Base erosion and profit shifting in eastern European countries

• Thesis title in Czech: Snižování daňového základu a přesun zisku ve východoevropských zemích
• Thesis title in English: Base erosion and profit shifting in eastern European countries
• Academic year of topic announcement: 2015/2016
• Thesis type: diploma thesis
• Thesis language: angličtina
• Department: Institute of Economic Studies (23-IES)
• Supervisor: prof. Petr Janský, Ph.D.
• Author: hidden - assigned by the advisor
• Date of registration: 05.10.2015
• Date of assignment: 05.10.2015
• Date and time of defence: 15.09.2016 00:00
• Venue of defence: IES
• Date of electronic submission: 29.07.2016
• Date of proceeded defence: 15.09.2016
• Opponents: doc. Ing. Ondřej Schneider, M.Phil., Ph.D.

Guidelines

Motivation

Base erosion and profit shifting has become a widely debated issue in last several years. The fact that tax avoidance and tax evasion of multinational corporations (MNCs) is a serious problem that can hinder development of both developed and developing countries has been identified and acknowledged not only by academics but by world leaders as well. In June 2012 the G20 leaders expressed concerns about base erosion and profit shifting (BEPS) and the need for prevention. In February 2013 the Organization for Economic Co-operation and development (OECD) published a report Addressing base erosion and profit shifting. In this report OECD presented studies regarding existence and magnitude of BEPS, examined matters of global developments that had impact on corporate taxes in past and reviewed BEPS opportunities that may be presented not only to MNCs but to all companies that are involved in cross-border activities. In June 2013 the first action plan by OECD was introduced which had on its agenda topics like for example establishing of international coherence of corporate income taxation or ensuring transparency of tax returns by MNCs. The BEPS initiative by OECD with approval of G20 is still ongoing today and by the end of 2015 the first implementation package should be presented.

As the big interest in this topic by the largest economic organizations suggests a lot of research in this field has already been done. There are several approaches to study profit shifting. The first approach is trade mispricing. According to this approach companies can manipulate prices of internationally traded goods to shift income across boarder. The main issue with this approach as stated by Fuest and Riedel (2012) is the identification of price manipulation. For example Baker (2005) uses confidential interviews with firms to identify mispriced trade transactions and then based on those interviews estimates the income shifted from country. Another method of distinguishing mispricing is through identifying abnormally priced import and export transaction with so called price filer matrix as used by Pak (2007) which tries to spot the suspiciously high or low transaction inside a group of imported and exported products and then used them as base for computation of income shifted in or out of a country. Both of these approaches have number of drawbacks which makes them unreliable, hard to interpret of impossible to replicate (Fuest and Riedel 2012).

The second approach to examine profit shifting is through profitability and investigation if firms observed profitability pattern can be explained by profit shifting. For example Oxfam (2000) uses foreign direct investment (FDI) into certain countries and World Bank’s estimated of returns of FDI and calculates the tax base that should be paid and identifies the gap between these calculated taxes and taxes reported in real data as tax loss due to profit shifting. Again this approach has been criticized by Fuest and Riedel for several issues.

Another and arguably better (Fuest and Riedel 2012) approach which will be the one used in this thesis is to try to identify profit shifting on micro not macro level. For this approach a detailed data on number of variables concerning individual companies is required. Fortunately in recent years several such data sources were developed and improved to be well suited for this topic. In this thesis I will use the ORBIS database developed and maintained by Bureau van Dijk. This database contains detailed information about both public and private companies all over the world. This approach using the ORBIS database was already used for example by Janský (2015), Fuest and Riedel (2012), or Maffini (2009).


Hypotheses:
1. Hypothesis #1: MNCs with ties to tax havens report lower pre-tax profits and pay lower taxes than MNCs without ties to tax havens and MNCs without ties to tax havens report lower pre-tax profits and pay lower taxes than national companies.
2. Hypothesis #2: MNCs especially those with connections to tax havens hold higher fraction of debt than national companies.
3. Hypothesis #3: Companies in high tax rate countries and/or high corruption rate report lower pre-tax profits and pay lower taxes than those in lower tax rate and lower corruption rate countries.


