Investment Liberalization and the Geography of Firm Location

Abstract

We set up a symmetric two-country model with two multinationals competing on the quantities and possibly manipulating their transfer prices.Governments choose both the corporate profit tax rate and the level of enforcement of the "arm's length" principle. We show that stronger enforcement increases equilibrium tax rates. We also find that a larger international ownership of multinationals leads to a "race to the top" in both policies between the two countries, while trade liberalization initially implies a "race to the bottom". But as trade becomes free enough, a further decrease in trade costs raises equilibrium tax rates and enforcement policies.

Transfer Pricing Rules, OECD Guidelines, and Market Distortions

“…More recently, authors use the marginal cost of production as the arm's length benchmark (see, e.g., Kind et al . ; Amerighi ; Peralta et al . ).…”

“…As a consequence, multinationals in the high‐tax country increase their price in the foreign market and reduce their sales there. Naturally, these distortions arise neither when multinationals are free to set their transfer prices and choose to repatriate all the profits to the low‐tax country, nor when tax authorities constrain the transfer price to equal the marginal cost of serving the foreign market (a benchmark that is used by, e.g., Kind, Midelfart‐Knarvik, and Schjelderup, ; Amerighi ; Peralta, Wauthy, and Van Ypersele ; and Nielsen, Raimondos‐Moller, and Schjelderup , ). As expected, pricing distortions translate into distorted organizational choices.…”