Multinational Corporations


1. Multinational Corporations

 
 Definition of MNC

Multinational firms arise because capital is much more mobile than labor. Since cheap labor and raw material inputs are located in other countries, multinational firms establish subsidiaries there. They are often criticized as being runaway corporations.

Economists are not in agreement as to how multinational or transnational corporations should be defined. Multinational corporations have many dimensions and can be viewed from several perspectives (ownership, management, strategy and structural, etc.)

The following is an excerpt from Franklin Root, International Trade and Investment

Ownership criterion

Some argue that ownership is a key criterion. A firm becomes multinational only when the headquarter or parent company is effectively owned by nationals of two or more countries.

For example, Shell and Unilever, controlled by British and Dutch interests, are good examples. However, by ownership test, very few multinationals are multinational. The ownership of most MNCs are uninational. (e.g., the Smith-Corona versus Brothers case)

Depending on the case, each is considered an American multinational company in one case, and each is considered a foreign multinational in another case. Thus, ownership does not really matter.

Nationality mix of headquarters managers

An international company is multinational if the managers of the parent company are nationals of several countries. Usually, managers of the headquarters are nationals of the home country. This may be a transitional phenomenon.

Very few companies pass this test currently.

Business Strategy

 global profit maximization

some are home country oriented,

others are host country oriented.

Successful firms: world-oriented, but must adapt to local markets.

 Root's definition

According to Franklin Root (1994), an MNC is a parent company that

(i) engages in foreign production through its affiliates located in several countries,

(ii) exercises direct control over the policies of its affiliates, and

(iii) implements transnational business strategies in production, marketing, finance and staffing that transcend national boundaries.

In other words, MNCs exhibit no loyalty to the country in which they are incorporated. 

Example

Barilla has plants and offices in Greece, France, Germany, Norway, Russia, Sweden, Turkey, US, and Mexico.

Wheat is purchased from around the world.

Reference  Howard V. Perlmutter, "The Tortuous Evolution of the Multinational Corporation," Columbia Journal of World Business, 1969, pp. 9-18.

 

 

2. Three Stages of Evolution

Export Stage

(i)  initial inquiries ⇒ result in first exports.

(ii) Initially, firms rely on export agents. ⇒ expansion of export sales

(iii) ⇒ foreign sales branch or assembly operations are established (to save transport cost)

Foreign production stage

 Why?

(i) There is a limit to foreign exports, due to tariffs, quotas and transportation costs.

(ii) Wage rates may be lower in LDCs.

(iii) Environmental regulations may be lax in LDCs (e.g., China). Itai-Itai disease in Japan since the 1920s was caused by cadmium poisoning. Contaminated effluents flowed into rice paddies and water source.) Watch the movie, Erin Brochovich.

(iv) meet Consumer demands in the foreign countries

 

DFI versus Licensing

Once the firm chooses foreign production as a method of delivering goods to foreign markets, it must decide whether to establish a foreign production subsidiary or license the technology to a foreign firm.

 Licensing

MacDonalds in Moscow
 Licensing is usually the first experience (because it is easy)

e.g.: Kentucky Fried Chicken in the U.K.

Licensing does not require any capital expenditure

Financial risk is zero.

royalty payment = a fixed % of sales
licensor may provide training, equipment, etc.

Problem: the parent firm cannot exercise any managerial control over the licensee (it is independent)

The licensee may transfer industrial secrets to other independent firms, thereby creating rivals.

 Direct Investment

 It requires the decision of top management because it is a critical step.

(i) it is risky (lack of information, large capital requirement)

US firms tend to establish subsidiaries in Canada first. Singer Manufacturing Company established its foreign plants in Scotland and Australia in the 1850s.

(ii) plants are established in several countries

(iii) licensing is switched from independent producers to its subsidiaries.

(iv) export continues (exports and FDI may be substitues or complements)

 Multinational Stage

The company becomes a multinational enterprise when it begins to plan, organize and coordinate production, marketing, R&D, financing, and staffing.

