A Model of the Cost of Income Shifting with an Application to Tax Planning and E-Commerce

This manuscript develops a model that incorporates income shifting into investments by U.S. multinationals in their foreign subsidiaries. The model demonstrates that, while there is always an incentive to shift income into the U.S. from high foreign tax rate subsidiaries, income shifting out of the U.S. to low tax rate countries occurs only when the required rate of return on foreign investments is low (repatriations are unlikely), i.e., it is not always optimal to shift to low-tax-rate countries. It also shows that the optimal amount of shifting relates to the interplay of costs and the tax rate differential. We apply the model to examine a setting where cross-sectional costs of income shifting likely vary based on the extent to which a firm is engaged in electronic commerce. Electronic commerce potentially alleviates costs by making it easier for firms to strategically locate sales among foreign jurisdictions, and to shift sales between domestic and foreign locations to benefit from the relative taxation of the two. Consistent with our theory, we find firms in industries with high levels of e-commerce have lower cash effective tax rates, and this effect is magnified for firms that are less likely to have taxable repatriations