Tariﬀ Elimination versus Tax Avoidance:
Free Trade Agreements and Transfer Pricing∗
Hiroshi Mukunoki†

Hirofumi Okoshi‡

May 19, 2021

Abstract
We explore the new roles of rules of origin (ROO) when multinational enterprises(MNEs) manipulate their transfer prices to avoid a high corporate tax. The ROO under afree trade agreement (FTA) require exporters to identify the origin of exports to be eligible
for a preferential tariﬀ rate. We ﬁnd that a value-added criterion of ROO restricts abusivetransfer pricing by MNEs. Interestingly, an FTA with ROO can induce MNEs to shift
proﬁts from a low- to high-tax country. Because the ROO augment tax revenues inside
FTA countries, they can transform a welfare-reducing FTA into a welfare-improving one.
Keywords: Rules of origin; Free trade agreement; Transfer pricing; Proﬁt shifting
JEL classiﬁcation codes: F13; F15; F23; H26∗ This study was conducted as a part of the Project “Analyses of Oﬀshoring” undertaken at the Research Instituteof Economy, Trade, and Industry (RIETI). We wish to thank Jay Pil Choi, Ruud Aloysius de Mooij, Carsten
Eckel, Clemens Fuest, Taiji Furusawa, Andreas Hauﬂer, Jung Hur, Jota Ishikawa, Hiro Kasahara, Yoshimasa
Komoriya, Ngo Van Long, Kiyoshi Matsubara, Kaz Miyagiwa, Monika Mrazova, Martin Richardson, Kensuke
Teshima, and the participants of the Canadian Economic Association meeting, RIETI, 58th congress of ERSA,
Microeconomics Workshop at the University of Tokyo, Summer Workshop on Economic Theory at Otaru Universityof Commerce, and 21st annual conference of ETSG, Workshop on International Economics at Osaka University,
76th Annual Congress of IIPF. Hiroshi Mukunoki acknowledges ﬁnancial support from JSPS KAKENHI (Grant
Numbers JP19H00594 and JP20K01659). Hirofumi Okoshi acknowledges the ﬁnancial support from Deutsche
Forschungsgemeinschaft. (German Science Foundation GRK1928). The usual disclaimer applies.
† Gakushuin University, Faculty of Economics, Mejiro 1-5-1, Toshima-ku, Tokyo171-8588, Japan‡ Okayama University, Faculty of Economics, 3-1-1 Tsushima-naka, Kita-ku Okayama-shi, Okayama, 700-8530,
Japan

1

Introduction

Tax avoidance by multinational enterprises (MNEs) has become controversial in the last two
decades of rapid globalization. The Organisation for Economic Co-operation and Development(OECD) estimates that countries lose 4–10% of corporate income tax revenue annually becauseof proﬁt shifting.1 One way to shift proﬁts across countries is to manipulate the price of
intra-ﬁrm trade (transfer price), which is known as abusive transfer pricing. Because MNEs
determine the prices of transactions among related companies, they manipulate these prices todecrease proﬁts in high-tax countries and conversely increase proﬁts in low-tax countries. Someempirical research has provided evidence of transfer pricing being used to save tax payments.2
Because the taxes paid by ﬁrms are one of the main sources of government revenues, tax
avoidance by MNEs has become a serious issue, as trade liberalization and the creation of
global value chains increase intra-ﬁrm trade and provide MNEs with greater opportunities toredistribute their tax base to low-tax countries.
Our primarily focus is on how such losses of tax revenues are linked to trade liberalization
driven by trade agreements. Trade agreements among countries facilitate ﬁrms’ exports andimports. They also inﬂuence ﬁrm behaviors in other respects including transfer pricing andgenerate more complicated welfare eﬀects. In particular, the speciﬁc rules needed to implement
trade agreements complicate the eﬀects of trade liberalization.
We focus on the rules of origin (ROO) of a free trade agreement (FTA), which require
exporters in member countries making tariﬀ-free exports to other member countries to provethat the exported products originated within the FTA.3 To meet the ROO, ﬁrms may change theirstrategies such as their input procurement. Conconi et al. (2018) concludes that the ROO of theNorth American Free Trade Agreement (NAFTA) reduce imports of inputs from non-member
1See http://www.oecd.org/tax/beps/, accessed on March 11, 2020.
2For instance, Swenson (2001), Clausing (2003), Cristea and Nguyen (2016) and Davies et al. (2018) provided
empirical evidence of the transfer price manipulation. Blouin et al. (2018) found that MNEs have conﬂicting
motives for using transfer pricing to lower corporate tax and tariﬀ payments.
3Regional trade agreements in goods are classiﬁed into FTAs and customs unions. Unlike customs unions,member countries of an FTA can set their own tariﬀ schedule against non-member countries. This oﬀers an
opportunity for ﬁrms producing outside the FTA to save tariﬀ payments by choosing as a transit country themember country whose tariﬀ against non-member countries is low, and then re-exporting from that country toother FTA member countries whose tariﬀs against non-member countries are higher. Stoyanov (2012) presents
evidence of ﬁrms’ incentive to transship a good through FTA members. To forestall ﬁrms from tariﬀ avoidance,
FTA members stipulate ROO.

1

countries, suggesting that such rules cause ineﬃciency in input procurement. Considering tax
avoidance, this also implies that the ROO can hinder MNEs from shifting proﬁts within the ﬁrm
because they may need to consider whether their intra-ﬁrm transactions satisfy the requirementsof the ROO.
One way to prove the origin is to satisfy the value-added (VA) criterion, which is closely
related to transfer price manipulation.4 The VA criterion requires ﬁrms to add a suﬃcient value
inside FTA member countries. Speciﬁcally, let 𝑝 denote the export price of the product and 𝑟denote the value of the input materials, which are used per unit of ﬁnal good production and do
not originate in the FTA. The VA criterion typically requires that the VA ratio ( 𝑝 − 𝑟)/𝑝 is above
the speciﬁed level. This method of calculating the VA content is called the “transaction value
method.” The value of the input materials depends on the transfer price if MNEs procure inputs
from related companies outside FTA countries, and, hence, a VA criterion can constrain MNEs
from engaging in tax avoidance through abusive transfer pricing. However, a VA criterion
allows the MNE an option to meet the ROO without changing its input sources. This violates
the principal purpose of the ROO to increase local procurement of inputs.
Although this possibility has been overlooked in the economic literature on transfer pricing
and FTA, it has been noted by some policy researchers. LaNasa III (1996) stated that “[v]alueadded rules of origin may be circumvented by the use of transfer pricing, . . . to increase theamount of local value added to ensure that the good qualiﬁes as originating in the country ofassembly, related parties could reduce the price of the imported materials used in the ﬁnishedproduct.” Eden (1998) examined the ROO of NAFTA and suggested that “. . . underinvoicing
parts coming outside North America and overinvoicing locally made parts would increase theNorth American content.” Falvey and Reed (1998) indicated that the VA criterion “. . . allows
room for manipulation of prices as well as quantities, and may generate additional incentives
for transfer pricing by multinationals.” Reuter (2012) similarly pointed out that “most rules oforigin are on a percent-of-value basis . . . By overinvoicing the value added, the MNE can moreeasily meet a rule-of-origin test and qualify for duty-free entry for its products into another
4Other ways to prove the origins of products include change in tariﬀ classiﬁcation criterion and speciﬁc process
criterion. Although the eﬀects of these criteria are also important, this study focuses only on the VA criterion.

