Analytical Framework Incentives and Disincentives of Profit S

48 single subsidiary-parent relationships with majority shareholders and ignore all connection either with ultimate owner or affiliated enterprise.

4.3. Analytical Framework

4.3.1. Basic Model 241 Imagine that multinational enterprise X only consist of two firms in different country: parent p and its subsidiary i. Each country have different statutory tax rate � and � � and assume that tax rate in parent country is lower than the subsidiary � � � . This setting could be making sense if tax haven is where the parent is located, while its foreign affiliate operates in developing country. Both firms have exogenous pre-tax profit true profit that will be declared as reported profit in the absence of any profit shifting, denoted by � and � � . From Chapter 2, I already explained that there are two channels to shifting profit, which is sensitive with corporate tax rates. Multinational enterprise X tends to allocate higher profit to their parent, since it has lower corporate tax rate. Fraction of profit from subsidiary, s, could be transferred to its parent either via debt shifting or transfer price manipulation or both. The profit shifting strategies, thus, will enlarge the global profit of multinational enterprise X, �. � = 1 − � � + + 1 − � � � � − ; Where � � - s ≥ 0 1 The above equation can also be interpreted that amount of profit shifting will increase as difference between corporate tax rate in parent and subsidiary become larger. Amount of s, will drive the overall tax burden of X. After profit shifting strategies, the reported profit for subsidiary in country i is now has � � ̇ . Suppose that government in country i, suspect that not only X apply aggressive tax planning and exploit profit shifting strategies. Country i then launch anti-avoidance rule. From the perspective of multinational enterprise X, this disincentive will heighten cost of profit shifting, cs. In the absence of anti-avoidance rule, X already face cost of profit shifting which derives from cost of tax and accounting service and other cost relates to establish profit shifting channel. After anti-avoidance rule take place, there are some additional cost: penalty, reclassification of transaction, and reputational cost. All of those cost are proportionate to the amount of s, in convex function where ′ 0 and ′′ 0. However, cs will be highly depending on tax environment in i, particularly on level of anti- avoidance rule enforcement by tax authority, � . Unfortunately, i as developing country has weak tax 241 As modified from Clemens Fuest, Shafik Hebous, and Nadine Riedel, “International Profit Shifting and Multinational Firms in Developing Countries,” IGC Working Paper January 2011: 4-6. 49 administration. 242 Then to overall cost function of profit shifting is � = � . with assumption that country p do not care about profit shifting or any effort to avoid it. From equation 1, now the global profit of X is � = 1 − � �̇ + 1 − � � � � ̇ − � . 2 In order to optimise their after-tax profit, parent firm in p will choose the amount s which satisfy first order condition of equation 2, as follows � � − � = � ′ 3 Equation 3 shows that the marginal gains from profit shifting equal to marginal cost from profit shifting. The left hand-side is incentive for profit shifting, while the right hand-side express disincentive. Therefore, the amount of s should choose at the level that at least disincentive is not more than incentive. As concern with the fact that tax administration in developing country is weak, then � is less than 1. Therefore, disincentive of profit shifting is never optimal. Consequently, government in country i should deal with more risk of profit shifting in this case outward profit shifting, concerning their supportive environment. 243 4.3.2. Empirical Model The basic model, as previously explained, has successfully demonstrated how the optimal level of profit shifting by multinational enterprise should countervail incentive and disincentive. However, it is not sufficient and needs further empirical model. According to Hines 2014, empirical studies on profit allocation can be classified in twofold. First, studies that compare reported profit for different firms located in various countries with different tax rates. The objective of these studies is to measure response of pre-tax profit in low and high tax environment. Second, studies that explore specific activities to reduce tax burden such as: pricing of controlled transactions, location of intangible