The Effects of Multinationals' Profit Shifting Activities on Real Investments

Abstract

This paper investigates whether the size of multinationals’ real investments in a high-tax country is affected by profit shifting activities. A simple theoretical analysis shows that tax rates abroad impact the cost of capital in the presence of profit shifting activities of multinational companies. As profit shifting opportunities constitute a competitive advantage, the respective size of investments should theoretically increase if profits can be shifted to a lower taxing country. An empirical analysis, based on a panel of German inbound investments, confirms a positive tax response of real investments with a decreasing tax rate at the foreign direct investor’s home country. Hence, the results suggest that the size of foreign investments in a high-tax country is positively affected by lower foreign taxation of shifted profits.