2

country in the free trade area.”5 The World Customs Organization notes that a disadvantageof the VA criterion of ROO is the possible exposure to transfer pricing.6 A recent report by
Deloitte Touche Tohmatsu Limited reports that exporters should consider an adjustment oftransfer prices when making use of FTAs.7
As Estevadeordal and Suominen (2003) reported that 68 of the 87 FTAs they analyzed
employ a VA criterion at least in a particular product category, the aforementioned statementssuggest that the eﬀect of FTAs on tax avoidance and welfare can be understood clearly if
we investigate the role of the ROO in restricting the abusive use of transfer pricing. Given
the experience of tax avoidance countries face, analyzing the anti-tax avoidance aspect of the
ROO holds crucial policy implications. In reality, diﬀerent groups of policymakers, namely,
customs and tax authorities, are responsible for designing trade policies and regulating transfer
pricing. The interaction between these two authorities has been rare. According to WCO (2018),“. . . the WCO is working with the OECD and World Bank Group to encourage Customs and tax
administrations to establish bilateral lines of communication in order to exchange knowledge,
skills and data, where possible, which will help ensure that each authority has the broadest
picture of an MNE’s business, its compliance record and can make informed decisions on thecollect revenue liability.” Thus, the increasing number of FTAs and volume of intra-ﬁrm tradenecessitates us to explore the relationship between transfer prices and ROO.
Against this backdrop, this study builds an international monopoly model to investigate an
MNE’s response to an FTA formation with two new elements: transfer pricing and ROO.8 We
consider a situation wherein an MNE produces ﬁnal goods within an FTA member country andexports the goods to other FTA member countries. The MNE procures inputs from either an
5Some practitioners see the link as one factor to be considered, noting that “if transfer pricing changes the value of local content, then the ROO as applied may remove
any FTA beneﬁt that was previously available” (see https://www.expertguides.com/articles/
oecd-beps-project-and-trade-new-perspectives/AREXIEUO, accessed on May 3, 2018).
6See
http://www.wcoomd.org/-/media/wco/public/global/pdf/topics/origin/overview/
origin-handbook/rules-of-origin-handbook.pdf accessed on May 3, 2018.
7The report states that “. . . in cases where the preferential calculation is based on the Value Added Rule andthe required threshold is barely reached, an adjustment of transfer prices might lead to the loss of the preferential status of an article.” See https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/tax/
deloitte-ch-en-making-use-of-free-trade-agreements.pdf, accessed on May 1, 2021.
8If we consider local ﬁrms among FTA members and oligopoly in the ﬁnal goods market, the fundamental
properties of our results remain unchanged, although the analysis becomes more complicated. See Mukunoki andOkoshi (2019) for the oligopoly version of the model.

3

FTA member country or a low-tax country outside the FTA. In the absence of ROO, the MNE
always prefers to produce inputs outside the FTA by itself and avoids tax by setting a hightransfer price. However, the presence of ROO restricts the manipulation of the transfer pricebecause a high transfer price reduces the VA ratio of the ﬁnal product inside the FTA. Thus,
the MNE chooses one of three options: (i) fully manipulating its transfer price to avoid tax
payments at the expense of the preferential tariﬀ of the FTA, (ii) procuring inputs inside an FTA
to comply with the ROO and eliminate tariﬀs, or (iii) adjusting its transfer price to comply with
the ROO to eliminate tariﬀs and pursue partial tax avoidance.9 This model exhibits the MNE’s
choice of the “tariﬀ elimination versus tax avoidance” via its location choice of producing inputs
and/or transfer price manipulation.10
When the MNE chooses the second option, it no longer avoids high tax. When it chooses
the third option, its transfer price deviates from the optimal abusive transfer price, which retains
part of the MNE’s tax base in the high-tax country. As the ROO restrict the abusive use oftransfer pricing through either a change in input procurement or an adjustment of the transfer
price, tax revenues in a high-tax country increase. Thus, the VA criterion works as an anti-tax
avoidance policy. Interestingly, the direction of shifted proﬁts can be from a low-tax country toa high-tax country when the MNE adjusts the transfer price to meet the VA criterion. Empiricalanalyses on transfer pricing should consider the possibility that the VA criterion of ROO aﬀects
transfer pricing.
The ROO can also increase the welfare gains of FTA countries because members can collecttax revenues from the MNE. Although consumers’ gains from the FTA are smaller than those
without ROO, tax revenues from the MNE can cover the smaller consumers’ gains and the lossof tariﬀ revenues. Our results present a new role of the ROO in preventing abusive transfer
pricing and increasing the welfare gains of FTA formation for member countries.
9Although the MNE uses its transfer price for complying with the ROO, it can still shift proﬁts from one country
to another to save tax payments when the VA requirement is less stringent and the tax gap is large. Nevertheless,the overall tax payments become larger because the transfer price is suboptimal from the viewpoint of tax savings.
10We use the terms “tax rate” and “tax revenue” to represent the corporate tax rate and corporate tax revenue,
respectively, which we distinguish from the tariﬀ rate and tariﬀ revenue.

41.1 Literature review
Our model contributes to the literature on transfer pricing policies since MNEs have beenaccused of tax avoidance activities. How to regulate transfer prices has been a central issue inpolicy debates. Several studies examine the eﬀects of policies on transfer price manipulation.
Elitzur and Mintz (1996) investigated the determinants of transfer prices when tax authorities
use the cost-plus method to infer the appropriate transfer price. Nielsen et al. (2003) compared
the use of transfer prices under two international tax systems, namely, separating account andformula apportionment.11
Bond and Gresik (2020) examined a high-tax country’s unilateral adoption of border adjusted
taxes and cash ﬂow taxes when heterogeneous ﬁrms choose either arm’s length transactions or
to establish their own subsidiaries in their input sourcing. Choi et al. (2020) examined the eﬀectof the arm’s length principle on a monopolistic MNE’s transfer pricing and tax competition.12
As their focus was on direct regulation on transfer pricing, the role of ROO in preventing abusivetransfer pricing is overlooked in the literature.
Our second contribution is to the literature on FTAs with ROO. Krishna and Krueger (1995)
showed that the ROO may work as hidden protection against input suppliers outside the FTA.
Ju and Krishna (2005) showed that ROO can either increase or decrease the price of FTA-madeinputs, depending on the number of ﬁrms complying with the rules. However, their focus wason intermediate goods markets, and they did not consider how ROO aﬀect consumers.
Demidova and Krishna (2008) extended the work of Ju and Krishna (2005) by including theheterogeneity of productivity of ﬁnal good producers. They showed that productivity sorting
ensures the negative relationship between the stringency of the rules and the demand for FTAmade inputs (i.e., wages). Ishikawa et al. (2007) focused on ﬁnal good markets, showing that
the ROO have a role to segment markets within the FTA, and that both inside and outside
11The traditional international corporate tax system is the separating account system that computes MNEs’
national tax base by regarding intra-ﬁrm transactions as inter-ﬁrm transactions. Conversely, under the formulaapportionment system, the tax payments of MNEs to one country depend on their consolidated tax base and the
proportion of activity operated in the country. See more details in Chapter XVI and Article 86 of European
Commission (2011).
12Bauer and Langenmayr (2013), Choe and Matsushima (2013), and Kato and Okoshi (2019) also investigatedthe eﬀect of the arm’s length principle on the input procurement decision, tacit collusion, and input production
location, respectively.

