Mukunoki, Hiroshi und Okoshi, Hirofumi:
Tariff Elimination versus Tax Avoidance: Free Trade
Agreements and Transfer Pricing

Munich Discussion Paper No. 2020-1
Department of Economics
University of Munich
Volkswirtschaftliche Fakultät
Ludwig-Maximilians-Universität München

Online at https://doi.org/10.5282/ubm/epub.71608

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

Hirofumi Okoshi‡

April 2, 2020

Abstract
This study explores the new roles of rules of origin (ROO) when multinational enterprises (MNEs) manipulate their transfer prices to avoid a high corporate tax. ROO of a free
trade agreement (FTA) require exporters to identify the origin of exports to be eligible fora preferential tariff rate. The results suggest that a value-added criterion of ROO restricts
MNEs’ abusive transfer pricing. Interestingly, an FTA with ROO can induce MNEs to shiftprofits from a low-tax country to a high-tax country. Because ROO augment tax revenues
inside FTA countries, they can transform a welfare-reducing FTA into a welfare-improving
FTA.
Keywords: Rules of origin; Free trade agreement; Transfer pricing
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, 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, and the participants of the Canadian Economic
Association meeting, RIETI, 58th congress of ERSA at Cork, Microeconomics workshop at Tokyo university,
Summer Workshop on Economic Theory at Otaru University of Commerce, and 21st annual conference of ETSG
at Bern. Hiroshi Mukunoki acknowledges financial support from JSPS KAKENHI Grant Numbers JP16H03620
and JP17K03706. Hirofumi Okoshi acknowledges financial support from Deutsche Forschungsgemeinschaft(German Science Foundation, GRK1928). The usual disclaimer applies.
† Faculty of Economics, Gakushuin University, Mejiro 1-5-1, Toshima-ku, Tokyo 171-8588, Japan‡ University of Munich, Munich Graduate School of Economics, Seminar for Economic Policy, Akademiestr.
1/II, D-80799 Munich, Germany

1 Introduction
For the past two decades, tax avoidance by multinational enterprises (MNEs) has been acontroversial topic as the world has become more globalized. According to estimates by theOECD, countries lost 4-10% of the corporate income tax revenue annually because of profit
shifting.1 One way to shift profits across countries is to manipulate the price of intra-firmtrade (transfer price), which is known as abusive transfer pricing. Specifically, because MNEs
determine the prices of transactions between related companies, they manipulate these prices todecrease profits in high-tax countries and increase profits in low-tax countries. Some empiricalresearch has provided evidence of transfer pricing being used to save tax payments.2 As thetaxes 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 to redistribute their tax
base to low-tax countries.
Our primary 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; however, they also influence firms’ behaviors in other respects including transfer
pricing and generate more complicated welfare effects. In particular, the specific rules needed
to implement trade agreements complicate the effects of trade liberalization. Here, 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 prove that the exported
products originated within the FTA.3 To meet ROO, firms may change their strategies such as
their input procurement. For instance, Conconi et al. (2018) concluded 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 transfer price manipulation. Blouin et al. (2018) found conflicting motives when MNEs use
transfer pricing to lower corporate tax as well as 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, which provides
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 re-exporting from that country to other
FTA member countries whose tariffs against non-member countries are higher. See, for example, Stoyanov (2012)
for evidence of firms’ incentive to transship a good through FTA members. To forestall firms from tariff avoidance,
the WTO stipulates ROO.

1

countries, suggesting that such rules cause input procurement to become inefficient. From theviewpoint of tax avoidance, this also implies that ROO can be an obstacle for MNEs to shiftprofits within the firm because they may need to consider whether their intra-firm transactions
satisfy the requirements of ROO.
One way to prove the origin is to satisfy a 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 input materials, which are used per unit of final good production and do not
originate in the FTA. Then, a 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 input materials depends on the transfer price if MNEs procure inputs
from related companies outside FTA countries. Therefore, a VA criterion can be a constraint
for MNEs to engage in tax avoidance via abusive transfer pricing.
Although this possibility has been overlooked in the economic literature on transfer pricing and that of FTA, it has been pointed out by some policy papers. For instance, Eden
(1998) examined the ROO of NAFTA and suggested that “. . . underinvoicing parts coming outside North America and overinvoicing locally made parts would increase the North American
content.” Falvey and Reed (1998) indicated that the VA criterion “. . . allows room for [the]manipulation of prices as well as quantities, and may generate additional incentives for transfer
pricing by multinationals.” Reuter (2012) also pointed out that “most rules of origin are on apercent-of-value basis. . . . By overinvoicing the value added, the MNE can more easily meeta rule-of-origin test and qualify for duty-free entry for its products into another country in thefree trade area.”5 Furthermore, the World Customs Organization suggests that one of the disadvantages of the VA criterion of ROO is possible exposure to transfer pricing.6 As Estevadeordal

4Other ways to prove the origins of products include changing the tariff classification criterion and specificprocess criterion. Although the effects of these criteria are also important, this study focuses only on the VA
criterion.
5Some practitioners see the link as one factor to be considered and state 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, 20182

and Suominen (2003) reported that 68 of the 87 FTAs they analyzed employ a VA criterion atleast in a particular product category, these statements tell us that investigating the role of ROO
to restrict the abusive use of transfer pricing is important to understand the impact of FTAs on
tax avoidance and welfare.
As countries have dealt with the tax avoidance problem, analyzing the anti-tax avoidance
aspect of ROO is important for policymakers. In reality, different groups of policymakers,
namely, customs and tax authorities, are responsible for designing trade policies and regulations
on transfer pricing. Therefore, the interaction between these two authorities has been rare.
According to WCO (2018), “. . . the WCO [World Customs Organization] 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 a MNE’s business, its
compliance record and can make informed decisions on the collect revenue liability.” Thus, as
the number of FTAs and volume of intra-firm trade have increased, exploring the relationshipbetween transfer prices and ROO is an urgent issue.
Against this background, 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.

1.1 Preview of the model and results
The MNE produces final goods within an FTA member country and exports the goods to theother FTA member country. The MNE procures inputs from either an FTA member country
or a low-tax country outside the FTA. We assume input production is efficient in the outside
country. Therefore, if the MNE procures inputs from a related company in a country outside
the FTA, it can exploit efficient inputs as well as shift profits across countries by manipulating
the transfer price.
In the absence of ROO, the MNE always prefers to produce inputs outside the FTA by itself
and engage in tax avoidance by setting a high transfer price. However, the presence of ROO
restricts the manipulation of the transfer price because a high transfer price reduces the VA
ratio of the final product inside the FTA. If the MNE procures inputs inside the FTA, it always
3complies with the ROO and exports its product without paying a tariff, although it cannot save
tax payments by transfer pricing. If the MNE locates its upstream affiliate in a country outside
the FTA, it either saves corporate tax payments by setting a high transfer price or complies with
the ROO to avoid a tariff burden by setting a low transfer price. Thus, the MNE chooses oneof three options: (i) procuring inputs inside an FTA to comply with the ROO and eliminate
tariffs, (ii) fully manipulating its transfer price to avoid tax payments at the expense of thepreferential tariff of the FTA, or (iii) adjusting its transfer price to comply with the ROO toboth eliminate tariffs and pursue partial tax avoidance.7 This model exhibits the MNE’s choiceof “tariff elimination versus tax avoidance” via its location choice of producing inputs and/ortransfer price manipulation.
The third option, adjusting the transfer price to comply with the ROO, is the optimal choicefor the MNE when the stringency of the VA criterion is low and adjusting the transfer priceis less costly for the MNE. However, stricter ROO induce the MNE to deviate more from theoptimal abusive transfer price, which retains a part of the MNE’s tax base in the high-tax
country. Because of this inefficient tax avoidance, a higher VA criterion changes the MNE’s
optimal choice. When the tax differential is huge and the MNE purchases inputs made in an
FTA country, the MNE gives up the FTA tariff but manipulates the transfer price to pursue tax
avoidance. This is because the tax avoidance motive is greater than the tariff avoidance motive.
As ROO restrict the abusive use of transfer pricing by either a change in input procurement
or an adjustment of the transfer price, tax revenues in a high-tax country increase. Thus, theVA criterion works as an anti-tax avoidance policy. An interesting result is that the direction ofshifted profits can be from a low-tax country to a high-tax country when the MNE adjusts thetransfer price to meet the VA criterion. This is because the gain from efficient input production
outside FTA countries becomes greater as the tariff falls, and this outweighs the loss from more
tax payments in a high-tax country. This case is possible when the tax gap is small.
We also show that ROO transform an infeasible FTA into a feasible one. In the absence of
ROO, an FTA formation is harmful for member countries when the initial tariff is small and

