Wednesday, September 26, 2012

Capital Flows Inside MNCs

A new research paper from the NBER working paper series looks at debt-shifting within MNCs, and finds that – surprise! – tax rates matter a great deal more than previously thought (abstract):

Corporate Taxes and Internal Borrowing within Multinational Firms
Peter Egger, Christian Keuschnigg, Valeria Merlo, Georg Wamser

This paper develops a theoretical model of multinational firms with an internal capital market. Main reasons for the emergence of such a market are tax avoidance through debt shifting and the existence of institutional weaknesses and financial frictions across host countries. The model serves to derive hypotheses regarding the role of local versus foreign characteristics such as profit tax rates, lack of institutional quality, financial underdevelopment, and productivity for internal debt at the level of a given foreign affiliate. The paper assesses hypotheses in a panel data-set covering the universe of German multinational firms and their internal borrowing. Numerous novel insights are gained. For instance, the tax-sensitivity found in this paper is many times higher than previous research suggests. This accrues mainly to three things: the consideration of the boundedness of the internal debt ratio as a dependent variable in comparison to its treatment as an unbounded variable in most of the previous work; the coverage of all (small and large) multinationals here rather than a focus on large units in previous work; and the inclusion of endogenous characteristics in other countries multinationals are invested in (due to endogenous weights) while previous work did not consider such effects at all or assumed them to be exogenous. Moreover, local and foreign (at other locations of a given affiliate) market conditions matter more or less symmetrically and in the opposite direction. There is a nonlinear trade-off between institutional quality or financial development on the one hand and higher profit tax rates on the other hand, and the strength of this trade-off depends on the characteristics of one location relative to the other ones a multinational firm has affiliates (or the headquarters) in.

The paper's fairly comprehensive in looking at determinants, and although the data used is primarily German, its a fairly deep dataset covering both large and small MNCs.

But in case you’re missing the implications here: multinationals with foreign-based units will tend to borrow funds through units in low tax jurisdictions (utilising formal “external” capital markets) which are then used to fund investment for units in higher-tax jurisdictions (using an “internal” capital market within the MNC).

The low-tax based unit earns interest income from the "internal loan" which is taxed less, while the high-tax based unit can claim higher deductions based on the greater interest it paid on its loan.

It also helps if the lending unit is located in a place with a more developed “external” capital market, which implies cheaper cost of funds.

Just one more way multinational corporations “move” taxable income to the tax jurisdictions of their choice.

Technical Notes

Peter Egger, Christian Keuschnigg, Valeria Merlo, Georg Wamser, "Corporate Taxes and Internal Borrowing within Multinational Firms", NBER Working Paper No. 18415, September 2012/p>


  1. Good afternoon, Hisham

    I believe there's a fine line between "tax avoidance" (morally reprehensible, maybe, but not illegal) and "tax evasion" (illegal).

    MNCs, like most (I won't say all) public-listed companies, are managed for the benefit of their owners (shareholders), hopefully for the long term.

    Tax avoidance is a legitimate tool to this end, in that it seeks to maximise profits.

    MNCs employ large numbers of tax specialists and lawyers to do this. In so doing, they continuously compare different countries' tax regimes as one of the criteria for deciding whether to do business in that country or give it a miss.

    Singapore chose the MNC route to kick start it's economy after the forced separation from Malaysia.

    In so doing, Singapore capitalised on it's traditional entrepôt role in the region and maximised it's attractiveness to MNCs through an aggressive programme of tax incentives, infrastructure investments and liberal immigration and labour market policies.

    MNCs liked what they saw in Singapore and set up shop there.

    Malaysia, because of social engineering policies and inequality constraints, chose not to go this route.

    One could argue that by so doing, Malaysia surrendered a great deal of "first mover advantage" to Singapore, and resulted in it trying to play catch-up now.

    I believe that personal income tax in Malaysia is a very small component of the government's tax revenues. The shortfall on the revenue side has to be made up from, among others, contributions from Petronas and corporate taxes (on local companies, SMEs and MNCs).

    The danger is that MNCs could move to more favourable cost and tax environments while retaining only a token or minimal presence in Malaysia. We are already seeing this in foreign financial institutions and MNCs, especially those in the high-tech and high-value add industries.

    But how can corporate taxes be cut, without corresponding cuts on the expenditure side of the budget?

