Notes from

Mongrain, Steeve, David Oh, and Tanguy van Ypersele. 2023. “Tax Competition in the Presence of Profit Shifting.” Journal of Public Economics 224: 104940.

The popular view is that governments should crack down on tax avoidance by multinational corporations, but in practice, lax anti-profit-shift are common.

The authors argue that, under certain conditions, lax enforcement can increase equilibrium tax rates by favoring investments and attracting more firms to a country.

The main arguments Link to heading

The impact of profit shifting on equilibrium tax rates is ambiguous. While the popular view suggests that governments should crack down on tax avoidance by multinational corporations, lax anti-profit-shifting policies can actually increase equilibrium tax rates and countries’ well-being by favoring investments.

Equilibrium tax rates Link to heading

Equilibrium tax rates refer to the tax rates that result in a stable balance between the supply of and demand for investment in a given country. In other words, it is the tax rate at which the government can collect the desired amount of revenue while still maintaining an attractive investment environment.

Race to the top—strategic tax-setting effects Link to heading

This profit shifting reduces the tax base of high-tax countries, leading to a decrease in their tax revenue. In response, high-tax countries may try to counteract this revenue loss by increasing their tax rates.

Laxer enforcement with high tax rates: why? Link to heading

  1. The spillover benefits of investment can influence a government’s decision to allow some profit shifting to occur. When stricter enforcement chases firms away by increasing the effective tax rate, this leads to a loss not only in tax revenue but also in spillover benefits. When this effect is strong, lax enforcement can be welcomed.

  2. The cost of enforcement relative to the total tax base can also influence a government’s decision. If the cost of enforcement is high relative to the tax base, then less than full enforcement may be optimal.

  3. The tax competition effect can also influence a government’s decision. A higher tax rate posted by the other country leads to an inflow of investment generating additional tax revenue and spillover benefits. If a decrease in enforcement promotes an increase in the tax rate by the other country, lax enforcement is again welcomed.

Contributions Link to heading

The main contribution of the paper to the theory of tax competition and profit-shifting is the development of a comprehensive model that considers all three channels of profit shifting simultaneously: tax-base erosion, capital allocation, and strategic tax-setting effects. This approach goes beyond the existing literature, which often focuses on only one or two of these channels. By incorporating all three channels, the paper provides a more holistic understanding of the dynamics and implications of profit shifting.

Additionally, the paper contributes to the understanding of why governments may prefer lenient profit-shifting controls. It identifies four elements that governments may consider when choosing the optimal level of enforcement, shedding light on the factors that influence a government’s decision to allow some profit shifting to occur.

Furthermore, the paper highlights the potential benefits associated with profit shifting, such as stimulating investments and allowing governments to fiscally discriminate between international firms and local firms. By considering these potential benefits, the paper adds nuance to the discussion on profit shifting and provides a more comprehensive picture of the forces at play.