7Although the MNE uses its transfer price for ROO compliance, it can still shift profits from one country toanother to save tax payments when the VA requirement is less stringent and the tax gap is large. Nevertheless, theoverall tax payments become larger because the transfer price is suboptimal from the viewpoint of tax savings.

4

the loss from the disappearance of tariff revenues exceeds consumers’ gains. In the presence of
ROO, FTA countries can collect tax revenues from the MNE. Although consumers’ gains fromthe FTA are smaller than those without ROO, tax revenues from the MNE can cover the smaller
consumers’ gains and the loss of tariff revenues. Our results present a new role of ROO in
preventing abusive transfer pricing and making the FTA an welfare-improving one for member
countries.
However, the country makes little tax revenue from the MNE when the absolute level of thecorporate tax in the high-tax country is low. In this case, ROO can deteriorate total welfare
inside FTA countries and make an initially feasible FTA infeasible.

1.2 Relationship to the literature
The welfare effects of FTAs with ROO have previously been analyzed, but such studies focus
on intermediate goods markets.8 Krishna and Krueger (1995) showed that ROO may work as
a hidden protection against input suppliers outside the FTA. Ju and Krishna (2005) showedthat ROO increase the price of FTA-made inputs and reduce total output if they are not sostringent such that all firms comply with the ROO, whereas they have the opposite effects if
ROO are sufficiently stringent such that some firms choose not to comply with them. In Ju
and Krishna (2005), however, the output price is fixed and they did not consider how ROO
affect consumers. Demidova and Krishna (2008) extended Ju and Krishna (2005) to include
the productivity heterogeneity of final good producers and showed that productivity sorting
ensures the negative relationship between the stringency of ROO and demand for FTA-madeinputs (i.e., wages). Ishikawa et al. (2007) focused on final good markets and showed that
ROO have a role to segment markets within the FTA and that both inside and outside firms
producing final goods may benefit from ROO at the cost of consumers. Mukunoki (2017)
showed that an FTA with ROO may harm consumers if it changes outside firms’ location
decisions. None of these papers, however, have considered transfer price manipulation to meet
ROO. Mukunoki and Okoshi (2019) investigated a firm’s export price manipulation to comply
with ROO, particularly how an MNE’s transfer price manipulation affects inputs imported from
8More broadly, many studies have investigated the welfare effects of regional trade agreements both theoretically and empirically. See Freund and Ornelas (2010) for a review of the literature on regional trade agreements.

5

outside FTA. Furthermore, Felbermayr et al. (2019) suggested that there is little rationale for
ROO because tariff circumvention is not profitable for 86% of bilateral trade because of thesmall differences in external tariffs and non-negligible transport costs. This study thus provides
a new rationale for ROO from the viewpoint of tax avoidance by an MNE.
Specifically, this study examines the connection between transfer pricing and trade policy.
Some studies have investigated the relationship between transfer pricing and trade barriers
including tariffs. 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.9 Then, the optimal transfer price is influenced by both corporate tax avoidance
and tariff avoidance. Kant (1988) regarded the transfer price as a tool to repatriate profits whena foreign subsidiary is not fully owned by the parent firm. With the partial ownership of theforeign affiliate, the profit shifted from the home to the foreign country is partly distributed toother owners. The study found that even when the tax rate in the home country is higher than
the tax rate in the host country, an MNE has an incentive to remit all the profit earned in the
low-tax host country if both the tariff and the proportion of the MNE’s ownership shares in theforeign affiliate are low. This research, however, did not explicitly consider trade liberalization
by forming an FTA, let alone the effects of ROO on transfer prices.
The presented model also contributes to the literature on transfer pricing policies since
MNEs have been accused of tax avoidance activities and how to regulate transfer prices has
been a central issue in policy debates. Several studies have examined the impacts of policies ontransfer 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 and formula apportionment.10 Choi et al. (2018) examined theimpact of the arm’s length principle, under which MNEs should set the same price for intra9Given the multiple roles of transfer prices, recent work has examined MNEs’ optimal strategies (Hyde andChoe, 2005; Nielsen et al., 2008; Dürr and Göx, 2011). None of them, however, link transfer pricing and ROO.
10The 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. On the contrary, under the formulaapportionment system, MNEs’ tax payments to one country depend on their consolidated tax base and the proportionof activity operated in the country. See more details in Chapter XVI, Article 86 ofEuropean Commission (2011).

6

firm transactions as for the same transaction conducted between independent firms.11 As theirfocus was on direct regulation on transfer pricing, transfer pricing for meeting ROO has been
overlooked in the literature.
The rest of the paper is organized as follows. In Section 2, we set up the model and derive
an equilibrium without ROO. Section 3 investigates the effect of an FTA with ROO. Section 5
discusses the robustness of the main results by relaxing some key assumptions. The last section
concludes.

2 ModelThere 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 in country F.12 For simplicity, the benchmark model ignores the output market in country
H and focuses only on the consumers in country F.13 The representative consumer’s utility incountry F is given by U = ax − x 2 /2, where x is the consumption of the final good. By utility
maximization, the inverse demand function becomes p = a − x.
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 always hosts a downstream affiliate of the MNE (firm MH ). The MNE’s headquarters(firm MO ) is located in country O.14 MO may also produce an input for final good production,
as explained below.
Firm MO has already operated in country O and makes positive profits, π, that are exoge11Bauer 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.
12If we consider local firms in the FTA members and oligopoly in the final good market, the fundamental
properties of our results remain unchanged, although the analysis becomes more complicated. See Mukunoki andOkoshi (2019) for an oligopoly version of the model.
13This assumption does not qualitatively change our main results as long as the two markets are segmented in
the sense that the MNE can make a separate decision in each market.
14This type of foreign direct investment (FDI) is known as export platform FDI, where the FDI firm exports
from the host country to other countries. For example, see Tekin-Koru and Waldkirch (2010) for Mexican evidenceof its increasing role as a host of export platform FDI. Tintelnot (2017) showed the share of output exported tocountries outside the host country by U.S. MNEs. For instance, the share of exports located in Belgium was 63%
in 2004.