For each of these operations, the firm must find the best location.

 

Global 500 (2008)
The World's Biggest Public Companies
(by sales)
A lion's share of MNCs are headquartered in the US:

Wall-Mart
Exxon Mobil
Royal dutch Shell
BP
Toyota
Chevron
ING
Total
General Motors
ConocoPhillips

How to tell whether a firm is multinational?

Rule of Thumb

A company whose foreign sales are 25% or more of total sales. This ratio is high for small countries, but low for large countries, e.g. Nestle (98%: Dutch), Phillips (94%: Swiss).

Examples: Manufacturing MNCs

24 of top fifty firms are located in the U.S.

9 in Japan (shrinking)

6 in Germany.

Petroleum companies: 6/10 located in the U.S.

Food/Restaurant Chains. 10/10 are headquartered in the U.S.

US Multinational Corporations: Exxon, GM, Ford, etc.

 

3. Motives for Foreign Direct Investment (FDI)

   New MNCs do not pop up randomly in foreign nations. It is the result of conscious planning by corporate managers. Investment flows from regions of low anticipated profits to those of high returns.
 1  Growth motive A company may have reached a plateau satisfying domestic demand, which is not growing. Looking for new markets.

 2 Bypass protection in importing countries

 Foreign direct investment is one way to expand. FDI is a means to bypassing protective instruments in the importing country.

Examples:

(i) European Community: imposed common external tariff against outsiders. US companies circumvented these barriers by setting up subsidiaries.

(ii) Japanese corporations located auto assembly plants in the US, to bypass VERs.

 

 3 avoid high transport costs

Build factors where consumers are.

 Transportation costs are like tariffs in that they are barriers which raise consumer prices. When transportation costs are high, multinational firms want to build production plants close to either the input source or to the market in order to save transportation costs.

Multinational firms (e.g. Toyota) that invest and build production plants in the United States are better off selling products directly to American consumers than the exporting firms that utilize the New Orleans port to ship and distribute products through New Orleans.

 4 avoid Exchange Rate fluctuations

 Japanese firms (e.g., Komatsu) invest here to produce heavy construction machines to avoid excessive exchange rate fluctuations. Also, Japanese automobile firms have plants to produce automobile parts. For instance, Toyota imports engines and transmissions from Japanese plants, and produce the rest in the U.S.

Toyota is behind GM and Volkswagen in China, and plans to expand its production in China and has no plans to build more plants in North America. (China's autoparts are cheaper.) It may have been a mistake for Toyota to overexpand its plants in the US. GM and Volkswagen have expanded their production plants in Shanghai.

komatsu

A Komatsu machine used in ethanol production in Ida Grove, Iowa.

 5 reduce competition  The most certain method of preventing actual or potential competition is to acquire foreign businesses.

GM purchased Monarch (GM Canada) and Opel (GM Germany). It did not buy Toyota, Datsun (Nissan) and Volkswagen. Subsequently, they later became competitors. Toyota is #1 in the car industry.

6 secure essential inputs A foreign country may have the necessary resources (e.g., rare earth minerals).
 7 cheap labor United Fruit has established banana-producing facilities in Honduras.

Due to high transportation costs, FPE does not hold. ⇒Cheap foreign labor. Labor costs tend to differ among nations. MNCs can hold down costs by locating part of all their productive facilities abroad. (Maquildoras)

Komatsu first established its European factory in Belgium in 1967, and its American subsidiary in 1970. Over the years it established many other subsidiaries throughout Europe, Russia, America and Asia.

 

 

4. Export versus Foreign Direct Investment

  Foreign production is not always an answer. Foreign markets can be better served by exporting, rather than by creating a foreign subsidiary if there are economies of scale. If large scale production reduces unit cost, it is better to concentrate production in one place.
 MES

MES is the minimum rate of output at which Average Cost (AC) is minimized. If minimum efficient scale (MES) is not achieved, then export.

In other words, if there exists excess capacity, why not utilize it and export outputs to other countries? There is no point in creating another plant overseas when domestic capacity is not fully utilized.

