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International tax planning and optimal policies
Lecture 1: Corporate tax avoidance using tax havens
Niels Johannesen
Department of Economics, University of Copenhagen
21 February 2012
Niels Johannesen
Corporate tax avoidance using tax havens
Today’s lecture
Introduction: what characterizes tax havens?
Tax havens in corporate tax planning and implications for
policy
what do …rms use tax havens for?
are tax havens good or bad? (Slemrod and Wilson, 2009; Hong and Smart 2010;
Johannesen, 2010 )
if tax havens are bad, why are they allowed to integrate into
the world economy? (Johannesen, 2012)
Niels Johannesen
Corporate tax avoidance using tax havens
What is a tax haven?
Low tax on capital
sometimes only certain types of capital (Janeba and Peters, 1999)
capital taxes may still be important revenue source (Schön, 2005)
Secrecy (OECD, 2009)
Regulatory dumping (Schjelderup, 2011)
Legal innovation (Lorenzetti, 1997)
Commercialization of state sovereignty (Slemrod, 2008)
Good governance (Dhamarpala and Hines, 2009)
A- uence
Smallness
Niels Johannesen
Corporate tax avoidance using tax havens
The 50 tax havens of the world
Source: Hines (2010)
Niels Johannesen
Corporate tax avoidance using tax havens
Tax havens and multinational …rms
Pro…t shifting to tax havens
transfer pricing (Kleinbard, 2011; Clausing, 2003; Bartelsman and Beetsma, 2003)
intra-…rm capital structure (Desai, Foley and Hines, 2004; Buettner and Wamser,
2009 )
Policy tools to combat pro…t shifting
transfer pricing rules (Peralta, Wauthy and Ypersele, 2006)
CFC rules (Ruf and Weichenrieder, 2012)
thin capitalization rules
withholding taxes on capital ‡ows
Niels Johannesen
Corporate tax avoidance using tax havens
Slemrod and Wilson (2009): Tax havens are bad
Standard tax competition model augmented with tax havens
World market for concealment services
supply by tax havens
demand by …rms in high-tax countries
production requires real resources
Concealment is countered by tax administrations
enforcement requires real resources
Tax evasion raises the marginal deadweight loss of taxation
Tax havens reduce welfare through two channels
waste of real resources
aggravation of the distortion of tax policies
Niels Johannesen
Corporate tax avoidance using tax havens
Hong and Smart (2010): Tax havens are good
Small, open economy
Individuals: workers and entrepreneurs
Two sectors:
multinational sector using labor and mobile "physical capital"
domestic sector using labor and immobile "entrepreneurial
capital"
Corporate tax on income generated by:
physical capital in multinational sector (no redistribution and
e¢ ciency cost)
entrepreneurial capital in the domestic sector (redistribution
and no e¢ ciency cost)
Niels Johannesen
Corporate tax avoidance using tax havens
Hong and Smart (2010): Tax havens are good
First-best:
zero tax on multinational …rms (Gordon, 1986)
positive tax on domestic …rms
desired redistribution and no e¢ ciency cost
Second-best:
same positive corporate tax rate in both sectors
some redistribution (from domestic sector) and some e¢ ciency
cost (from multinational sector)
Consider the e¤ect of introducing tax havens:
multinational …rms shift a fraction b of capital income to tax
haven
e¤ective tax rate on multinationals: (1 b )t
increasing in t has smaller e¢ ciency cost and same
redistributive e¤ect
Tax havens enhance welfare
Niels Johannesen
Corporate tax avoidance using tax havens
Johannesen (2010): Tax havens may or may not be good...
Build new theoretical framework for understanding tax policies
in the presence of pro…t shifting
standard framework with two countries (Hau‡er and Schjelderup, 2000)
symmetric equilbrium with no pro…t shifting (empirically
non-satisfactory)
no equilibrium in pure strategies with multiple countries
(theoretically non-satisfactory)
insight: tax competition between many identical countries !
possibility of asymmetric policy equilibrium with low-tax and
high-tax countries
Study the e¤ect of tax havens in this framework
insight: tax havens may increase the revenue of countries by
inducing low-tax countries to become high-tax countries
Niels Johannesen
Corporate tax avoidance using tax havens
Theoretical framework
Large number of identical countries
Single multinational …rm
Production plant with technology f (kn ) in each country
Firm chooses kn and (qn1 , qn2 , ..., qnN ) for each n
kn is real capital (and tax base)
qnm is tax base shifted from country n to country m
Tax revenue in country n:
tn
∑ qnm + ∑ qmn
kn
m
m
= tn fkn
qn g
Governments maximize tax revenue - FOC:
fkn
qn g =
Niels Johannesen
tn
∂kn
∂tn
∂qn
∂tn
Corporate tax avoidance using tax havens
Shifting costs I
What happens if pro…t shifting is costless?
