Economic Integration and Agglomeration ofMultinational Production with Transfer Pricing
Hayato Kato1

Hirofumi Okoshi2

1 Osaka U.
2 Okayama U.

Asian Meeting of Econometric Society@ Curtin U Malaysia.
June 2021

1 / 33• Corporate tax rates are a major determinant of multinational enterprises’(MNEs’) location choice.

Fig. Corporate taxes and foreign affiliates in OECD countries in 2008-16.
Source: OECD Stat.
2 / 33• However, foreign affiliates in low-tax countries do not necessarily engage
in manufacturing activities, contradicting with policymakers’ expectation.

Fig. Corporate taxes and the share of manufacturing affiliates.
Source: OECD Stat.

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The location patterns of MNEs may be quite different fromthose of single-plant firms
because their location choices depend on profit shifting
between their multiple affiliates.
Using a two-country spatial model, we investigate which country,
the low-tax or the high-tax one, attracts multinationalproduction.
Our special focus is on the role of trade costs, which cruciallyaffects the effectiveness of transfer pricing.

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Transfer pricing• Revenue losses from tax evasions of MNEs are estimated at 4-10% of
global corporate income tax revenues.
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Relation to the literature. Our model: new economic geography model with profit shifting,highlighting trade costs and agglomeration.
. Multinationals and taxes• Haulfer and Wooton (1999); Baldwin and Krugman (2004); Shen (2018);
Wang (2020). Transfer pricing with location/organization choice.
• Haufler and Schjelderup (2000); Stöwhase (2005, 2013); Bauer andLangenmayr (2013); Keuschnigg and Devereux (2013); Egger and Seidel(2013); Behrens et al. (2014); Kato and Okoshi (2019)→ Transfer pricing, location choice and trade costs have been studied
separately.
 Our framework unifies these elements.
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AgendaThe model
Location choice of MNEs
Suggestive evidence
Robustness and extensions

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Model8 / 33

ModelFootloose capital model (Martin and Rogers, 1995; Pflüger,2004).
Two countries.
◦ High-tax country 1 and low-tax country 2: t1 > t2 .
Two sectors.
◦ Differentiated manufacturing goods are traded with trade costs.
◦ Homogeneous agricultural good is costlessly traded.
Two factors.
◦ Internationally mobile capital.
◦ Immobile labor.
◦ The amount of factors is the same between countries.
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• MNEs in the manufacturing sector has an production plant and aforeign affiliate (distribution center).

• Ni : #MNEs with their production plants in country i.
• N1 + N2 = (constant): the total # of MNEs is fixed.
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Consumers
Utility function of an individual consumer in country 1:
u1 = µ log Q1 + q1O ,σ" 2 Z# σ−1
X
σ−1Q1 ≡q̃i1 (ω) σ dω.
i=1ω∈Ωi

ω: variety; σ > 1: the elasticity of substitution.

The utility maximization gives the aggregate demand for amanufacturing variety:−σµL1
pi1 (ω)qi1 (ω) ≡ L1 q̃i1 (ω) =P1
P111 / 33

MNEs
The post-tax profit of an MNE with production in country 1:
Π1 = (1 − t1 )π11 + (1 − t2 )π12 − 2R1 ,
R1 : rental rate of capital.
Profit of production plant:
π11 ≡(p − a)q+ (g1 − τ a)q12 .
{z}| 11 {z 11}|

from domestic market

from intra-firm trade

g1 : transfer price, τ > 1: trade costs, a: unit labor requirement.

Profit of foreign affiliate:
π12 ≡ (p12 − g1 )q12 .
|{z}from foreign market

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MNEs’ decision

Timing of decisions:
1. MNEs’ location decision.
2. MNEs set a transfer price for intra-firm transaction.
3. Foreign affiliates set a final good’s price for foreign market.
Solve the problem backward.

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Optimal prices
An MNE with production in country 1 sets prices as:
σg1
στ at2 − t1
g1 =, p12 =, where ∆t1 ≡.
σ − ∆t1σ−1
1 − t1gi is always positive.

The direction of profit shifting:◦ t1 > t2 → ∆t1 < 0 → g1 , p12 ⇓◦ Larger tax difference → lower transfer price.
cf. Empirically supported by Calusing (2003).

Intra-firm trade profit in the high tax country ⇓:(g1 − τ a)q12 ⇓ (and thus π11 ⇓).
Foreign affiliate’s profit in the low tax country ⇑:π12 = (p12 − g1 )q12 ⇑.
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Under t1 > t2 .

