University of Groningen
Taxing the multinational enterprise
Foss, Nicolai J.; Mudambi, Ram; Murtinu, Samuele
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Journal of International Business Studies
DOI:
10.1057/s41267-018-0159-3
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Foss, N. J., Mudambi, R., & Murtinu, S. (2019). Taxing the multinational enterprise: On the forced redesign
of global value chains and other inefficiencies.
Journal of International Business Studies
,
50
(9), 1644-1655.
https://doi.org/10.1057/s41267-018-0159-3
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POINT
Taxing the multinational enterprise: On
the forced redesign of global value chains
and other inefficiencies
Nicolai J Foss
1
,
Ram Mudambi
2
and
Samuele Murtinu
3
1
Bocconi University, Milan, Italy;
2
Department of
Strategic Management, Fox School of Business,
Alter Hall, Temple University, Philadelphia,
PA 19122, USA;
3
University of Groningen,
Groningen, The Netherlands
Correspondence:
R Mudambi, Department of Strategic
Management, Fox School of Business, Alter
Hall, Temple University, Philadelphia,
PA 19122, USA.
Tel: 1-215-204-1692;
Fax: 1-215-204-8029;
e-mail: ram.mudambi@temple.edu
Abstract
The taxation of the multinational enterprise (MNE) has been a continuing
concern for policymakers. We argue that the changing nature of the mobile
MNE (e.g., its improved ability to fine-slice the value chain and disperse it
geographically) makes it increasingly important to rethink current tax policies.
First, there should be more focus on the inefficiencies that arise when taxation
leads to the inefficient location of MNE activities. Thus, MNEs may shift
activities to low-tax jurisdictions that offer lucrative pecuniary and non-
pecuniary incentives, but do not enable their investments to maximize their
contribution to global value creation. Second, international tax regimes should
ensure that MNEs pay for their consumption of local public goods, and public
finance scholars have long known that the taxation-based distortions are
minimized when the tax objects are immobile. However, the bulk of current tax
policies are aimed at corporate profits that are both poor proxies for the
consumption of local public goods as well as extremely mobile. Integrating
theory from international business, public finance and economic geography,
our analysis demonstrates that moving the incidence of taxation from corporate
profits to dividends and consumption would unambiguously improve both
wealth creation and efficiency.
Journal of International Business Studies (2019) 50, 1644–1655.
https://doi.org/10.1057/s41267-018-0159-3
Keywords: finance; taxation; corporate profit taxation; transfer pricing; public goods
If all that were necessary to bring about compliance with the criminal laws were
to increase penalties, the crime problem would have been solved long ago.
Milton Handler (1975)
INTRODUCTION
Taxing multinational enterprises (MNEs) has been a consistently
frustrating experience for governments and international agencies
(Feldstein, H ines, & Hubbard, 1995). The use of transfer pricing
that in principle allows MNEs to shift profits from high-tax to low-
tax regimes has been a perennially contentious issue, and worries
have grown as global financial flows through offshore financial
centers have increased.
1
Frustrations seem to have grown as
liberalization and pro-market policies have eased the mobility of
Received: 25 June 2017
Revised: 13 February 2018
Accepted: 15 April 2018
Online publication date: 11 June 2018
Journal of International Business Studies (2019) 50, 1644–1655
ª 2018 Academy of International Business All rights reserved 0047-2506/19
www.jibs.net
financial capital (Grilli & Milesi-Ferretti, 1995), and
as the relative decline of the tangible component of
industrial production has made physical capital a
much less effective barrier against the mobility of
firms’ activities (Grossman & Rossi-Hansberg, 2008;
Mudambi, 2008).
It is hardly surprising that governments, needing
to finance public goods as well as government
transfers, are expending significant resources on
investigating and regulating MNEs and trying to set
up, monitor and enforce international tax treaties
and arrangements. Such resources add additional
inefficiencies to the well-known deadweight losses
associated with taxation, identified in the volumi-
nous public choice and public finance literature
(e.g., Tullock, 1967; Goolsbee, 1998).
