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Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop (2022)

Chapter: 4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis

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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
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4

Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis

Paper Authors: Nadia Accoto (Bank of Italy), Stefano Federico (Bank of Italy), and Giacomo Oddo (Bank of Italy)

Presenter: Giacomo Oddo (Bank of Italy)
Moderator: Nadim Ahmad (Organisation for Economic Co-operation and Development)

The workshop paper by Nadia Accoto, Stefano Federico, and Giacomo Oddo explores the profit-shifting actions of multinational firms (MNEs) in the context of intellectual property products (IPPs). Like the workshop paper presented by Shang-Jin Wei (Wang et al., Chapter 3), this paper discusses potential mismeasurement in trade in services by looking at intangible capital, such as IPPs. The concern motivating this paper is that international service payments to related parties can be strategically manipulated to reduce tax obligations by creating income in low-tax jurisdictions and deductions in high-tax jurisdictions.

Giacomo Oddo, an economist at the Bank of Italy, introduced his presentation by defining some important terms. IPPs are immaterial and exchangeable goods or assets, such as patents, trademarks, copyrights, software, managerial expertise, algorithms, databases, and research and development (R&D) information. Payment for these products and services qualifies as trade in services and enter balance-of-payment statistics. About one-fifth of total services trade in the European Union is composed of trade in IPP or intangible assets. IPPs have an increasing presence on the balance sheets of MNEs (Haskel and Westlake, 2018), and these products are easily and cheaply transferable across borders and between firms (Griffith et al., 2014). Together, they provide MNEs new strategies for profit shifting.

Oddo explained that the paper uses Italian firm-level data to understand this phenomenon. The analysis contains three steps: (1) analyze the geographic and industry characteristics of Italy’s IPP services trade, (2) apply the Tørsløv methodology (Tørsløv et al., 2018) to Italian firm-level data, and (3) verify

Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×

whether profit-shifting estimates and imports of IPP services are correlated at the firm level.

Oddo continued that the paper relates to two vast strands of literature: the rising role of intangible capital in the economic activity of firms (Corrado et al., 2009; Haskel and Westlake, 2018; Jenniges et al., 2019; Jona-Lasinio and Manzocchi, 2012) and the profit-shifting activity of MNEs to tax havens (Barrios and d’Andria, 2020; Bilicka, 2019; Bruner et al., 2018; Clausing, 2016; Davies et al., 2018; Dharmapala, 2014; Riedel, 2018; Sallusti, 2019; Tørsløv et al., 2018). The paper contributes to the literature at the intersection of these two strands of work by focusing on the role of intangible capital in profit shifting. Other work in this area includes Dischinger and Riedel (2011), Griffith et al. (2014), Beer and Loeprick (2015), Alstadsæter et al. (2018), and Barrios and d’Andria (2020).

DATA AND DESCRIPTIVE STATISTICS

Next, Oddo stated that he and his coauthors used a dataset that merges Bank of Italy data on trade in services with balance sheet data, and covers 2,600 Italian firms from 2013 to 2017. There are 30 types of services, following the extended balance of payments services (EBOPS) classification, which the authors aggregated into three types: IPP services, headquarter (HQ) services, and other services. The IPP services category contains royalties for the use of and rights to intellectual property, software and computing services, and general R&D behavior and information. The HQ services category contains accounting, auditing, and tax services; managerial and entrepreneurial consulting; and other services between associated firms. The other services category includes residual services in the dataset not included in the prior types. Both the IPP and HQ service types allow for profit shifting as they contain services in knowledge-based sectors.

The paper follows Hines and Rice (1994) and Tørsløv et al. (2018) and divides countries by their status as a tax haven. Oddo presented descriptive statistics, based on his and his coauthors’ sample of 2,600 Italian firms, about the distribution of trade in services by their tax-haven status. IPP services imports come from tax-haven countries at a higher proportion with respect to HQ or other services. There are also differences across sectors. Manufacturing firms play an important role in the international trade of services—when looking at trade in IPP services, these firms account for 67 percent of exports and about 40 percent of imports. Exports of IPP services are concentrated relative to imports of IPP services, for which there is more dispersion in activity.

