Earnings shocks and tax-motivated income-shifting: evidence from European multinationals


This paper presents a new approach to estimating the existence and magnitude of tax-motivated income shifting within multinational corporations. Existing studies of income shifting use changes in corporate tax rates as a source of identification. In contrast, this paper exploits exogenous earnings shocks at the parent firm and investigates how these shocks propagate across low-tax and high-tax multinational subsidiaries. This approach is implemented using a large panel of European multinational affiliates over the period 1995–2005. The central result is that parents' positive earnings shocks are associated with a significantly positive increase in pretax profits at low-tax affiliates, relative to the effect on the pretax profits of high-tax affiliates. The result is robust to controlling for various other differences between low-tax and high-tax affiliates and for country-pair-year fixed effects. Additional tests suggest that the estimated effect is attributable primarily to the strategic use of debt across affiliates. The magnitude of income shifting estimated using this approach is substantial, but somewhat smaller than that found in the previous literature.

Research Highlight 2011

Earnings shocks and tax-motivated income shifting: evidence from European multinationals

Differences in corporate tax rates across countries create opportunities for tax arbitrage by multinational companies. But identifying the existence and magnitude of such tax motivated profit shifting is fraught with difficulty. Most studies rely on measuring the effect of variation in corporate tax rates on the profitability of affiliates. This research instead exploits shocks to earnings in the parent firm and analyses how these shocks propagate across the affiliates of a multinational group. Specifically, it assesses the shifting of exogenous earnings shocks to low-tax subsidiaries, relative to high-tax subsidiaries. The study exploits a large European micro dataset which provides detailed accounting and ownership information on 1.6 million firms. The results show strong support for the profit shifting hypothesis. While the effect of earnings shocks at the parent firm on the income of high-tax affiliates is indistinguishable from zero, we find a significantly positive impact on the income of low-tax affiliates. Quantitatively, the estimates suggest that at the margin around 2% of additional parent earnings are shifted to low-tax subsidiaries.

Nadine Riedel