5

ﬁrms producing ﬁnal goods may beneﬁt from the ROO at the cost of consumers. Mukunoki(2017) showed that an FTA with ROO may harm consumers if it changes outside ﬁrms’ location
decisions. Mukunoki and Okoshi (2021) investigated a ﬁrm’s export price manipulation tocomply with the ROO, particularly how an MNE’s transfer price manipulation aﬀects the
inputs imported from outside the FTA. None of these studies, however, consider transfer pricemanipulation to meet ROO. Felbermayr et al. (2019) suggested that there is little rationale for
ROO because tariﬀ circumvention is not proﬁtable for 86% of bilateral trade owing to the small
diﬀerences in external tariﬀs and non-negligible transport costs. This study thus provides a new
rationale for the ROO from the viewpoint of tax avoidance by an MNE.
This study also examines the connection between transfer pricing and trade policy. In
this regard, Horst (1971) showed that the optimal transfer price is inﬂuenced by not only tax
diﬀerentials but also tariﬀs. Schjelderup and Sorgard (1997) showed that if the importing
country imposes an ad valorem tariﬀ on inputs, an MNE can save tariﬀ payments by reducing
its export price. Subsequently, the optimal transfer price is inﬂuenced by both corporate tax
avoidance and tariﬀ avoidance.13 Kant (1988) regarded the transfer price as a tool to repatriate
proﬁts when a foreign subsidiary is not fully owned by the parent ﬁrm. The study found thateven when the tax rate in the home country is higher than that in the host country, an MNE has
an incentive to remit all the proﬁts earned in the low-tax host country. These studies, however,
did not explicitly consider trade liberalization by forming an FTA, let alone the eﬀects of ROO
on transfer prices.
The rest of the paper is organized as follows. Section 2 presents the model and derive an
equilibrium. Section 3 investigates the eﬀects of FTA formation on proﬁt shifting, consumers,
and the MNE’s proﬁt. Section 4 discusses total welfare of member countries and the eﬀect of
input tariﬀ. The last section concludes. Online Appendix explains the robustness of the main
results by relaxing some key assumption.
13Given the multiple roles of transfer prices, the recent literature examines MNEs’ optimal strategies (Hyde andChoe, 2005; Nielsen et al., 2008; Dürr and Göx, 2011). None of them, however, link transfer pricing and ROO.

6

Figure 1: Model

2

Model

There are three countries, 𝐻, 𝐹, and 𝑂; countries 𝐻 and 𝐹 are potential FTA members. Fig. 1
illustrates the model. A single ﬁrm, an MNE, produces a ﬁnal good using inputs and sells it incountry 𝐹. For simplicity, the benchmark model ignores the output market in country 𝐻 andfocuses only on the consumers in country 𝐹. This assumption does not qualitatively change ourmain results as long as the two markets are segmented in the sense that the MNE can make aseparate decision in each market. The representative consumer’s utility in country 𝐹 is given
by 𝑈 = 𝑎𝑥 − 𝑥2 , where 𝑥 is the consumption of the ﬁnal good. By utility maximization, the2demand function becomes 𝑥 = 𝑎 − 𝑝.
One of the two member countries, country 𝐻, has a location advantage for ﬁnal good
production because of low factor prices, a large pool of skilled labor and so on. Therefore,
country 𝐻 hosts a downstream aﬃliate of the MNE (ﬁrm 𝑀𝐻 ). The MNE’s upstream aﬃliate(ﬁrm 𝑀𝑂 ) is located in country 𝑂. Firm 𝑀𝑂 may also produce an input for ﬁnal good production,
as explained below.
Firm 𝑀𝑂 has already operated in country 𝑂 and generates positive proﬁts, 𝜋, which areexogenously given. To produce the ﬁnal product, ﬁrm 𝑀𝐻 needs to procure one unit of inputs

7

for the production of one unit of ﬁnal products.14 Firm 𝑀𝐻 can procure the input from aperfectly competitive input market inside FTA countries, which supply the input at the priceof 𝑤. Alternatively, ﬁrm 𝑀𝑂 located in country 𝑂 can produce the input at the cost of 𝑤 − Δ.
We assume Δ > 0 and Δ ∈ (0, 𝑤]. Therefore, input production in country 𝑂 is more eﬃcientthan that in country 𝐻. This implies that the self-production of the input in country 𝑂 gives the
MNE not only a lower input cost but also a tax-saving opportunity via the manipulation of thetransfer price, which is denoted by 𝑟. We assume away transfer pricing that realizes negative
reported proﬁts because tax authorities can audit tax avoidance.
Without the FTA, country 𝐹 imposes a speciﬁc tariﬀ, 𝜏, on imports of the ﬁnal good. We
consider the case in which 𝜏 < 𝑎 − 𝑤 + Δ holds to rule out zero output in the equilibrium. The
governments in countries 𝑂 and 𝐻, respectively, levy 𝑡 and 𝑇 as a corporate tax on reported
proﬁts as well.15 To focus on the eﬀect of FTA formation on the ﬁnal good market, tariﬀs on
inputs are assumed away.16 Hereafter, we focus on the case in which 𝑇 ≥ 𝑡 holds. Without lossof generality, we set 𝑡 = 0.
This situation is consistent with the real-world observation. For instance, Mexico andBelgium have higher corporate taxes than other countries, and these countries are major hostcountries of export platform foreign direct investment (FDI), where the FDI ﬁrm exports fromthe host country to other countries. For example, see Tekin-Koru and Waldkirch (2010) for
Mexican evidence of its increasing role as a host of export platform FDI. Tintelnot (2017)
showed the share of output exported to countries outside the host country by the United States’
MNEs. For instance, the share of exports in Belgium was 63% in 2004.

2.1 The equilibrium without ROO
Let us ﬁrst derive the market equilibrium without the ROO in each scheme of the MNE choice. In
the inshoring scheme, denoted as scheme 𝐼, the MNE purchases the input from local producers.
14We can consider a more general situation wherein the MNE uses a continuum of inputs, and determines theextent to which it uses intra-ﬁrm inputs for ﬁnal good production. As explained in Online Appendix B.1, this
modiﬁcation does not change the qualitative results of the benchmark model.
15In this model, we postulate that the governments in countries 𝑂 and 𝐻 adopt a territorial tax system instead ofa worldwide one. Most OECD countries, except Chile, Israel, Mexico, and South Korea, have adopted a territorial
tax system. The United States moved from a worldwide tax system to a territorial tax system in December 2017.
16This assumption is relaxed in section 4.2.

8

Firm 𝑀𝐻 earns proﬁts under the cost of inputs 𝑤 and tax rate 𝑇. In the oﬀshoring scheme,
denoted as scheme 𝑂, the MNE’s upstream aﬃliate in country 𝑂, ﬁrm 𝑀𝑂 , produces the input
at the production cost of 𝑤 − Δ. Firm 𝑀𝑂 sells the input to ﬁrm 𝑀𝐻 at the input price, denoted
by 𝑟. Thus, 𝑟 is the transfer price of the MNE.
In the inshoring scheme, the MNE maximizes the post-tax proﬁt, Π = (1 − 𝑇)( 𝑝 − 𝑤 −𝜆𝜏)𝑥 + 𝜋, subject to 𝑝. The equilibrium price and sales are respectively given by 𝑝 𝐼 = 𝑎+𝑤+𝜆𝜏2
and 𝑥 𝐼 = 𝑎−𝑤−𝜆𝜏
where 𝜆 is a state variable that takes zero if the MNE qualiﬁes for an FTA
2
tariﬀ rate, and unity otherwise. By substituting them, the equilibrium post-tax proﬁts under theinshoring scheme becomeΠ 𝐼 = (1 − 𝑇) (𝑥 𝐼 ) 2 + 𝜋 .
|{z} |{z}
𝐼
𝜋𝐻

(1)

