Why do countries change the taxation of foreign-source income of multinational firms?
| Date | 01 March 2020 |
| Published date | 01 March 2020 |
| DOI | 10.1177/0192512118824677 |
| Subject Matter | Articles |
https://doi.org/10.1177/0192512118824677
International Political Science Review
2020, Vol. 41(2) 287 –302
© The Author(s) 2019
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DOI: 10.1177/0192512118824677
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Why do countries change the
taxation of foreign-source
income of multinational firms?
Mi Jeong Shin
Shanghai University of Finance and Economics, China
Abstract
Why do some countries continue to tax income that multinational firms create overseas, even as other
countries increasingly adopt a system that only taxes income generated within the country? I argue that this
phenomenon reflects an interaction between trade openness and the number of veto players. Increasing
trade openness incentivizes governments to move to a territorial tax system, because firms that operate
across borders want to avoid various tax liabilities in multiple countries. Yet countries with fewer veto
players are more likely to move to a territorial tax system than those with many veto players. To test
my hypothesis, I employ survival and logistic regression analyses of 15 advanced industrialized countries
between 1981 and 2013. Overall the findings conform to the expectation: Economically open countries with
fewer veto players are more likely to shift to a territorial tax system than those with many veto players.
Keywords
Territorial taxation, worldwide taxation, foreign-source income of multinationals, trade openness, veto
players
Introduction
The European Union (EU) has recently investigated tax avoidance of many American multina-
tional corporations (MNCs) such as Google, Apple, Amazon, Starbucks, and McDonald’s
(Brundsden, 2016a). The United States (USA) has criticized the European Commission for these
crackdowns, arguing that they target funds the MNCs owe to the US Treasury (Oliver and
Brundsden, 2016). This tension has roots, in part, in the different international tax systems of the
EU and the USA. The US tax system is worldwide, and it imposes taxes on foreign-source income
of MNCs upon repatriation. Conversely, the EU has a territorial tax system that imposes taxes only
on profits generated in its own jurisdictions and it exempts MNCs’ foreign profits from domestic
Corresponding author:
Mi Jeong Shin, School of Public Economics and Administration, Shanghai University of Finance and Economics, 777
Guoding Road, Yangpu, Shanghai, 200433, China.
Email: mjshin0815@gmail.com
824677IPS0010.1177/0192512118824677International Political Science ReviewShin
research-article2019
Article
288 International Political Science Review 41(2)
taxation. Despite tax treaties to avoid double taxation, profits generated by US multinationals in
Europe can, in principle, be taxed by both governments.
Over the last two decades, many countries in the Organization for Economic Cooperation and
Development (OECD) have transitioned into a territorial tax system, but the USA and a few other
countries continue to follow a worldwide tax system. This is puzzling, yet political science scholar-
ship has ignored these differences. Previous research, mostly by business scholars, has focused on
the effects of changes in international tax systems on firms’ behavior, but not what might drive
these changes. This is partly because the previous studies have largely ignored the politics that
translate economic factors into policy outcomes. It likewise reflects a separation between studies
of corporate taxation from studies of taxation of foreign-source income of MNCs. Yet, as I describe
in the theoretical section, the way governments tax foreign-source income of multinationals is not
distinguishable from broader corporate taxation policy in the political science scholarship.
In this article, I first attempt to explain why some countries have switched to a territorial tax
system and others have not by considering the impact of both economic and political features.
Drawing upon the corporate taxation literature, I argue that increasing trade openness prompts
countries to adopt a territorial tax system to attract investment by MNCs. Yet domestic institutions,
veto players, counteract this effect across countries. I test the interactive effects of trade openness
and veto players on the likelihood of changing a country’s international tax system in a sample of
15 advanced industrialized countries between 1981 and 2013, using survival and logistic regres-
sion analyses. The main findings are that trade openness pushes countries to move to a territorial
tax system, but this effect is stronger for countries that have fewer veto players.
The next section provides background and an overview of the existing literature. The third sec-
tion proposes theoretical perspectives to explain the change in the international tax system. The
fourth section introduces data, variables, and methods. The empirical results are presented in the
fifth section. The final section summarizes findings and discusses avenues for future research and
implications.
Background and literature review
Foreign-source income refers to income that MNCs generate in a foreign country. Foreign Direct
Investment (FDI) host countries tax this income based on their domestic law. Thus, to avoid impos-
ing double taxation on their MNCs, FDI source countries either provide a tax credit for foreign
income taxes paid or an exemption from home country taxation (see PriceWaterhouseCoopers,
2010).
Countries can generally be categorized as having either a worldwide or territorial system for
taxing resident companies’ foreign income, although most have some mixed features.1 Countries
with worldwide tax systems impose taxes on the income resident firms produce through domestic
or foreign activities. Countries with a territorial tax system impose taxes on resident firms based on
income only created within the country, not on that generated in foreign subsidiaries. To under-
stand substantive differences between worldwide taxation and territorial taxation, we can take a
look at two examples of how different international tax systems impose taxes on foreign-source
income residential firms in the USA, which has a worldwide tax system, and Japan, which has had
a territorial system since 2009. Suppose that a US multinational firm operates a subsidiary in
Japan. The Japanese subsidiary makes profits and sends part of its earnings to its parent company
in the USA. Then, the Japanese subsidiary pays tax to the Japanese government on their total profit.
The firm needs to pay taxes on the income sent to the USA, but has a foreign tax credit that is
equivalent to the taxes paid to the Japanese government (Clausing, 2012: 704–705). By contrast, a
Japanese multinational firm that operates a subsidiary in the USA pays taxes on the profits of the
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