Tax policy reform in Chile, aimed at reducing corporate profit shifting schemes, did not accomplish its intended effects. Instead, the impact was increased business for the tax consulting industry.

In 2019, Google reported 26.5 billion USD in profits in Bermuda. This is clearly not because all of Google’s customers or all of their workers happen to live in that beautiful country. Much more likely, this has to do with strategic tax avoidance by the company, and the fact that Bermuda happens to be a low-tax haven.

It is a long-standing concern that multinational corporations avoid paying taxes by shifting profits to low-tax countries. Profits can be shifted from one country to another by strategically pricing intra-group transactions of goods, services, and assets. For instance, a subsidiary in Chile can buy services at high prices from an affiliate in a low-tax country. This transaction reduces the tax base in Chile and increases it in the low-tax country, lowering the overall tax bill of the multinational corporation. Such profit shifting can severely impact the public finances of governments around the world.

For this reason, the OECD has spearheaded internationally standardized regulations with the goal of curbing international tax avoidance. These reforms involve increased reporting and monitoring of international transactions to enforce the so-called “arm’s length principle.” This principle stipulates that subsidiaries of a multinational firm should transact as if they were separate entities, exchanging goods, services, and assets at their prevailing market price. In practice, the arm’s length principle can be hard to monitor, and the OECD reforms have therefore required more and more reporting to justify the location and pricing of cross-border activities within a multinational group.

“It turns out that there was one great beneficiary of the reform: the tax consulting industry.”

But as multinational firms are required to report more and more information to the tax authorities, and tax authorities spend more and more resources trying to monitor them, a key question remains: How effective are these efforts? And what role does the powerful tax consulting industry play in all of this?

Rigorous evaluation of these questions has proven difficult.Access to the necessary micro-level tax data is scarce, and countries often increase such regulations gradually over time, making it difficult to measure their effects. In a new paper (The Race Between Tax Enforcement and Tax Planning), we shed light on these issues by exploiting a large tax policy reform in Chile aimed at limiting profit shifting. This 2011 reform catapulted Chile from being a laggard to a leader in the adoption of existing OECD regulations at the time.

This provides us with the rare opportunity to analyze the impact of such regulation. We combine extensive quantitative analyses with qualitative insights from in-depth interviews with tax experts. The quantitative analysis uses micro-level administrative tax data on the universe of all medium- and large-size firms in Chile. The qualitative insights are based on interviews with transfer pricing consultants, in-house tax managers at multinational firms, and officers of the tax authority.

The rich administrative tax data allow us to analyze impacts on all potential channels of international profit shifting: payments for services, interests, intellectual property, and goods. We use a difference-in-differences event study design to compare the payments these firms make to their affiliates abroad to those they make to unrelated firms in the same countries. To our own and the tax authority’s surprise, we found zero effects on each of these channels, as well as on total taxes paid by multinationals. The policy turned out to be ineffective in achieving its stated goals.

Did nothing happen at all? Then why was this reform generally perceived among affected firms as a sea change in the taxation of multinational firms in Chile? To find out more, we conducted in-depth interviews with in-house tax accountants, tax consultants, and auditors.

It turns out that there was one great beneficiary of the reform: the tax consulting industry. In Chile, the number of consultants advising multinationals on international transfer pricing at the Big Four consulting firms (i.e., Deloitte, EY, KPMG, and PWC) increased twelvefold in just a couple of years.

Through the qualitative interviews, we learned about some interesting dynamics in this process. Following the reform, many multinationals started to employ tax consultants for compliance support. The consultants then leveraged these relationships to upsell client firms, encouraging them to engage in more complex tax planning. Through such tax planning, consultants helped multinationals to “optimize” their tax payments. This dynamic led to a big increase in demand for transfer pricing experts.

The Big Four consulting firms were able to quickly respond to this demand shock in Chile by importing experts from subsidiaries in other countries, such as Argentina, Colombia, Spain, and Venezuela. This was possible due to the internationally standardized nature of transfer pricing regulations, which made the consultants’ deep experience with transfer pricing regulations in other countries transferable to Chile.

This ability is important because tax consultants for corporations often outnumber officers in the tax authority by an order of magnitude. A report from the British Parliament (Public Accounts Committee, 2013) on tax avoidance and the role of large accountancy firms put it as follows:

“HMRC [the British tax authority] appears to be fighting a battle it cannot win in tackling tax avoidance. Companies can devote considerable resource to ensure that they minimise their tax liability. There is a large market for advising companies on how to take advantage of international tax law, and on the tax implications of different global structures. The four firms employ nearly 9,000 people and earn £2 billion from their tax work in the UK. In the area of transfer pricing alone, there are four times as many staff working for the four firms than for HMRC.”

Our interviews in Chile provide rich qualitative information about the impact of the reform on multinationals and tax consultants. We were able to test some of these insights quantitatively with the administrative tax data. By iterating between qualitative and quantitative analysis, we can test hypotheses generated from the interviews with our administrative tax data.

Specifically, the interviews revealed that one of the most popular strategies was to consolidate service cost centers in a few, tax-advantaged locations. We confirm this mechanism in the administrative tax data, where we find that, indeed, multinationals concentrate their payments to affiliates abroad in fewer countries following the reform. This reduction happens only for non-tax haven countries and—in line with the mechanisms described in the interviews—is concentrated in payments for services. Examples include payments for marketing, HR, or sales activities within the multinational conglomerate. It is particularly difficult for a tax authority to ascertain whether these services are priced in accordance with the arm’s length principle.

Overall, these results suggest that accounting for the tax advisory sector is key to understanding the effects of tax regimes. New reporting and compliance requirements can create an incentive to purchase external tax preparation services, which may in turn facilitate the adoption of more sophisticated tax planning strategies.

Given that the reform increased both compliance and enforcement costs, but did not result in additional tax collections, our combined evidence suggests that the reform benefited the tax advisory industry but decreased overall welfare. In the race between enforcement and tax planning, in this case tax planning seems to have won.

Over the past five years, Juan Carlos Suárez Serrato has received research grants from the International Tax Policy Forum, the Kauffman Foundation, the Russell Sage Foundation, and the Washington Center for Equitable Growth. None of the results in this or other papers have been reviewed by any funding agency.

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