The impact of thin‐capitalization rules on the location of multinational firms’ foreign affiliates

• Author: Valeria Merlo,Nadine Riedel,Georg Wamser
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/roie.12440
• Date: 01 February 2020

Rev Int Econ. 2020;28:35–61.

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INTRODUCTION

Policymakers all over the world increasingly respond to public outrage about how little taxes are

payed by multinational corporations (MNCs) like Apple, Amazon, Google, Facebook, Microsoft, or

Starbucks. Media reports about substantial tax avoidance by these firms as well as tight public budgets

after the financial crisis have provoked governments to take drastic measures to prevent avoidance

Received: 25 February 2019

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Revised: 25 July 2019

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Accepted: 26 July 2019

DOI: 10.1111/roie.12440

ORIGINAL ARTICLE

The impact of thin‐capitalization rules on the

location of multinational firms’ foreign affiliates

ValeriaMerlo1

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NadineRiedel2

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GeorgWamser1

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction

in any medium, provided the original work is properly cited.

© 2019 The Authors. Review of International Economics published by John Wiley & Sons Ltd

1University of Tübingen, Tübingen,

Germany

2University of Bochum, Bochum, Germany

Correspondence

Valeria Merlo, Department of Economics,

University of Tübingen, Nauklerstr. 47,

Tübingen 72074, Germany.

Email: valeria.merlo@uni-tuebingen.de

Abstract

This paper examines how restrictions on the tax deductibil-

ity of interest cost affect location choices of multinational

corporations (MNCs). Many countries have introduced so‐

called thin‐capitalization rules (TCRs) to prevent MNCs

from shifting their tax base to countries with lower tax rates.

As of 2012, in our sample of 172 countries, 61 countries

have implemented a TCR. Using information on nearly all

new foreign investments of German MNCs, we provide a

number of new and interesting insights in how TCRs af-

fect the decision of where to locate foreign entities. In par-

ticular, stricter TCRs are found to negatively affect location

choices of MNCs. Our results include estimates of own‐ and

cross‐elasticities of location choice and also novel results on

the relative importance of tax base vs. tax rate effects. We

finally provide estimates for different uncoordinated as well

as coordinated policy scenarios.

JEL CLASSIFICATION

H25; F23; H26

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MERLO Et aL.

activities.1

This government action is supported by the OECD report on base erosion and profit shift-

ing (BEPS) published in 2013, in which the OECD raises concerns about corporate tax revenue losses,

recognizing that profit shifting by MNCs is “a pressing and current issue for a number of jurisdic-

tions” (OECD, 2013a, p. 5).

The OECD identifies intragroup financial transactions as one of the main strategies used by MNCs

to save taxes. In particular, there is a great deal of evidence that MNCs thinly capitalize foreign enti-

ties operating in high‐tax countries by excessively using debt financing there. This debt is often pro-

vided through lending entities facing low or even zero taxes via an internal capital market (see Egger,

Keuschnigg, Merlo, & Wamser, 2014). The implication is that tax base (taxable profit) is shifted out of

high‐tax countries through interest payments across borders. The BEPS report recommends to “limit

base erosion via interest deductions and other financial payments” (OECD, 2013b, Action 4, p. 17).

As a matter of fact, measures to restrict interest deductions associated with excessive debt financ-

ing and profit shifting have been implemented for some time by many countries. For example, 61 out

of 172 analyzed countries have been using so‐called thin‐capitalization rules (TCRs) in 2012 (see

Merlo & Wamser, 2014). From 1996 until 2012, 37 countries have introduced a TCR, while only four

countries abolished their TCRs.2

A small but growing literature in economics confirms the effectiveness of TCRs in removing tax

incentives related to debt financing. Buettner, Overesch, Schreiber, and Wamser (2012) as well as

Blouin, Huizinga, Laeven, and Nicodème (2014) find that affiliates of MNCs no longer respond to

tax incentives if TCRs are introduced or made stricter. Weichenrieder and Windischbauer (2008),

Overesch and Wamser (2010), as well as Wamser (2014) analyze a reform of the German TCR and

find that foreign firms adjusted their capital structures after stricter rules were introduced. Thus, this

literature suggests that TCRs are effective and countries may use them as a policy instrument to re-

strict tax planning of MNCs.

Another way of interpreting the results of this literature is that new or stricter TCRs lead to a

broader tax base. To the extent that a broader tax base leads to higher effective tax payments, a

straightforward prediction is that stricter TCRs reduce real investment activity of firms, ceteris

paribus. However, the question of how TCRs are related to real investment activities of MNCs has

been widely neglected in the literature. One exemption is the paper by Buettner, Overesch, and Wamser

(2014), in which the intensive margin of foreign activity (in terms of foreign affiliates’ investments in

fixed assets) is analyzed. That paper confirms that TCRs exert negative effects on investments, partic-

ularly in countries with relatively high taxes.

Our paper contributes to this literature in several ways. First, we assess the impact of TCRs on

the extensive margin of foreign activity (location choice). Second, we use new data on TCRs and all

worldwide (first) location choices of German MNCs over a time span of 11 years. Third, we calculate

realistic own‐ and cross‐tax as well as TCR elasticities by using a mixed logit (or random coefficient)

model. The latter allows for heterogeneity in the responsiveness of firms to corporate tax incentives.

Fourth, we provide numerous interesting policy results, including (i) an assessment of the relative

importance of tax base vs. tax rate effects; (ii) estimates on real world policy options for unilateral

measures against profit shifting; (iii) an assessment of the implications of a coordination in policies

against profit shifting.

Our results can be summarized as follows. First, lower corporate taxes and laxer TCRs exert pos-

itive effects on the probability of choosing a given location to set up the first foreign affiliate. For

example, a 1% lower tax in the United Kingdom would lead to an increase of about 0.66% in the

probability of choosing the United Kingdom as a host country for the first foreign affiliate. The find-

ings of tax and TCR effects are robust to a number of additional tests. These include variations in the

estimation specification and also the analysis of subsequent (second) location decisions (following