00:00:00
Daniel Garrett: What we're
going to argue in— in my paper is that
there is also a
00:00:03
substitution effect. That is to
say, instead of just saying that, yes, the US companies get
wealthier and so they get
00:00:10
bigger, and that has some
positive spill ups for workers, it's also that they're now facing
marginal tax costs in different
00:00:16
jurisdictions where doing more
business in the US is relatively more expensive, and doing more
business outside of the US
00:00:22
is relatively cheaper. So
we're going to say, yes, there is a wealth effect, but there's
also a substitution effect. And
00:00:27
we're going to show through kind
of a particular study of a 1997 regulatory rule that I think
we're going to get to in a
00:00:35
minute— we show that the
substitution effect seems to dominate when we look at the local markets in which
these firms operate.
00:00:41
Welcome to <i>The Ripple Effect</i>, the
podcast that takes you on a
00:00:44
journey through the minds of
Wharton faculty. I'm your host, Dan Loney, and in each episode,
we'll be diving deep into the
00:00:50
inspiration behind the
groundbreaking research that Wharton professors have
conducted and exploring how
00:00:57
their findings resonate with the
world today. Dan Loney: Well, there has
been for some time
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conversation
about what the tax structure around international businesses
is, and maybe even should be.
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Daniel Garrett is an Assistant
Professor of Finance here at the Wharton School. He has done some
research recently into this,
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especially the potential impact
on companies back here in the United States, and he joins me
here in studio. Great to see
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you. How are you? - I'm doing
well. How are you, Dan? Thank you. I guess let's start with
kind of looking at the basics of
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international tax structure,
because it's a topic that probably not a lot of people
talk about a lot, but it's
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obviously a very important one, to draw your attention
for this research. I'll say in my circles, a lot of people
talk about it a lot. A whole
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lot, in fact. So the basic
structure of international taxation can have two flavors.
The way in which it has been in
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the US historically has been
what we call a worldwide tax system, where we have
corporations. So you can imagine
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your large corporations, your
Apples and Googles of the world. They operate not just in the US,
but they operate in many
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countries around the world, and
they make income in many countries around the world. And
so historically, the US has kind
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of said we're going to tax all
of your income, regardless of where it's generated. Another
approach is called territorial
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income taxation, which is to
say, instead of taxing Apple's profits all around the world,
we'll only tax the profits they
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generate directly in the US. Of
course, where that gets really tricky is trying to say exactly,
when you are a big global
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company that's making sales,
where are costs allocated, and where are revenues allocated?
And so such, where the profits
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allocated, can be quite tricky,
a tricky thing to pin down. And so then, when you talk about the
research that you did, part of
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it was to look at how all of
these components kind of factor in and potentially impact
corporations, but also domestic
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workers as well. Yeah. So I think whenever we talk
about tax reform, we're usually
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thinking about, the end goal is
trying to come up with increasing welfare and
increasing opportunity for
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people in the US, is usually kind
of the— the political statement that people are making when
they're saying we want to lower
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tax rates. We want to raise tax
rates, et cetera. What we do in our research is we try to say, okay,
a lot of countries around the
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world have been moving from
worldwide systems where they're going to tax all of the profit
of the corporations that reside
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in their jurisdictions, to only
taxing the local profits. And so we're trying to say, what does
this do to the way in which
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firms invest in local
communities, and what does that do to the prevalence of local
jobs and that sort of thing? So
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yes, to really distill that down, we
want to say, when we cut Apple's tax rates in Europe, what
happens to the number of people
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Apple is employing in the US,
and the number of people that are being employed in support
roles?
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Not just by Apple, but by
other companies. And I guess to a degree, the
expectation is that there would
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be a— maybe a potential backside
benefit here in the United States, if you have the lower
rates overseas, that there
00:03:50
should be a benefit coming back
to the US at some point. - Yeah. So the idea is one of an income—
what I'll describe as a wealth
00:03:56
effect, or maybe an income
effect. The idea is we have big multinational corporations in the
us. Most of the largest
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corporations in the world are US
firms. So the idea is, if the US government can maybe make these
firms just a little bit more
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competitive in foreign
jurisdictions— so we'll say, "Okay, so you have to pay a 21%
tax rate in the US, but sure,
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you can only pay a 12 and a half
percent tax rate in other jurisdictions, so you can be
really competitive. The idea is
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that's going to make these US
firms bigger. It's going to make them more competitive. It's
going to make them wealthier.
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And then that's going to kind of
flow down into how many workers they wind up hiring, or how much
domestic investment they wind up
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doing. So that's what I'll call
a wealth effect. What we're going to argue in my paper is
that there is also a
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substitution effect. That is to
say, instead of just saying that, yes, the US companies get
wealthier and so they get
00:04:46
bigger, and that has some
positive spill ups for workers, it's also that they're now facing
marginal tax costs in different
00:04:52
jurisdictions where doing more
business in the US is relatively more expensive, and doing more
business outside of the US is
00:04:58
relatively cheaper. So we're
going to say, yes, there is a wealth effect, but there's also
a substitution effect. And we're
00:05:03
going to show through kind of a
particular study of a 1997 regulatory rule that I think
we're going to get to in a
00:05:10
minute, we show that the
substitution effect seems to dominate when we look at the
local markets in which these
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firms operate. And that being the
check the box, as you refer to in your
research.