If foreign demand exceeds the minimum efficient scale, then FDI.

   
  If demand is less than MES, do not build a foreign production plant.
   

 

5. International Joint Ventures

 What is JV?  JV is a business organization established by two or more companies that combines their skills and assets.

 Three forms


Pudong

(i) A JV is formed by two businesses that conduct business in a third country. (US firm + British firm jointly operate in the Middle East)

(ii) joint venture with a local firm, e.g., GM + Shanghai Automotive Industry Corporation (SAIC) = Shanghai GM.

(iii) joint venture includes local government.

Anglo-Iranian Oil Company => was nationalized in 1951:
National Iranian Oil Company
Suez Canal was built by Suez Canal Company (opened in 1869), which was to operate it for 99 years. Nasser nationalized it 1956, 12 years before the lease expired.
 Why form JV?

(i) Large capital costs - costs are too large for a single company

(ii) Protection - LDC governments close their borders to foreign companies. JV bypasses protectionism.

e.g.: US workers assemble Japanese parts. The finished goods are sold to the US consumers.

 Problem  Control is divided. The venture serves "two masters"
 Welfare effects

(i) The new venture increases production, lowers price to consumers.

(ii) The new business is able to enter the market that neither parent could have entered singly.

(iii) Cost reductions (otherwise, no joint ventures will be formed)

(iv) increased market power => not necessarily good for consumers.

   

 

6. Where are MNCs?

  Their offices are located in major international cities, metropolitan areas, and port cities to meet local consumer demands and to acquire resources such as materials and laborers.

Green Gate, Long Street (Gdansk)

Dutch (multinational company) buildings in Long Street, Gdansk, Poland. These were destroyed by Germans during WWII, but were meticoulously rebuilt in accordance with the blue print after the war.

Adolf Hitler demanded that Gdansk be given to Germany, claiming that Gdansk residents were predominantly German. Backed by France and Britain, Poland refused. With this excuse, Hitler invaded Poland on September 1, 1938.

A night scene of multinational firms at Hong Kong harbor.

A view from the mountain top on the other side. Many multinational companies are housed in tall buildings in Hong Kong.

 

7. US Tax Policy towards MNCs

   Operating in many countries, MNCs are subject to multiple tax jurisdictions, i.e., they must pay taxes to several countries. National tax systems are exceedingly complex and differ between countries.

Differences among national income tax systems affect the decisions of managers of MNCs, regarding the location of subsidiaries, financing, and the transfer prices (the prices of products and assets transferred between various units of MNCs)

 Overlapping ⇒ double taxation

 Multiple Tax Jurisdictions create two problems, overlapping and underlapping jurisdictions. When overlapping occurs, two or more governments claim tax jurisdictions over the same income of an MNC. The overlapping may result in double taxation.

 Underlapping ⇒ tax avoidance  Conversely, when underlapping occurs, an MNC falls between tax jurisdictions and escape taxation. Underlapping encourages tax avoidance.
Territorial Tax system National governments may claim territorial jurisdiction or national tax jurisdiction or both.

TT: The government taxes business income that is earned on the national territory.

  • Any business income earned on the US territory is subject to income tax, regardless of whether the business is owned by foreigners.

  • any foreign source income earned by the nationals are exempt from taxation. This approach is used by France, Italy, Netherlands. About 30 countries
  • Tax comptition: Since countries have different tax rates, multinational companies choose low tax countries to save, invest, and produce. Governments may compete to attract multinational enterprises by offering them lower tax rates and other incentives. This is called tax competition. Since high tax countries lose lucrative businesses, they want to harmonize tax rates, especially within a free trade area or customs union (e.g., European Community). For more information on this subject, see Daniel Mitchell's article, Heritage Foundation article on tax competition.
 National Tax system NT: Both domestic and foreign source income of national companies are subject to income tax. US government taxes both domestic and foreign source incomes of US MNCs.


Remark: Most governments that adopts NT system also claim Territorial Tax jurisdiction. This creates the problem of double taxation.

