Internal debt and welfare [original]

Received: 8 February 2021

Accepted: 22 December 2021

DOI: 10.1111/jpet.12567

ORIGINAL ARTICLE

Internal debt and welfare

Zarko Y. Kalamov

School of Economics and Management,

University of Technology Berlin, Berlin,

Germany

Correspondence

Zarko Y. Kalamov, School of Economics

and Management, University of

Technology Berlin, Straße des 17. Juni

135, 10623 Berlin, Germany.

Email: [email protected]

Abstract

This paper analyzes how multinational firms' internal

debt financing affects high‐tax countries. It uses a dy-

namic small open economy model and takes into account

that internal debt impacts both the multinational firms'

investment decisions and the government's tax policy.

The government has incentives to redistribute income

from firm owners to workers. If the government's redis-

tributive motive is not too strong, internal debt reduces

welfare in the short term by decreasing tax revenues.

However, debt financing stimulates capital accumulation

and exerts a positive long‐term welfare impact.

1|INTRODUCTION

Multinational enterprises (MNEs) shift a large proportion of their profits to tax havens. In 2015

more than $600 billion, or 36% of multinationals' worldwide profits, were shifted (Tørsløv et al.,

2018). Internal debt serves as one of the main channels of international tax planning and

accounts for 25%–30% of the shifted profits (Beer et al., 2020; Heckemeyer & Overesch, 2017).

Hence, in its initiative on base erosion and profit shifting, the OECD calls for, inter alia,

measures to address base erosion through internal debt (OECD, 2013,2015). Moreover, the

number of countries applying thin‐capitalization rules (TCRs; i.e., rules that limit interest

deductibility) increases over time (Merlo & Wamser, 2015).

Here, I analyze the welfare effects of internal debt in the short and long run. I show that

these effects are not necessarily negative. Furthermore, they may be nonmonotone, with ne-

gative short‐and positive long‐term welfare implications.

J Public Econ Theory. 2023;25:196–224.196

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From 1996 to 2012, the number of countries applying TCRs increases from 24 to 61 (Merlo & Wamser, 2015). Also,

21 countries made the rules stricter, and only six countries relaxed them.

This paper builds a dynamic small open economy model. There is one high‐tax (nonhaven

or host) country that hosts a national firm and a subsidiary of a foreign‐owned MNE. Workers

supply labor that is perfectly mobile between the national and multinational sectors. The MNE

invests mobile capital in the host country, and capital adjustment is subject to installation costs.

Because of installation, it takes time for new investment to augment the firm's capital stock.

The MNE's headquarters can channel equity financing to its subsidiary as internal debt through

a financial center located in a tax haven. The host country government uses a TCR to restrict

such behavior. Moreover, it chooses a time‐invariant corporate tax rate and redistributes in-

come from firm owners to workers.

First, I study the short‐and long‐term welfare implications of allowing for some internal

debt use. The short term differs from the long term because installation of new investment

prohibits the MNE from adjusting its capital stock immediately. The results are, in general,

ambiguous. However, if the government's redistributive motive is sufficiently weak, welfare

declines unambiguously in the short term and increases in the long term. The intuition is the

following. A TCR relaxation stimulates profit shifting and lowers the MNE's cost of capital for

a given statutory tax rate. The increase in profit shifting reduces the tax revenues directly,

while the cost of capital effect stimulates investment and may increase the optimal tax rate. In

the short term, the capital stock adjusts slowly because new capital installation takes time.

Hence, welfare declines if the change in the optimal tax rate cannot compensate for the loss of

tax revenues (which is the case for a sufficiently weak redistributive motive). In the long

term, capital accumulates, which increases welfare to a level that is ultimately higher than its

initial level.

Second, I analyze the optimal internal debt restriction as well as the timing of its benefits

and costs. Similarly to the case of a TCR relaxation, the optimal TCR balances short‐term

marginal costs and long‐term marginal benefits.

Furthermore, a numerical simulation of the model looks at the welfare effects of increasing

the TCR from zero to its optimal level. It shows that the negative short‐term effects may be

long‐lived. Moreover, when the government has strong redistributive motives, the numerical

analysis finds positive short‐and negative long‐term welfare changes. This case emerges when

the optimal tax rate increases strongly following the reform and the long‐term capital stock

declines.

Nonmonotone welfare effects emerge due to the dynamic nature of the MNEs' responses to

TCR reforms, which is supported by the empirical literature. Weichenrieder and

Windischbauer (2008) and Buslei and Simmler (2012) analyze the short‐term effects of two

reforms in Germany from 2001 and 2008, respectively. Weichenrieder and Windischbauer

(2008) look at the impact on the capital stock of subsidiaries of foreign‐owned MNEs in

Germany 2 years after the 2001 reform, while Buslei and Simmler (2012) analyze investment of

the same type of firms 1 year after the 2008 reform. Both papers do not identify any significant

effects on the capital stock and investment, respectively. Moreover, Harju et al. (2017) measure

the real effects of a 2014 TCR reform in Finland through its impact on output in the 2 years

following the reform. They do not find any significant effects.