𝐼
𝜋𝑂

𝜋𝑖𝑠 represents the reported proﬁts of ﬁrm 𝑀𝑖 under scheme 𝑠 ∈ {𝐼, 𝑂}.
In the oﬀshoring scheme, the MNE maximizes
Π𝑂 = (1 − 𝑇) ( 𝑝 − 𝑟 − 𝜆𝜏)𝑥 + [{𝑟 − (𝑤 − Δ)}𝑥 + 𝜋]{z}
| {z } |

(2)

𝑂
𝜋𝑂

𝜋𝑂
𝐻

𝜕Π𝑂
𝑂
with respect to 𝑟 and 𝑝, subject to 𝜋𝑂
𝐻 ≥ 0 and 𝜋𝑂 ≥ 0. Since 𝜕𝑟 = 𝑇𝑥 > 0 always

holds, the MNE is willing to set the optimal transfer price as high as possible. Therefore,
the optimal abusive transfer price is set at the level that transfers all the proﬁts earned in ahigh-tax country to a low-tax country, 𝑟 = 𝑝 − 𝜆𝜏.17 Next, the post-tax proﬁts are rewritten as
Π𝑂 = [{𝑝 − 𝜆𝜏 − (𝑤 − Δ)}𝑥 + 𝜋]. By maximizing them with respect to 𝑝, the price, sales, and, 𝑥 𝑂 = 𝑎−𝑤+Δ−𝜆𝜏, and 𝑟 𝑂 = 𝑎+𝑤−Δ−𝜆𝜏,transfer price in equilibrium are given by 𝑝 𝑂 = 𝑎+𝑤−Δ+𝜆𝜏222respectively. Thus, the post-tax proﬁts under the oﬀshoring scheme are given byΠ𝑂 = (𝑥 𝑂 ) 2 + 𝜋.

(3)

Irrespective of the formation of an FTA, the MNE always prefers the oﬀshoring scheme to
17We assume there is no cost of shifting proﬁts across countries. This is a conventional way of determining
the optimal transfer price in the literature, when the cost of proﬁt shifting is absent. We relax this assumption byintroducing a standard convex concealment cost in Online Appendix B.2.

9the inshoring scheme, as
Π𝑂 − Π 𝐼 = (𝑥 𝑂 ) 2 − (1 − 𝑇)(𝑥 𝐼 ) 2 ≥ 0(4)holds given 𝜆, because 𝑥 𝑂 > 𝑥 𝐼 . Intuitively, the oﬀshoring generates more proﬁts because
procurement from its upstream aﬃliate provides the MNE with both eﬃcient input production
and the opportunity to shift proﬁts.
For notational convenience, we use the superscript “∗” for the variables in the pre-FTA caseand “c” for the post-FTA variables without ROO hereafter.

2.2 The equilibrium with ROO
Let us next consider an FTA formation with the ROO. As stated in the Introduction, our focus ison the VA criterion of ROO. Speciﬁcally, a VA criterion is applied to exports of the ﬁnal goodin the FTA. For notational convenience, we use “f ” as a circumﬂex for the variables in thepresence of the ROO. After an FTA is formed, ﬁrm 𝑀𝐻 needs to meet the VA criterion to beeligible for the elimination of 𝜏. Speciﬁcally, the ROO require ﬁrm 𝑀𝐻 to add a proportion ofat least 𝛼 (∈ (0, 1]) of the values of exported goods within FTA. There are three cases that we
explain sequentially below.
First, if ﬁrm 𝑀𝐻 chooses the oﬀshoring of input production and sets an abusive transfer
price, 𝑟 = 𝑝, the VA ratio is always zero, which fails to meet the requirements of the ROO.
Hence, the ﬁnal goods exports of the MNE incur tariﬀ 𝜏, even after the formation of the FTA.
We call this case scheme 𝑁 (non-compliance).18 The equilibrium outcomes of this scheme are
obtained by setting 𝜆 = 1 in 𝑝 𝑂 , 𝑥 𝑂 , and 𝑟 𝑂 , as well as in the other corresponding welfare
components. Second, if ﬁrm 𝑀𝐻 chooses the inshoring of input production (scheme 𝐼), the VA
ratio is 1, and it satisﬁes the requirement of the ROO. The equilibrium outcomes are obtainedby setting 𝜆 = 0 in 𝑝 𝐼 and 𝑥 𝐼 .
Third, if ﬁrm 𝑀𝐻 chooses the oﬀshoring of the input production and sets 𝑝 and 𝑟 such that
18Some empirical evidence shows that not all ﬁrms use FTA tariﬀs, because of the existence of the ROO, thatis, the eﬀects of FTA formation are heterogeneous across ﬁrms. See, for example, Takahashi and Urata (2010) andHayakawa et al. (2013).

10

they satisfy
𝑝 −𝑟
≥ 𝛼,
𝑝

𝛼≡

(5)

it complies with the ROO, and the tariﬀ is thus eliminated. A combination of 𝑝 and 𝑟 thatrealizes (5) with strict inequality cannot be the equilibrium price. In section 2.1, we show that
the MNE’s post-tax proﬁt after FTA formation is maximized by setting 𝑝 = 𝑟 without the ROO.
This implies that, as long as 𝑝−𝑟
𝑝 > 𝛼 holds, the MNE always has an incentive to reduce 𝑝 − 𝑟
by adjusting 𝑝 and 𝑟.19 Therefore, the MNE optimally sets 𝑝 and 𝑟 such that (5) is satisﬁed withequality, which yields:𝑟 = (1 − 𝛼) 𝑝.

(6)We call this case scheme 𝐵 (binding ROO).
By substituting (6), and 𝜆 = 0 into (2), the post-tax proﬁts under scheme 𝐵 are given byΠ𝐵 = (1 − 𝑇) 𝛼𝑝𝑥 + [{(1 − 𝛼) 𝑝 − (𝑤 − Δ)}𝑥 + 𝜋] = {1 − 𝛼𝑇 }( 𝑝 − 𝑐 𝑀 )𝑥 + 𝜋,|{z} |
{z
}
𝐵
𝜋𝐻

(7)

𝐵
𝜋𝑂

𝑤−Δ
(> 𝑤 − Δ) represents the “perceived marginal cost” of producing the ﬁnal
where 𝑐 𝑀 = 1−𝛼𝑇

good.20 The perceived marginal cost is higher than the physical marginal cost, 𝑤 − Δ, as longas 𝛼 is positive and 𝑇 > 0. Both an increase in the stringency of the ROO (i.e., 𝛼) and the tax
in country 𝐻 (i.e., 𝑇) increases the perceived marginal cost. We can interpret the perceived
marginal cost as follows. Without any ROO, the MNE shifts all the proﬁts to a low-tax country
by setting 𝑟 = 𝑝. From 𝑟 = 𝑝, the introduction of the ROO decreases the transfer price by asmuch as 𝛼𝑝 and increases the per-unit tax payments of the MNE by as much as 𝛼𝑝𝑇 > 0. Thismeans that the ROO decrease the MNE’s marginal gains from selling the ﬁnal good in terms of
the post-tax proﬁts. Therefore, the MNE becomes less aggressive in the product market underscheme 𝐵. The lower incentive to sell the ﬁnal good is reﬂected in the perceived marginalcost. The price setting of the MNE is made with 𝑐 𝑀 instead of 𝑤 − Δ, that is, the binding ROO
19For instance, the MNE can always reduce its tax payments and increase the post-tax proﬁts by increasing 𝑟
and setting 𝑝 such that it does not aﬀect its sales in the product market.
20The terminology “perceived marginal cost” is often used in the analysis of vertically related industries in thecontext of industrial organization. See Choi et al. (2020) for an application of this terminology in the tax avoidance
literature.