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We call it check the box. Yes, that's— that's the
common term for this particular accounting rule.
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Well, when you talk about check the
box regulations, which did have an impact, I guess, going back
to the— the end of the 20th
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century, what kind of impact has
it had over the last— what? I guess three decades at this
point?
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Yeah. So, we look at
check the box, which was a 1997
rule that essentially made profit shifting and tax
avoidance for US firms operating
00:05:48
outside of the US much easier.
What we show is that the firms that benefited most from this
new flexibility to engage in
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profit shifting and tax
avoidance in other jurisdictions, so in non-US jurisdictions, that
these firms seemed to decrease
00:06:04
their investment in the US and
employment in the places where these firms operate declines in
the US. So showing that,
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essentially, these firms are
moving— appearing to move employment from US operations
into foreign operations.
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But this also came kind of full
circle, going back, I guess, to the first Trump Administration, with
the TCJA and the repatriation
00:06:26
holiday, what, back in 2017, I
guess. So there's a mandatory repatriation, kind of a one-time very low tax on
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permanently reinvested earnings
abroad and unrepatriated earnings by US firms. This
happened in 2018. There was an
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earlier— I guess it technically,
of course, was passed in December of 2017. So, some— some
firms started reporting
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interactions with this tax in
the fourth quarter of 2017. It mostly happened in 2018 and
beyond. What we look at is
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actually an earlier version of a
repatriation holiday, which was in 2004 as part of the American
Job Creation Act, AJCA, which
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also gave an optional lowering
of repatriation taxes for earnings that were housed in
corporations outside of the US.
00:07:20
So they would— they would get to
lower their repatriation tax cost by 85% if they repatriated.
And so what happened in 2004 is
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most firms didn't repatriate.
Many firms did repatriate, and they brought back about $300
billion in 2004, which is much
00:07:33
less than the most recent kind
of bunch of repatriations. So then, when you have a situation
where you have
00:07:40
check the box regulations and a repatriation
holiday all kind of in the mix, does that kind of almost double
the impact that you see coming
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back against workers
here in the US? So we think of these as kind of
two separate but very much
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interacting rules. So check the
box says, essentially, you can engage in profit shifting as
long as you do it outside of the
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US. A repatriation holiday says,
okay, so those profits you shifted outside of the US, now
when you want to bring them back
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to the US, they're a little bit
cheaper. So we think that essentially lowering the tax
rates should kind of change the
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marginal cost of operating in
different places, but lowering the repatriation costs should
essentially allow us to now move
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all this cash that we've built
up overseas and bring it back into the US, potentially. So
those are two kind of very
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related ideas, but different
mechanisms that the government has at their disposal in order
to kind of raise these taxes.
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How much focus is this starting to
draw right now, I guess? Oh, it's drawing a lot. I think it's
actually drawing probably a
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little bit less than it did in
the first round of TCJA, and that most of the mandatory
repatriations have already
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happened. So we have a lot less
kind of cash built up overseas. I think a lot of what we're
going to be talking about is
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this marginal tax rates of US
versus non US jurisdictions, and maybe trying to make those, that—
that gap, a little bit smaller,
00:09:01
maybe making that gap— so I
think that's— that's where I see a lot of the focus. Not so much,
on the repatriation taxes and
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the repatriation holidays.
Which, of course, in my research, we do find that the
repatriation holiday has very
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little impact on domestic
markets, whereas check the box and lowering foreign effective
tax rates does seem to have a
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material impact on domestic
markets, with— with lower foreign taxes being associated with
lower foreign— or
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lower domestic employment.
Excuse me. In terms of doing this
research, was there anything
00:09:35
that kind of caught your eye, that maybe surprised
you to a degree? So let me— let me point out two
things that I think are really
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interesting. So in this
research, one of the things we're able to do that I think
is really cool, is we can tie US
00:09:46
firms, publicly traded firms, to
the global footprint of where they operate in the US. And we
can show that— of course, they
00:09:53
don't operate everywhere in the
US. Most places in the US have large publicly traded firms, but
there are very— there are
00:09:57
geographic clusters where they
operate a lot. These clusters, starting around 1997 and going
through 2006, had pretty
00:10:03
substantial declines in
employment relative to places where these firms didn't exist.
I think that's an interesting
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stylized fact that no one has
ever really shown before that we're able to show with a bunch
of statistical rigor. The second
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thing that I think is really
interesting, that went against what my intuition was, is that
most of the foreign employment
00:10:20
growth of US firms during this
period was not in developing markets. It was not in China or
Brazil. It was actually in the
00:10:28
Eurozone. Which, of course, is
kind of commonly thought of as a very high tax place. But US
firms, who are benefiting from
00:10:34
check the box, are able to pay
very low tax rates while they're operating in the Eurozone. So I
think there's kind of a little
00:10:41
bit of— I was very surprised when
I started looking through the BEA data on kind of where US
multinational firms
00:10:48
have non-US employment. One of the other things that you
noted in your paper is also the
00:10:54
impact of the scale and the size
of the company in terms of this
process as well.