In this paper, we highlight an additional source
of welfare loss that has received much less attention
– namely the distortion that is introduced when
taxation leads to the inefficient location of produc-
tive MNE activities. MNEs may shift activities to
low-tax jurisdictions that offer lucrative pecuniary
and non-pecuniary incentives – rather than to
those locations where these investments would
maximize their contribution to global value cre-
ation. Such low-tax jurisdictions often do not offer
the mix of external capabilities (e.g., a highly
skilled local labor force, universities, demanding
users) that optimally complement the internal
capabilities of the MNE. However, MNE managers
may choose the immediate benefits of tax incen-
tives over the longer-term global value creation
generated by selecting the location that has the
best match with their internal capabilities. This
implies that tax arbitrage considerations can create
distortions that thus far have received little atten-
tion in the scholarly literature and that are partic-
ularly salient in the context of international
business.
We offer three key and related arguments. First,
the changing nature of the MNE is an important
part of the development described above. MNE
location choices are increasingly ‘‘fine-grained’’ and
flexible as they slice their value chains into ever-
narrower specialized activities. Accordingly, think-
ing about how to optimally design the overall MNE
taxation regime needs to start from a theory of the
MNE that incorporates such ‘‘fine slicing’’ (Mu-
dambi, 2008). We argue that the received theory of
the MNE tends to portray modes of international
investment as both highly ‘‘lumpy’’ and irre-
versible. MNE investment location is viewed as
both ‘‘all or nothing’’ and ‘‘once and done.’’
Established theory therefore has difficulties
accounting for the increasingly fine-grained
breakup of global value chains and is a less reliab le
guide for thinking about how taxation may impact
upon the location of activities and the welfare gains
or losses associated with location choices.
Second, we argue that a key objective in design-
ing international tax regimes is to ensure that
MNEs pay for their consumption of local public
goods. In accordance with basic public finance
theory, this requires identifying less mobile MNE
tax objects. However, the bulk of current tax
policies are aimed at corporate profits that are
extremely mobile.
Third, in addition to being highly mobile, cor-
porate profits are also a poor proxy for the extent of
MNEs’ consumption of local public goods. A firm’s
consumption of public goods tends to be highly
correlated with its level of production. However,
with the massive worldwide decline in spatial
transaction costs (defined as all the costs of under-
taking bus iness transactions over geographical
space, including transportation costs), value cre-
ation and sales locations have become increasingly
disjointed. Value creatio n tends to be driven by the
availability of knowledge-intensive resources or
factors of production, while sales are based on
demand conditions. It has long been known that
corporate profits stem from MNEs’ R&D and mar-
keting knowledge stocks that have little relation-
ship with input use and public goods
consumption.
2
Overall, we go beyond the existing discussion of
the taxation of MNEs that tends to concentrate on
the static issue of transfer pricing. Specifically, we
discuss the dynamics of tax competition involving
MNEs and public decision-makers. On the one
hand, MNEs are increasingly mobile and able to
shift activities flexibly across locations. On the
other hand, public decision-makers (at various
levels) may have mixed motives to tax MNEs.
These include the real imperatives of raising
resources to fund local public goods as well as
populist political posturing in electoral competi-
tion (Rogoff, 1990). Further, public decision-makers
face difficulties not only in imposing taxes on
MNEs, but also in coordinating tax initiatives
among themselves (e.g., because national elections
are not synchronous).
3
The paper is organized as follows. In next section,
we focus on the organization of the modern MNE
and discuss how it has changed over the past
several decades. Following that, we provide a broad
Taxing the multinational enterprise Nicolai J Foss et al
1645
Journal of International Business Studies
overview of the current international tax system as
it pertains to these firms. This allows us to pinpoint
the inefficiencies of the current system. In the next
section, we integrate public finance theory (that
gives primacy to location-centered objectives) with
the realities of today’s MNE; this enables us to
outline a theoretical and practically feasible system
that both minimizes inefficiencies and links taxa-
tion to the activities associated with MNEs’ con-
sumption of local public goods.
