Antonio De Vito, Martin Jacob, Dirk Schindler, Guosong Xu
Review of Finance, Volume 29, Issue 2, March 2025, Pages 531–565, https://doi.org/10.1093/rof/rfaf006
This paper studies how corporate tax hikes transmit across countries through multinationals’ internal networks of subsidiaries. Prior theoretical models of tax competition suggest that the investment of a multinational in one country should increase if the business unit is exposed to a foreign corporate tax hike. The rationale is that following the tax hike, the parent firm will shift resources from the foreign jurisdiction with higher taxation to the other subsidiary with relatively lower taxation. However, we argue that focusing on tax competition is incomplete because it does not capture the complete picture of multinationals’ networks, which feature significant intra-firm production linkages.
As a novel contribution of this paper, we first develop a model that incorporates (i) tax competition between jurisdictions and (ii) production linkages between subsidiaries within a multinational firm. We show that production linkages can generate negative spillover effects. The intuition is that a tax hike in an upstream subsidiary makes the intermediate good more costly, which reduces the marginal after-tax profitability in a downstream subsidiary and, hence, its investment. Likewise, when a tax hike happens in the downstream subsidiary, the after-tax profitability in the downstream subsidiary falls. This makes investment in the intermediate input by the upstream subsidiary less attractive. Hence, investments decline following a foreign tax hike.
We empirically show that local business units cut investment by approximately 0.5% for a 1% increase in foreign corporate tax, consistent with the negative spillover effect of foreign tax hikes. Our empirical exercise is based on a large sample of subsidiary-level data of multinational companies from 20 European countries during 2004–2017. Using exogenous tax hikes and a stacked difference-in-differences design, we confirm our theoretical prediction that when within-firm supply chain connections are material, the negative spillover dominates the positive spillover effect suggested by the conventional wisdom of tax competition.
Our results are important for policymakers given the increasing budget deficits around the world and the call for raising (corporate) taxes. For example, our results suggest that there may be an unintended negative effect on corporate investment in high-tax countries when the Global Minimum Tax (OECD Pillar 2) is implemented in lower-tax countries with
substantial productive (upstream) subsidiaries, such as Hungary.