Tax competition when transfer price is regulated
DOI:
https://doi.org/10.14456/tresp.2019.1Keywords:
Corporate tax policy, Transfer pricing, International trade, Multinational enterprisesAbstract
This paper aims to find the government's optimal corporate tax that maximises revenue (or welfare), as well as minimises distortions of the firm's choices of investment and profit location. We construct a theoretical model of tax competition and tax coordination between two governments when a multinational firm minimises taxes through transfer pricing and the governments have two policy instruments: the tax rate and the transfer pricing penalty rate. We find that (1) tax competition results in too-low a tax rate and under-provision of public goods; (2) when the countries' exogenous penalty rates are different, under government cooperation, the optimal tax rate in each country also different; (3) an attempt by the OECD to have a single transfer pricing penalty rule may not be the only optimal solution for small cooperative governments; and (4) countries over-regulate the multinational firm's transfer prices when they compete on transfer pricing penalty rates. The paper suggests that a country with lenient transfer pricing rules (tax rates) should maintain low tax rates (transfer pricing rule) and a country with a tougher transfer pricing rule (tax rates) should maintain high tax rates (transfer pricing rule).
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