all pro…ts are shifted to the country with the lowest tax rate
policy equilibrium where all countries apply zero tax rate
Typical assumption in literature: shifting costs are a convex
function of (∑m qnm )
only some pro…ts are shifted but all to the country with the
lowest tax rate
no policy equilibrium in pure strategies with multiple countries
Niels Johannesen
Corporate tax avoidance using tax havens
Shifting costs II
The assumption of the paper:
shifting costs in country n
Cn (qn1 , qn2 ...qnN ) =
(∑m qnm )2 N ∑m (qnm )2
+
+Φ
2α
2β
marginal cost in country n of shifting pro…ts from n to m:
proportional to total shifting out of n: 1α (∑m qnm )
proportional to shifting from n to m: 1β qnm
Implication: if tm < tk << tn , then qnk > 0 provided that tk
is su¢ ciently close to tm
Interpretation: diversi…cation motive in pro…t shifting
Small behavioral responses to small tax changes: imperfect tax
competition for pro…ts
Parameter β/α measures closeness to perfect competition
Niels Johannesen
Corporate tax avoidance using tax havens
Equilibrium (no tax havens)
Under some parametric assumptions there exists an
asymmetric equilibrium (t H , t L , z ) where:
tH > tL
a fraction z of the countries apply the low tax rate t L
a fraction (1 z ) of the countries apply the high tax rate t H
Both t H and t L satisfy FOC for revenue maximization and
generate the same revenue
Niels Johannesen
Corporate tax avoidance using tax havens
Illustration of equilibrium (no tax havens)
Niels Johannesen
Corporate tax avoidance using tax havens
Tax havens
Tax havens are jurisdictions with zero tax rate and zero real
investment
Assume the existence of aN tax havens
If a > a then there exists a separating equilibrium t N
all countries apply tax rate t N
all tax havens apply zero tax rate
If a < a then countries earn more revenue in separating
equilibrium t N than in asymmetric equilibrium (t H , t L , z )
more pro…t shifting for unchanged tax policies (negative
"leakage e¤ect")
less attractive to be low-tax country ! some low-tax countries
become high-tax countries ! less pro…t shifting (positive
"crowding e¤ect")
The existence of tax havens may help countries collecting tax
revenue from multinational …rms
Niels Johannesen
Corporate tax avoidance using tax havens
Discussion
Main insights:
in a world without tax havens the bene…t of being a low-tax
destination for shifted pro…ts persists ! asymmetric
equilibrium with low-tax countries and high-tax countries and
pro…ts shifted from the latter to the former.
tax havens may improve welfare by alleviating tax competition
for pro…ts between countries
Niels Johannesen
Corporate tax avoidance using tax havens
Johannesen (2012): Why …scal barriers against tax havens
are missing...
Other papers compare outcomes with tax havens and without
tax havens
The extent to which tax havens are integrated in the world
economy depends on policy choices
More than half of EU-countries have zero withholding tax rate
on interest payments to havens
Possible explanations
political economy
tax havens are good
Can we explain why benevolent governments do not protect
themselves against harmful tax havens?
Niels Johannesen
Corporate tax avoidance using tax havens
Theoretical framework
Two countries and one tax haven
Each country inhabited by workers and entrepreneurs
operating a …rm
Two types of entrepreneurs: avoiders and compliers
Each entrepreneur optimally chooses one of the following
"…rm types"
no production ("no …rm")
domestic plant ("national …rm")
domestic and foreign plant and no haven sub ("multinational
…rm")
domestic and foreign plant and haven sub ("planning …rm")
Niels Johannesen
Corporate tax avoidance using tax havens
Theoretical framework
Technology at …xed inputs:
F (α, θ ) =
α
α
c (θ )
m c (θ )
if the plant is domestic
if the plant is foreign
where:
α is "skill level" of entrepreneur
θ is the debt-asset ratio of the plant
c (θ ) is an "agency cost" of deviating from optimal level e
θ
m is a "cost of distance"
Important things to note:
no external loans ! some internal loans even if tax disfavored
scope for welfare improving economic integration
Niels Johannesen
Corporate tax avoidance using tax havens
Financial structure - multinational …rm
Niels Johannesen
Corporate tax avoidance using tax havens
Financial structure - planning …rm
Niels Johannesen
Corporate tax avoidance using tax havens
Policy
Governments maximize private consumption subject to
revenue requirement G
Three policy instruments:
corporate tax
internal …scal barrier - tax on interest payments to the other
country
external …scal barrier - tax on interest payments to the tax
haven
Policy a¤ects real outcomes through two channels:
…nancial structure of …rms
allocation of resources between the three …rm types
Niels Johannesen
Corporate tax avoidance using tax havens
Economic equilibrium
Generally:
entrepreneurs with highest skills: domestic and foreign plant
entrepreneurs with intermediate skills: domestic plant
entrepreneurs with lowest skills: no plants
The threshold skill levels may di¤er between avoiders and
compliers
if external barrier below threshold
