorts of mechanisms.

Loney: That being said, how much do you think this continues to be a policy question as we move forward? And how much are corporations thinking about this as we move forward?

Garrett: They’re thinking a lot about this. When corporations are making location decisions, they’re always going to be thinking about, what is the tax rate? Is it likely to go up to go up to 28%? Is it likely to drop to 15%? Those are substantial differences in the required return and investment needs to make, depending on what the effective tax rate is going to be.

I think this is a big discussion going forward. The last decade or so, the big discussion has been driven by the OECD Base Erosion and Profit Shifting Group, the BEPS group, thinking about trying to push a global minimum tax. I won’t speak to whether that is politically possible or not possible at this point, but I do think we are likely going to keep talking a lot about this international tax competition. In the literature, we broadly call it the race to the bottom, and different countries having an incentive to try to say, “We want to undercut our neighbors so that our neighbors’ firms come to here.”

Loney: Is there a path that you could see where the dynamics of this change, with a benefit to the domestic worker as well?

Garrett: What would benefit a domestic worker, according to our paper, would be an equalization of foreign and domestic tax rates. Right now we say there’s a tax wedge, where if a firm could choose wherever they wanted to be, they would not make the choice of the countries that they operate in. That’s not the same choice they would make if the taxes were equalized.

Insofar as there’s some deadweight loss because of the mismatch between where firms are operating and where firms would like to operate if there wasn’t this tax consideration, that fixing that could make things better off. Insofar as if all of the corporate tax rates hit zero, that might make things a little bit better. But then that makes it really hard to tax capital income, which I think there are other potential equity reasons that we might want to tax capital income. There are lots of arguments about that in the literature. But I do think that we are moving potentially toward a world where that gap between foreign and domestic effective tax rates is getting a little bit smaller. I’ll leave it at that.