7

Figure 1: Model
nously given. To produce the final product, firm MH needs to procure one unit of inputs forthe production of one unit of final products.15 Firm MH can procure the input from a perfectlycompetitive input market inside FTA countries, which supply the input at the price of w. Alternatively, firm MO located in country O can produce the input at the cost of w − ∆. We assume∆ > 0 and ∆ ∈ [0, w]. Therefore, input production in country O is more efficient than that incountry 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 the transfer
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 + ∆ holds to rule out negative output in the equilibrium.
In addition, the governments in countries O and H respectively levy t and T as a corporate tax
on reported profits.16, 17 To focus on the impact of FTA formation on the final good market,
tariffs on inputs are assumed away. Hereafter, we focus on the case in which T ≥ t holds.18
15We can consider a more general situation in which the MNE uses a continuum of inputs and decides the extent
to which it uses the intra-firm inputs for final good production. As explained in Section 5.2, this modification does
not change the qualitative results of the benchmark model.
16We use the terms “tax rate” and “tax revenue” to represent the corporate tax rate and corporate tax revenue,
respectively. Here, tax rate and tax revenue are distinguished from tariff rate and tariff revenue.
17In this model, we postulate that the governments in countries O and H adopt a territorial tax system insteadof a worldwide one. After the United States moved from a worldwide tax system to a territorial tax system in xxxx,
most OECD countries have since adopted a territorial tax system.
18This situation is consistent with the real-world observation. For instance, Mexico and Belgium have higher
corporate taxes than other countries and these countries are major host countries of export platform FDI. See also82.1 The equilibrium without ROO
Let us first derive the market equilibrium without ROO in each scheme of the MNE choice. In
the inshoring scheme, denoted as scheme I, the MNE purchases the input from local producers.
Firm MH earns profits under the cost of inputs w and a tax rate T. In the offshoring scheme,
denoted as scheme O, the MNE’s headquarters in country O, firm MO , produces the input at
the production cost of w − ∆. Firm MO sells the input to firm MH at the input price denoted byr. Thus, r is the transfer price of the MNE.
The post-tax profits under the inshoring scheme are given by()2
a − w − λτ
Π = (1 − T)+(1 − t) π ,
|{z}
2
|
{z
}
πI
I

(1)

O

I
πH

where λ is a state variable that takes zero if the MNE qualifies for an FTA tariff rate and unity
otherwise. πis represents the reported profits of firm Mi under scheme s ∈ [I, O].
In the offshoring scheme, the MNE maximizes

Π O = (1 − T) (p − r − λτ)x +(1 − t) [{r − (w − ∆)}x + π]|{z}
| {z }O
πO

πO
HO ≥ 0 and π O ≥ 0. Since ∂ΠO = (T − t)x > 0 always holds,
with respect to r and x, subject to πH∂rO

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 a high-tax country
to a low-tax country, r = p − λτ.19 Thus, the post-tax profits under the offshoring scheme are
given by(a − w + ∆ − λτ
Π = (1 − t)2
O)2

+ (1 − t)π.

(2)

Irrespective of the formation of an FTA, the MNE always prefers the offshoring scheme tofootnote 14.
19We 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 cost-for-profit shifting is absent. We relax this assumption byintroducing a standard convex concealment cost in Section 5.3.

9

the inshoring scheme as(a − w + ∆ − λτ
Π − Π = (1 − t)
2
O

I

)2

(

a − w − λτ− (1 − T)
2

)2

≥0

(3)

holds. Intuitively, 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 variables for post-FTA without ROO hereafter.

2.2 The welfare effects of FTA formation without ROO
To explore the welfare effects of FTAs, we focus on the total welfare of FTA countries. If theredistribution of gains from the FTA is possible between member countries, the FTA is feasible
if total welfare increases. The total welfare of FTA countries is the sum of the consumer surplus
in country F (CS s ), tax revenues of country H paid by the MNE (T RHs ), and tariff revenues incountry F (T RFs ):W s = CS s + T RHs + T RFs =(x s )2+ T πHs + λτx s .
2(4)

Total welfare does not include the post-tax profits of the MNE because it is owned by residents
outside the FTA.
Since member countries cannot collect tax revenues when the MNE chooses offshoring,
total welfare under offshoring becomese − WO∗ = CS
c − CSO∗ − T RO∗
W
F=

2(a − w + ∆)−2(a − w + ∆) + 3τ
⋛ 0 ⇐⇒ τ ⋛≡ τW .
8
3(5)

As equation (5) shows, an FTA without ROO generates a trade-off between an increase in the
consumer surplus and disappearance of tariff revenues. When the initial tariff rate is high, theconsumers’ gains exceed tariff revenues and the FTA formation increases the total welfare ofmember countries. This section concludes with the following proposition.

10

Proposition 1. In the absence of ROO, the MNE always procures inputs from its upstream
affiliate outside FTA countries. Forming an FTA benefits member countries when the initial
tariff rate is high (τ > τW ) and hurts them when it is low (τ < τW ).

3 Equilibrium with ROO
In this section, we consider FTA formation with ROO. As stated in the Introduction, our focus
is on the VA criterion of ROO. Specifically, a VA criterion is applied to exports of the final
good in the FTA. For notational convenience, we use “f” as a circumflex for the variables in
the presence of ROO.

3.1 The MNE’s decisions in each scheme
After an FTA is formed, firm MH needs to meet the VA criterion to be eligible for the eliminationof τ. Specifically, ROO require firm MH to add a proportion of at least α(∈ [0, 1]) of the valuesof exported goods within the FTA. There are three cases, which we explain sequentially below.
If firm MH chooses the offshoring of input production and sets an abusive transfer price,br = p, the VA ratio is always zero, which fails to meet the requirement of the ROO. Hence,

the final good exports of the MNE incur the tariff, τ, even after the formation of the FTA. We

call this case scheme N (non-compliance).20 The equilibrium outcomes of this scheme are
obtained by setting λ = 1 in equations (2) and (4), as well as in the other corresponding welfare
components.
For firm MH to utilize the FTA tariff, it has to comply with the ROO by either (i) inshoring
the input procurement (scheme I) or (ii) setting r such thatpO − r
≥α
α≡
pO

(6)

is satisfied. We call this case scheme B (binding ROO). It is apparent that (pO − r)/pO isdecreasing in r and thereby the VA ratio, α, is more likely to exceed α as the MNE sets a lower
20Some empirical evidence shows that not all firms use FTA tariffs because of the existence of ROO, whichmeans the impacts of FTA formation are heterogeneous across firms. See, for example, Takahashi and Urata (2010)
and Hayakawa et al. (2013).

11

O
r. Remember that ∂Π
∂r > 0 holds. Then, the optimal transfer price is set such that it binds

equation (6), which is calculated aser B = (1 − α)p.

(7)

As the ROO become stricter, the MNE needs to add more VA inside the FTA and thus
the optimal transfer price must decrease by αp, which is regarded as the adjustment factor formeeting the ROO. We can easily see that er B is decreasing in α and is equivalent to br with α = 0.
Given the optimal transfer price, the post-tax profits of the MNE are given byΠ B = (1 − T) (p − er B )x B +(1 − t) [{er B − (w − ∆)}x B + π]|{z}
| {z }B
πO

B
πH= {1 − t − α(T − t)}(p − cM )x B + (1 − t)π,(8)(1−t)(w−∆)(≥ w − ∆) represents the “perceived marginal cost” of producing thewhere cM = {1−t−α(T−t)}

final good.21 The perceived marginal cost is higher than the physical marginal cost, w − ∆, aslong as α is positive and T > t. Given the level of t, both an increase in the stringency of the
ROO (α) and that in the tax differential (T − t) increase 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 er = p. From er = p, the introduction of the ROO
decreases the transfer price by as much as αp and increases the per-unit tax payments of the

MNE by as much as α(T − t)p > 0. This means that the ROO decrease the MNE’s post-tax
profits of selling the final good and makes it less aggressive in the product market under scheme
B. The lower incentive to sell the final good is reflected in the perceived marginal cost.
The output decision of the MNE is made with cM instead of w − ∆, generating the following
equilibrium profit:eB =Π{(1 − t)(a − w + ∆) − α(T − t)a}2+ (1 − t)π.
4{1 − t − α(T − t)}(9)21The terminology “perceived marginal cost” is often used in the analysis of vertically related industries in thecontext of industrial organization. See Choi et al. (2018) for an application of this terminology in the tax avoidance
literature.

