Multinational enterprises (MNEs) actively engage in intra-firm transactions across borders. Bernard et al. (2010) report that over 46% of US imports comprised intrafirm transactions in 2000. At the same time, corporate tax rates substantially differ across countries, and some countries adopt preferential tax measures. This implies that MNEs have an incentive to manipulate internal transfer prices to save tax payments, an activity often called ‘transfer pricing’.  Indeed, inspections by the Vietnamese tax authorities have found that “the most common trick played by FDI enterprises to evade taxes was hiking up prices of input materials and lowering export prices to make losses or reduce profits in books”. A number of academic papers also present empirical evidence that MNEs shift their profits from high-tax countries to low-tax jurisdictions (Hines and Rice 1994, Huizinga and Laeven 2008, Bauer and Langenmayr 2013, Davies et al. 2018). For instance, Egger et al. (2010) find that the average subsidiary of an MNE pays about 32% less tax than similar local firms in high-tax countries. According to Goldman Sachs, the tax saving by US MNEs amounts to $2 trillion, equivalent to four years’ worth of US corporate tax revenues (Nikkei, 31 August 2016).

Transfer pricing regulation

To address the issue of tax erosion stemming from tax-motivated FDI, governments impose transfer-pricing rules to control transfer-price manipulation. In particular, the Organisation for Economic Co-operation and Development (OECD) proposed that internal transfer prices follow the so-called arm’s length principle (ALP) in its guidelines for transfer pricing published in 1995 and revised in 2010. The basic approach of the ALP is that the headquarters and affiliates of an MNE should be treated as “operating as separate entities rather than as inseparable parts of a single unified business” and the controlled internal transfer price should mimic the market price that would be obtained in comparable uncontrolled transactions at arm’s length. This kind of comparative analysis is at the heart of the application of the ALP. Currently, the ALP is the international transfer-pricing principle to which OECD member countries have agreed.

Against this background, our new paper (Choi et al. 2020) develops a framework to explore the interplay between transfer-pricing regulations and tax competition.  To this end, we first analyse MNEs’ incentives for manipulating transfer prices to avoid tax payments and the implications of the ALP, when imperfect competition prevails in the final-good market. More specifically, we consider a stylised set-up of two countries with different corporate tax rates, wherein a monopolist that produces and sells its final products in the high-tax country can set up its subsidiary, which produces intermediate goods, in the low-tax country to engage in tax-saving transfer pricing. We show that this monopolistic MNE shifts all its profits to the low-tax country by choosing the standard monopoly price as the transfer price, replicating the monopoly outcome in the market.

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The use of such extreme transfer-pricing activities naturally calls for regulation. Tax authorities audit tax-avoidance behaviors by comparing the prices used in intrafirm transactions with those of similarly uncontrolled transactions between independent parties (i.e. arm’s length prices); this method of the ALP is called the comparable uncontrolled price (CUP) method. In practice, however, it is often difficult to find a comparable transaction of similar products between independent enterprises. This would be particularly so when the final good market is monopolistic and the production of the good requires unique inputs.  In such cases, other ALP methods, such as the cost plus (CP) method, are applied. We thus consider transfer-price caps to be a regulatory measure as in Raimondos-Moler and Scharf (2002), Peralta et al. (2006), Becker and Fuest (2012), and Matsui (2012), among others. In this setup, the choice of a transfer-price cap can be interpreted as a regulation on the maximum allowable mark-up in the CP method.

Tradeoffs between production inefficiency and consumer welfare

Our model allows for a very simple characterization of the MNE’s profit maximisation strategy with the possibility of profit shifting.  It shows that transfer pricing entails lowering what the MNE perceives as its marginal cost of production. The ‘perceived marginal cost’ declines as a result of transfer pricing, because the marginal tax saving that arises from an additional shipment of intermediate goods serves as the marginal benefit of production for the MNE. Not surprisingly, therefore, FDI occurs even if it is less efficient to produce the intermediate goods internally at its foreign subsidiary, because it can be used as a vehicle to lessen its tax burden with an inflated internal price. Interestingly, however, profit shifting with the transfer-pricing regulation may also benefit consumers, because transfer pricing lowers the monopolist’s perceived marginal cost, thereby leading to more production which alleviates allocative inefficiency due to market power. Thus, the MNE’s home country may want to encourage its firm’s tax-saving, transfer-pricing activities to some extent in order to enhance social welfare.  This result can be considered another manifestation of the theory of the second best: in the presence of a distortion in the economy, introducing another market distortion may partially counteract the first, leading to a more efficient outcome (Lipsey and Lancaster 1956).

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Interplays between tax competition and transfer pricing regulations

We have also considered tax competition between (exogenously determined) source and host countries to explore the interplay between tax competition and transfer-pricing regulation. In tax competition (where the host country sets its tax rate after observing the source country), each government non-cooperatively sets the tax rate to maximise its social welfare. We show that the nature of tax competition can depend on the tightness of transfer-pricing regulation. In particular, the source country is willing to set a higher tax rate and tolerate profit shifting to a tax-haven country under sufficiently tight regulation. However, if regulation is too lax, tax competition leads to a ‘race to the bottom’ and eliminates any incentives for tax motivated FDI. This finding implies that a tax-haven country does not always prefer lax transfer-pricing regulation. Thus, the incentives of the host and FDI source country can be aligned to set up global regulatory standards for transfer pricing.

Finally, we have extended our tax competition model to endogenously determine the identity of the source country in a framework with multiple industries. This extended setup allows us to rationalise our basic model by deriving an equilibrium outcome that the larger country is willing to set a higher corporate tax rate than the smaller country in the presence of transfer-pricing regulation. We often observe in reality that firms in large countries establish subsidiaries in small tax-haven countries and engage in transfer pricing. The result that the large country sources FDI also provides some justification for using the aforementioned model with the Stackelberg tax-setting nature, because it is reasonable to think that in reality small tax-haven countries set their tax rates after observing large countries’ tax rates. The welfare impacts of transfer pricing obtained in the sequential-move game can also be extended to the setting of the simultaneous-move game.

Extensions to oligopolistic settings

Our discussion has mainly focused on the simple monopoly setting; however, with oligopolistic market competition, additional issues could arise. For instance, with oligopolistic competition in the final-good market of the FDI source country, the internal transfer price has additional strategic effects that further strengthen the incentive to inflate the transfer price at the expense of rivals’ profits. Tax-motivated FDI by the MNE has spillover effects that reduce tax revenue from other final-good producers as well as the MNE. Moreover, with the presence of competitors that use similar inputs, the CUP method may be adopted as an application of the ALP. In such a case, we can also uncover a novel mechanism for input foreclosure when the input market is also imperfectly competitive. The MNE may have an incentive for input foreclosure even if it is a more efficient input producer. The new mechanism stems from the dependence of the transfer price on the market price of a ‘comparable’ input, which is endogenously determined. Some of these issues are analysed by Choi et al. (2018). In addition, with oligopolistic competition, each firm’s FDI decision may depend on other firms’ FDI decisions. These issues represent potential areas for future research.

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Editor’s note: The main research on which this column is based (Baek et al. 2019) first appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan


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