If you were a multinational firm, where would you locate your activities and investments? A handful of economic factors play a role in this decision, but for tax-related aspects, you would think in terms of an average effective tax rate. It’s not that complicated; let me explain.
Taxes matter. Taxes specifically play a role in where multinational firms locate their economic activity, for example, plants and equipment. In the debate on corporate tax reform, however, the discussion of individual countries’ corporate tax rates and how they affect multinational firms’ decisions to invest focuses almost exclusively on the statutory tax rate. Although the statutory tax rate in some sense is a useful proxy, it’s actually often quite distinctly different in magnitude from the rate that is more meaningful: the average effective tax rate.
For example, in Laura Tyson’s excellent testimony on why reform of the corporate tax system is critical for the long-term competitiveness of the U.S. economy, she mainly highlights the statutory tax rate as the tax-related basis for firms’ decisions concerning where to locate investments. This is often the case throughout the corporate tax reform discourse. Granted, the statutory tax rate serves as a method of simplification. Yet, it portrays an incomplete picture of why and how multinationals make location decisions with respect to taxes.
Economic theory suggests that, from a tax perspective, firms base their decisions on the average effective tax rate. The simplified decision tree featuring country-specific average effective tax rates (AETR) illustrates this concept, in the eyes of a multinational firm.
In the decision tree above—all else equal—since country A has the lowest average effective tax rate, this is where the firm will choose to locate its investment, assuming the firm faces a choice between two or more mutually exclusive investment projects (“if I invest here, then I can’t invest there”).
The reason why multinational firms may view the average effective tax rate as a better measure of the actual tax burden is because of the various deductions, exemptions, and credits that countries offer in order to attract foreign direct investment. The R&D credit is a classic example of such a measure. As a result, these types of tax incentives often reduce the statutory tax rate across a firm’s aggregated operations or investments for any given country—thus, resulting in the average effective tax rate painting a more nuanced picture of a firm’s tax liability taken as a whole.
Of course, it’s important to point out that lowering the statutory rate to begin with will automatically make it easier for a country to achieve a lower average effective tax rate.
Furthermore, after the firm has decided in which country to locate its investment, the next decision relates to how much the firm should invest. This decision, the size of the investment, is impacted by the marginal effective tax rate, which is the tax that the firm would need to pay on each additional dollar of pre-tax income generated by the investment, taking into account provisions such as exemptions, deductions, and credits. If the marginal effective tax rate on a certain investment results in too high a percentage of additional income being unavailable to the firm due to taxes, the firm will simply reduce the size of the investment to a level that yields a marginal after-tax return that makes sense.
The question, “in which country should I invest?” is a key consideration for multinational firms that has critical implications for individual countries and policymakers. As many policymakers in countries around the world have realized, multinational firms are extremely valuable, as they are massive engines of economic growth and substantially higher wages. In this context, the average effective tax rate serves as a meaningful proxy from a tax standpoint, with respect to where a firm may want to locate its investments and operations. As the debate concerning reform of the U.S. corporate tax system unfolds, it’s important to consider more fully how taxes are viewed in the eyes of a multinational firm.
