Corporate tax rates in response to profit shifting
October, 26th 2015
Multinational companies (MNCs) spanning multiple tax jurisdictions have opportunities to minimize their overall global tax incidence by tweaking profit declared in different countries. This shifting of profits from high tax-rate countries to lower ones, termed base erosion and profit shifting (BEPS), disconnects the jurisdiction of profit reporting from the geography of economic value creation. The OECD/G20 BEPS Project is attempting to bridge this disconnect and better align rights-to-tax with economic activity.
From an MNC’s perspective, BEPS is tax-planning to maximize profitability and shareholder value. However, many economies rely heavily on corporate tax income, and in most countries, government spending is procyclical to business revenues. Shrinkage in the corporate tax base due to large-scale profit shifting could jeopardize fiscal spending. BEPS tilts the playing field in favour of large, tax-aggressive MNCs, creates competitive disparity against domestic and non-tax aggressive MNCs, and increases the relative tax burden on ordinary citizens.
In the last few years, several high-profile MNCs have come under public scrutiny for BEPS activities in the US and Europe. Combined with popular unrest against austerity and cuts in welfare spending by the state, the practice of BEPS by MNCs has attained unprecedented salience in recent times. The global consensus emerging around the OECD/G20 BEPS Project is relevant to both the Indian companies expanding abroad and Indian policymakers attempting to position India competitively in today’s densely connected global economy.
The scale of profit shifting is enormous. Based on work done since 2013, the OECD/G20 BEPS Project estimates that there is a global corporate income tax revenue loss of 4% to 10%, translating to $100-240 billion annually, associated with profit shifting. In my recent research work with Rejie George from IIM-Bangalore (IIM-B), we estimate using a new model of profit shifting that about 6% of total corporate revenues of MNCs operating in India was shifted out during the period 2001 to 2010. (The research paper is available at
Measuring and monitoring BEPS and its economic impact is one of OECD/G20 BEPS project’s central goals. However, how do we disentangle business activities genuinely driven by economic efficiency from BEPS behaviour? Answering this question is key to formulating policies to tackle BEPS. There are significant limitations to existing data and reporting for tax purposes. Additionally, corporates raise concerns of proprietary information leakage against recommendations for more transparency and disclosure.
Our research proposes a method to estimate overall BEPS using publicly available company financials and ownership data. At the core of our approach is the argument that companies will shift earnings such that the costs and benefits of engaging in BEPS balance each other. High domestic tax rates vis-a-vis the rest of the global economy create an incentive to shift earnings out. For instance, Indian corporate income tax rates in the 30-40% range, compared with 20-25% in OECD and other Asian countries, create an incentive to shift earnings out of India.
Counterbalanced against the differences between local and global creating an incentive towards BEPS are the forces of strong institutions of macroeconomic governance, as well as effective corporate governance, that impose costs if local profits are shifted outside.
Our analysis shows that for India between 2001-10, the incentive compatible corporate tax rate that would avoid BEPS would be 25%. Coincidentally, this finding is aligned with finance minister Arun Jaitley’s assertion that India needs to lower its corporate tax-rate to 25%.
However, lowering the tax rate is only one of the many possible policy levers to tackle BEPS. The estimated rate of 25% is conditional on the given global average tax rates and existing quality of market and non-market institutions in India. In the long run, improving the quality of country-level institutions of economic governance and superior corporate governance would significantly restrict BEPS outflow. For instance, we find that improving India’s World Bank Governance scores on the indicators of “government effectiveness” and “voice and accountability” could significantly reduce overall BEPS. Similarly, a 1% increase in foreign institutional investor shareholding in the subsidiary and the resulting improvement in insider vigilance could reduce shifting by 2-3%.
Our findings thus lend empirical support to the recommendation that Indian corporate tax rates be reduced to 25% to tackle BEPS outflow over the short term. In the long run, the much needed structural reforms and improvement in corporate governance will also contribute to reducing the BEPS phenomenon.