Organizational Capacity and Firm Profitability

The paper presented in this ZEW Research Seminar analyses the effect of a firm’s organizational capacity on reported profitability of multinational enterprises (MNEs). Better organizational practices improve productivity and, in principle, increase potential taxable profits of firms. However, higher adoption of these practices may also enable more efficient allocation of profits across tax jurisdictions. The authors present new evidence that MNE subsidiaries with better practices, located in high-tax countries report significantly lower profits and have higher incidence of bunching around zero returns on assets. This is in contrast with the positive relationship with firm performance in these subsidiaries. They show these results are driven by patterns consistent with profit shifting behavior. Using an event study design, it is found that firms with better practices are more responsive to corporate tax rate changes. The results suggest organizational capacity, especially monitoring-related practices, enable firms to engage in shifting profits away from their high-tax subsidiaries.