Oddo explained that IPP services are traded overwhelmingly by very large firms (defined as those with more than 1,000 employees), which account for more than 70 percent of export activity and approximately 63 percent of import activity. The authors also considered ownership status, dividing the sample into foreign-owned firms (those whose parent company is located abroad), local firms (those whose parent company is in Italy), and firms that are not part of any group. Close to 60 percent of IPP service imports are made by foreign-owned firms. Oddo pointed out that one interesting dimension of variation is the difference

Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×

between ownership and control brought up in the discussion of the workshop paper presented by Shang-Jin Wei (Wang et al., Chapter 3). With some regression analysis, the authors found that foreign-owned firms are positively correlated with IPP trade activity after controlling for size, industry, and year fixed effects.

METHODOLOGY

Oddo described the Tørsløv et al. (2018) method as comparing the profitability rates of local and foreign-owned firms. Profitability is determined by an index that divides the pretax corporate profit by the compensation of employees. The central finding of the Tørsløv et al. (2018) paper is that firm profitability is higher in tax havens for foreign-owned firms, while firm profitability is higher for local firms in non–tax havens. Assuming all firms face Cobb-Douglas production functions, meaning an assumption of equal capital intensities between foreign-owned and local firms, then a nonzero difference between local and foreign-owned profitability must be due to profit shifting. Shifted profits are then the difference between expected profits (profits at the same profitability index as local firms) and their actual profits.

Acknowledging that this methodology is imperfect, Oddo presented four potential weaknesses, which all reflect data limitations:

  • First, there is an implicit assumption that local firms do not engage in profit shifting and therefore their profitability is the true profitability.
  • Second, the Cobb-Douglas assumption (stating that there are equal capital intensities between foreign-owned and local firms) may not hold empirically.
  • Third, the definition of foreign-owned firms does not align between the Foreign Affiliates Statistics and FDI data employed in this method.
  • Lastly, the depreciation of foreign-owned firms is obtained as a residual and may lead to implausible estimates for some countries.

By applying the methodology to microdata, the authors overcame the third and fourth issues, so their efforts were focused primarily on the first two issues.

EMPIRICAL RESULTS AND APPLICATION TO ITALIAN FIRMS

Oddo said that he and his coauthors first verified the firm profitability index results from Tørsløv et al. (2018), namely that foreign-owned firms are less profitable than local firms in Italy, presenting significant results that confirm this relationship. The authors aggregated microlevel data in three ways to compute the profit-shifting activity of foreign-owned firms:

Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
  • First, the authors followed the past literature by aggregating across the entire sample of firms, known as the direct approach.
  • Second, they aggregated on an industry-by-industry basis and then used a process known as the sum-across-sectors approach.
  • Lastly, they aggregated on a firm-by-firm basis, comparing each foreign-owned firm with the average of local firms in the same industry; this is known as the granular approach.

The second and third aggregation techniques offered similar results, and Oddo focused on the results of first two before turning to the third technique later in the presentation.

Oddo introduced several results from analyzing profit shifting in all industries at once (see Figure 4-1). According to analysis using the first aggregation technique—the direct approach—foreign-owned firms shift 32 percent of adjusted profits. According to the second aggregation technique—sum-across-sectors—an estimate of 15 percent of total adjusted profits are shifted by foreign-owned firms; however, the profit-shifting intensity varies with industry. The importance of industrial composition is highlighted by the difference in the two estimates. The macro approach used in Tørsløv et al. (2018) may introduce nonnegligible bias to estimates (see Barrios and d’Andria, 2020). Relaxing the Cobb-Douglas assumption, employing instead a range of values for the elasticity of substitution between labor and capital from 0.7 to 1.3, alters the profit-shifting estimates to between 4 percent and 42 percent of adjusted profits, respectively. Both approaches offer similar values to other estimates in the literature. The macro estimate, 32 percent, is lower than Tørsløv et al. (2018), while the micro estimate, 15 percent, is very close to the estimate in Sallusti (2019), which uses the granular approach on Italian firm-level data.

