Implicit Corporate Taxes and Income Shifting

Implicit tax theory predicts that as capital moves to tax-favored investments, the expected pretax returns on those investments decrease. At the global level, this should create a positive relation between country-level tax rates and firm-level pretax returns. However, theory in income-shifting predicts reported pretax returns are inversely related to tax rates, as firms shift profits into lower-tax countries. We analytically model these two theories and empirically test our predictions in two samples of European firms: single-country firms and affiliates of multinational firms. In the sample of single-country firms, we find robust evidence of country-wide implicit taxes, but that this effect is driven by closed economies (non-EU countries). In the sample of multinational firms, we find that the effects of income shifting overwhelm the effects of implicit taxes. Our results imply that certain measures of income shifting estimated using reported profits can be understated when the effects of implicit taxes are ignored, but these effects are less problematic when the research setting includes mostly open economies. Our granular setting of multiple countries and affiliate level data helps explain prior research that finds decreasing corporate implicit tax effects over time, particularly for multinationals.