12

The post-tax profits under scheme B are a decreasing function of α because an increase in α
induces the MNE to set a transfer price that deviates more from the level at which it avoids tax
payments in the high-tax country.

3.2 The MNE’s choice of scheme
Among the three possible schemes (I, N, and B), the MNE chooses the one that maximizes
e I with Π
e N . Since both profits are independent of the VA
its profits. Let us first compare Π

threshold, α, 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 incountry H. If the tax differential is small, scheme I is more preferable for the MNE. Thus, there
e such that Π
eI = Π
e N holds. As a larger tariff discourages theexists a unique threshold of T, T,e

MNE from choosing scheme N, ∂∂τT > 0 holds.22

eB = Π
b
Let us next compare the profits in scheme B with those in schemes N and I. Since Π

e N and Π
e I , and Πe B is decreasing in α, we can derive aholds at α = 0, which is larger than Πunique threshold, α N (resp. α I ), above which the MNE prefers scheme N (resp. scheme I) to
scheme B. Intuitively, under 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.23 In other words, the MNE’s gains from tariff elimination byadjusting 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, which is illustrated in Figure 2.
e andProposition 2. After an FTA with ROO is formed, the MNE chooses (i) inshoring if T ≤ T
e < T and α > α N hold, and (iii)
α > α I hold, (ii) offshoring and its exports incur a tariff if T

offshoring and it adjusts its transfer price to meet The ROO if α ≤ min{α I , α N } holds.

()2
e = 1 − (1 − t) a−w+∆−τ < 1. We can confirm that T
e is greater
22Formally, the threshold is calculated as T
a−w
than t if and only if ∆ < τ holds. To secure the existence of the equilibrium with scheme I, we additionally assume∆ < τ hereafter.
23Here, the MNE meets the ROO by changing its transaction input price. An offshoring firm may also adjust
its export price p to meet the VA criterion. This possibility is analyzed by Mukunoki and Okoshi (2019).

13

Figure 2: The equilibrium MNE’s choice
Proof. See Appendix A.1.
Remember that the MNE always chooses the self-production of inputs before an FTA isformed. 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, even though the production
cost is higher. As Conconi et al. (2018) showed, ROO lower the likelihood of input procurementfrom 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) pointed out, some firms
may not utilize FTA tariffs because of the burden of the ROO. This possibility corresponds toe ≤ T and α N ≤ α in Figure 2. A standard explanation of the non-use of an FTA
the areas T

is that export firms must incur additional costs to meet the ROO. Our model suggests anotherburden of meeting the ROO: it increases tax payments by restricting the MNE’s freedom toadjust its transfer price.

14

4 Welfare effects with ROO
In this section, we explore the welfare effect of the FTA with ROO. As the FTA has no effectif the post-FTA equilibrium scheme is scheme N, we investigate the welfare effects in schemes
I and B. Hereafter, we discuss the effect on each component of welfare and the total welfare
of member countries. We also discuss the optimal level of the ROO that maximizes members’
joint welfare.

4.1 Consumer surplus
Let us begin with the effect on consumers. Under scheme I, FTA formation increases themarginal cost of production from w − ∆ 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 that the MNE chooses scheme I only if ∆ < τ holds (see footnote 22).
Therefore, the 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.24
Under scheme B, the MNE also faces a higher marginal cost because the perceived marginal
cost is higher than w − ∆. As in scheme I, however, the MNE chooses scheme B only if thecost reduction from tariff elimination dominates the increase in the marginal cost of production(see the Appendix for details). Therefore, the FTA always increases the exports of the MNE
whenever scheme B becomes the equilibrium outcome. Putting the two cases together, we havethe following proposition.
Proposition 3. An FTA formation with ROO always benefits consumers if the MNE utilizes
an FTA tariff and has no effect on consumers otherwise. The presence of ROO decreases
consumers’ gains.
Proof. See Appendix A.2.
Although FTA formation is beneficial for consumers, ROO decrease consumers’ gains
because of the increase in the production cost due to the inefficient procurement of inputs(scheme I) or increase in the perceived marginal cost (scheme B). Hence, ROO have no effect
24Specifically, the change in exports becomes ∆x I ∗ = e
x I − x O∗ = (τ − ∆)/2, which is positive if ∆ < τ holds.

15

on consumers’ gains in scheme B because the tariff is eliminated and the MNE continues to
produce the efficient input by itself. However, they actually diminish the increase in exports andconsumers’ gains because giving up full tax avoidance increases the MNE’s perceived marginalcost. We should recognize this export-decreasing effect of ROO driven by the change in the
MNE’s transfer pricing.

4.2 Tax revenue
When the MNE engages in transfer pricing, an FTA with ROO enables member countries torecover some of the MNE’s tax base. When the MNE procures the input from the local input
market (scheme I), there are no opportunities to shift profits and all the tax base is retained incountry H. When the MNE adjusts its transfer price to meet the VA criterion of ROO, a part of
the tax base is retained in country H because of the limited use of abusive transfer pricing.
Notably, we can confirm that 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−∆+

a − w + ∆ − λτ
.
2
|
{z
}

(10)

Tax avoidance motive

The second term of equation (10) represents the tax avoidance motive, which makes the transfer
price as high 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 and the optimal transfer price is expressed aserB = w − ∆ +a−w+∆
2| {z }Tax avoidance motive−α{(1 − t)a + (1 − T)(w − ∆) − α(T − t)a}.
2{1 − t − (T − t)α}
|
{z
}

(11)

Tariff eliminative motive

The third term of equation (11) captures the tariff elimination motive, which is zero at α = 0
and increasing in α. If the Tariff elimination motive is sufficiently large such that er B is lower
16

Figure 3: The direction of the MNE’s shifted profits
than w − ∆, the profits of the MNE are shifted from the low-tax country to the high-tax country,
which is in sharp contrast to the conventional effect of transfer pricing.
Therefore, the direction of profit shifting relies on the size of the two motives. Indeed,r B < w − ∆ holds and profits shift from
we can derive a unique threshold of α, αr , such that e

a high-tax country to a low-tax country if α > αr holds. Figure 3 illustrates the reversal of
profit shifting.25 The dotted line represents αr and the dotted area in the figure is the case inwhich profits flow from a low-tax country to a high-tax country. The following propositionsummarizes the effect on tax revenue.
Proposition 4. An FTA formation with ROO reduces the profits of the MNE shifted from ahigh-tax country to a low-tax country if the MNE utilizes an FTA tariff. The MNE rather shifts
its profits from a low-tax country to a high-tax country if tariff elimination motive of transfer
pricing is sufficiently large.
Proof. See Appendix A.3.
This proposition sheds new light on the role of ROO that has been overlooked in policy
debates. As Proposition 2 shows, an FTA formation with ROO can induce the MNE to give up

25We use the following parameters for the figure: a = 1, w = 1/2, ∆ = 1/32, τ = 1/4, and t = 1/10.

