Multinational firms and tax havens

A new column by Anna Gumpert, James Hines and Monika Schnitzerat at VoxEU.org looks at the investment activities of multinational firms in tax havens. They argue that multinational firms may invest in tax havens to avoid taxation in non-haven countries, but other motives, such as business opportunities in these countries, may also drive such investment.

The Gumpert, Hines and Schnitzerat research uses data on German firms to investigate the motives for tax haven investment. Tax avoidance does appear to be a motive, particularly for manufacturing firms. Policies that raise the costs of reallocating profits maybe be effective in attenuating firms’ use of tax havens.

The column ends by arguing that

While the tax haven investments of some multinational firms attract considerable public attention, many multinational firms do not have affiliates in tax havens. Our evidence is consistent with tax avoidance as a motive for tax haven investments, in particular for manufacturing firms. At the same time, the size of a multinational firm’s operations and business opportunities in tax havens also induce multinational firms to invest in tax havens. As higher costs of reallocating profits attenuate firms’ tax haven use in response to higher taxation, policy measures that raise the costs of income reallocation may be effective at discouraging tax haven investment, as long as they do not induce firms to shift real activities to tax havens.

Of course there does seem a much simpler way of stopping the use of tax havens, lower the company tax rate in non-haven countries.

Why would a firm want to become a multinational?

A question asked at the Federal Reserve Bank of St. Louis. Another way to think about the question is to ask why is it worthwhile to carryout a cross border transaction within the boundaries of a firm rather than by using the market? Three reasons are given:

Ownership Advantage

Multinational firms usually develop and own proprietary technology (the Coca-Cola formula is patented and kept extremely secret) or widely recognized brands (such as Ferrari) that other competitors cannot use. Multinationals often are technological leaders and invest heavily in developing new products, processes and brands, while usually keeping them confidential and protected by intellectual property rights. Maintaining stronger protection of these elements helps firms enjoy greater profits from innovation.

Localization Advantage

Multinationals usually try to build facilities that produce and sell their products in locations near the consumer (the Polish consumers of Coke in our example). This helps reduce transportation costs or helps the company fit in better with local tastes and needs. Proximity to demand also helps firms adapt their products and services to different markets. At the same time, they also may take advantage of lower production costs (for example, labor costs, energy, sometimes even lower environmental standards) or more abundant production factors, such as expert engineering or greater raw materials). For example, the Polish affiliate of Coca-Cola also owns bottling plants in the Beskidy Mountains region of Poland, which is rich in mineral water for making other beverages.

Internalizing Benefits

Finally, multinationals want to internalize the benefits from owning a particular technology, brand, expertise or patents that they find too risky or unprofitable to rent or license to other firms. Enforcing international contracts can be costly or ineffective in countries in which the rule of law is weak and court procedures are long and inefficient. In these cases, the company also may risk losing its ownership advantage, which it has created at a substantial cost.

In house production can lower the cost of the transaction and lessen the likelihood of hold-up that could occur when using another firm. When a transaction can be specified clearly enough to be written into a contract so that any possible problems can be dealt with via court proceedings then an outside contractor or firm can be utilised. But where, say quality is hard to control via contract since the nature of "high quality" can not be specified precisely enough to make a contract enforceable in court, then in house production is more likely.

The gravity of knowledge

Thanks to an email from Eric Crampton I have been alerted to a paper, with the title given above, by Wolfgang Keller and Stephen Ross Yeaple on the transfer of knowledge between countries. More precisely the transfer of knowledge between countries but within multinational companies. The paper appears in the American Economic Review, 2013, 103(4): 1414–1444, and the abstract reads,

We analyze the international operations of multinational firms to measure the spatial barriers to transferring knowledge. We model firms that can transfer bits of knowledge to their foreign affiliates in either embodied (traded intermediates) or disembodied form (direct communication). The model shows how knowledge transfer costs can be inferred from multinationals’ operations. We use firm-level data on the trade and sales of US multinationals to confirm the model’s predictions. Disembodied knowledge transfer costs not only make the standard multinational firm model consistent with the fact that affiliate sales fall in distance but quantitatively accounts for much of the gravity in multinational activity.

