In particular, we investigate the transfer prices arising from tax-incentivized foreign direct investment and the consequences of ALP when the final good market is dominated by imperfect competition. In order to counter such extreme transfer pricing activities, the parent country of an MNE can tighten its transfer pricing regulations by lowering the transfer pricing ceiling. We show that transfer prices involve a reduction in what the MNE perceives as its marginal cost of production.
Thus, the MNE's home country may wish to encourage its firm's tax saving and transfer pricing activities. 8 We show that the nature of tax competition may depend on the tightening of transfer pricing regulation. We identify the aforementioned new logic of an equilibrium outcome that the larger country is willing to impose a higher tax rate than the smaller country in the presence of transfer pricing regulation.
MNE operates under rigid transfer pricing regulation along the lines of the CP method. We show that the home country chooses a higher tax rate than the foreign country if and only if transfer pricing regulation is tight enough. As a standard case, we first consider transfer price selection by the MNE without any transfer price adjustment.
Without any transfer pricing regulation, the optimal choice of γ for the MNO cannot be less than γ 0.
Transfer-pricing Regulation and the MNE’s Decisions
Optimal Taxation and Transfer-pricing Regulation
Country 2’s Best Response
Country 1’s Optimal Tax Rate
However, if t 1 becomes moderately large (i.e. t < t 1 ≤ t), then it may be optimal for Country 2 to lower the tax rate to induce more output and thus tax revenue in response to an increase in Country 1's tax rate . Finally, if the tax rate in Country 1 becomes sufficiently large (i.e., ¯ t < t 1 < 1), the incentive to shift profits by increasing production becomes too large, while the zero profit condition is binding on the MNE headquarters. Since output is limited and cannot increase any more, Country 2 follows as Country 1 increases its tax rate.
Proposition 3 reveals that country 2 will undercut country 1's tax rate so that the firm in country 1 establishes a foreign subsidiary to engage in transfer pricing if and only if transfer pricing regulation is tight. Accordingly, it chooses the zero tax rate to prevent country 2 from undercutting the tax rate; then the firm has no incentive to engage in FDI to avoid tax. W In this case, the firm engages in FDI if and only if ω > ξ, as illustrated in Figure 4. Since Country 2 enjoys a positive welfare level if and only if the firm establishes its subsidiary there, Country 2's welfare improves if and only if ω > ξ. As Figure 4 illustrates, Country 1's welfare increases if and only if ω > ω 1 ∗ , and world welfare increases if and only if ω > ω. FDI occurs and country 2's welfare improves if and only if ω > ξ, country 1's welfare increases if and only if ω > ω 1 ∗ , and world welfare increases if and only if ω > ω. Since country 2, as a tax haven, can only generate tax revenue from the MNE when ¯ γ < γ ¯ ∗ , it does not always prefer a more relaxed transfer pricing regulation when we consider that country 1's willingness to allow transfer pricing depends on the tightness of such regulation. Does it always have an incentive to choose a higher tax rate to become an FDI source country. We assume L 1 ≥ L 2 , and show that otherwise symmetric countries have different tax strategies in equilibrium when L 1 is sufficiently larger than L 2 : the largest country, State 1, will choose a tax rate higher than that of country 2, to deliberately allow its firm to engage in transfer pricing to save tax payments. If Country 1 chooses a higher tax rate than Country 2, it becomes an FDI source country that maximizes its social welfare, given by (10), for a given t 2 . If Country 1 chooses a lower tax rate than Country 2, on the contrary, it becomes an FDI host country and its best response is given by. To show that country 1's best response is given by (20), we derive country 1's social welfare when it receives and hosts FDI, respectively.