    Which is why, once the post-election euphoria has worn off, the government of the day will find itself between a rock and a hard place as far as budgets and deficits are concerned.

    A corollary: it's easy to drive out the MNCs, but terribly hard to attract them back once they have jumped ship to more salubrious jurisdictions!

  2. Hi Jasper,

    "The danger is that MNCs could move to more favourable cost and tax environments while retaining only a token or minimal presence in Malaysia. "

    Actually for the most part, I do believe its the exact opposite. The "activities" are here and in other high tax countries, its just that the "profits" are booked elsewhere (read: Singapore, the Caymans etc>.

    I don't think we would have been competitive against SG even if we tried this route. Based on the latest numbers for 2011, Singapore took in 70% of ASEAN's share of retained earnings FDI, and 50% of the global total. They've beaten the whole world in this particular game, not just us.

  3. Dear hisham

    How are you?

    Budget season is upon us. I am sure you have been busy.

    Wanna ask what is your opinion on the PR shadow budget presented today?

    Would love to hear your comparative views on BN and PR budget once both parties have put out their proposals.

    Always a great and I hope you and family are doing well.

    1. Thanks for the kind wishes.

      Yes, busy as a beaver - I've just finished doing a complete first read through of PR's budget.

      Some things I like (phased reduction in excise duties) and some have me scratching my head (the whole RM4000 per household thing). I'm aiming for a quick overview by tomorrow or Friday morning, before the official budget announcement.

    2. Cant wait to hear your take on both budget proposals!

  4. Hi HishamH

    Much as this expose would prick for good certain delusionary thought balloons into non-existence, it is a necessity in order to bring reality back into its proper perspective. The so-called first mover advantage based on a low tax incentivisation, liberal market friendly policies etc etc are a collocation of hogwash designed to underpin the myth of Singapork as an investor, MNC friendly paradise.

    The harsh reality is otherwise: Singapork is the SEA lynchpin for moneylaundering and tax evasion. If you look at the global map, all these so called low-tax, market friendly paradises straddle strategic zones. For the Americas, you have the Caymans, the British Virgin Islands etc. For much of Europe: Switzerland, For South Asia and SEA : Singapork; for East Asia; HK. In the case of the latter three zones, these bastard banana nations also double up as a paradise for main/regional HQs of MNCs keen on "maximising their profits" via illegal means.

    Sometime back you provided a valuable link of UNCTAD on FDI stock and flows. If you care to map the countries/territories onto that data, you will come away shaking your head in disbelief.

    Engggak gilakah Cayman Islands, British Virgin etc are enjoying superhumungous outflows from essentially piffling indigenous economies, would be an Bahasa Indon-laced question you may ask to a better picture.

    All these countries have another thing in common apart from their geographically strategic spread, they have no resources in terms of minerals, oil etc, the one resource available and widely at that was money. So the cue to project themselves as market friendly entities when the actuality was they were intent on emplacing themselves at the centre of laundering tax evasion moolah, illict gains from drug lords, gangsters and pimps, casino peddlars plus corruption stuff.


    It was hunky dory as the world turned a blind eye when the good times were on the roll but come 2008 onwards, as the pall descended and revenues shrank in the Western economies, they (the Western economies) had no alternative but to go out and hunt for these stolen hoards parked in these so-called low-tax market friendly haven. The rest is history and rest assured there will be much unraveling in the foreseeable future.

    The evidence is overwhelming apart from the UNCTAD data, we have the US State Department Blacklist, FATF reports, White papers in the Indian Parliament, Indonesian and Filipino parliamentary motions which among others finger Singapore and of course anecdotal evidence:

    You think the guy would be mad to blurt out like a drunkard and how come he was not thrown into a Singaporkian jail for his troubles...go figure.

    Anyone here or elsewhere who tries to peddle a different tale is a liar, a paid troll and a deluded one at that. That explains the total silence to a Yank elsewhere.....hahahahahahaha

    Warrior 231

    For dessert :

    P/s: Do you find any of the countries mentioned ever nurturing a manufacturing giant like Apple or Samsung etc....nyet, zilch, nado, kosong, nil...why? hahahahahahaha so much of being high-tech mavens when reality screams them as moneylaundering pariah banana states hahahahahahaha

  5. Hi, Hisham

    Before I get engaged in polemics with the warrior (and thereby subvert your blog), what is your opinion on the points he has made?