Oddo offered a comparison of the shifted profits by foreign-owned firms with the value of IPP (and HQ) services imported by the same group of firms. This analysis is broken into two parts: a macro and micro stage.

  • The macro stage asks if the IPP (and HQ) import flows are large enough on aggregate to accommodate the predicted macro profit-shifting estimates. The profit-shifting estimates using the macro approach are too large to be accounted for with only imports of IPP and HQ services from tax havens.
  • The micro stage asks if profit-shifting firms are the same firms that import IPP and HQ services. The more conservative micro approach yields an estimate of shifted profits that can be explained almost completely by the IPP and HQ imports from tax havens. However, there is still some difference in the two values, implying that all imports of IPP and HQ services from tax havens were for the purpose of shifting profits.
Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
Image
FIGURE 4-1 Profit-shifting estimates.
SOURCE: Presentation by Giacomo Oddo.

In the second stage of their analysis, Oddo described, the authors asked if profit-shifting firms are the same firms that import IPP and HQ services from tax havens. The authors used the third approach to aggregation, outlined above, and correlated the estimated shifted profit with the firm-level flow of imported IPP and HQ services. At this level, shifted profits are correlated only with imports of IPP from tax havens. This means that the HQ services do not appear to be related to profit shifting. This relationship is stronger when considering only the subsample of large importers of services. This subsample of firms displays high rates of imports of IPP services from tax havens and has large alleged shifted profits.

SUMMARY

Oddo concluded by discussing the contribution of the paper to the current literature. The authors used both macro- and micro-level approaches to estimate the profit-shifting activity of firms with respect to imports of IPP services. The authors find that Italian imports of IPP services are compatible with the hypothesis that such flows are used for the purpose of shifting profits to tax havens. Forty percent of imports of IPP services come from tax havens, while only 30 percent of imports of other services come from tax havens, with large foreign-owned firms accounting for almost 66 percent of this activity. The baseline estimates of shifted profits vary between 15 percent and 30 percent of adjusted profits; however, the estimates are dependent on modeling assumptions that may cast doubt on the results. Lastly, Oddo reported that he and his colleagues found a positive

Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×

correlation at the firm level between profit shifting and IPP imports from tax havens; but they also found that, at the aggregate level, other channels also contribute to profit shifting.

DISCUSSION

Discussant: James Hines (University of Michigan)

James Hines, Richard A. Musgrave collegiate professor of economics and L. Hart Wright collegiate professor of law at the University of Michigan, began the discussion by complimenting the authors on good work, great data, and their contribution to the literature on an important and fascinating topic. Hines expressed confidence that firms shift profits using IPP service trade as a channel. However, he argued that the current estimates in the literature greatly exaggerate the extent to which this occurs. Hines described this paper as offering great data for further study of profit-shifting behavior of firms, but thinks a thorough investigation of the literature is important.

Hines continued by noting the difficulty present in attempting to use service transactions to shift income. Due to rules on arm’s-length pricing, an MNE cannot simply shift intangible assets to a foreign affiliate in a tax haven. Rather, the foreign affiliate must acquire the asset, which creates taxable income in the jurisdiction where the asset changes hands. Royalties on the intangible assets are supposed to take place at a fair market rate; however, MNEs have an incentive to understate the value during the transfer and to overstate the value when paying royalties. This means it is very difficult to measure what the genuine market prices should be, which provides reasons for most companies to avoid shifting intangible assets to tax havens—still, some do engage in this activity. Hines reiterated that there are rules and the rules are enforced, but he also acknowledged that the rules are much more difficult to enforce for trade in services.

Hines brought up the concern that IPP services are the main channel for shifting profits from high-tax countries to low-tax countries, which, given the difficulty in valuing such services, is well founded. One major concern around the estimates of profit-shifting activity is that the counterfactual is unknown; in other words, it is unknown where the income would have been earned if there were no havens. Another major concern is the double-counting of profits in tax havens. For example, if a U.S. firm invests in a German affiliate and routes it through Bermuda, then the German profits show up in the Bermuda profits, even though the German profits were taxed in Germany. Hines explained that these prior critiques do not necessarily pertain to this paper, but rather to the literature as a whole. Moving to a more relevant critique for this paper, Hines observed that employment or labor compensation is a bad proxy for the location of where profits are truly earned, as firm profits are decreasing in labor expense (Hines, 2010); thus, this proxy is a valid option only if there are no alternatives.

