We investigate how R&D contributes to rising foreign profitability in U.S. multinational corporations through wage and tax incentives. Our results suggest that wage savings increase foreign profit margins derived from foreign R&D, while tax incentives increase foreign profit margins derived from domestic R&D. By exploring their relative importance, we find that wage savings are more important than tax incentives in explaining foreign profit margins when the wage discount substantially exceeds tax incentives, and vice versa. Cross-sectional tests show that firms respond more to foreign R&D wage savings when they have access to local human talent, but less as the cost of conducting foreign R&D increases. Firms respond less to tax incentives to shift income derived from domestic R&D as transfer pricing risk increases. Our evidence sheds light on the importance of R&D-related income shifting that potentially separates the location of economic activity from the location of income.
JEL Classifications: H25; H26.