The Foreign Market Effect and Estimating Tax-Motivated Income Shifting

We present evidence that the negative association between foreign profitability and tax rates - conventionally interpreted as income shifting - is appreciably driven by the economics of foreign markets unrelated to international tax planning. To improve income shifting estimates, we propose incorporating country fixed effects in foreign profitability-based tests or using domestic profitability-based tests to validate results. We demonstrate that including country fixed effects lowers estimated outbound income shifting from $44.0 million to $29.3 million per US multinational firm annually, representing a 33.4 percent reduction. These recommendations benefit future income shifting research employing profitability-based models.