The paper analyzes multinational enterprises' incentives to manipulate internal transfer prices to take advantage of tax differences across countries, and implications of transfer-pricing regulations as a countermeasure against such profit shifting. We find that tax-motivated foreign direct investment (FDI) may entail inefficient internal production but may benefit consumers. Thus, encouraging transfer-pricing behavior to some extent can enhance social welfare. Furthermore, we consider tax competition between two countries to explore its interplay with transfer-pricing regulations. We show that the FDI source country will be willing to set a higher tax rate and tolerate some profit shifting to a tax haven country if the regulation is tight enough. We also indicate a novel mechanism through which it is the larger country that undertakes tax-motivated FDI, the pattern we often observe in reality.
Bibliographical noteFunding Information:
This paper is an extensively revised version of a part of Choi et al. (2018) . The authors wish to thank Arnaud Costinot (coeditor) and two anonymous referees for helpful comments and suggestions. We also thank Hayato Kato, Yuka Ohno, Pascalis Raimondos, Martin Richardson, Jay Wilson and participants in various conferences and seminars for valuable discussions and comments. This research was initiated during Choi's visit to Hitotsubashi Institute for Advanced Study whose hospitality is greatly appreciated. Choi acknowledges financial support from the Ministry of Education of the Republic of Korea and the National Research Foundation of Korea : Grant Number NRF-2020S1A5A2A01040865 . Furusawa and Ishikawa acknowledge financial support from the Japan Society of the Promotion of Science through the Grant-in-Aid for Scientific Research (A): Grand Numbers 19H00594 and 17H00986.
© 2020 The Authors
All Science Journal Classification (ASJC) codes
- Economics and Econometrics