Strategic Consolidation under Formula Apportionment

This paper argues that profit-shifting activities exist for multi-jurisdictional enterprises (MJEs) under a tax system of consolidation and formula apportionment (FA). A theoretical model discusses how a MJE can exploit strategically its impact on the definition of the consolidated group. The analysis shows that the MJE will not consolidate if intra-group tax-rate differences — and thereby potential gains from profit shifting — are large. We test this prediction using confidential firm-level tax-return data for the local business tax in Germany. The identification strategy exploits a quasi-experiment derived from a major company tax reform in 2001 that significantly reduced the costs associated with separating out individual affiliates. Our results show that, evaluated at the sample mean, an increase in the tax-rate variance among a MJE's affiliates by one standard deviation reduces the number of consolidated affiliates by 20 percent.