11

increase the equilibrium price, since 𝑐 𝑀 > 𝑤 − Δ holds.
By maximizing (7) with respect to 𝑝, we obtain equilibrium price, sales, and transfer price
as 𝑝e𝐵 = 𝑎+𝑐2 𝑀 , e
𝑥 𝐵 = 𝑎−𝑐2 𝑀 , and e𝑟 𝐵 = (1 − 𝛼) 𝑎+𝑐2 𝑀 , respectively. We thus have the following
proposition:
Proposition 1. Suppose that an FTA is formed and the MNE chooses oﬀshoring. The ROO
induce the MNE to set a lower transfer price and a higher output price if it complies with the
ROO.
Proof. See Appendix A.1.
The MNE adjusts both transfer price and output price to satisfy (5). If the MNE keeps
𝑝 = 𝑝b𝑂 and only lowers 𝑟 to satisfy the VA ratio, the increase in the tax burden hurts the MNE
more. If the MNE only raises 𝑝 keeping 𝑟 = b
𝑟 𝑂 , it loses its proﬁt in the product market evenmore. The rise in output price implies that the tariﬀ pass-through is smaller with the ROO than
without them because a part of tariﬀ reduction is countered by an adjustment of the output priceto meet the VA criterion. A smaller tariﬀ pass-through reduces the consumers’ gains from an
FTA formation, as shown in section 3.2.
By substituting the equilibrium price and sales, the equilibrium post-tax proﬁt of the MNE
under scheme 𝐵 becomese𝐵 =Π{(1 − 𝛼𝑇)𝑎 − 𝑤 + Δ}2+ 𝜋.
4(1 − 𝛼𝑇)(8)e 𝐵 is a decreasing function of 𝛼because an increase in 𝛼 forces the MNE to set a transfer priceΠand an output price that deviate more from the levels at which it avoids tax payments in thehigh-tax country.

2.3 The MNE’s choice of scheme
In section 2.1, we have argued that the MNE always chooses scheme 𝑂 before an FTA formation,
and also after an FTA formation without the ROO. In an FTA formation with the ROO, schemes
𝐼, 𝑁, and 𝐵 are possible equilibrium outcomes. Among the three possible schemes (𝐼, 𝑁, and𝐵), the MNE chooses the one that maximizes its proﬁts.

12

e 𝐼 with Π
e 𝑁 . Since both proﬁts are independent of the VA threshold, 𝛼,Let us ﬁrst compare Π
the tariﬀ level and tax diﬀerential determine which proﬁt is larger. The MNE faces a trade-oﬀ
between tax avoidance and tariﬀ avoidance. If the tax diﬀerential is large, the MNE prefers
scheme 𝑁 to scheme 𝐼 because of the stronger incentive to avoid tax payments in country 𝐻.
If the tax diﬀerential is small, scheme 𝐼 is preferable for the MNE. Thus, there exists a uniquee𝐼 = Π
e 𝑁 holds. As a higher tariﬀ discourages the MNE frome such that Π
threshold of 𝑇, 𝑇,echoosing scheme 𝑁, 𝜕𝜕𝜏𝑇 > 0 holds.21
e 𝐵 is decreasing
Next, we compare the proﬁts in scheme 𝐵 with those in schemes 𝑁 and 𝐼. Π
e𝐵 = Π
b𝑂 holds at 𝛼 = 0, which is larger than Πe 𝑁 and Π
e 𝐼 . Therefore, we can derive ain 𝛼, and Π
unique threshold, 𝛼 𝑁 (resp. 𝛼 𝐼 ), above which the MNE prefers scheme 𝑁 (resp. scheme 𝐼) to
scheme 𝐵. Intuitively, under a less-strict ROO, the MNE prefers scheme 𝐵 to schemes 𝑁 and 𝐼
because adjusting the transfer price to comply with those ROO becomes less costly as the VA
criterion becomes less stringent. In other words, the proﬁts of MNE from tariﬀ elimination, by
adjusting the transfer price, become smaller as the FTA is attached to more stringent ROO.
Putting the above comparisons together, we characterize the equilibrium outcomes as follows:
Proposition 2. The MNE chooses oﬀshoring (scheme 𝑂) before an FTA formation or after an
FTA formation without the ROO. After an FTA formation with the ROO, the MNE chooses (i)inshoring (scheme 𝐼) if 𝑇 ≤ 𝑇e and 𝛼 > 𝛼 𝐼 hold, (ii) oﬀshoring and its exports incur a tariﬀ(scheme 𝑁) if 𝑇e < 𝑇 and 𝛼 > 𝛼 𝑁 hold, and (iii) oﬀshoring, and it then adjusts its transfer priceto meet the ROO (scheme 𝐵) if 𝛼 ≤ min{𝛼 𝐼 , 𝛼 𝑁 } holds.
Proof. See Appendix A.2.
The equilibrium outcomes with the ROO is illustrated in Figure 2. The MNE always
chooses the self-production of inputs before an FTA is formed. After an FTA is formed, this
proposition suggests that the MNE may change its input procurement from self-production to
the purchase of local inputs, despite higher production cost. As Conconi et al. (2018) showed,
2
< 1. We can conﬁrm that 𝑇e is positive if and
21Formally, the threshold is calculated as 𝑇e = 1 − 𝑎−𝑤+Δ−𝜏
𝑎−𝑤
only if Δ < 𝜏 holds. To secure the existence of the equilibrium with scheme 𝐼, we additionally assume Δ < 𝜏hereafter.

13

Figure 2: The equilibrium MNE’s choice
the ROO lower the likelihood of input procurement from non-FTA countries. This “input trade
diversion” corresponds to the area of scheme 𝐼 in Figure 2.
Further, as Takahashi and Urata (2010) and Hayakawa et al. (2013) noted, some ﬁrms may
not use FTA tariﬀs because of the burden of the ROO. This possibility corresponds to the areaof scheme 𝑁 in Figure 2. A standard explanation for the non-use of an FTA is that export ﬁrms
must incur additional costs to meet the ROO. Our model suggests another burden of meeting the
ROO: It increases tax payments by restricting the MNE’s freedom to adjust its transfer price.

3 Eﬀects of FTA formation
We have explored the equilibrium outcomes of an FTA with the ROO. This section analyzes
how an FTA formation prevents the MNE’s proﬁt shifting and how it aﬀects the consumer
surplus and the MNE’s proﬁt.

3.1 FTA as an anti-tax avoidance policy
Let us explore how an FTA formation aﬀects the MNE’s tax avoidance. When the MNE engages
in transfer pricing, an FTA with the ROO enables member countries to recover some of the14

MNE’s tax bases. When the MNE procures the input from the local input market (scheme 𝐼),
there are no opportunities to shift proﬁts, and all the tax bases are retained in country 𝐻. Whenit adjusts its transfer price to meet the VA criterion of the ROO, a part of the tax base is retainedin country 𝐻 because of the limited use of abusive transfer pricing.
Notably, we can conﬁrm that the ROO reverse the direction of proﬁt shifting across countries.
To see this point more clearly, it is useful to decompose the optimal transfer prices into the “taxavoidance motive” and “tariﬀ elimination motive.” In the pre-FTA equilibrium, the optimaltransfer price is always above the marginal cost of input production:𝑟 = 𝑤−Δ+𝑎 − 𝑤 + Δ − 𝜆𝜏
.
2
|
{z
}

(9)

Tax avoidance motive

The second term of (9) represents the tax avoidance motive, which makes the transfer price ashigh as making the proﬁt of the downstream aﬃliate of the MNE zero.
In scheme 𝐵 of the post-FTA equilibrium, the tariﬀ elimination motive counters the tax
avoidance motive. The optimal transfer price is expressed ase𝑟𝐵 = 𝑤 − Δ +𝑎−𝑤+Δ2| {z }Tax avoidance motive−𝛼{(1 − 𝛼𝑇)𝑎 + (1 − 𝑇)(𝑤 − Δ)}.
2(1 − 𝛼𝑇)
|
{z
}

