Implications of Flexibility in Income Shifting under Losses

This study develops theory and discusses implications of flexibility in income shifting for multinational corporations that have both profit- and loss-making affiliates. Our theoretical model shows that when multinationals do not have flexibility to adjust their income-shifting strategies within a tax year in response to losses (i.e., they must implement 'ex-ante' income-shifting strategies), they take the expected loss-adjusted tax rate differential into account rather than the larger statutory tax rate differential. This central finding suggests that prior empirical studies using the statutory tax rate differential risk underestimating the tax sensitivity of income shifting. We also find that flexibility to adjust income-shifting strategies to losses has important implications for how and why the profit distribution of multinationals' affiliates differs from domestic corporations: Under inflexibility, some affiliates will form a fat tail in the loss part of the distribution. Finally, we provide guidance for future empirical work based on our theoretical predictions.