Economic Integration and Agglomeration of Multinational Production with Transfer Pricing

TL;DR

This paper models how multinational firms choose locations and shift profits via transfer pricing, revealing that trade costs and tax competition influence plant distribution and international regulation effectiveness.

Contribution

It introduces a two-country model incorporating transfer pricing and trade costs, showing non-monotonic effects of trade costs on plant location and highlighting policy implications.

Findings

High trade costs lead to plant concentration in low-tax countries.

Lower trade costs can reverse plant location patterns.

International transfer pricing regulation can improve tax competition outcomes.

Abstract

Do low corporate taxes always favor multinational production over economic integration? We propose a two-country model in which multinationals choose the locations of production plants and foreign distribution affiliates and shift profits between them through transfer prices. With high trade costs, plants are concentrated in the low-tax country; surprisingly, this pattern reverses with low trade costs. Indeed, economic integration has a non-monotonic impact: falling trade costs first decrease and then increase the plant share in the high-tax country, which we empirically confirm. Moreover, allowing for transfer pricing makes tax competition tougher and international coordination on transfer-pricing regulation can be beneficial.