(10)

Tariﬀ eliminative motive

The third term of (10) captures the tariﬀ elimination motive, which is zero at 𝛼 = 0 andincreasing in 𝛼. If the tariﬀ elimination motive is suﬃciently large, such that e𝑟 𝐵 is lower than𝑤 − Δ, then the proﬁts of the MNE shift from a low-tax country to a high-tax country, which isin sharp contrast to the conventional eﬀect of transfer pricing.
Therefore, the direction of proﬁt shifting relies on the size of the two motives. Indeed, we
can derive a unique threshold of 𝛼, 𝛼𝑟 , such that e𝑟 𝐵 < 𝑤 − Δ holds and proﬁts shift from ahigh-tax country to a low-tax country if 𝛼 > 𝛼𝑟 holds. Figure 3 illustrates the reversal of proﬁt
shifting.22 The dotted curve represents 𝛼𝑟 , and the dotted area in the ﬁgure represents the casein which proﬁts ﬂow from a low-tax country to a high-tax country. The following propositionsummarizes the eﬀect on tax revenue.
1
22We use the following parameters for the ﬁgure: 𝑎 = 1, 𝑤 = 12 , Δ = 32
, and 𝜏 = 41 .

15

Figure 3: The direction of the MNE’s shifted proﬁts
Proposition 3. An FTA formation with the ROO reduces the proﬁts of the MNE that are shiftedfrom a high-tax country to a low-tax country if the MNE uses an FTA tariﬀ. The MNE shifts its
proﬁts from a low-tax country to a high-tax country if the tariﬀ elimination motive of transfer
pricing is suﬃciently large.
Proof. See Appendix A.3.
This proposition sheds new light on the role of the ROO that has been overlooked in policy
debates. As Proposition 2 shows, an FTA formation with the ROO can induce the MNE toabandon the self-production of inputs as an opportunity to avoid tax.23 This result suggests thata VA criterion provides another channel to keep MNEs away from tax avoidance by restricting
the extent of abusive transfer pricing. Although the main purpose of imposing the ROO is toprevent trade circumvention, the ROO also play a role in preventing tax avoidance.
Furthermore, Proposition 3 provides a new empirical implication for estimating transfer
pricing. As our model shows, the optimal transfer price depends on the stringency of the VA
criterion, suggesting that the observed transfer prices can reﬂect not only the tax avoidance
motive but also the tariﬀ elimination motive.24
23This eﬀect is observed in the other two criteria of ROO, that is, the change in tariﬀ classiﬁcation criterion andspeciﬁc process criterion.
24Although there are other ways of shifting proﬁts, such as using internal debt and making royalty payments,
the tariﬀ elimination motive behind the transfer pricing of tangible assets remains.

16

3.2 Eﬀects on consumer surplus and the MNE’s overall proﬁt
Let us next explore the eﬀect of an FTA formation on consumers and the MNE’s overall proﬁt.
Under scheme 𝐼, FTA formation increases the marginal cost of production from 𝑤 − Δ to 𝑤
because the MNE changes the location of its input procurement. However, the FTA formation
also eliminates the tariﬀ, 𝜏, faced by the MNE. We can easily conﬁrm the following: The MNEchooses scheme 𝐼 only if Δ < 𝜏 holds (see footnote 21). Therefore, an FTA always decreases the
MNE’s marginal cost of exports whenever scheme 𝐼 becomes the equilibrium outcome, and it
always increases the exports of the MNE.25 Tariﬀ elimination increases the free-on-board (f.o.b)
price, 𝑝 − 𝜏, but its degree is always less than the tariﬀ level, and it decreases the consumer
price. Thus, an FTA formation beneﬁts consumers and the MNE under scheme 𝐼.
Under scheme 𝐵, the MNE also faces a higher marginal cost because the perceived marginal
cost is higher than 𝑤 − Δ. As in scheme 𝐼, however, the MNE chooses scheme 𝐵 only
if the cost reduction from tariﬀ elimination dominates the increase in the marginal cost of
production (see Appendix A.2 for details). Therefore, the FTA always increases the exportsof the MNE whenever scheme 𝐵 becomes the equilibrium outcome. As before, the tariﬀ
elimination increases the f.o.b price and decreases the consumer price. Thus, an FTA formation
beneﬁts consumers and the MNE under scheme 𝐵.
Under scheme 𝑁, the situation is the same as that in the pre-FTA equilibrium, and the
FTA has no eﬀects on the equilibrium outcomes. Putting the two cases together, we have thefollowing proposition:
Proposition 4. An FTA formation with the ROO always beneﬁts consumers and the MNE if the
MNE uses an FTA tariﬀ and has no eﬀect on consumers and the MNE otherwise. The presenceof the ROO decreases both consumers’ and the MNE’s gains.
Proof. See Appendix A.4.
Although FTA formation is beneﬁcial for consumers and the MNE, the ROO decrease theirgains because of the increase in the production cost owing to the ineﬃcient procurement of
inputs (scheme 𝐼) or increase in the perceived marginal costs (Scheme 𝐵). In scheme 𝐵, the25Speciﬁcally, the change in exports becomes Δ𝑥 𝐼 ∗ = e
𝑥 𝐼 − 𝑥 𝑂∗ = 𝜏−Δ
2 , which is positive if Δ < 𝜏 holds.

17

MNE gives up full tax avoidance, and the adjustment of transfer price to meet the ROO increases
the MNE’s perceived marginal cost. We should recognize this export-decreasing eﬀect of the
ROO driven by the change in the MNE’s transfer pricing.

4

Discussion

We have shown that an FTA with ROO can prevent the MNE’s tax avoidance. In this section, we
explore how FTA formation aﬀects the total welfare of member countries. This study employs apartial-equilibrium model focusing on one industry, and we should be careful about evaluating
the welfare impacts of FTA because there should also be gains/losses in other industries.
Nevertheless, our analysis provides new element to consider the desirability of FTA in the realworld.
Besides that, the benchmark model also assumes that country 𝐻 does not impose a tariﬀ
on inputs imported from country 𝑂. The member countries may have an incentive to prevent
tax avoidance by the MNE by setting a high tariﬀ on inputs, which reduces the gains fromproducing inputs outside the FTA. This diminishes the role of the ROO in preventing abusivetransfer pricing. We show that the main results of the benchmark model remain unchanged even
if country 𝑂 optimally sets the level of input tariﬀ.

