Production Location of Multinational Firms under Transfer Pricing:
The Impact of the Arm’s Length Principle
Hayato Kato1

Hirofumi Okoshi2

1 Keio University
2 LMU Munich

ATW2018 @ Univ of Auckland
March 2018

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Corporate tax rates are one of the major determinants of firms’
location decisions.
Consider two countries with different tax rates.
Q. Which country does a MNE with multiple plants choose tolocate?

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Corporate tax rates are one of the major determinants of firms’
location decisions.
Consider two countries with different tax rates.
Q. Which country does a MNE with multiple plants choose tolocate?
A1. Most of the plants are located in the low-tax country(co-location).

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Corporate tax rates are one of the major determinants of firms’
location decisions.
Consider two countries with different tax rates.
Q. Which country does a MNE with multiple plants choose tolocate?
A1. Most of the plants are located in the low-tax country(co-location).
A2. Some plants are located in the high-tax country, while others arein the low-tax country (separate location).

2 / 33Corporate tax rates are one of the major determinants of firms’
location decisions.
Consider two countries with different tax rates.
Q. Which country does a MNE with multiple plants choose tolocate?
A1. Most of the plants are located in the low-tax country(co-location).
A2. Some plants are located in the high-tax country, while others arein the low-tax country (separate location).
→ MNEs can internationally shift profits between affiliates bymanipulating intra-firm prices (transfer prices).
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Transfer pricing• MNEs use transfer pricing to avoid tax payments.

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Location choice under transfer pricing

MNEs may locate some plants/affiliates in high-tax counties for
tax-manipulation motives.
Q1. In what situations do MNEs choose co-location/separatelocation?

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Global attention

The OECD has launched a project to discuss international
measures to prevent tax evasions of MNEs (“Base Erosion andProfit Shifting”).
Revenue losses from tax evasions of MNEs are estimated at from
4-10% of global corporate income tax revenues.

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Arm’s Length Principle (ALP)
MNEs are supposed to follow the Arm’s Length Principle (ALP).
→ Upstream affiliates should set the same price for both related
and unrelated downstream firms.

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Arm’s Length Principle (ALP)

Q2. How does the imposition of ALP affect MNEs’ location
decisions?
Q3. Does ALP increase tax revenues?

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Related literature. Empirics.
• Swenson (2001: NTJ); Clausing (2003: JPubE); Bernard, Jensen andSchott (2006: NBER). Earlier studies on transfer pricing.
• Schjelderup and Søgard (1997: ITAX); Haufler and Schjelderup (2000:OEP); Nielsen, Raimondos and Schjelderup (2003, 2008: JPET). Transfer pricing and ALP without location choice.
• Bauer and Langenmayr (2013: JIE); Egger and Seidel (2013: EER); Choi,Furusawa and Ishikawa (2017). Location choice (tax competition) without transfer pricing/ ALP.
• Haufler and Wooton (1999: JPubE); Ma and Raimondos (2015)

 Our contribution: location choice + transfer pricing + ALP.
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SetupPartial equilibrium model with imperfect competition.
A downstream affiliate of a MNE is located in the host country.
The MNE locates an upstream affiliate whether in the host(co-location) or the parent (separate location).

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Benchmark case (no ALP)(= Different input prices between the D affiliate and the local rival)

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Scheme 1: Co-location
Pre-tax profits of the D affiliate and the local rival:
π = (p − g )q,π∗ = (p∗ − g∗ )q∗ .
Post-tax profit of the MNE:
Π = (1 − T )π̄ + (1 − t)(πu + π),| {z } |{z}ParentHostwhere πu ≡ (Pre-tax profit of the U affiliate)= (g − c)q + (g∗ − c)q∗ .
One-to-one transformation from inputs to final goods.
π̄: exogenous profit in the parent.

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Co-location scheme: Equilibrium
Input prices:g=

1 + c (2 − b)(1 − c),−22(2 − b 2 ){z}|Strategic effectg∗ =1+c.
2b: (inversed) measure of product differentiation.
g < g∗ because of strategic effect: input prices are set so as tomake the D affiliate competitive.

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Co-location scheme: Post-tax profit

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Separate-location scheme: Equilibrium
Input pricesgS =1+c(2 − b)2 (2 + b)(1 − c)(t − T )(2 − b)(1 − c)+−,22(2 − b 2 )2(2 − b 2 )[2t − (4 − b 2 )T + 2 − b 2 ]{z} |{z}|=gg∗S =

Tax−manipulation effect

1+c(> g S ).
2t < T → Tax-manipulation effect is negative.
→ The MNE shifts profits from the U affiliate in the parent to theD affiliate in the host.
→ g S gets lower as the tax difference is larger.
Empirically supported by Clausing (2003: JPubE).
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Separate-location scheme: Post-tax profit

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Equilibrium location choice

3−2b 2 +1• If parent’s tax rate T is high enough: T > T ≡ b3b−2b2 −2b+4 .
S• U locates in the parent if Π < Π while in the host otherwise.

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Empirical implications
Taxes as a determinant of bilateral FDI flow from country j to i:
FDIij = β0 + β1 (Taxi − Taxj ) + X β + uij .
Lower taxes are supposed to attract more FDI: β1 < 0.
Empirical studies report mixed estimates of β1 (a survey byBlonigen 2005).
Our story suggests that if the tax difference is huge,
one may get β1 > 0.

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Arm’s Length Principle (ALP) case(= Same input prices between the D affiliate and the local rival)

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Equilibrium quantity and price under ALP

Co-location scheme:
g̃ =

1+c
1−c−
22(3 + 2b)

Separate-location scheme:g̃ S =

1−c1+c(1 − c)(2 + b)(t − T )−+22(3 + 2b) (3 + 2b)[t − 2(2 + b)T + 3 + 2b]
|{z}
=g̃

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Comparison of input prices

Benchmark case (no ALP):• Arm’s Length price for rivals ⇑ ∵ market power.
• Internal/transfer price for D affiliates ⇓ ∵ strategic andtax-manipulation effects.
With ALP, these two prices must be identical.
Given the location, it holds that(transfer price) < (price under ALP) < (Arm’s length price).

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Equilibrium location under ALP• U always locates in the low-tax host (co-location).

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Tax revenues

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• Before ALP → Separate location = U affiliate in the parent.
• After ALP → Co-location = U affiliate in the host.

• Does this location change lead to greater tax revenues?
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Tax revenues in the host

By imposing ALP, the host attracts the U affiliate.
Upstream profit ⇑ → tax revenues in the host ⇑.
Because of no tax manipulation and strategic effects, the transfer
price becomes higher, making the D affiliate less competitive.
Downstream profit ⇓ → tax revenues in the host ⇓.
As the negative effect dominates, ALP decreases tax revenues inthe host.

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Tax revenues in the world
Global tax revenues = Tax revenues in the host and the parent.
Without ALP, the U affiliate sets a too low transfer price toobtain positive profits.
Negative profits are covered by profits from other business.
With ALP, the U affiliate gets positive profits.
ALP in general increases global tax revenues.

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Conclusion
Q1. Location choice.
A. If the international tax difference is large, the separate locationis chosen.
Q2. The impact of ALP.
A. The introduction of ALP may change location patterns.
Q3. Tax revenues.
A. Location change induced by ALP decreases revenues in thehost, but increases in the world.

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Thank you for your attention !

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