Formula Apportionment or Separate Accounting? Tax-Induced Distortions of Multinationals' Location Investment Decisions

Regina Ortmann, Erich Pummerer

Publication: Working/Discussion PaperWU Working Paper


We examine which tax allocation system leads to more severe distortions with respect to locational
investment decisions. We consider separate accounting (SA) and formula apportionment (FA). The
effects of both systems have been hotly debated in Europe in the past years. The reason is that the EU
Member States are striving to implement a common European tax system that would lead to a switch
from SA to FA. While existing studies focus primarily on the impact of taxes on locational decisions
under either SA or FA, the main innovation of this paper is that it compares both systems with regard
to the level of distortions they induce. We compare the optimal pre-tax investment decision with the
optimal after-tax investment decision and infer from the difference in the allocation of investment
funds which tax allocation system causes more severe distortions. We assume that the multinational
group (MNG) has comprehensive book income shifting opportunities under SA. We find that the
investment incentives under SA are opposed to those under FA for a profitable investment project.
Whereas under SA as much as possible should be invested in a high-tax country, under FA as much as
possible should be invested in a low-tax country. The distortions of locational investment decisions
tend to be more severe under SA than under FA if a greater share of investment funds is to be invested
in a low-tax country from a pre-tax perspective and the investment is profitable. Vice versa, locational
decisions may be more distorted under FA if the optimal pre-tax investment decision requires
investing a major share of funds in the high-tax country. In contrast to the often stated insensitivity of
FA towards income shifting, we find the introduction of a tax allocation system based on FA in
Europe could lead to a severe shift of economic substance to low-tax countries. The results of this
paper are of particular interest for European policy makers and MNGs as our findings may induce
European MNGs to reassess their recent locational investment decisions in the face of a potential
future change in the applied tax allocation system. (authors' abstract)
Original languageEnglish
Place of PublicationVienna
PublisherWU Vienna University of Economics and Business
Publication statusPublished - 2015

Publication series

NameWU International Taxation Research Paper Series

WU Working Paper Series

  • WU International Taxation Research Paper Series

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