4.1

Total welfare of member countries

To explore the welfare eﬀects of FTAs, we focus on the total welfare of FTA countries. The total
welfare of FTA countries under scheme 𝑠 ∈ {𝐼, 𝑂, 𝐵, 𝑁 } is the sum of the consumer surplus in𝑠 ), and tariﬀ revenues incountry 𝐹 (𝐶𝑆 𝐹𝑠 ), tax revenues of country 𝐻 paid by the MNE (𝑇 𝑅𝐻

country 𝐹 (𝑇 𝑅 𝐹𝑠 ):𝑊𝑠(𝑥 𝑠 ) 2𝑠𝑠𝑠𝑠= 𝐶𝑆 𝐹 + 𝑇 𝑅 𝐻 + 𝑇 𝑅 𝐹 =+ 𝑇 𝜋𝐻+ 𝜆𝜏𝑥 𝑠 .
2

(11)

Total welfare does not include the post-tax proﬁts of the MNE because it is owned by residents
outside the FTA. We have the following proposition. See Online Appendix B.3 for the proof.
Proposition 5. An FTA formation without the ROO beneﬁts member countries when the initial18

tariﬀ rate is high (𝜏 > 𝜏𝑊 ) and hurts them when it is low (𝜏 < 𝜏𝑊 ). An FTA formation with the
ROO beneﬁts member countries if (i) the post-FTA scheme is scheme 𝐼, and 𝑇 > 𝑇e𝑊 holds or(ii) the post-FTA scheme is scheme 𝐵 and 𝛼 > 𝛼𝑊 holds. It has no eﬀect on member countries
if the post-FTA scheme is 𝑁. Otherwise, an FTA with the ROO hurts member countries.
Let us ﬁrst explain the welfare eﬀect of an FTA formation without ROO. The post-FTA
equilibrium scheme is always scheme 𝑂. The member countries cannot collect tax revenues
both before and after the FTA formation. The FTA generates a trade-oﬀ between an increase in
the consumer surplus and disappearance of tariﬀ revenues. When the initial tariﬀ rate is high(𝜏 > 𝜏𝑊 ), the consumers’ gains exceed tariﬀ revenues and the FTA formation increases the total
welfare of member countries.
The presence of the ROO changes the welfare eﬀect of FTA formation. The FTA has
no eﬀect if the post-FTA equilibrium scheme is scheme 𝑁, but it aﬀects the total welfare in
scheme 𝐼 or scheme 𝐵. As discussed in section 3.2, the ROO reduce consumer gains from FTA
formation in country 𝐹 in these schemes. However, the ROO also help generate tax revenues incountry 𝐻 if the MNE changes its input procurement from country 𝑂 to country 𝐼, or it adjusts
its transfer price to comply with the ROO. Thus, the ROO can either increase or decrease thewelfare gains from FTA formation.
If the post-FTA scheme is scheme 𝐼, an FTA formation improves the total welfare of the
FTA members when the tax gap is relatively high, and the positive eﬀects from generating a tax
revenue is large enough. Similarly, if the post-FTA scheme is scheme 𝐵 and 𝛼 is high, then the
MNE needs to adjust its transfer price to comply with the ROO. In this case, the positive eﬀect
from gaining the tax revenue is large enough to improve the total welfare.
We found there exists a case wherein an FTA without the ROO worsens the total welfare, but
an FTA with the ROO improves it. There is also a case where an FTA with the ROO improves
the total welfare, but an FTA without the ROO worsens it (see Online Appendix B.3 for details).
However, note that this study employs a partial equilibrium model that focuses on one speciﬁc
sector. In reality, an FTA should aﬀect many sectors. The welfare eﬀects discussed here explain
only a part of the overall eﬀects of the FTA. Nevertheless, the analysis of this study is distinct
in that it suggests a new mechanism through which the ROO change the welfare eﬀects of an
19

FTA formation.

4.2 A tariﬀ on inputs
In the benchmark model, we have assumed that country 𝐻 imposes no tariﬀ on imported inputs.
Given the zero external tariﬀ, only the ROO can hinder the MNE’s transfer pricing. However,country 𝐻 may have an incentive to set an input tariﬀ to prevent the loss of the tax revenue.
Even if we consider an input tariﬀ, and its degree is determined endogenously by country 𝐻,
the main results of the baseline model holds, as long as the corporate tax in country 𝐻 is notvery high. See Online Appendix B.4 for the detailed discussion.
This is because, with a low corporate tax in country 𝐻, the main source of country 𝐻’s
welfare is not the tax revenue from the MNE, but the tariﬀ revenue from the input tariﬀ. Let 𝜉
be a tariﬀ on inputs in country 𝐻. Then, country 𝐻’s welfare is either the tax revenue from the𝐼 ) if inputs are produced in country 𝐻, or the tariﬀ revenue (𝑇 𝑅 𝑂 = 𝜉𝑥 𝑂 ) if
MNE (𝑇 𝑅 𝐻𝐼 = 𝑇 𝜋 𝐻
𝐻inputs are produced in country 𝑂. If 𝜉 exceeds the threshold level, 𝜉 𝑀 , then the MNE chooses𝑂𝐼
inshoring over oﬀshoring. If 𝑇 < 𝜉𝑥
is satisﬁed for some 𝜉 < 𝜉 𝑀 such that 𝑇 𝑅𝑂
𝐻 > 𝑇 𝑅𝐻
𝜋𝐼
𝐻

holds, the optimal external tariﬀ to maximize tariﬀ revenue becomes 𝜉𝑇 = 𝑎−𝑤+Δ−𝜏
. In this2case, country 𝐻 does not impose a tariﬀ that induces inshoring and prevents proﬁt shifting. If 𝑇
𝐼
is large enough, 𝑇 𝑅𝑂
𝐻 ≤ 𝑇 𝑅 𝐻 always hold and country 𝐻 sets the tariﬀ that induces inshoring,𝜉 ≥ 𝜉 𝑀 . As our main results are obtained when 𝑇 is small, they are not qualitatively changed
by introducing an input tariﬀ of country 𝐻.
Although introducing an input tariﬀ does not change the main results, it is worth discussing
which members of the FTA, country 𝐻 or country 𝐹, beneﬁt more from imposing an importtariﬀ that hinders transfer pricing (i.e., 𝜉 ≥ 𝜉 𝑀 ). If 𝑎 − 𝑤 − 𝜏 < Δ holds, then 𝜉𝑇 < Δ, andthe MNE’s marginal cost is lower under oﬀshoring. In this case, country 𝐹 prefers oﬀshoring
because the MNE’s exports to country 𝐹 is larger. If 𝑎 − 𝑤 − 𝜏 > Δ holds, we have 𝜉𝑇 > Δ
and the MNE’s marginal cost is lower under inshoring conditions. In this case, country 𝐹𝐼
prefers inshoring. Therefore, when 𝑇 𝑅𝑂
𝐻 ≤ 𝑇 𝑅 𝐻 and 𝑎 − 𝑤 − 𝜏 < Δ holds, an input tariﬀ that𝐼
prevents transfer pricing hurts country 𝐹, but it beneﬁts country 𝐻. When 𝑇 𝑅𝑂
𝐻 > 𝑇 𝑅 𝐻 and𝑎 − 𝑤 − 𝜏 > Δ holds, the prohibitive input tariﬀ beneﬁts country 𝐹 but hurts country 𝐻. In other20

cases, the prohibitive input tariﬀ either beneﬁts or hurts the two countries at the same time.

5

Conclusion

The recent proliferation of FTAs has been advancing trade liberalization among countries,
and the cross-border economic activities of MNEs prevail globally. This study investigateda vertically integrated MNE’s input production and pricing strategies to analyze the welfare
eﬀects of FTA formation when the MNE can manipulate its transfer price of intra-ﬁrm trade.
As in previous studies, the MNE uses its transfer price to avoid a high corporate tax. After theformation of an FTA, however, there emerges another reason for transfer price manipulation in
the presence of the ROO. Speciﬁcally, if the ROO of the FTA employ a VA criterion, the FTA
induces the MNE to manipulate the transfer price to comply with the ROO and be eligible fortariﬀ elimination.
When the VA criterion of the ROO is low, the MNE prefers transfer price manipulation, sinceadjusting the transfer price is straightforward. However, once the required VA level is high, thetransfer price adjustment decreases the eﬃciency of tax avoidance, such that the manipulationof the transfer price for the ROO is suboptimal. If the tax gap between a country outside an FTA
and a member country is large, the MNE produces a necessary input in the outside country at
the expense of the FTA tariﬀ rate because the gain from tax avoidance is large. If it is small,the MNE procures the input into the inside country to qualify for the FTA tariﬀ. This result is
in line with empirical and anecdotal evidence that (i) FTAs sometimes induce input relocation
to inside FTA countries, (ii) not all ﬁrms export using the preferential tariﬀs of FTAs, and (iii)transfer price manipulation is a factor in the diﬀerence in corporate tax rates and the required
VA criterion of ROO.
Our model also showed the possibility that ROO can prevent proﬁt shifting by an MNE byeither a change in procurement strategy or another use of transfer prices. The formation of FTAs
with the ROO is expected to work as an eﬀective policy to not only induce trade liberalization,
but also keep MNEs away from tax avoidance.
A remarkable result is that the direction of the MNE’s shifted proﬁts is contrary to that under21

