Studies of international transactions often assume that national economies function as separate “islands” or “planets.” Each has its own markets and currency, and international trade and finance occurs when the residents of one economy exchange goods and services or financial assets with those of another. The balance of payments keeps track of the transactions. But in reality firms treat the differences across nations as opportunities to increase their profits, and their decisions on basing the location of their activities–or how they report the basing of the activities–reflect this.

Multinational companies are not new entities; they can be traced back to the European trading companies that colonized the Americas, Asia and Africa. In the twentieth century, firms expanded across borders to get around trade barriers, to obtain access to raw materials, and to produce their goods more cheaply using foreign labor. Advances in the technology of shipping (container ships) and communications (Internet) spurred the development of global supply chains. Firms divided the production of goods among countries in order to manufacture them at the lowest cost before assembly into a final product. Shipments of these intermediate goods have become a major component of international trade, and intermediate inputs represent a significant portion of the value of exports .

This stratification of production has several implications, as Shimelse Ali and Uri Dadush of the Carnegie Endowment for International Peace have pointed out. Bilateral trade balances, for example, are distorted. U.S. imports from China contain a significant amount of intermediate inputs from other countries. Measuring only the value-added by Chinese firms to their exports lowers its trade surplus with the U.S. by a significant amount.

Moreover, tariffs on intermediate goods have impacts all along the global supply chain. The trade restrictions imposed by the Trump administration are rippling through the U.S. economy, raising the costs of production for those firms that depend on foreign supplies of goods that are subject to the tariffs. Daniel Ikenson of the Cato Institute has found that the U.S. transportation, construction and manufacturing sectors are those that are among those most affected by the tariffs. If the tariffs are not removed, firms will reconsider investing in new production facilities.

Global supply links also affect the current accounts of the nations where the multinationals are based. When these firms establish foreign subsidiaries in order to take advantage of cheaper costs abroad, then their home countries record less trade but more primary income resulting from the operations of the subsidiaries. The countries that receive the largest amounts of primary income include the U.S., Japan, France and Germany, all home countries of multinationals with extensive foreign operations. Net primary income does not receive as much publicity as fluctuations in the balance of trade, but the primary income balance has increased in magnitude, and in some cases dominates the current account. Japan’s net income surplus has in some years more than offset its trade deficits, while the United Kingdom’s current account deficit is due primarily to its net income deficit.

These foreign operations also give the multinational firms the opportunity to take advantage of differences in national tax systems. Stefan Avdjiev and Hyun Song Shin of the of the Bank for International Settlements and Mary Everett and Philip R. Lane of the Central Bank of Ireland have shown some of the consequences of these maneuvers. Firms can manipulate the value of their foreign profits in order to lower their tax liabilities. Until recently, the U.S. taxed multinational firms headquartered here on their global profits, with credits given for foreign taxes. The foreign profits were not taxed until they were repatriated. Firms could book profits in low-tax jurisdictions—known as “tax havens”—and keep those profits outside the U.S.

Those foreign profits could be increased by lowering the recorded cost of inputs from the U.S. and raising the value of goods sent back, thus increasing the profits recorded by the foreign subsidiary. Such “transfer prices” should be based on their market value, but in many cases there are none, which give the firms the opportunity to understate their domestic profits and overstate their foreign profits, which are subject to the lower tax. Similarly, intellectual property assets could be shifted to low-tax jurisdictions.

Thomas R. Tørsløv and Ludvig Wier of the University of Copenhagen and Gabriel Zucman of UC-Berkeley have investigated this movement of profits to tax havens. They estimate that about 40% of multinational profits are shifted to tax havens, such as Ireland, Luxembourg and Singapore.  As a result, the home countries of the multinational firms—particularly the non-haven European Union nations—lose tax revenues. The shareholders of the multinationals—particularly those based in the U.S.—are among the main winners.

Governments are well aware of the activities of the multinationals, and the loss of tax revenues. Kim Clausing of Reed College has estimated that profit shifting by U.S. multinational corporations reduces U.S. government tax revenues by more than $100 billion each year. The Organization of Economic Cooperation and Development has taken the lead in formulating policies to tackle what it calls “Base Erosion and Profit Shifting (BEPS). To date over 100 countries have agreed to participate. The recent tax code changes in the U.S. have greatly reduced the incentive for U.S. firms to record and hold profits overseas. Multinationals such as Google and Starbucks are receiving close scrutiny of their international profits, and Apple has been ordered to pay back taxes to Ireland.

The OECD’s initiative, as well as the work of advocacy groups such as the Tax Justice Network, has increased the visibility of the activities of the multinationals designed to lower taxes. But the existence of different factor costs and divergent tax codes will always provide incentives for tax lawyers and accountants to devise new ways of lowering the taxes of the multinationals. In a Westphalian world, domestic governments are reluctant to give up their sovereignty. As a result, multinationals that are much more adept in dancing around national borders will  take advantage of any opportunities they see.