17

the self-production of inputs as well as the opportunity to avoid tax.26 This result suggests thata VA criterion provides another channel to keep MNEs away from tax avoidance by restricting
the extent of abusive transfer pricing. Thus, although the main purpose of imposing ROO is toprevent trade circumvention, ROO also play a role in preventing tax avoidance.
Furthermore, Proposition 4 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.27

4.3 Total welfare of member countries
Let us discuss how the presence of ROO changes the effect of FTA formation on the total
welfare of member countries. Remember that Proposition 1 suggests that an FTA without ROO
is feasible in the sense that it increases the total welfare of member countries if and only if theinitial tariff is sufficiently large (τ > τW ).
As seen in this section, ROO reduce consumers’ gains from an FTA formation in country
F. However, ROO also help generate tax revenues in country H if the MNE changes its input
procurement or adjusts its transfer price to comply with the ROO. This indicates that ROO canmake an infeasible FTA without ROO feasible and they can also make an initially feasible FTA
without ROO infeasible.
Let us first discuss the welfare effect of an FTA formation in schemes I and B. In the caseof scheme I, total welfare is sum of the consumer surplus and tax revenue from the MNE:
22

e I = (a − w) + T (a − w) .
W
8
4

(12)

e I with WO∗ , we obtain the threshold of T, T
eW , such that W
e I = WO∗ holds at
By comparing W

26This effect would be observed in the other two criteria of ROO, that is, the tariff classification criterion andspecific process criterion.
27Although 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.

18eW , which is given by
T =T
eW = 2(a − w)(∆ + τ) − (τ − ∆)(∆ + 3τ) .
T2(a − w)2(13)

e I > WO∗ for T > T
eW and W
e I > WO∗ holds for T < T
eW . An FTA with ROO improves
We have W
total welfare when the corporate tax in country H is sufficiently large and the tariff revenue

gains from the ROO dominate the loss of the consumer surplus.
Total welfare under scheme B also includes tax revenue from the MNE, given byeB =W{(1 − t)(a − w + ∆) − αa(T − t)}28{1 − t − α(T − t)}2)({(1 − t)(a + w − ∆) − αa(T − t)}{(1 − t)(a − w + ∆) − αa(T − t)}.
+ Tα4{1 − t − α(T − t)}2(14)

e B = W).
b Starting
At α = 0, regime B is identical to the post-FTA equilibrium without ROO (We B . On thefrom α = 0, an increase in the stringency of ROO has two opposite effects on W

one hand, a stricter VA requirement reduces the transfer price and thereby increases the tax
revenue that country H collects. On the other hand, it diminishes consumers’ gains from an
FTA formation by increasing the MNE’s perceived marginal cost and reducing the amount ofe B and α. Specifically, theexports. There is thus an inverted U-shaped relationship between W
eBW> 0 holds when α is small, whereas the latter effectformer effect dominates the latter and ∂∂αeBWdominates the former and ∂∂α< 0 holds when α is large.28

Because of the increased tax revenue, ROO can make an initially infeasible FTA feasible.
Suppose τ < τW , with which an FTA without ROO reduces total welfare (see Proposition 1).
Since stricter ROO improve post-FTA welfare in scheme B, post-FTA welfare can be larger
than pre-FTA welfare even with τ < τW . Specifically, we can specify a threshold of α, αW ,e B = W O∗ holds.29 When αW < min[α I , α N ] holds, an FTA formation improvesat which W
exB

28Let α x be the threshold of α such that the amount of exports is constant before and after the FTA is formed,
2W
fB
fB
fB
W
< 0, and W∂α |α=α x < 0, there exists a unique threshold,= xO∗ . Since we have ∂∂α|α=0 > 0, ∂∂α
2
fB

W
x
αW
= 0 holds.
0 ∈ [0, α ), such that ∂α |α=αW
0x29At α = α , an FTA formation does not change the MNE’s exports of the final good or the consumer
surplus. We can simplify the change in total{(welfare) (to the sum) of }tax revenue and the loss of tariff revenue,
T (1−t)B
a+w−∆+τ
x
O∗
O∗
W ∈
B
e
π H − τx = τx
W − WO∗ |α=α x = T α eT −t2(w−∆+τ) − 1 > 0. This means that a threshold αe B = W O∗ .
[0, α x ) exists that satisfies W

19

Figure 4: ROO and the feasibility of an FTA formation
the total welfare of member countries in scheme B for α > αW .30 The left figure of Figure 4
provides a numerical example that αW < min[α I , α N ] holds.31 In the shaded area in scheme
B, an FTA formation improves total welfare. Further, an FTA formation can improve total
welfare in scheme I. As shown above, an FTA formation improves total welfare in scheme I ifeW holds. Therefore, ROO can transform an infeasible FTA into a feasible one because
T >T
the increased tax revenue from the MNE compensates for the tariff revenue loss.

Proposition 5. When τ < τW holds and an FTA formation is infeasible without ROO, an FTA
formation with ROO improves the total welfare of member countries if the MNE adjusts its
transfer price to comply with the ROO and αW < α < min[α I , α N ] hold or if the MNE purchaseseW holds. In these cases, ROO make an initially infeasible FTA feasible.
local inputs and T < T

However, ROO may negatively affect total welfare and make an initially feasible FTA

formation infeasible. The right figure of Figure 4 corresponds to the case with τ > τW , where
the formation of an FTA without ROO is beneficial for member countries. The dotted curvein scheme B represents αr , above which we see the reversal of profit shifting discussed in theprevious section. The figure shows that an FTA stays feasible even if we take ROO into account,so that ROO increase the gains of forming an FTA under scheme B in the equilibrium becausee B is an inverted U-shaped curve in α, we always have W
e B > W O∗ at α = min[α I , α N ] because
30Although WINxmin[α , α ] < α holds. This means that an FTA formation always improves total welfare for αW < α ≤min[α I , α N ].
31The parameters are set as follows: a = 1, ∆ = 1/32, and τ = 1/4. The left figure is drawn with w = 1/2 andt = 1/10, whereas the right figure uses w = 2/3 and t = 0.

20

eB
∂W
∂α > 0|α=0 holds. If both α and T are high so that scheme N is the equilibrium outcome, there

is no welfare change from an FTA formation. Moreover, if the equilibrium outcome is schemeeW holds, the gains from increased tax revenue are smaller than the loss from the
I and T ≤ Tlower consumer surplus. In this case, ROO transform a welfare-improving FTA formation intoa welfare-reducing one.
The next proposition summarizes these results.
Proposition 6. When τ ≥ τW holds and an FTA formation is feasible without ROO, an FTA
formation with ROO deteriorates total welfare if it induces the MNE to purchase local inputs
eW holds. In this case, ROO can make an initially feasible FTA
to meet the ROO and T ≤ T

infeasible.

From Propositions 3 and 4, we know that an FTA with ROO benefits consumers andmakes profit shifting difficult. Proposition 5 suggests that ROO with a certain level of α canbe necessary for FTA formation. A formation of an FTA with ROO works as an effective
policy not only to promote trade liberalization but also to prevent the MNE from engaging intax avoidance, and the latter effect is important to secure welfare-improving FTA formation.
Proposition 6 suggests, however, that ROO can also deter the formation of an FTA if it is feasible
without ROO.

5 Discussion
Our benchmark analysis provided a set of new results not thus far explored in the extant literature.
In this section, we discuss an extension of the model and the robustness of the main results byrelaxing some of the assumptions made in the benchmark model.