common knowledge when the MNE manipulates the transfer price for the ROO. Although the
ROO reduce consumers’ gains of the FTA formation, member countries can beneﬁt more with
the ROO owing to the emergence of the MNE’s tax base. There is a case where the ROO cantransform a welfare-reducing FTA into a welfare-improving one.
There remains room for further research. We assumed that tax rates and tariﬀ rates are
exogenously given. It would be intriguing to investigate how the formation of an FTA aﬀects
the outcomes of tax competition among countries as well as the optimal tariﬀs set by FTA
members. Another direction in which to extend the model is to examine the eﬀects of regulations
on transfer pricing, such as the arm’s length principle, in the presence of ROO. Finally, further
empirical investigation on the relationship between ROO and transfer pricing is essential.

Appendix
A.1 Proof of Proposition 1> 0. By comparing
By comparing the equilibrium output prices, we have 𝑝e𝐵 − 𝑝b𝑂 = 𝑐 𝑀 −(𝑤−Δ)2}𝑎−(1−𝑇)(𝑤−Δ)](1−𝛼)𝑇 𝑎
the equilibrium transfer prices, we obtain e𝑟𝐵 − b𝑟 𝑂 = − 𝛼[{1−𝛼𝑇2(1−𝛼𝑇)< − 2(1−𝛼𝑇)< 0,where the ﬁrst inequality is due to 𝑎 > (𝑤 − Δ).

A.2 Proof of Proposition 2
Without the ROO, (4) indicates that the MNE always chooses scheme 𝑂 before an FTA formation. With the ROO, the post-tax proﬁts of the MNE under schemes 𝑁 and 𝐼 are givenbye 𝑁 = (𝑎 − 𝑤 + Δ − 𝜏) + 𝜋,Π42e 𝐼 = (1 − 𝑇) (𝑎 − 𝑤) + 𝜋.
Π
4
2

(A-1)
(A-2)

The condition under which the MNE prefers scheme 𝐼 to scheme 𝑁 is given by

𝑎−𝑤+Δ−𝜏Π − Π > 0 ⇐⇒ 𝑇 < 1 −
𝑎−𝑤
e𝐼

e𝑁

22

2

e
≡ 𝑇.

(A-3)

From (8), we can easily conﬁrm that the following inequality holds:
e 𝐵 | 𝛼=0 = (𝑎 − 𝑤 + Δ) + 𝜋 > max{Π
e𝑁 , Π
e 𝐼 }.
Π
4
2

(A-4)

e 𝐵 with respect to 𝛼 is
Further, the ﬁrst derivative of Πe𝐵
𝑇 {(1 − 𝛼𝑇)𝑎 − 𝑤 + Δ}(1 − 𝛼𝑇 + 𝑤 − Δ)
𝜕Π
=−
< 0.
𝜕𝛼
4(1 − 𝛼𝑇)

(A-5)

Let 𝛼𝑥 denote the cutoﬀ level of 𝛼𝑥 such that e
𝑥 𝐵 = 𝑥 𝑂∗ (= e𝑥 𝑁 ) holds. Speciﬁcally, we havee𝑥 𝐵 ⋛ 𝑥 𝑂∗ ⇐⇒ 𝛼 ⋚𝜏
≡ 𝛼𝑥 .
(𝑤 − Δ + 𝜏)𝑇(A-6)

If evaluated at 𝛼 = 𝛼𝑥 , (8) becomes2e 𝐵 | 𝛼=𝛼 𝑥 = (𝑤 − Δ) (𝑎 − 𝑤 + Δ − 𝜏) + 𝜋 < Πe𝑁 .
Π4(𝑤 − Δ + 𝜏)

(A-7)

e𝐵 ≥ Π
e 𝑁 holds
This implies that there exists a unique cutoﬀ level of 𝛼, 𝛼 𝑁 ∈ (0, 𝛼𝑥 ), such that Π
e𝐼
e𝐼 e𝑁
e
e Moreover, remember that 𝜕 Πwith 𝛼 ≤ 𝛼 𝑁 and 𝑇 ≥ 𝑇.
𝜕𝑇 < 0 and Π = Π holds at 𝑇 = 𝑇.

Then,e𝐼 > Π
e𝐼 | e = Π
e𝑁 > Π
e 𝐵 | 𝛼=𝛼 𝑥
Π
𝑇=𝑇

(A-8)

e𝐵 > Π
e 𝐼 holds if the following condition is satisﬁed:
e Note that Π
holds for any 𝑇 ∈ [0, 𝑇].
𝑤−ΔΠ | 𝛼=1 > Π ⇐⇒ 𝑇 < 1 −
.
𝑤
e𝐵

e𝐼

(A-9)

e𝐵 ≥ Π
e 𝐼 holds
This implies that there exists a unique cutoﬀ level of 𝛼, 𝛼 𝐼 ∈ (0, 𝛼𝑥 ), such that Πewith 𝛼 ≤ 𝛼 𝐼 and 1 − 𝑤−Δ ≤ 𝑇 < 𝑇.
𝑤

23

A.3 Proof of Proposition 3
From (10), we obtain(1 − 𝛼𝑇) 2 + (1 − 𝑇)(𝑤 − Δ)
𝜕e
𝑟𝐵
=−
< 0.
𝜕𝛼
2(1 − 𝛼𝑇) 2(A-10)> 𝑤 − Δ holds at 𝛼 = 0 and e
Therefore, e𝑟 𝐵 = 𝑤 − Δ + 𝑎−𝑤+Δ
𝑟 𝐵 takes the minimum value at2
𝛼 = 1, which is given bye𝑟 𝐵 | 𝛼=1 = 0 < 𝑤 − Δ.

(A-11)

Scheme 𝐵 is the equilibrium at any 𝛼 if 𝑇 < 𝑇e holds. Therefore, there exists a unique 𝛼𝑟 suchthat e𝑟 𝐵 < 𝑤 − Δ holds when 𝛼 > 𝛼𝑟 holds.

A.4 Proof of Proposition 4
Under scheme 𝐼, the changes in the amount of supplies from the pre-FTA equilibrium to thepost-FTA equilibrium without the ROO are
𝜏−Δ
> 0,
2
Δ
e
𝑥𝐼 − b𝑥 𝑂 = − < 0,2e𝑥 𝐼 − 𝑥 𝑂∗ =(A-12)(A-13)

because 𝜏 > Δ holds. Under scheme 𝐵, the FTA formation increases the amount of exports tocountry 𝐹 when 𝛼 < 𝛼𝑥 holds. From Proposition 2, we know that 𝛼 < 𝛼𝑥 holds under scheme
𝐵 and we always have e𝑥 𝐵 > 𝑥 𝑂∗ . In addition, we can easily conﬁrm thate𝑥𝐵 − b𝑥𝑂 = −(𝑤 − Δ)𝛼𝑇<02(1 − 𝛼𝑇)holds.

24(A-14)

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