Working Paper: CEPR ID: DP7375
Authors: Christian Keuschnigg; Michael P. Devereux
Abstract: To prevent profit shifting by manipulation of transfer prices, tax authorities typically apply the arm's length principle in corporate taxation and use comparable market prices to `correctly' assess the value of intracompany trade and royalty income of multinationals. We develop a model of heterogeneous firms subject to financing frictions and offshoring of intermediate inputs. We find that arm's length prices systematically differ from independent party prices. Application of the principle thus distorts multinational activity by reducing debt capacity and investment of foreign affiliates, and by distorting organizational choice between direct investment and outsourcing. Although it raises tax revenue and welfare in the headquarter country, welfare losses are larger in the subsidiary location, leading to a first order loss in world welfare.
Keywords: arms length principle; corporate finance; corporate tax; foreign direct investment; outsourcing; transfer prices
JEL Codes: D23; F23; H25
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| arms-length principle (ALP) (F16) | lower transfer prices (F16) |
| lower transfer prices (F16) | less profit shifting (F29) |
| lower transfer prices (F16) | decreased debt capacity (G32) |
| lower transfer prices (F16) | decreased investment of foreign subsidiaries (F23) |
| arms-length principle (ALP) (F16) | distort organizational choices (L29) |
| distort organizational choices (L29) | push firms towards outsourcing instead of FDI (F23) |
| arms-length principle (ALP) (F16) | raise tax revenue and welfare in headquarters country (H29) |
| arms-length principle (ALP) (F16) | reduce welfare in subsidiary location (H53) |
| reduce welfare in subsidiary location + raise tax revenue and welfare in headquarters country (H29) | net negative impact on global welfare (F69) |