THE MULTINATIONAL ENTERPRISE AND
GLOBAL VALUE CREATION
Progress in thinking about international corporate
taxation has to start from a descriptively accurate
theory of the MNE. The received view of the MNE in
the international business and the management
literature still fundamentally derives from the origi-
nal pioneering work of Buckley and Casson (1976)
and other co-founders of the theory of the MNE,
notably Rugman (1981), Hennart (1982)andTeece
(1985). The basic idea is that the MNE is an organi-
zation that internalizes transactions across national
borders. It emerges because cross-border internaliza-
tion is superior to market transactions in terms of
value-maximization/transaction cost minimization.
Much early theory focused on the difficulties (i.e.,
transaction costs) of trading intangible assets (capa-
bilities, culture) across national borders as a key
motive for the existence of the MNE and used similar
reasoning to explain its size and scope. The logic
typically was (and still is) thatownership advantages –
of whatever kind – can be optimally leveraged within
a hierarchy across national borders to locations where
their deployment results in net value-added.
However, international business theory has long
recognized that the structures that govern transac-
tions across borders are many and different (e.g.,
Benito, Petersen, & Welch, 2009). Further, both the
organization theory and international business
literatures have highlighted the fact that firms’
modes of operation can be organized and governed
in a variety of ways. They innovatively create
combinations of governance instruments that are
superior to generic ‘‘governance structures’’ in
handling new or local challenges (Zenger &
Hesterly, 1997). Much of this is made possible by
fundamental advances in managem ent practic es,
methods of allocating costs, and improved ways of
measuring multidimensional performance. Many
of these advances can be traced to advances in
information and communication technologies,
which represent important drivers of falling spatial
transaction costs (Iammarino & McCann, 2006;
Cano-Kollmann, Cantwell, Hannigan, Mudambi, &
Song, 2016). Spatial transaction costs include both
pure iceberg transport costs, as well as other costs
(including the portion of transport costs that are
not affected by distance) arising from transacting
across space. These costs arise from institutional
differences and consist of items like drawing up and
monitoring contracts across institutional and cul-
tural boundaries, protecting valuable commercial
knowledge in regimes where intellectual property
rights are not as well developed as in the home
country, and so on (Mudambi, Li, Ma, Makino ,
Qian, & Boschma, 2018). One implication is that
activities can be dispersed across geographical
locations to a much larger extent. These develop-
ments are highly visible in the context of the MNE.
Global Value Chains and the Modern MNE
The modern MNE differs markedly from the picture
painted in the MNE literature of yesteryear. Part of
the reason is that when the theory of the MNE
began to emerge in the 1960s and 1970s, the world
was considerably less liberalized and shot through
with customs barriers and many other hindrances to
establishing business abroad. Given that spatial
transaction costs across countries and markets were
significant, it made sense to enter foreign markets by
moving entire value chains. At that time, spreading
value chains across multiple destinations was pro-
hibitively costly. This may have led to activities in
MNE value chains being located in countries where
the ‘‘optimal activity-specific’’ productive efficiency
was not maximized because of transaction costs
along the entire value chain (Mudambi & Puck,
2016; Verbeke & Asmussen, 2016). In other words,
the emphasis on the ‘‘discrete, structural alterna-
tives’’ in the analysis of the MNE reflected reality.
However, sustain ed liberalization and the open-
ing of markets and locations around the world
mean that MNEs can not only engage in ‘‘tax-
shifting’’ at lower cost, but can also break the
shackles of discrete, structural choices: they are in a
much better position to realize the benefits of
specialized local resources. First, like firms in gen-
eral, MNEs engage in ongoing experimenta tion
with regard to the way they organize transactions
and access the services of outside partners across
borders (Buckley, 2011). In this process, MNE
boundaries are becoming increasingly diffuse and
porous (Buckley, 2009). Second, empirical analyses
of the loca tion choices of MNEs suggest that they
Taxing the multinational enterprise Nicolai J Foss et al
1646
Journal of International Business Studies
increasingly disaggregate their global value chains
into fine-sliced activities. These activities are often
placed in or sourced from very different locations,
before the final value proposition is orchestrated
through reaggregation (Mudambi, 2008; Contrac-
tor, Kumar, Kundu, & Pedersen, 2010; Buckley,
2011). While this gives rise to substantial manage-
ment challenges, the ongoing trend toward fine-
slicing global value chains (Beugelsdijk, Pedersen,
& Petersen, 2009) suggests that specialization and
location advantages dominate the increased costs
of managing complex contractual and other cor-
porate arrangements across borders. Thus, the
centrifugal tren d is efficiency-increasing overall.
