Foreign Taxes, Domestic Income, and the Jump in the Share of Multinational Company Income Abroad

Since 1996 the foreign share of U.S. multinational corporations’ worldwide income has risen sharply. For example, in a sample of large nonfinancial MNCs, the aggregate foreign share increased from 37.1 percent in 1996 to 51.1 percent in 2004. This increase is decomposed into its major sources, and the role of taxes in each component is evaluated. We also examine the sources of the decline in average effective foreign tax rates, such as the introduction of the check-the-box provisions in 1997. The basic components of the 14.0 percentage point change are the increase in domestic losses (6.0 percent), the increase in companies’ worldwide profits holding their share constant at the 1996 level (5.0 percentage points) and finally letting each company’s foreign share change (3.0 percentage points). There is some evidence that lower average foreign tax rates in 2004 were associated with greater domestic losses but it probably contributed no more than 1 percentage point of the 6.0 percentage point component. The very rapid income growth of companies that already had a large foreign share in 1996, which explains the 5.0 percentage point second component, raises the question as to the role of taxes in determining each company’s share in 1996. In fact a company’s average effective foreign tax rate had an important effect, particularly on foreign and domestic profit margins. Domestic profit margins were higher if the average foreign tax rate was higher. The difference between average foreign effective rates and the U.S. effective rate seems to explain 3 to 4 percentage points of the 5 percentage point component. Finally the reduction in average foreign effective tax rates, of about 5.0 percentage points from 1996 to 2004, explains about 2.0 percentage points of the 3.0 percentage point change in foreign share component. This was all through the impact on foreign and domestic profit margins and not through a shift in sales. Indeed there was a major shift in foreign and domestic profit margins on sales over the period, with mean foreign profit margins rising by 5.0 percentage points and falling by 2.0 percentage points at home. In examining the sources of the decline in average effective foreign tax rates, we conclude that the ‘check-the-box’ provisions enabled U.S. companies to reduce their foreign tax burdens by about 2.0 percentage points. The active finance exception, which permitted U.S. companies to defer income from a financial business, also introduced in 1997, contributed about another percentage point to the decline in foreign rates.