There is a belief among policymakers that a lower foreign tax burden of domestic multinational firms will result in more jobs and increased wages at home. Daniel Garrett, assistant professor of finance at Wharton, challenges this belief in his 2024 paper, “Effects of International Tax Provisions on Domestic Labor Markets,” co-authored with Eric Ohrn of Grinnell College and The Brookings Institution as well as Juan Carlos Suárez Serrato of Stanford and NBER, and supported by the Jacobs Levy Center. In this Q&A, Assistant Professor Garrett discusses his paper’s findings and how the designs of international tax systems affect domestic workers.
Your paper examines two historical adjustments to how the U.S. taxes multinational corporations – “check-the-box” regulations and the “repatriation holiday.” What’s the difference between these two changes and why is this distinction important?
Daniel Garrett: The U.S. historically operated a worldwide tax system with foreign tax credits where all income earned by U.S. companies was taxable at the U.S. rate if the foreign tax rate is lower.
For example, suppose a U.S. firm operated in a relatively high-tax country, like Germany, and a relatively low-tax country, like Ireland. Such a firm would pay taxes on German income to Germany and the tax rate would be higher than the tax rate on income earned in the U.S. However, this firm would pay taxes on Irish income to Ireland at a rate lower than the U.S. rate, so they would owe U.S. tax on the difference between the Irish taxes paid and the relatively higher U.S. tax rate.
“Check-the-box” (CTB) entity election regulations in 1997 opened the door for foreign tax planning, allowing our hypothetical firm to shift income from high-tax Germany to low-tax Ireland without triggering U.S. taxation. This change dramatically lowered effective tax rates on foreign income by allowing U.S.-based multinational corporations to indefinitely delay U.S. taxes and only pay the tax rate of the low-tax countries as long as they don’t directly repatriate the low-tax income to the U.S. parent company. The related “repatriation holiday” in 2004-06 allowed firms to move earnings from foreign subsidiaries to the U.S. parent company without incurring most of the indefinitely delayed taxes.
So, CTB lowers the tax rate on foreign income as it is earned while the repatriation holiday lowers the tax rate on moving cash across international borders.
We ask: do either the current tax rates on foreign income or frictions in accessing foreign cash matter for U.S. workers?
On average, we find evidence that U.S. firms respond to lower foreign tax rates of CTB by decreasing activity in the U.S. while increasing total global activity. On the other hand, we find that the repatriation holiday led to no change in domestic activity in the U.S. by the firms that repatriated. The larger lesson of these two watershed moments in the construction of the U.S. international tax system is that foreign and domestic activity appear substitutable, and the large firms who substitute out of the U.S. are responding primarily to lower tax rates on income as it is earned and not to frictions related to trapping cash abroad.
You conclude that policies lowering the foreign taxes of U.S.-based multinational corporations are unlikely to benefit domestic workers. Were you surprised by this result? Why or why not?
Daniel Garrett: I was surprised that we found that lowering the foreign taxes of U.S.-based multinational corporations is unlikely to benefit domestic workers.
There is existing research that finds that U.S. firms increase their domestic activities when their foreign subsidiaries become more profitable. The general logic of such a response is natural: if a foreign subsidiary is generating more income, then there is more money that the parent company can spend developing new products and investing in the domestic business. We refer to this as the “scale effect” wherein the whole business grows when costs decrease or profits increase at a subsidiary.
When faced with a much lower foreign tax rate on corporate earnings, our paper argues that this scale effect is paired with a “substitution effect”— the firm may shift more activity to foreign jurisdictions to take advantage of lower effective tax rates. For the average U.S.-based multinational corporation, we find evidence that this substitution effect is larger than the scale effect.
However, we don’t observe net substitution for the subset of research-intensive firms where the domestic parent is involved in creating lots of intellectual property that they sell through foreign subsidiaries.
What motivated you and your co-authors to study how domestic workers are impacted by international taxation?
Daniel Garrett: This paper is part of our larger agenda to understand how corporate taxes impact workers.
Tax “incidence” is the idea that whoever remits a tax payment is not necessarily the same agent who bears the economic cost of the tax. A classic model of tax incidence between capital and labor suggests that the input that is less mobile bears tax incidence. Therefore, if capital is more mobile than labor, then a corporate income tax will cause capital to move and workers wind up bearing the tax incidence even though corporations are remitting the tax. The last 50 years of corporate tax research have found all sorts of complications that make measuring incidence interesting and important.
We were really motivated to study the impact of international tax cuts on domestic workers, in particular, by discussion surrounding the Tax Cuts and Jobs Act of 2017. In digging into the many adjustments in tax law, we realized it was challenging to learn about individual incentives because of the large number of moving pieces. Instead, we turned to historical tax adjustments with less other changes happening in the background to learn about why U.S. workers may or may not be impacted by taxes remitted by multinational corporations in foreign countries.
How do you think your findings might contribute to our understanding of multinational companies’ behavior and their effects on the U.S. job market?
Daniel Garrett: We find two headline results: that firms appear to decrease U.S. activity when facing lower tax rates abroad, and that the presence of repatriation frictions is not important to the location of activity of U.S.-based multinational firms.
That firms respond to incentives and move to places where tax rates are lower may seem unsurprising in the face of 44 years of declining global statutory tax rates (from 40% to 23% on average according to the Tax Foundation). Clearly countries have been continually cutting tax rates to try to get more business activity and to create jobs.
What is more surprising is that we document lower foreign effective tax rates lead to less domestic activity and fewer jobs—not just more activity in the foreign market with lower rates. Further, this substitution is not being driven by cash that is trapped abroad since the repatriation holiday does not reverse the original substitution in response to lower foreign tax rates. On average, we find that U.S.-based multinational corporations treat the foreign and domestic market as substitutes.
Our findings question the conventional wisdom that decreasing the foreign tax burden of domestic multinationals will lead to more job creation and higher wages at home. Tax policies that do not incentivize multinationals to shift jobs abroad, such as a country-by-county Global Minimum Tax, are likely better options for policymakers hoping to protect domestic jobs.
Any final thoughts you’d like to share?
Daniel Garrett: It is really, really hard to learn about the activities of multinational firms because of their massive scale. Often, if we want to learn about how a firm responds to a certain policy or tax, we compare one firm that receives some policy or tax treatment to another firm that doesn’t receive that treatment. The problem with international tax changes has been that there are not reasonable comparison firms. There is no analogue to Apple that doesn’t have international operations that we can compare to when Apple is hit by a change in international tax policy.
This fundamental difference between multinational and domestic firms makes it nearly impossible to comprehensively answer simple questions like “Do U.S. multinationals cut domestic employment when they face lower tax rates abroad?”
We take the approach of comparing places in the U.S. with U.S. multinationals to other places in the U.S. that are otherwise similar but where these multinational firms don’t operate. This “local labor markets approach” is a fundamentally different way to study multinational firms that we are hoping will create possibilities to ask new questions about the operations of multinational firms going forward.
Learn more about Daniel Garrett and his research here.
Dive further into this topic with this Brookings blog post.
Visit the Jacobs Levy Center’s website.