However, in accordance with my results, the empirical literature finds significant long‐term

real effects of debt financing. Buettner et al. (2008) analyze the long‐term impact of TCR on

investment using a panel data set of German multinationals' affiliates in 36 countries. They find

statistically and economically significant adverse effects of both the implementation and

tightening of TCRs. Moreover, Buettner et al. (2018) find significant negative long‐term impacts

of TCRs on the MNEs' capital stock and the capital stock's tax rate sensitivity in high‐tax

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countries. In addition, De Mooij and Liu (2018) use panel data of MNEs operating in

34 countries over 2006–2014. They find that a TCR introduction doubles the tax rate sensitivity

of investment. Furthermore, Blouin et al. (2014) show that TCRs imposed on affiliates of US

MNEs lower the overall firm valuation as measured by Tobin's

. Because Tobin's

is a good

predictor of investment (Erickson & Whited, 2000; Philippon, 2009), the results of Blouin et al.

(2014) also suggest a long‐term impact of TCR on investment. Furthermore, Suárez Serrato

(2019) studies the long‐term real effects of elimination of tax haven use by US multinationals

and finds negative investment and employment effects. While Suárez Serrato (2019) cannot

distinguish between different profit‐shifting channels, his results are consistent with this pa-

per's predictions.

Therefore, my results highlight the importance of the timing of policy reforms' empirical

evaluation. For example, a long‐run analysis of the reforms analyzed by Weichenrieder and

Windischbauer (2008), Buslei and Simmler (2012), and Harju et al. (2017) might produce

different outcomes.

Furthermore, the paper's results have the following policy implications. Consider, for ex-

ample, a reform that restricts the TCR in a country. The reform is likely to raise tax revenues in

the short term at the cost of adverse long‐term investment effects. Hence, policymakers may

need to complement such reforms with other measures that stimulate investment. Moreover,

the observed growth in the use of TCRs (Merlo & Wamser, 2015) may be attributed to pol-

icymakers maximizing short‐term objectives. This may happen owing to political economy

reasons. Foremny and Riedel (2014) find evidence that local business taxes' growth significantly

slows in election years and significantly increases in the year after an election. A possible

explanation of the results is that shortly before (after) an election, policymakers care more (less)

about reelection and are more (less) likely to put a higher weight on their policy's short‐run

impact. This paper's results suggest that TCR policies may also involve a conflict between the

short and long term. Hence, if political economy considerations affect the choice of corporate

taxes, they may also impact the setting of TCRs.

Moreover, this paper contributes to the theoretical literature on the welfare implications of

internal debt, which finds conflicting results. The two seminal papers are by Hong and Smart

(2010) and Haufler and Runkel (2012) and both studies consider static models. First, Hong and

Smart (2010) find that (some) internal debt is unambiguously welfare‐improving for a small

open high‐tax country. I show that the results of the static model of Hong and Smart (2010)

hold in the long term but might be reversed in the short term. Second, Haufler and Runkel

(2012) find in a two‐country model with a fixed capital supply and no redistributive motive by

the government that zero internal debt is optimal (from the social planner's perspective).

my model, the short‐term capital stock is fixed due to its adjustment costs. In the absence of a

strong redistributive motive, welfare is decreasing in internal debt in the short term. Thus, the

Haufler and Runkel (2012) result also holds in the short term of a one‐country model with

elastic capital supply.

Additionally, the paper examines two extensions of the model. The first extension considers

a time‐varying statutory tax rate and shows that all results remain qualitatively unchanged. The

second extension endogenizes the domestic firm's capital stock, which is shown to be declining

in the TCR. The reason is that, by stimulating investment by the MNE, internal debt exerts a

Haufler and Runkel (2012) also find that local governments choose to allow for debt financing. However, this is a

race‐to‐the‐bottom result. Thus, debt financing makes each country worse‐off.

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positive effect on wages, and hence lowers both labor and capital demand in the domestic

sector. While this extension is analytically intractable, numerical analysis shows that the long‐

term welfare effects of TCR relaxation may be negative (owing to its negative impact on

domestic capital).

This paper is related to the literature on the implications of profit shifting for nonhaven

countries' welfare. All in all, there is no consensus on whether tax havens are good or bad. On

the one hand, eliminating tax havens is beneficial to nonhaven countries if it improves public

good provision (Haufler & Runkel, 2012; Slemrod & Wilson, 2009) or if it removes the secrecy

of firm ownership (Weichenrieder & Xu, 2019). On the other hand, eliminating tax havens may

have an ambiguous impact on nonhavens' welfare if it intensifies the tax competition among

the high‐tax countries (Johannesen, 2010) or if it is only partial and lowers competition among

the remaining havens (Elsayyad & Konrad, 2012). Some profit shifting may benefit high‐tax

countries if it raises the optimal tax rates of low‐tax jurisdictions (J. Becker & Fuest, 2012).