    More to the point - are they valid?

    It seems strange to me that Singapore is singled out as THE target for the warrior's ire (and angst).

    1. Jasper, without the melodramatic short, there's more than a grain of truth here. As far as tax avoidance and tax evasion are concerned, the numbers are highly suspicious. The flow and stock data of capital is mostly publicly available, if you care to check yourself.

      Singapore, the Cayman Islands, British Virgin Islands, all rank in the top 20 for FDI. But FDI is made up of three components - greenfield investments, M&A and long-term portfolio investment, and retained earnings. It's the retained earnings part that is problematical, because its simply booking of profits.

      It's not just the internal capital markets in the post you commented on before, but also trade mispricing dodges - exports from Singapore to Malaysia have one value when they leave Singapore, and a substantially different value when they land in Malaysia. Same thing for goods going the other way.

      For most trade data, this is explained by CIF (carriage, insurance & freight), but the discrepancy is too big for that, especially considering that we don't see the same issue with trade with Japan or America for instance.

      We have the same trade mispricing problem with China as well, so its not just Singapore.

    2. Sorry, should have added - check out the Bloomberg link warrior posted. Andy Xie's a well respected economist, I used to read his stuff all the time. When he says something, I take it seriously.

  6. Hisham

    Is there anything wrong or illegal about companies booking profits in low-tax jurisdictions?

    The last time I checked, tax avoidance is not a crime. Tax evasion is.

    The US government has been trying to get American MNCs to book a substantial part of their overseas profits in the US. The MNCs and their lobbyists are fighting this tooth-and-nail.

    If foreign investors park their funds in Bursa Malaysia-listed companies and in Malaysian bonds, isn't that portfolio investment into Malaysia? Isn't that something that Bank Negara monitors closely?

    1. Jasper, you're absolutely right that there is nothing technically illegal with the practice of booking profits in the lowest tax jurisdiction you can find - that is perfectly rational behaviour.

      By the same token, it is also perfectly rational behaviour for the country where the actual economic activity (and thus the actual revenue-creation) occurs to want a share of the benefits in terms of taxes - after all, in-country infrastructure and public services are used to support this activity.

      Thar's where the issue of fairness and inequity arises - which is not the case with portfolio capital flows. So while there may not be any illegality involved, ethics and fairness certainly are.

      This is of course, purely in terms of internal capital markets.

      For trade mispricing - this is very clearly both wrong and illegal as it involves under- and over-declaration of the value of goods on customs clearance. The practice is also unfortunately prevalent and large, and appear to run through some but not all Malaysian trade partners - the discrepancies are in excess of RM50 billion a year.

      I'm not sure what the relevance of your last paragraph to this subject is.

    2. Hi, Hisham

      To take up your point about "trade mispricing", aren't there agencies in Malaysia (offhand I can think of MIDA, Matrade, the Customs Department, the Income Tax folks) who can address this issue and deal with it on a bilateral basis with the trade partners in question?

      The more so if this is, as you say, wrong and illegal.

      So, just what have the Malaysian agencies been doing about this?

      My last paragraph in my earlier post referred to foreign portfolio investment into Malaysia. Is this good or bad, seeing as how these investments can be "footloose and fancy free"?

      As for the issue of retained profits, there is nothing to prevent Malaysia from joining the ranks of the low-tax jurisdictions, is there?

      Which, imho, could be easily done if the government gets it's finances sorted out!

    3. Jasper,

      With respect to the government agencies involved, they've only just been made aware of the problem. It's not actually detect something that can be detected unilaterally. Yes the issue has to be dealt with on a bilateral basis, as there are tax implications for both export and import countries.

      With respect to allowing foreign portfolio investment, which is frankly off-topic to this post, as a general rule the empirical finding is that there is no link with economic growth or development. In other words, it's not something to be particularly welcoming of.

      As far as Malaysia cutting corporate taxes, that is not something I would want to see - for one thing, it's a race to the bottom; for another, low corporate taxes encourage wage suppression and higher income and wealth inequality. Not exactly a recipe for social harmony and stability, especially given Malaysia's multiracial make-up.

  7. Zuo De here, before i forget to identify myself again like my last post.

    I read "low corporate taxes encourage wage suppression" and have been using what little brain i have and really ... please elaborate a bit more, oh my brain hurts ...

    Thank you and keep up the good work.