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Location choice of MNEs

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Location decisionZero-profit conditions determine the capital return, Ri .
An MNE locates production in country 1 if R1 > R2 .
N1 = n1 L:#MNEs with production in country 1.
N2 = (1 − n1 )L: #MNEs with production in country 2.
Interior equilibrium:
R1 = R2 → n1 ∈ (0, 1).
Otherwise, corner equilibrium:e.g., R1 > R2 → n1 = 1.

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Location choice under no profit shifting

If transfer pricing cannot be used, the profit of an MNE withproduction in country 1 becomesΠ1 = (1 − t1 )(p11 − a)q11 + (1 − t2 )(p12 − τ a)q12 − 2R1 .

The transfer price g does not show up.

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• No profit-shifting case: (transfer price = true marginal cost)• As trade costs decline, production plants relocate to the low-tax
country.

Fig. Plant share under t1 > t2 .
φ ≡ τ 1−σ ∈ [0, 1]: an inverse of trade costs = the trade openness.
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Location choice under profit shifting

If transfer pricing can be used, the profit of an MNE withproduction in country 1 becomesΠ1 = (1 − t1 )[(p11 − a)q11 + (g1 − τ a)q12 ]+ (1 − t2 )(p12 − g1 )q12 − 2R1 .

The transfer price g shows up.

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• Profit-shifting case:• As trade costs decline, production plants first relocate to thelow-tax country and then move to the high-tax country 1.

.
Fig. Plant share under t1 > t2 .
• Introducing profit shifting reduces tax revenues in country 1.

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• At low trade costs, exporting is easy and profit shifting is effective.
• MNEs with production in the low-tax country become less competitivein both countries. ∵ Strategic location choice.
→ Locate production in the high-tax country.

Fig. Under t1 > t2 .
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Suggestive evidence

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Fig. Plant share under t1 > t2 .
• Supposing host country h has a higher tax rate than source country s,i.e., TAXh > TAXs ,(∂(Manufacturing affiliates from s to h) < 0 if φ < φ#.
∂φ> 0 if φ > φ#24 / 33

Estimation equation
According to our theory, bilateral trade openness matters!
Manufacturing affiliates
Affiliates in all sectors

= β1 (TAXh,t − TAXs,t ) × φh,sh,s,t+ β2 (TAXh,t − TAXs,t ) × φ2h,s + X β + eh,s,t .

φh,s : bilateral trade openness between h and s.
In empirics, we use 1/ log(bilateral distance between h and s).
Expected signs: β1 < 0, β2 > 0.
Data
◦ Number of affiliates: OECD stat.
◦ φh,s = 1/ log(bilateral distance between h and s): Mayer andZignago (2011).
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Endogeneity issues
Tax policies in the host country may be influenced by affiliates
there.
We use a difference in political stability for an IV of thecross-country tax difference.
Our identification assumption is that political stability affects thelocation choice of affiliates only through corporate taxes,
once other policies affecting business conditions are appropriatelycontrolled for.
Data
◦ IV. Political stability: World Government Indicators.
◦ Controls. Index of Economic Freedom: Heritage Foundation.
Unit-labor costs, Labor productivity: OECD stat.
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Turning point: φ# = 3.09/(2 × 10.83) ' 0.142 or exp(1/φ# ) ' 1144km.

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Robustness and extensions

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Transfer-pricing regulation

The plant incurs an additional cost of concealing profit-shiftingactivities:
π11 = (p11 − a)q11 + (g1 − τ a)q12 −δ|g1 − τ a|q12 .
{z} |{z} |{z}|Domestic profits

Shifted profits

Concealment cost

Higher δ means a tougher regulation.

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Fig. Impact of transfer-pricing regulation.
• As regulation δ is tougher, agglomeration in high-tax country 1 is lesslikely.

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Tax competition
Consider tax competition in the situation where φ is very high.
Two countries are now assumed to be asymmetric in terms of
the efficiency level in tax administration.
As a result of tax competition with profit shifting,(i) the country with more efficient tax administration sets a higher
tax rate than the other country, while hosting all production
plants.
⇐ Consistent with previous analysis.
(ii) compared with no-profit-shifting case, tax competition becomesfierce.
⇐ Room for international coordination on regulation.
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Conclusion
We presented a spatial model with transfer pricing.
Q. Which country attract production activities?
A. High trade costs → the low-tax country.
Low trade costs → the high-tax country.
A naive view that lower taxes favor multinational production
may be challenged.
The results are robust against a number of extensions such astransfer-pricing regulation, tax competition and pure export
option.
Implications for empirics:
The impact of tax difference on FDI may differ depending on
trade openness.
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Thank you for your attention!

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