Moreover, international tax planning may be good for nonhavens if MNEs' organizational form

responds to tax discrimination (Bucovetsky & Haufler, 2008), if governments respond to tax

planning by changing their tax enforcement strategies (Chu, 2014), or in the presence of

lobbying by the owners of immobile capital (Chu et al., 2015). Peralta et al. (2006) find possible

beneficial welfare effects of profit shifting among nonhaven countries when the MNE also

chooses the location of its productive subsidiary. Choi et al. (2020) find that some profit shifting

may mitigate inefficiencies of MNE production and thus benefit consumers in high‐tax

countries.

This paper differs from the remaining literature by developing a dynamic model that dif-

ferentiates between the short‐and long‐term effects of profit shifting. It is also the first to derive

nonmonotone welfare effects of profit shifting.

Moreover, closely related are Gresik et al. (2015,2020) who analyze, in a static model, the

interrelation of internal debt and transfer pricing. They analyze the case where transfer price

manipulation is so aggressive that it eliminates the benefits of Foreign Direct Investment (FDI).

In such cases, setting a restrictive TCR is the optimal policy that discourages MNEs from

investing in the country.

This paper is also related to the literature on dynamic tax competition. Wildasin (2003)is

the first to show that the government of a dynamic small open economy chooses a positive

time‐invariant tax on capital, while Wildasin (2011) extends the analysis to two mobile factors

of production. Moreover, Wildasin (2003) shows that mobile capital taxation may benefit im-

mobile factors of production in the short run even if it is harmful in the long run. Thus, he

derives nonmonotone welfare effects of capital taxation. This paper extends the seminal

Wildasin (2003) framework to study profit shifting. By doing so, I show that profit shifting may

also exert similar nonmonotone effects.

Finally, this paper is related to the recent literature that studies the real effects of profit

shifting. Suárez Serrato (2019) finds that eliminating profit shifting to tax havens lowers in-

vestment, employment, and wages of affected US multinationals with negative spillover effects

to other firms. Alvarez‐Martinez et al. (2018) find profit shifting to have positive effects on

Furthermore, Desai et al. (2006a) find empirical evidence that high‐growth firms are more likely to operate in tax

havens. Desai et al. (2006b) explain this result theoretically in a model, where tax haven use raises the return on

investment.

Additionally, this literature analyzes the interaction between tax competition and economic growth (see, e.g.,

D. Becker & Rauscher, 2013; Köthenbürger & Lockwood, 2010).

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investment and gross domestic product (GDP) in the European Union (EU), the United States,

and Japan (these effects are, however, insufficient to compensate for the loss in tax revenues).

Buettner et al. (2008,2018) and De Mooij and Liu (2018) find negative effects of internal debt

restrictions on investment by MNEs' subsidiaries, while De Mooij and Liu (2020) find similar

effects for restrictions on transfer price manipulation. Klemm and Liu (2019) show that profit

shifting may stimulate investment in both high‐and low‐tax countries. The present paper

contributes to this literature by linking the real effects of profit shifting to welfare in the short

and long term.

The rest of the paper is structured as follows. Section 2presents the model. Sections 3and 4

derive the optimal tax policy and the welfare effects of internal debt, respectively. Section 5

presents the extensions, and Section 6concludes.

2|THE MODEL

I consider a dynamic model of a small open high‐tax country akin to the static framework of

Hong and Smart (2010). There are two types of infinitely lived agents in the economy: workers

and a representative entrepreneur. The economy produces a single homogeneous good in

two firms (sectors): a domestic firm owned by the entrepreneur and a foreign‐owned subsidiary

of a multinational firm. Workers supply one unit of labor, which is fully mobile between the

national and multinational sectors.

The domestic sector employs labor input

and fixed entrepreneurial capital

produce the homogeneous good.

Suppressing the exogenous capital stock, the domestic

production technology is given by

L()

d,where

G>0>

LLL

, where the subscript denotes a

partial derivative. Thus, labor has positive, but diminishing marginal product. Denote the

time‐invariant statutory tax rate as

,theperiod

labor employed by the national sector as

and the period

wage rate as

Then, the after‐tax profit of the entrepreneurial firm in

period

πτGL wL=(1−)( ( ) −)

Ddd

(1)

In each period, the entrepreneur maximizes the after‐tax profit (1) over the labor input L

which results in the labor demand equation

Lw()=

Ltt

d(2)

The MNE's subsidiary is modeled similarly to Turnovsky and Bianconi (1992) and Wildasin

(2003). It uses the constant returns to scale technology FKL(, )

m, where

is the capital stock,

the labor input, and F(

)

⋅has positive but diminishing marginal products. The firm has an

initial capital stock

K(0) =

. The initial capital stock is fully equity financed by the parent,

either through new equity issues or retained earnings.

Table 1summarizes the definitions of all variables and parameters in the model.

I relax the assumption of a time‐invariant tax in Section 5.

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