00:10:59
So this is— there's another
strand of literature that we're kind of speaking to about the
nature of organizational
00:11:05
complexity. And so, of course,
one of the things that— I told you check the box kind of allows
profit shifting— or allowed
00:11:13
profit shifting, I'll say. Of
course, a lot of the profit shifting that was done required
very large and complex
00:11:20
structures, such that firms that
have more subsidiaries in more places—one of the famous styles
of subsidiary organization that
00:11:27
allowed profit shifting is
called the Double Irish Dutch Sandwich, that required having at
least two subsidiaries in
00:11:32
Ireland and one in the
Netherlands. And so lots of very large firms got very large and
very complex around this time.
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Now assigning causality to tax
law versus other maybe regulatory ways in which firms
want to move their costs and
00:11:49
revenues— there could be other
things moving on that we're not able to kind of rule out
everything, but we do think that
00:11:54
these tax laws are part of what
is driving a lot of this increasing complexity. But the dynamic of how some of
these countries have changed,
00:12:01
you know, how they operate their
tax law— Ireland, you mentioned being one of them that's really
been focused on a lot in the
00:12:09
last few decades— really has
brought a lot of this conversation, a lot of this
tumult, to the forefront, hasn't it?
00:12:15
Yeah. So yeah, Ireland is a big
one. There are lots of big— what the literature will refer to as
tax havens. We do think Ireland
00:12:21
is a particularly big part of
the story that we are measuring, insofar that the US
multinational firms at this
00:12:28
period were really increasing
their employment in Europe a lot. I don't know if I have too
much to say about the specific
00:12:34
countries that were doing it.
But has been— there have been a bunch of regime changes.
So the Double Irish was actually
00:12:39
wound down in the last few
years. There are all sorts of kind of changes in which
countries are vying for getting
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US subsidiaries to be formed in
their jurisdictions, and that sort of thing. But I don't think
we— it's really hard. I'll say
00:12:55
that there's a lot of research
into exactly which jurisdiction— which foreign jurisdictions are
doing exactly what activities
00:13:02
and how that's impacting US
multinational work. We're kind of looking at the US side of, how
is the US allowing or
00:13:09
disallowing using those sorts of
mechanisms? That being said, how much do you
think this continues to be a
00:13:15
policy question as we move
forward? And, how much, you know, are our corporations
00:13:20
obviously thinking about this
as we move forward as well? They're thinking a lot
about this. When corporations
00:13:25
are choosing— making location
decisions, they're always, of course, going to be thinking
about, what is the tax rate? Is
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it likely to go up to 28%? Is it
likely to drop to 15%? Those are kind of substantial differences,
in the required return an
00:13:36
investment needs to make,
depending on kind of what the what the effective tax rate's
going to be. I think this is a
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big discussion going forward.
The last decade or so, the big discussion has been driven by
the OECD Base Erosion and Profit
00:13:49
Shifting group, which— the BEPS
group— thinking about trying to push a global minimum tax. I
won't speak to whether that is
00:13:58
politically possible or not
possible at this point, but I do think we are likely going to
keep talking a lot about this
00:14:05
international tax competition.
And this— in the literature, we broadly call it the race to the
bottom. And different countries
00:14:13
having an incentive to try to
say, "We want to undercut our neighbors, so that our neighbors'
firms come to here."
00:14:18
Let me finish up with this,
then. Is there a path that you could see where the dynamics of
this change, but also there is a
00:14:25
benefit to the domestic worker
as well? Yeah. So what would benefit a
domestic worker, according to
00:14:33
our paper, would be a— a— a— I want to call it an equalization of foreign and
domestic tax rates. So right now
00:14:46
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— of the
00:14:53
countries that they operate in.
That's not the same choice they would make if the taxes were
equalized. - Right. - So insofar
00:14:58
as there's some— some deadweight
loss because of the mismatch between where firms are
operating and where firms would
00:15:02
like to operate if there wasn't
this sort of tax consideration, that fixing that could make
things better off, insofar as
00:15:10
if all of the corporate tax
rates hit zero, that might make things a little bit better. But
then, of course, that makes it
00:15:16
really hard to tax capital
income, which I think there are other potentially equity reasons
that we might want to tax
00:15:22
capital income. There are lots
of arguments about that in the literature. But I do think that
we are moving, potentially,
00:15:31
toward a world where those— that
gap between foreign and domestic effective tax rates is getting a
little bit smaller.
00:15:36
Dan, great to talk to you again.
Thanks very much. Dan, thank you so much. Thank you. Daniel Garrett,
who's Assistant Professor of
00:15:41
Finance here at the Wharton
School. Thank you for listening to <i>The Ripple Effect</i>. We hope
you found this episode
00:15:47
informative and engaging. Don't
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00:15:54
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