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US drug companies' foreign profits grow. Suspiciously.

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Sandy Huffaker/The New York Times/File

(Read caption) Scientist Jing Yuan works in a lab at Pfizer in San Diego. Foreign profits at Pfizer and six other US drug companies quadrupled between 1997 and 2008 while their domestic profits fell by a third. Research suggests they're shifting profits abroad to avoid high US taxes.

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Marty Sullivan of Tax Notes magazine has documented the location of profits of U.S. pharmaceutical companies for years. Each article he writes contains eye-popping figures. Last week’s was no different.

In the March 8 issue, Marty used annual reports to chart the before-tax profits of seven large U.S. drug companies over the last decade or so. Here’s the story: between 1997 and 2008, foreign profits of Abbot Laboratories, Bristol-Myers Squibb, Eli Lilly, Johnson & Johnson, Merck, Pfizer, and Scherling-Plough quadrupled from about $9 billion to $37 billion. Over the same period, their U.S. profits fell by a third from $17 billion to $11 billion. Bottom line: the share of U.S. pharmaceuticals’ profits earned abroad has grown dramatically—from about one-third in the late 1990s to nearly four-fifths in 2008.

What’s going on? Do taxes play a role? In a recent working paper, Treasury’s Harry Grubert, who has studied the location of U.S. multinational profits at least as long as Marty has written on the topic, sheds some light on the issue.

Harry uses tax return data to look at all U.S. multinationals (except financial companies), not just pharmaceuticals. He documents a 14 percentage point increase in the foreign share of U.S. multinationals’ worldwide income from about 37 percent in 1996 to 51 percent in 2004 (the most recent year of available data).

Harry considers five possible explanations for the dramatic increase in profits abroad: 1) the globalization of sales; 2) the growth in domestic losses; 3) the decrease in taxes abroad and consequent pressure to shift income to low-tax locations to take advantage of those lower rates; 4) the higher growth rate of companies already doing more business abroad at the beginning of the period than other companies; and 5) changes over the period in how the U.S. taxes international income.

Harry’s analysis suggests that it’s taxes and not the globalization of sales that play an important role in explaining the jump in the foreign share of U.S. companies’ profits. Low and falling average tax rates abroad—they fell by about 5 percentage points between 1996 and 2004—have led U.S. companies to shift their profits overseas. And U.S. tax policy has also played a role. Marty’s story and Harry’s analysis both suggest that the U.S. needs to change its tax policy towards multinationals.

Taxes do matter for the location of profits. How many more Tax Notes stories and careful studies do we need before we engage in a thoughtful discourse on international tax reform?

The problem is not the absence of options: we could lower the corporate tax rate and tax all foreign profits as they are earned, we could exclude foreign profits from U.S. taxation (though that could make the income shifting problem even worse), we could make incremental reforms (and, to his credit, President Obama has suggested some in his budgets), or we could use formulas to allocate profits (although Harry and I caution against such a move in recent work). The point is that we need to engage in a serious dialog on international taxation soon —before U.S. multinationals have shifted all of their profits abroad.

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