Dhammika Dharmapala: Making Sense of Profit Shifting

Making Sense of Profit Shifting: Dhammika Dharmapala

In this interview, Professor Dharmapala outlines the latest thinking on profit shifting, with a specific focus on the examination of the magnitude of profit shifting, the potential distinctiveness of firms engaging in profit shifting, and the political economy of international taxation and multilateral cooperation. This interview is part of our 2015 Tax Foundation Forum series and has been edited for clarity and length.

Tax Foundation: What is known about profit shifting?

Dhammika Dharmapala: I think that quite a lot is known, although there is much that remains unclear. The academic literature has been studying this topic since the 1990s. Overall, I would say that it finds strong evidence that multinational firms are responsive—in terms of the reporting of income—to tax differentials across jurisdictions.

This is not perhaps in itself all that surprising, and I think more relevant for policy makers, quite possibly, is the magnitude of profit shifting.

In terms of the magnitude, the early studies from the 1990s used aggregate country-level data. And they found quite large effects. More recently, scholars have used firm-level unconsolidated data, that is, data sets that provide separate data on each multinational’s affiliates. They have found a much smaller magnitude of profit shifting.

Just to give you a sense of what I would judge to be the consensus estimate that comes out of this academic literature: Imagine you have a multinational affiliate in a country that reduces its tax rate from 35 percent to 25 percent, i.e., by 10 percentage points. An affiliate that was previously reporting $100,000 of income would, according to these estimates, increase its reported income in that country, which now has a lower tax rate, to $108,000. This corresponds to what economists refer to as a ”semi-elasticity” of 0.8...

[The Heckemeyer and Overesch study] is one source for this. They find that to be the consensus estimate. There are actually some more recent studies that have found smaller estimates still, even though overall there's still evidence for profit shifting occurring. But I do think policy makers need to take into account the magnitude as well as the existence of profit shifting...

Lohse and Riedel have a working paper that’s primarily about the effects of transfer pricing regulations on profit shifting. But their estimates are that the overall magnitude of profit shifting is actually smaller than that. It's about half the magnitude of that 0.8. semi- elasticity.

So we know a fair amount about the phenomenon, but there are certainly many unanswered questions as well.

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