The income of Puerto Rican affiliates of U.S. corporations is essentially untaxed by either Puerto Rico or the United States. This lowers the tax penalty on investment there, and also makes it attractive to shift reported taxable income from the U.S. parent corporation to the Puerto Rican affiliate. This paper investigates these two interrelated impacts of taxation by developing a structural econometric model of the joint decisions regarding investment and income shifting, and estimating the model using firm-level data on the activity U.S. corporations in Puerto Rico. The results suggest that the income shifting advantages are the predominant reason for U.S. investment in Puerto Rico.

Three interrelated aspects of U.S. multinational corporation activity are analyzed here: the ability to shift profits from high-tax countries to low-tax countries; the impact of host country taxes and tariffs on the distribution of real capital; and the influence of these policies on international trade patterns of the United States and host countries. The cross-sectional empirical analysis indicates that the observed pattern of reported profits in high and low-tax countries is consistent with income shifting behavior and that real investment responds to host country effective tax rates and tariffs. The United States appears both to import more from and export more to low-tax countries where MNC investment is greater, but this bilateral focus must be amplified to consider multilateral effects if trade benefits are to be projected.