Hines asserted that, while it is true that MNEs shift profits and arrange financing to minimize their tax burden, it is difficult for them to do so; only the

Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×

largest firms engage in this activity. Fewer than half of U.S. MNEs and fewer than 20 percent of German MNEs have any tax-haven affiliates. Additionally, if such profit shifting was easy to do, there would not be a negative correlation between tax rates and FDI. If profit shifting was easy, MNEs would not care where their FDI went since they would shift the profits to a haven regardless of the tax rate in the invested country.

In order to show that profit shifting is overreported, Hines presented an example from Germany, where firms have a strong incentive to locate profits in low-tax countries, because of high German taxes. However, the data show that only a small number of firms, 20 percent, have an affiliate in a tax haven. For the largest German MNEs, those that report annual revenue of at least 759 million euros, this percentage is higher, but even these firms reported less than 9 percent of their 2016–2017 profit as earned in a tax haven. On the other hand, the Tørsløv et al. (2018) methodology yields an estimate that 64 percent of German corporate-sector profits is shifted to tax havens, a value that is impossibly high given the 9 percent figure above.

Moving forward, Hines suggested that the authors focus in on more subtle, disjointed questions. Most important, when and why do firms engage in this behavior? Within this question, what observable factors, in addition to firm size and industry, are associated with tax-haven activity? Many firms report negative profits, and it would be interesting to understand what role IPP payments and receipts play in the reported profits. Do firms that pay IPP royalties to tax-haven affiliates also receive royalties from them, or are they unaffiliated firms? What are the observable factors associated with Italian affiliates that receive royalties for IPP when the payer is an affiliate firm in a tax haven? Lastly, to what extent do patterns of service payments differ based on the nationality of foreign-owned firms? Hines suggested Dharmapala and Riedel (2013) and Clausing (2001) as empirical models that may aid in this research. He ended by noting that this is an exciting project and that he is looking forward to the authors’ future work.

Oddo began by thanking Hines for the enlightening and delightful discussion. He agreed with Hines with respect to the downsides of the Tørsløv et al. (2018) methodology and with the assessment that the estimates in the literature are exaggerated. He thanked Hines for the valuable suggestions for future work.

During the question-and-answer segment, moderator Nadim Ahmad, of the Organisation for Economic Co-operation and Development, suggested that the authors look at differential tax rates over time to explore temporal changes. Hines also suggested that, given that profits vary over time and many companies experience losses in some years, the authors examine whether there is a correlation between higher overall profitability and royalty payments to tax-haven affiliates.

Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×

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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
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Suggested Citation:"4 Trade in Services, Intangible Capital, and the Profit-Shifting Hypothesis." National Academies of Sciences, Engineering, and Medicine. 2022. Innovation, Global Value Chains, and Globalization Measurement: Proceedings of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/26477.
×
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In recent decades, production processes of intermediate and final products have been increasingly fragmented across countries in what are called global value chains (GVCs). GVCs may involve companies in one country outsourcing stages of production to unrelated entities in other countries, multinational enterprises (MNEs) offshoring stages of production to units of the MNE overseas, or both. GVCs can also involve completely independent companies merely sourcing their parts from whichever upstream company may be the most competitive, with no control arrangement necessarily involved. The changing global trade environment and the changes in firms' behavior have raised new and more complicated issues for policy makers and have made it difficult for them to understand the extent and operations of GVCs and their spillover effects on national and local economies.

To improve the understanding, measurement, and valuation of GVCs, the Innovation Policy Forum at the National Academies of Sciences, Engineering, and Medicine convened a workshop, "Innovation, Global Value Chains, and Globalization Measurement" May 5-7, 2021. This proceedings has been prepared by the workshop rapporteurs as a factual summary of what occurred at the workshop.

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