If I'm getting this right the paper assumes that knowledge can move over geographic space in one of two forms: embodied or disembodied. When knowledge moves in an embodied form the costs of moving it can be measured as the cost of goods trade. For disembodied knowledge it is harder to see movements of it and harder to calculate the costs of moving this type of knowledge. The paper claims to shed new light on this issue by casting the question in terms of the operations of multinational firms.

Multinationals have an incentive to endow offshore affiliates with their knowledge as efficiently as possible—after all, knowledge transfer costs raise overall costs and therefore reduce competitiveness. The paper model focuses on the difficulty of communicating knowledge from one person to another versus the costs of moving knowledge in goods. Knowledge can often not fully be codified, and communicating knowledge is prone to errors; just ask any teacher! The authors explain,

In the model, multinational firms produce final goods from individual intermediate inputs that vary in the extent that their production requires non-codified knowledge. Inputs highly dependent on noncodified knowledge are called knowledge intensive. Because not all knowledge can be codified, offshore production calls for communication between home country CEOs and affiliate managers. We assume that communication is more costly the more knowledge-intensive inputs are, but these costs are invariant to physical distance. Alternatively, the multinational can transfer knowledge by shipping ready-to-go inputs embodying the knowledge. This entails no communication costs since the input is produced near the expert at home, however shipping incurs trade costs that rise in geographic distance. The reason why multinational sales in knowledge-intensive industries suffer most strongly from gravity is that here disembodied knowledge transfer costs are highest, and to avoid them means embodied knowledge transfer whose costs rise in distance.

Two predictions follow from the model,

First, the knowledge intensity of production affects the level of affiliate sales around the world. The competitiveness of affiliates, measured in terms of their sales, falls as trade costs rise, and the effect of trade costs is strongest for knowledge-intensive goods, precisely because it is here that the scope for offshoring is most limited by costly disembodied knowledge transfer. Second, the knowledge intensity of production affects the composition of knowledge transfers that the multinational will employ. The affiliate’s cost share of imports gives the relative importance of embodied knowledge transfer. It falls more slowly with distance in knowledge-intensive industries than in less knowledge-intensive industries. As trade costs increase, multinational affiliates substitute away from importing inputs, but their ability to do so is constrained by how high disembodied knowledge transfer costs are. Therefore, trade costs have the weakest influence on affiliate imports in relatively knowledge-intensive industries.

The authors have a data set, from United States’ Bureau of Economic Analysis, involving information information on the sales and intermediate goods trade of individual multinationals. Testing the model the authors find

[ ... ] strong support for both predictions using variation in multinational activity across industries and countries. Consistent with the model, there is evidence that both the level of the affiliate’s sales and its imports are affected by the ease to which knowledge can be transferred across space. A quantitative analysis based on these micro estimates shows that both market size and geography are central determinants of aggregate
foreign direct investment (FDI). This is in contrast to the benchmark model which largely ignores the geography dimension.

Moreover, the model predicts that as trade costs change relative to communication costs, the nature of trade in terms of its knowledge intensity changes systematically. Specifically, an increase in trade costs makes disembodied knowledge transfer more attractive so that the average knowledge intensity of inputs that continue to be traded increases. Despite the large body of work on the factor service content of trade, this is one of the few results on the knowledge content of trade of which we are aware. We find strong supportive evidence for this prediction from the international trade of US multinational firms.

One interesting implication of this work is to do with vertical integration. An observation in industrial organisation is that firms that are part of a domestic production chain do not transfer as many goods within the chain as theories of vertical integration would suggest they should. This outcome could be because knowledge inputs are the key inputs determining the firm's organisational structure. Given this, it follows that the spatial organisation of a firm will depend on the spatial barriers to disembodied knowledge transfer. As such barriers fall the vertical links between firms will become increasingly invisible as there is less embodied knowledge transfer and more disembodied transfer.