To better understand the drivers and efficiency
implications of the above trend, we need to now
consider both how MNEs are currently taxed and
how locations may compete for MNE activities. The
current tax regime leads to the inefficient location
of MNE activities and thus to inefficiencies in
global value creation. Further, attempts to attract
MNE activities can introduce an element of waste-
ful rent-seeking as locations spend res ources trying
to attract MNEs in competition with other loca-
tions. Additional inefficiencies may result when
locations manage to attract MNE activities (e.g., by
tax breaks or subsidies that may vary in terms of the
extent to which they are hidden) that do not really
fit with the location’s comparative advantage (see
especially McCann & Mudambi, 2004, Table 2:
p. 512).
HOW MNES ARE CURRENTLY (INEFFICIENTLY)
TAXED
The current system of corporate taxation levies
taxes in each location where the MNE reports
profits. It treats MNEs ‘‘as loose collections of
separate entities operating in different countries,
rather than as conglomerates making profits in a
global marketplace’’ (Forbes, 2013). Historically,
this may have arisen from the fact that tax regimes
were designed by practitioners trained in interna-
tional economics and international finance, disci-
plines that have rarely incorporated insights from
international business (Mudambi, 1998a). These
problems have grown worse, since as we have
noted, spatial transaction costs have been rapidly
falling worldwide at least sinc e the beginning of the
1970s
4
and the dispe rsion of MNE global value
chains across locations has dramatically increased
(Mudambi & Puck, 2016; Verbeke & Asmussen,
2016).
Public decision-makers fear that MNEs may free-
ride on the location’s provision of public goods,
that is, they can gain access to (sometimes very
high quality) public goods, but effectively evade
paying their ‘‘fair’’ share of taxes for the provision
and maintenance of these goods. Since govern-
ments usually generate quite high deficits and
accumulated debt, additional revenues from tax-
able corporate profits during their terms in office
translate into additional resources they can use to
increase public spen ding, boosting their political
capital (Rogoff, 1990). However, the goal of max-
imizing tax revenues – as opposed to fostering MNE
investments and knowledge spillovers – is myopic
and inefficient in the long run (Haufler & Sch-
jelderup, 2000).
5
First, corporate income taxes lower MNEs’ incen-
tives to invest, because the higher cost of capital
lowers investment return. By increasing corporate
income taxes, governments benefit from additional
tax revenues in the short term but lose out on the
outcomes and spillovers from corporate invest-
ments (e.g., new employment) in the long run
(Mukherjee, Singh, & Z
ˇ
aldokas, 2017).
6
Further,
governments risk losing the positive externalities
that flow from MNE location; in fact, MNEs are
‘‘flagship firms’’ that are typically at the center of a
dense web of buyers, suppliers and specialized
support firms (Rugman & D’Cruz, 1997). The
potential loss of welfare in the long run caused by
MNE exit seems to be confirmed by the extant
empirical evidence (Devereux, Griffith, & Kle mm,
2002), which has shown that the most prof-
itable MNEs are also the ones whose capital is more
mobile across countries.
Second, because of the flexibility of global value
chains, MNEs can easily shift their profits from
relatively higher corporate inco me tax countries to
relatively lower corporate income tax countries, by
means of tax planning strategies and preferential
tax regimes (for more details, see, Mintz, 2004, and
Mintz & Smart, 2004). To address this practice of
transfer pricing and the associated profit shifting,
OECD governments are coordinating their actions
against preferential corporate tax treatments
designed to attract MNEs, aiming to redu ce tax
competition among countries.
7
However, as argued
by Devereux and Vella (2014), the OECD Base
Erosion and Profit Shifting (BEPS) initiative is quite
far from either solving profit shifting problems or
generating a stable long-run tax system. Even
though tax harmonization among some countries
may work, in general we do not expect to see a
Taxing the multinational enterprise Nicolai J Foss et al
1647
Journal of International Business Studies