5.1 The optimal VA requirement
We showed that the MNE’s choice and welfare effect of an FTA critically depend on the levelof α. Here, we discuss how member countries choose α if it is endogenously determined.
eBW
As ∂∂α|α=0 > 0 holds, the optimal level of the VA ratio, which is denoted by αOpt , isalways positive. Under scheme B, total welfare is an inverted U-shaped curve in α, and it is21

Figure 5: The welfare of member countries with the optimal level of α
eB

∂W
W
I
N
maximized at α = αW
0 at which ∂α = 0 is satisfied. If α 0 < min[α , α ] holds, and theWIN
welfare-maximizing level within scheme B becomes αW
0 . If α 0 ≥ min[α , α ] holds, however,it becomes the upper bound of α in scheme B, min[α I , α N ].
A further increase in α changes the equilibrium scheme from scheme B to either scheme Nor scheme I. The full tax avoidance in scheme N means that total welfare is independent of thecorporate tax in country H. Total welfare in scheme I, however, is increasing in T because it
generates more tax revenues.
Figure 5 illustrates a numerical example that shows maximized total welfare in each schemewith optimal VA criterion, when τ < τW holds.32 The solid curve is total welfare in scheme
B given that α is optimally set to maximize total welfare. The two dotted lines illustrate totaleα , which
welfare in schemes I and N. In this example, we can see a threshold of T, denoted as T

eB = WeI.
satisfies W

eα holds, Scheme B realizes the highest total welfare. In this case, the optimal
If T < Teeα < T < T
VA criterion is the highest one that realizes scheme B, αOpt = min[1, α I ]. If T

holds, Scheme I brings the highest total welfare. In this range of T, the optimal α is any α thateinduces the MNE to purchase local inputs within FTA countries, or αOpt ∈ (α I , 1]. If T > T
32This figure is drawn with the following parameters: a = 1, w = 1/2, ∆ = 1/32, τ = 1/4, and t = 1/10.

22

holds, scheme B again realizes the highest total welfare. However, the optimal level is less thanNthe highest one that realizes Scheme B, and it is given by αOpt = αW
0 < α . This is easily

understood by considering the perceived marginal costs. Remember the perceived marginal costrises as the tax gap widens or the VA criterion becomes stricter. A higher perceived marginal
cost decreases the amount of exports, e
x B , as the tax gap widens or the VA criterion becomes
stricter. Since the degree of the decrease in exports and its welfare cost are small when the tax

eα holds. If the tax gap is large,
gap is small, the increase in tax revenues dominates when T < Thowever, the optimal level of the VA requirement in scheme B balances out the gains from theincreased tax revenues and losses from the increased perceived marginal cost.

This numerical analysis suggests that to determine the stringency of ROO, policymakers
should take into account its effects on tax revenues. In reality, VA thresholds are usually set
between 30% and 60%.33 Our model predicts that the VA criterion of ROO may play a positiverole in preventing tax avoidance by MNEs and secure welfare gains for member countries when
the host countries of export platform MNEs impose high tax rates. This is actually the case withNAFTA (now USMCA), where Mexico attracts FDI and levies a high corporate tax. Moreover,as different VA thresholds are imposed on different products, the design of a VA criterion or
choice of ROO criteria should differ across the products MNEs actively produce.

5.2 Partial procurement of inputs
We have assumed that the MNE makes a binary choice about input procurement, that is, a“make all or buy all” choice. It would be more realistic to suppose that the MNE purchases
some proportion of parts from local suppliers and procures the rest via intra-firm transactions,which we refer to as scheme P.
Suppose that the MNE uses a continuum of inputs indexed in the [0, 1] space. Let β ∈ [0, 1]
denote the proportion of inputs that firm MH procures from firm MO in country O. This meansthat the 1 − β proportion of the input is procured within FTA countries. The amount of intra-firm

33See
http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=TAD/TC/
WP(2015)28/FINAL&docLanguage=En.

23

trade becomes βx and the modified VA ratio is given by p−βr
p . The MNE maximizes
Π = (1 − t)[β{r − (w − ∆)}x + π] + (1 − T)[{p − βr − (1 − β)w}x](15)with respect to x, r, β, which is subject to πH ≥ 0, πO ≥ 0, and p−βr
p ≥ α.
P
Since ∂Π∂r > 0 holds, the optimal transfer price, r , is again set at the level such thatp − βr P − (1 − β)w = 0 is satisfied. Furthermore, we can also confirm that ∂Π∂ β > 0 always
holds, which implies that the MNE sets β as high as possible. Formally, the optimal β satisfies
αpβ = max{0, 1 − w ≡ β P }. Let x P denote the corresponding optimal level of x. Then, theequilibrium post-tax profits in scheme P becomePΠ = (1 − t)

[(

)
]
α∆
P
P
(p − cM )x + π ,
1−
w

(16)

P = w(w−∆) , which falls between w − ∆ and w.
where the modified perceived marginal cost is cM
w−α∆

The reason why the optimal β can be zero is explained as follows. Given that the MNE setsw
the abusive transfer price as r P , the VA ratio with r = r P becomes (1−β)w
p . If p ≤ α holds, the

MNE can never comply with the ROO when β > 0. Since wp 1, there exists a unique cutoff of α,α Pβ=0 , above which the MNE sets β P = 0. In this case, the MNE manipulates its transfer price tocomply with the ROO (i.e., scheme B), or it may choose scheme I or N. Thus, we can conclude
that schemes N, I, and B are still the equilibrium outcomes when α ≥ α Pβ=0 holds, whereas thearea of scheme B is replaced with that of scheme P below α < α Pβ=0 .
One notable difference from the benchmark model is that ROO can transform a feasible
FTA into an infeasible one in scheme P. This happens in the benchmark model when theequilibrium outcome is scheme I. However, in this modified setup, the MNE’s tax base is zero
and ROO reduce the gains from an FTA formation, which generates a possibility that ROO
P be the threshold such
worsen total welfare if the required VA ratio is high. Specifically, let αW

e P = W O∗ holds. Then, an FTA formation is infeasible when α > α P holds.
that WW

24

5.3 Concealment costs for transfer price manipulation
In the benchmark model, the MNE can freely manipulate the transfer price. Here, we show thatthe assumption of costless transfer pricing is not critical to obtain the main results.
In practice, MNEs need to explain the plausibility of transfer pricing to shift profits acrosscountries. As MNEs shift more profits between countries, explaining the reasons for thegreater deviation from the appropriate price, or the arm’s length price, becomes more difficult.
Following the literature on transfer pricing, we introduce the following “concealment cost” inthe case of offshoring, which is increasing in the gap between the transfer price and production
cost of inputs:
C(r, x O ) =δ{r − (w − ∆)}2 x O
.
2

(17)

