Consumption Taxes and Corporate Tax Planning - Evidence from European Service Firms

Abstract

There is an increasing political concern that firms in the globalized, digital economy avoid income and consumption taxes. We examine income and consumption tax planning of service firms in Europe through managing the respective tax bases and hypothesize that both tax planning channels are interrelated. We exploit corporate affiliate-level panel data and a unique setting in Europe over the period 2007-2015 with 71 staggered and plausibly exogenous corporate income and consumption tax rate changes (and differences). We find that firms significantly respond to incentives from value-added taxes evidenced by a tax-rate semi-elasticity of reported sales of around 0.5. Consistent with greater discretion over the jurisdiction of value-added tax liability, we find a significantly larger effect for firms in the digital service sector. We then show that income tax-motivated profit shifting behavior depends on the extent to which firms report sales in order to minimize consumption taxes. In particular, we document that income tax-motivated profit shifting behavior is completely attenuated for firms that, on average, respond to higher (lower) value-added taxes via reporting lower (higher) sales. Our study offers a new explanation why some firms avoid more income taxes than others. The results suggest that minimizing the consumption tax burden can be a dominating tax consideration that imposes a constraint on income-tax motivated transfer pricing.