avoiders operate planning …rms and are taxed more lightly
than compliers
marginal planning …rm less productive than marginal
multinational …rm
Niels Johannesen
Corporate tax avoidance using tax havens
First-best policies
First-best tax policy:
prohibitive external barrier
zero internal barrier
corporate tax raises the entire revenue
Properties of economic equilibrium:
no planning …rms
optimal degree of economic integration
undistorted …nancial structure of …rms
Niels Johannesen
Corporate tax avoidance using tax havens
EU-style cooperation
Countries precommit to a zero internal barrier and set external
barrier and corporate tax rate non-cooperatively (Council Directive
2003/49/EC on taxation of interest and royalty income)
Unique policy equilibrium:
zero external barriers
corporate tax raises the entire revenue (higher rate than before)
Intuition:
zero tax cost of conduit …nancing ! planning …rms channel all
interest payments through country with lowest external barrier
bertrand competition drives external barriers to zero
Properties of economic equilibrium:
tax planning with tax havens
too much economic integration
distorted …nancial structure of planning …rms (too much debt)
Niels Johannesen
Corporate tax avoidance using tax havens
Second-best environments
If political / institutional frictions make it impossible to
implement the …rst-best policy, then the internal barrier is
optimally positive
Standard second-best argument - raising the internal barrier
marginally above zero has
…rst-order social bene…t (conduit …nance more expensive)
second-order social cost (distortion of multinational-national
…rm margin)
Formal application where countries cannot cooperate on
enforcement
Niels Johannesen
Corporate tax avoidance using tax havens
Discussion
Main insights:
protection against tax havens is an endogenous outcome
countries have mixed incentives when choosing a policy
position towards tax havens
trade-o¤ between international economic integration and
protection against tax havens
Niels Johannesen
Corporate tax avoidance using tax havens
References I
Bartelsman, E.J., Beetsma, R.M.W.J., 2003. Why pay more? Corporate tax avoidance through transfer
pricing in OECD countries. Journal of Public Econonomics 87, 2225–2252.
Buettner, T., Wamser, G., 2009. Internal Debt and Multinationals’Pro…t Shifting - Empirical Evidence
from Firm-Level Panel Data. Oxford University Centre for Business Taxation, Working Paper no. 09/18.
Clausing, K.A., 2003. Tax-motivated transfer pricing and US intra…rm trade prices. Journal of Public
Econonomics 87, 2207–2223.
Desai, M.A., Foley, F., Hines, J.R., 2004. A Multinational Perspective on Capital Structure Choice and
Internal Capital Markets. Journal of Finance 59(6), 2451-2488.
Dharmapala, D., Hines, J., 2009. Which Countries Become Tax Havens? Journal of Public Economics 93,
1058-1068.
Gordon, R., 1986. Taxation of investment and savings in a world economy. American Economic Review 76,
1086-1102.
Hau‡er, A., Schjelderup, G., 2000. Corporate tax systems and cross country pro…t shifting, Oxford
economic papers, 52, pp. 306–325.
Niels Johannesen
Corporate tax avoidance using tax havens
References II
Hines, J.R., 2010. Treasure Islands. Journal of Economic Perspectives 24(4), p 103-126.
Hong, Q., Smart, M., 2010. In praise of tax havens: international tax planning and foreign direct
investment. European Economic Review 54, 82–95.
Janeba, E., Peters, W., 1999. Tax evasion, tax competition and the gains from nondiscrimination: The
case of interest taxation in Europe. Economic Journal 109, 93-101.
Johannesen, N., 2010. Imperfect Tax Competition for Pro…ts, Asymmetric Equilibria and Bene…cial Tax
Havens”. Journal of International Economics 81, 253-264.
Johannesen, N., 2012. Optimal Fiscal Barriers to International Economic Integration in the Presence of
Tax Havens. Journal of Public Economics 96(3-4), 2012, 400-416.
Kleinbard, E., 2011. Stateless Income. USC Legal Studies Research Paper No. 11-6
Lorenzetti, J.T., 1997. The O¤shore Trust: A Contemporary Asset Protection Scheme. Commercial Law
Journal 102, 138-165.
Niels Johannesen
Corporate tax avoidance using tax havens
References III
OECD, 2009. Tax Co-operation 2009 - Towards a level playing …eld.
Peralta, S., Wauthy, X., Ypersele, T., 2006. Should countries control international pro…t shifting? Journal
of International Economics 68, 24–37.
Ruf, M., Weichenrieder, A., 2012. The Taxation of Passive Foreign Investment Lessons from German
Experience. Canadian Journal of Economics, forthcoming
Schön, W., 2005. Playing di¤erent games? Regulatory competition in tax and company law compared.
Common Market Law Review 42, 331–365.
Schelderup, G., 2011. Secrecy Jurisdictions. Unpublished working paper.
Slemrod, J., 2008. "Why Is Elvis on Burkina Faso Postage Stamps? Cross-Country Evidence on the
Commercialization of State Sovereignty." Journal of Empirical Legal Studies, 5(4): 683-712
Slemrod, J., Wilson, J.D., 2009. Tax competition with parasitic tax havens. Journal of Public Economics
93, 1261–1270
Niels Johannesen
Corporate tax avoidance using tax havens