In this concealment cost, the parameter δ captures the difficulty of concealing tax avoidance,
which reflects a well-enforced tax authority, for example. The post-tax profits under offshoring
are modified asΠ O = (1 − t)[{r − (w − ∆)}x O π] + (1 − T)[(p − r − λ M τ)x O ] − C(r, x O ),= (1 − t)π + (1 − T)(p − cCM )x O ,(18)
2+ δ{r−(w−δ)}is the effective marginal cost.
where cCM = (1−t)(w−∆)+(1−T)λτ−(T−t)r
1−T
2(1−T)In this setup, the concealment cost can prevent the MNE from transferring all the profits
from country H to country O. In other words, the MNE can choose the transfer price and final
good price such that p > r + λ M τ holds, even in the absence of ROO. Given that some of the
MNE’s tax base remains in country H, our welfare analysis has several modifications.
First, an FTA formation in the absence of ROO now depends on the tax differential between
T and t. Substituting the optimal level of r that maximizes Π O into cCM , the perceived marginal
2

cost in the equilibrium is calculated as cCM = w − ∆ + λτ − (T−t)
2δ . Thus, as the tax difference
between countries widens, the perceived marginal cost lowers. Since the MNE becomes lesswilling to increase r because of the concealment cost, it has an incentive to increase x O andlower p, which saves the MNE’s tax payments in country H by narrowing the gap between p andr + λ M τ. This incentive is reflected in the perceived marginal cost. Because the elimination of25

tariffs increases the gap between p and r + λ M τ, it gives the MNE an extra incentive to increasex O to avoid tax payments. The increase in x O is advantageous for member countries because it
benefits consumers. Therefore, in the presence of concealment costs, an FTA formation without
ROO is more likely to benefit member countries as the tax gap widens.
Second, p > r + λ M τ implies that the VA ratio is positive even in the absence of ROO. In thebenchmark model, the MNE always chooses a zero VA ratio in FTA countries in the absence of
ROO. This implies that the VA requirement of ROO affects neither the MNE’s transfer pricing
nor its location choice when α is sufficiently small because the MNE has already satisfied therequired VA ratio.
Even if we consider these new elements, the nature of our results does not change. Specifically, an FTA formation without ROO may harm member countries, and ROO can transform an
infeasible FTA into a feasible one. The opposite case is also possible, where ROO transform afeasible FTA into an infeasible one.

5.4 The role of profit shifting
So far, we have analyzed the impact of ROO given the MNE always has an option to manipulatetransfer price to shift profits. In the literature on tax avoidance, whether profit shifting itself
is harmful for high-tax countries is one of the main interests. Although profit shifting hurts
high-tax countries by reducing tax revenues, the effect is more complicated than it seems. For
instance, Hong and Smart (2010) theoretically showed that the use of tax havens is beneficial
for a high-tax country because it stimulates the economic activities of MNEs and enables ahigh-tax country to set an even higher tax rate. Here, we provide another reason why MNEs’
profit shifting is beneficial for high-tax countries. To this end, we consider the situation inwhich the MNE cannot manipulate transfer price.
In this alternative setup, the intra-firm transaction takes place at the price of w − ∆ and all
the tax base of the MNE remains in country H irrespective of whether an FTA is formed. Thismeans that scheme O is always the optimal choice for the MNE in the pre-FTA equilibrium.
a−w+∆≡ αUB . Therefore,
Once an FTA with ROO is formed, the VA ratio is calculated as α = a+w−∆

the MNE keeps producing its own inputs in country O as long as α ≤ αUB holds. If α > αUB
26

holds, however, the MNE cannot comply with the ROO on the self-production of inputs. In thiscase, the MNE always starts procuring inputs inside the FTA (scheme I) because the gains fromthe elimination of tariff is greater than the loss from the higher input cost (i.e., τ > ∆). Fromthe viewpoint of welfare, FTA countries prefer the MNE to produce its own inputs (scheme O)
and thus they set the optimal VA ratio below αUB .
Given this equilibrium property under no profit shifting, we compare the post-FTA welfareof high-tax member countries with and without profit shifting. The required VA ratio with profit
shifting is also set at the level that maximizes the joint welfare of member countries. We findthat if the corporate tax rate in the high-tax country, T, is relatively small, profit shifting can
improve the welfare of high-tax member countries.34
The intuition behind this outcome is explained as follows. Without profit shifting, country
H can collect tax revenues from the MNE, but these are relatively small because T is notlarge. Thus, the welfare of high-tax member countries becomes relatively small in these tax
environments. With profit shifting, Proposition 4 suggests that the MNE rather shifts its profits
from a low-tax country to a high-tax country if τ is relatively high and the tariff elimination
motive of transfer pricing is large. This implies that allowing transfer pricing actually leads
to larger tax revenues in high-tax countries because the MNE manipulates its transfer price toeliminate tariffs rather than avoid tax. Thus, our analysis provides the possibility that transfer
pricing benefits a high-tax country.

6 Conclusion
The recent proliferation of FTAs is playing a key role in advancing trade liberalization between
countries and the cross-border economic activities of MNEs prevail globally. This study
investigated a vertically integrated MNE’s input production and pricing strategies to analyze thewelfare effects of FTA formation when the MNE can manipulate its transfer price of intra-firmtrade. As in previous studies, the MNE uses its transfer price to avoid a high corporate tax. Afterthe formation of an FTA, however, there emerges another reason for transfer price manipulationin the presence of ROO. Specifically, if the ROO of the FTA employ a VA criterion, the FTA
34The detailed calculation of the numerical example in this case will be provided upon request.

27

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,transfer price adjustment decreases the efficiency of tax avoidance so that the manipulation of
the transfer price for the ROO is suboptimal. If the tax gap between a country outside the 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 in 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
via either a change in procurement strategy or another use of transfer prices. Owing to theemergence of the MNE’s tax base, ROO can transform an infeasible FTA into a feasible one.
Therefore, the formation of FTAs with 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 the opposite of that under common
knowledge when the MNE manipulates the transfer price for ROO.
The above argument does not indicate that the highest VA criterion is always optimal because
it deteriorates the efficiency of tax avoidance, increases the MNE’s perceived marginal cost,and reduces the amount of exports to another FTA member country. Our analysis showed thatthe optimal VA level depends on corporate tax rates. This implies that policymakers should pay
close attention to the link between tariffs and corporate taxes even though cooperation between
customs departments and tax authorities is rarely observed in reality.
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

28

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 2
The post-tax profits of the MNE under schemes N and I are given by2

e N = (1 − t)(a − w + ∆ − τ) + (1 − t)π,
Π
4
(1
−
T)(a
−
w)2
eI =
Π
+ (1 − t)π.
4

(A-1)
(A-2)

The condition under which the MNE prefers scheme I to scheme N is given by(a−w+∆−τΠ − Π > 0 ⇐⇒ T < 1 − (1 − t)
a−w
eI

eN

)2

e
≡ T.

(A-3)

From equation (9), we can easily confirm that the following inequality holds:
2eN, Πe I }.
e B |α=0 = (1 − t)(a − w + ∆) + (1 − t)π > max{ Π
Π
4

(A-4)

e B with respect to α is
Further, the first derivative of Πe B (T − t){(1 − t)(a − w + ∆) − (T − t)aα}∂Π[−{1 − t − (T − t)α} − (1 − t)(w − ∆)] < 0.
=∂α4{1 − t − (T − t)α}(A-5)

x B = x O∗ (= ex N ) holds. Specifically, we have
Let α x denote the cutoff level of α x such that eex B ⋛ x O∗ ⇐⇒ α ⋚(1 − t)τ
≡ αx.
(T − t)(w − ∆ + τ)

29

(A-6)

If evaluated at α = α x , equation (9) becomes
)
(
2
eN .
e B |α=αx = (1 − t)(w − ∆)(a − w + ∆ − τ) + (1 − t)π < ΠΠ4(w − ∆ + τ)

(A-7)

eN ≥ Π
eN
This implies that there exists the unique cutoff level of α, α N ∈ (0, α x ), such that ΠeIe Moreover, remember that ∂ Π < 0 and ΠeeI = Π
e N holds at T = T.
holds with α ≤ α N and T ≥ T.
∂T
Then,

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

(A-8)

e Note that Π
eB > Π
e I holds if the following condition is satisfied:holds for any T ∈ [t, T].
)
(
w−∆
I
B
e
e
.
Π |α=1 > Π ⇐⇒ T < 1 − (1 − t)
w

(A-9)

eB ≥ Π
e I holds
This implies that there exists the unique cutoff level of α, α I ∈ (0, α x ), such that Π)(e≤ T < T.
with α ≤ α I and 1 − (1 − t) w−∆
w

A.2 Proof of Proposition 3
Under scheme I, the changes in the amount of supplies from the pre-FTA equilibrium to thepost-FTA equilibrium without ROO are
τ−∆
> 0,
2
−∆
e
xI − b
xO =
< 0,
2

e
x I − x O∗ =(A-10)(A-11)

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

30(A-12)

A.3 Proof of Proposition 4
From equation (11), we obtain{1 − t − (T − t)α}2 + (1 − T)(1 − t)(w − ∆)
∂e
rB
< 0.
=−
∂α
2{1 − t − (t − t)α}2(A-13)

r B takes the minimum value at
Therefore, er B = w − ∆ + a−w+∆> w − ∆ holds at α = 0 and e2
α = 1, which is given byer B |α=1 = 0 < w − ∆.