property, dividend repatriation and many more. 244 With regards to basic model on previous section, I will only focus on the first classification. Pioneer studies on quantification of causality between corporate tax policy and pre-tax profit initiated by Grubert and Mutti 1991 245 and Hines and Rice 1994 246 . However, the last is widely cited in many empirical studies to scaling magnitude of profit shifting. The idea proposed by Hines and Rice 242 The argument is highly relevant in the case of transfer pricing rule. See Céline Azémar, “International Corporate Taxation and U.S. Multinationals Behaviour: An Integrated Approach,” The Canadian Journal of Economics, Vol. 43, No. 1 2010: 237 – 238. 243 Differentiating equation 3: � � −� � = � � ′′ also show that incentive for profit shifting tax rate difference will greater than the disincentive for profit shifting, concerning the low capability of tax authority in i developing country. 244 James R. Hines Jr., “How Serious Is the Problem of Base Erosion and Profit Shifting?” Canadian Tax Journal, Vol. 62, No. 2 2014: 449. 245 Harry Grubert and John Mutti, “Taxes, Tariffs and Transfer Pricing in Multinational Corporate Decision Making,” The Review of Economics and Statistics, Vol. 73, No. 2 1991: 285-293. 246 James R. Hines, Jr. and Eric M. Rice, “Fiscal Paradise: Foreign Tax Havens and American Business,” The Quarterly Journal of Economics, Vol. 109, No. 1 1994: 149-182. 50 HR assumes that pre-tax profitability of affiliation member of multinational group consist of true profit and shifted income 247 , � � = � � + � . Amount of shifted income is driven by the level of incentive, which is corporate tax difference between affiliate and their parent, � = � � � � − � . Therefore, the equation to measure profit shifting is: � � = � � + � � � � − � = � � 1 + � � − � 4 Taking logs, equation 4 is approximated by: log � � = log� � + � � − � 5 The problem to measure true profit is solved with the involvement of production function specification on their mathematical model. With Cobb-Douglas function = � � � � � � � � � , where c is constant, A is the level of productivity, L is labour input, and K is capital input; they tried to estimate the size of true profit as they assumed that profits are return of investment capital. They used cross-section data for 1982 from Bureau of Economic Analysis BEA with the following empirical model: log � � = + � � − � + log � + log � + log � � + � 6 � � represents affiliate’s profit with specification on natural logarithm of firm’s reported pre-tax profit as a linear function of tax rate differential. 248 Level of productivity, A, a proxy represented by GDP per capita; L specified by cost of employees; while K specified by fixed asset. Variable  represent level of tax incentive for profit shifting strategy, measured by tax rate differential between parent and affiliate. Moreover, parameter will represent marginal effect on how reported profit response to the change of tax incentive, ceteris paribus. In 2008, Huizinga and Laeven HL adopt this approach in more complex setting. Tax factor, on their model, was not merely depends on tax rate difference but a composite index of any opportunity and incentive to have profit shifting. 249 Moreover, since they use multi-country perspective in European countries, they also counted tax rate differentials for all affiliations and not only parent. Further, new approach to measure such issue was proposed by Dharmapala and Riedel 2013. They investigated exogenous earnings shocks at parent firm and how these earnings distributed between 247 See James R. Hines, Jr. and Eric M. Rice, “Fiscal Paradise: Foreign Tax Havens and American Business,” The Quarterly Journal of Economics, Vol. 109, No. 1 1994: 149-182. 248 Dhammika Dharmapala, “What Do We Know About Base Erosion and Profit Shifting? A Review of the Empirical Literature,” Coase-Sandor Institute for Law Economics Working Paper, No. 702 2014: 3. 249 Variable = −� � ∑ �� −�� � � −� � � �≠� ∑ �� −�� � �= , involved the scale of firm’s operation within the group, measured by shares of sales. See Harry P. Huizinga and Luc Laeven, “International Profit Shifting within Multinationals: A Multi-country Perspective,” Journal of Public Economics, Vol. 92, Issues 5-6 2008: 1168-1169. 51 affiliations in different location high and low tax environment. 250 However, since that HL approach is more relevant with theoretical and analytical framework of this thesis, Dharmapala and Riedel’s approach will beyond scope of analysis.

4.4. Source of Data