Following the release of the Panama Papers and the Pardise Papers, there has been renewed research into profit shifting by multinational firms. This column utilises a novel dataset to show that well-managed subsidiaries, independently of their headquarters, allow a company to be more responsive to tax changes, shifting more profits from high-tax to low-tax jurisdictions. The authors argue this is because better managed subsidiaries allow more effective tax planning by headquaters and are better placed to implement HQ directives.
It is well documented that firms with ‘better’ (or more structured) management practices do better along many dimensions – they tend to be larger and more productive, grow faster, and are more innovative and less likely to die (Bloom et al. 2013, Scur et al. 2021, Bandiera et al. 2020, Adhvaryu et al. 2022). They also tend to be more profitable, at least on average. But this latter relationship is less straightforward than the others. This is because profitability measures — such as returns on assets (ROA) — inherently include strategic decisions on reporting and are likely to reflect aggressive accounting practices of firms more so than actual performance (Bertrand and Schoar 2003).
The Panama Papers and Paradise Papers in 2016 and 2017 revealed that many multinational firms (MNEs) engage in these aggressive accounting practices, spurring renewed interest in measuring the extent of profit shifting to tax havens and the resulting tax revenue losses for governments (e.g. Bilicka 2019). It is now clear that profit shifting is a major global issue, with estimates suggesting that 36% of MNE profits are legally shifted to tax havens (Wier and Zucman 2022, Tørsløv et al. 2018). Yet we still have limited understanding of what enables these MNEs to move profits to tax havens.
In a recent paper (Bilicka and Scur 2024), we propose that local-level organisational capacity – which we measure as the quality of management practices at the subsidiary level – acts as an important enabler (or hinderer) of HQ-level profit shifting. Using a new dataset that we built combining subsidiary-level management practices data with accounting records for MNEs across 21 countries, we document three sets of results:
1. Well-managed subsidiaries are less profitable in high-tax countries
The average positive relationship between ‘good’ management practices and subsidiary profitability only holds in low-tax countries, while the relationship with productivity holds in both high-tax and low-tax jurisdictions.
Specifically, we show that a well-managed subsidiary in a country with tax rates around the 75th percentile (30%) reports 2.86 percentage point (pp) lower profitability relative to a similar subsidiary in a country with tax rate around the 25th percentile (22%). Crucially, we show that this difference is likely the result of subsidiaries’ more active engagement in the profit shifting activities (if any) of their parent company. While we can’t observe profit shifting directly, we can observe whether MNEs have a subsidiary located in a ‘tax haven’ – a country with very low or zero corporate taxes. If this is true, it is often used as a flag for ‘aggressive tax avoidance’ behaviour. Consistent with the channel we propose, our results are driven by these ‘aggressive’ MNEs. This relationship is depicted in Figure 1, where in Panel A we demonstrate the negative relationship between firm profitability and management for MNE subsidiaries that belong to more aggressive MNEs and operate in high tax countries. No such negative relationship occurs in low tax countries and in any of the countries where a non-aggressive MNE operates.
Figure 1 ROA and operations management in low- and high-tax country-years by aggressiveness
Panel A: Aggressive MNEs
Panel B: Non-aggressive MNEs
2. Subsidiaries of well-managed MNEs are more responsive to tax changes
Profit shifting is, however, an inherently dynamic process. Again, we can’t observe firms moving profits from one subsidiary to another, but we can observe differences in the final reported profits across different subsidiaries when countries change their tax rates. In particular, we use the fact some countries cut tax rates at different times to estimate the extent to which good management practices enable subsidiaries to respond to these tax changes.
We find that MNEs with well-managed subsidiaries respond to tax cuts by reporting approximately 66% (2.5pp) higher profits in the subsidiaries operating in those countries, and that this effect is – again – driven by those MNEs that are also classified as aggressive tax avoiders (Figure 2). Even more so, for firms making positive profits, the share of total MNE profits in countries that recently cut their corporate taxes also increased for well-managed subsidiaries of MNEs. It is telling that none of these differences hold when we look at productivity outcomes, suggesting there is really something different about profit reporting relative to raw production outcomes.
Figure 2 Tax cuts and reported profits
3. Tractable and predictable production processes enable aggressive tax avoiders to shift profits more effectively
The weight of the evidence suggests that MNEs that want to shift profits are better able to do so if their subsidiaries have adopted management best practices. But why might it be that such local-level organisational capacity affects reporting processes that are generally seen as HQ-level activities? To ground the empirical analysis, we propose a framework focusing on a mechanism where subsidiaries adopting better management practices have more tractable and predictable production plans. We propose this allows MNEs the flexibility needed to allocate profits according to their tax planning strategies, and then we take this to our data.
We iteratively considered each management practice – there are 18 measured in the World Management Survey – and their relationship with reported profits in high- and low-tax jurisdictions. Broadly, practices linked to tractability and predictability of production, as well as performance tracking and links to MNE-related incentives (rather than subsidiary-specific incentives) are most likely to enable profit shifting.
So why does this matter?
It is intuitive to assume that if an MNE HQ issues a directive, everyone follows it. In the case of profit shifting, if the HQ tells a particular subsidiary to purchase an amount of another subsidiary’s intermediate intangible input (say, consulting expertise), or lend/borrow some cash from another subsidiary, the managers at these subsidiaries simply do as they are directed. However, this assumes that the local subsidiaries have the capacity to act as they are directed. We show that the landscape of heterogeneity in firm’s organisational capacity is crucial for understanding whether such assumptions can be made.
Further, our findings are distinct from – and complementary to – the literature on the effect of individual managers and manager-specific qualities on profit shifting. While this literature focuses on the characteristics of individuals who are in the position of manager, we focus on the organisational structure those managers operate in. To be sure, there could certainly be an interaction effect: for any given level of organisational capacity, a good manager can be better able to leverage the subsidiary’s good management practices relative to a bad manager. But we propose that even a good manager will not be able to shift profits effectively without the appropriate structures in place. Empirically, we show that the link between good management practices and reported profits does not change when we control for executive compensation (an often-used proxy for manager quality). We do find, however, that our results are driven by subsidiaries that belong to MNEs with more centralised decision-making.
Ultimately, our results have important policy implications for how we understand the relationship between management and firm performance. Specifically, heterogeneity in firm management practices can mediate the effectiveness of tax policy and should be taken into account when governments consider the expected impact of their policy plans. Since well-managed multinational subsidiaries in high-tax countries report lower profits, this could lead to lower corporate tax revenues in those countries, with potentially important welfare implications. A related implication is that the landscape of subsidiary organisational capacity may significantly impact the effectiveness of national tax cuts, as we find the subsidiaries that respond to such cuts tend to be those that are well-managed. There is also a concern for measurement in national accounts: total factor productivity estimations require accurate reporting of inputs such as materials and capital and if multinationals are systematically mis-reporting such inputs as a result of profit shifting activities, this could matter for productivity estimates.
Source : VOXeu