(A-14)

e holds. Therefore, there exists a unique α such
Scheme B is the equilibrium at any α if T < Trthat er B < w − ∆ holds when α > αr holds.

B. Key Symbols for Notations
SchemeNo FTA (w/ “∗”)Offshoring (s = O)
FTA w/o ROO (w/ “c”)
Offshoring (s = O)
FTA w/ ROO (w/ “f”)
Inshoring (s = I)
Non-compliance (s = N)
Binding ROO (s = B)λExportTransfer price

MNE’s post-tax profits

FTA Welfare

1

x O∗

r∗

Π O∗

W O∗

0

b
xO

b
r

bO
Π

bO
W

0
1
0

e
xI
e
xN
e
xB

e
rI
e
rN
e
rB

31

eI
Π
eN
Π
eB
Π

eI
W
eN
W
eB
W

References
Bauer, C.J., Langenmayr, D., 2013. Sorting into outsourcing: Are profits taxed at a gorilla’s
arm’s length? Journal of International Economics 90, 326–336.
Blouin, J.L., Robinson, L.A., Seidman, J.K., 2018. Conflicting transfer pricing incentives andthe role of coordination. Contemporary Accounting Research 35, 87–116.
Choe, C., Matsushima, N., 2013. The arm’s length principle and tacit collusion. International
Journal of Industrial Organization 31, 119–130.
Choi, J.P., Furusawa, T., Ishikawa, J., 2018. Transfer pricing and the arm’s length principle
under imperfect competition. CESifo Working Paper No. 7303.
Clausing, K.A., 2003. Tax-motivated transfer pricing and US intrafirm trade prices. Journal of
Public Economics 87, 2207–2223.
Conconi, P., García-Santana, M., Puccio, L., Venturini, R., 2018. From final goods to inputs:
the protectionist effect of rules of origin. American Economic Review 108, 2335–65.
Cristea, A.D., Nguyen, D.X., 2016. Transfer pricing by multinational firms: New evidence
from foreign firm ownerships. American Economic Journal: Economic Policy 8, 170–202.
Davies, R.B., Martin, J., Parenti, M., Toubal, F., 2018. Knocking on tax haven’s door: Multinational firms and transfer pricing. Review of Economics and Statistics 100, 120–134.
Demidova, S., Krishna, K., 2008. Firm heterogeneity and firm behavior with conditional
policies. Economics Letters 98, 122–128.
Dürr, O.M., Göx, R.F., 2011. Strategic incentives for keeping one set of books in internationaltransfer pricing. Journal of Economics & Management Strategy 20, 269–298.
Eden, L., 1998. Taxing multinationals: Transfer pricing and corporate income taxation in North
America. University of Toronto Press.
Elitzur, R., Mintz, J., 1996. Transfer pricing rules and corporate tax competition. Journal of
Public Economics 60, 401–422.
32

Estevadeordal, A., Suominen, K., 2003. Rules of origin in the world trading system, in:document presented at the Seminar on Regional Trade Agreements of WTO (Geneva, 14
November).
European Commission, 2011. Proposal for a council directive on a common consolidated
corporate tax base (CCCTB). COM (2011) 121 final .
Falvey, R., Reed, G., 1998. Economic effects of rules of origin. Weltwirtschaftliches Archiv
134, 209–229.
Felbermayr, G., Teti, F., Yalcin, E., 2019. Rules of origin and the profitability of trade deflection.
Journal of International Economics 121, 103248.
Freund, C., Ornelas, E., 2010. Regional trade agreements. Annual Review of Economics 2,
139–166.
Hayakawa, K., Hiratsuka, D., Shiino, K., Sukegawa, S., 2013. Who uses free trade agreements?
Asian Economic Journal 27, 245–264.
Hong, Q., Smart, M., 2010. In praise of tax havens: International tax planning and foreign
direct investment. European Economic Review 54, 82–95.
Horst, T., 1971. The theory of the multinational firm: Optimal behavior under different tariff
and tax rates. Journal of Political Economy 79, 1059–1072.
Hyde, C.E., Choe, C., 2005. Keeping two sets of books: The relationship between tax andincentive transfer prices. Journal of Economics & Management Strategy 14, 165–186.
Ishikawa, J., Mukunoki, H., Mizoguchi, Y., 2007. Economic integration and rules of origin
under international oligopoly. International Economic Review 48, 185–210.
Ju, J., Krishna, K., 2005. Firm behaviour and market access in a free trade area with rules oforigin. Canadian Journal of Economics/Revue canadienne d’économique 38, 290–308.
Kant, C., 1988. Foreign subsidiary, transfer pricing and tariffs. Southern Economic Journal ,162–170.
33

Kato, H., Okoshi, H., 2019. Production location of multinational firms under transfer pricing:
The impact of the arm’s length principle. International tax and public finance 26, 835–871.
Krishna, K., Krueger, A., 1995. Implementing free trade areas: Rules of origin and hidden
protection. Technical Report. National Bureau of Economic Research.
Mukunoki, H., 2017. The welfare effect of a free trade agreement in the presence of foreign
direct investment and rules of origin. Review of International Economics 25, 733–759.
Mukunoki, H., Okoshi, H., 2019. Rules of origin and consumer-hurting free trade agreements.
Munich Discussion Papers .
Nielsen, S.B., Raimondos-Møller, P., Schjelderup, G., 2003. Formula apportionment andtransfer pricing under oligopolistic competition. Journal of Public Economic Theory 5,
419–437.
Nielsen, S.B., Raimondos-Møller, P., Schjelderup, G., 2008. Taxes and decision rights in
multinationals. Journal of Public Economic Theory 10, 245–258.
Reuter, P., 2012. Draining development?: Controlling flows of illicit funds from developing
countries. World Bank Publications.
Schjelderup, G., Sorgard, L., 1997. Transfer pricing as a strategic device for decentralized
multinationals. International Tax and Public Finance 4, 277–290.
Stoyanov, A., 2012. Tariff evasion and rules of origin violations under the Canada-US free trade
agreement. Canadian Journal of Economics/Revue canadienne d’économique 45, 879–902.
Swenson, D.L., 2001. Tax reforms and evidence of transfer pricing. National Tax Journal ,7–25.
Takahashi, K., Urata, S., 2010. On the use of FTAs by japanese firms: Further evidence.
Business and Politics 12, 1–15.
Tekin-Koru, A., Waldkirch, A., 2010. North–south integration and the location of foreign direct
investment. Review of International Economics 18, 696–713.
34

Tintelnot, F., 2017. Global production with export platforms. The Quarterly Journal of Economics 132, 157–209.
WCO, 2018. WCO guide to customs valuation and transfer pricing, World Customs Organization.

35