   

 

8. US Taxation of Foreign Source Income

 NT 1. In general the US government does not distinguish between income earned abroad and income earned at home (NTJ).

However, to avoid double taxation, the US government gives credit to MNEs headquartered in the US for the amount of tax paid to foreign governments.

 Burke-Hartke Bill

2. Foreign Trade and Investment Act of 1972 (Burke-Hartke Bill) was defeated.

According to this plan, foreign taxes would be treated as business expenses. For example,

Assume: t = 40% t* = 30% (Spain)

Pretax profit = $1,000

MNC's profit after foreign tax = 1,000 - 300 = 700

If foreign tax is treated as business expense, then

MNC's tax to IRS = 700 × 40% = 280.

Total taxes = 300 + 280 = 580. (45% more)

(To raise more revenue, this idea is being discussed recently.)

 Current Method
Taxes to foreign government = 1000 x 30% = 300

US taxes = 1000 × 40% = 400

but foreign tax credit = 300

Net tax to IRS = 400 - 300 = 100.

Total taxes = 300 + 100 = 400.

  It is essential to have a low tax rate to attract FDI. Foreign investers may invest in Canada or Mexico, rather than in the US.
 corporate tax rates

Japan = 40.69%
China = 33%
Germany =38.31%
France = 33.33% (41% after €1 million ⇒ 75%)
Finland = 26%
Hong Kong = 17.5%
Macau = 12%
US = 40%, Canada = 26%, Mexico = 30%
Russia = 13%
Depardieu (French actor): Putin approved his Russian citizenship)


 

 

10. Transfer Pricing

 Intrafirm trade Transfer prices are the prices paid for imports/exports between the headquarters and subsidiaries. 
 Why manipulate TP?

MNCs manipulate prices between the headquarter and the subsidiaries so that profits are highest in the low tax country.

Purpose: to minimize the total tax a multinational firm pays.

MNCs try to reduce their overall tax burden. An MNC reports most of its profits in a low-tax country, even though the actual profits are earned in a high tax country.

 Example  tp = tax rate in the parent country

th = tax rate in the host country

If tp > th, then lower export prices to the subsidiary in the host country, and raise import prices from the subsidiary. => lower tax.

 
Kunsthalle Museum, Hamburg
 
MNC's Goal: maximize profit in the country with the lowest tax rate.

In High tax countries: To reduce MNC profits:

(i) lower selling price, and

(ii) raise buying prices

In Low Tax countries, do the opposite

Total tax = $135 ($7000 × 15%)

Thus, a multinational company's overall tax could be paid at the minimum of all tax rates of the countries in which it operates.

Abuses in pricing across national borders are illegal (if they can be proved). MNCs are required to set prices at "arms length" (set prices as if they are unrelated).

IRS argued that Toyota Inc. of Japan had systematically overcharged its US subsidiary for years on most of trucks, automobiles and parts sold to the US.

Because of abuses in transfer pricing, taxable profits were shifted to Japan. Toyota once agreed to pay $1 billion to IRS. 

   

11. Taxation and Gains from Factor Mobility

 why invest overseas

US firms invest overseas because the returns are higher there.

(private gains)

 National gains  natonal gains can be higher when investment stays home.
 example  Assume both countries have the same corporate tax rates = 40%

                 US                    Canada
Pretax profits   10%                   12%
Tax               4%                    4.8%
Net to investors  6%                    7.2%


Total Gains from domestic investment = 10% (= 4% + 6%)
because tax revenues can be used for public purposes.
Total Gains from foreign investment = 7.2% (because US government gets nothing). The tax revenue which could have been used to build US highways would be used by Canadian government to build their highways.
   
 

12. FDI Shares

  Stock of outward FDI (The Economist)
1914

(when WWI broke out)

Britain 45%

US 18%

Japan 2%

1967 US 50%, Britain 14%, Japan 2%
2009 US 23%, Britain 9%, China 6% (and rising to 10% in 2010)