Methodology:
Using a large dataset extracted from ORBIS database I will use panel data to test for hypotheses formulated earlier. The dataset contains data for 16 countries: Baltic states (Estonia, Latvia, Lithuania), Middle and Eastern European countries (Czech Republic, Slovak Republic, Hungary, Belarus, Poland, Ukraine), Balkan states (Bulgaria, Romania, Croatia, Slovenia, Serbia, Bosnia and Herzegovina) and Russia. All key variables for testing our hypotheses are available such as detailed information about both pre-tax and after-tax profits, details about size of companies, ownership structure, subsidiaries and their ties to tax havens countries, as well as data about companies’ long term and short term debts or taxes paid. The data are available between years 2005 and 2014.

The number of companies included in this dataset is close to a million so there will be no problem in forming a control group from national firms and treatment group from MNCs with and without ties to tax havens. Due to different sizes of countries there is no surprise that there is a big difference between numbers of companies residing in different countries. For example almost half of companies in our dataset are from Russia as it is by far biggest country included. To account for this fact one might follow identification strategies used in earlier papers for example Maffini (2009).
Expected Contribution:
By this work I will try to add to a growing discussion about shifting income of multinational corporations across border of domestic country with special focus on those MNCs with ties to tax havens for which the possibility of tax avoidance and tax evasion can be especially enticing. By working with a large and unique panel dataset I will try to provide empirical evidence about such behaviour of companies in eastern Europe. Unlike other papers which are exploring profit shifting on a micro level such as Janský (2015) or Fuest and Riedel (2012) I will try to observe evidence of tax avoidance across whole region not only for single country. Also by including a several years instead of a single year with the highest number of observations I will be able to control for time constant differences between observations.

A goal of this thesis is not only to find evidence of profit shifting in Eastern Europe but also to provide a small inside into why companies might want to shift their profit from domestic countries. Of course there is an obvious reason that companies want to save on tax payments by shifting some of the profits from high tax countries and therefore increase its profit. But there can be another reason that companies are trying to shift some of their income out of corrupt or politically unstable countries. An investigation of these motives is in similar paper either omitted completely or as it is for example in Fuest and Riedel (2012) it is only briefly touched but any rigorous analysis of these motives is still missing.

References

Crivelli, E., Mooij , R., Keen .M.(2015) Base Erosion, Profit Shifting and Developing Countries. IMF working paper.

Fuest, C., & Riedel, N. (2012). Tax Evasion and Tax Avoidance: The Role of International Profit Shifting. In P. Reuter (Ed.), Draining Development? Controlling Flows of Illicit Funds from Developing Countries (pp. 109–142).

Janský, Petr, Kokeš, Ondřej. (2015). Corporate Tax Base Erosion and Profit Shifting out of the Czech Republic. Post-Communist Economies.

Janský, P., & Prats, A. (2014). International Profit Shifting out of Developing Countries and the Role of Tax Havens. Development Policy Review.

Maffini, Giorgia (2009), Tax Payments of Multinational Groups with Operations in Tax Havens, mimeo.

OECD. (2013). Addressing Base Erosion and Profit Shifting. Paris: OECD. Retrieved from http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/addressing-base-erosion-and-profit-shifting_9789264192744-en#page1.

OECD. (2013). Action Plan on Base Erosion and Profit Shifting. Retrieved from http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/action-plan-on-base-erosion-and-profit-shifting_9789264202719-en#page1.

Oxfam (2000), Tax Havens – Releasing the Hidden Billions for Poverty Eradication, Oxfam GB Policy Paper.

Preliminary scope of work

Outline:
1. Introduction
2. LIterature survey
3. Tax havens and profit shifting
4. Data description
5. Methodology
6. Regression results
7. Conclusion