Economic Integration and Agglomeration of Multinational Production with Transfer Pricing

Abstract

Do low corporate taxes always favor multinational production over economic integration? We propose a two-country model in which multinationals choose the locations of production plants and foreign distribution affiliates and shift profits between them through transfer prices. With high trade costs, plants are concentrated in the low-tax country; surprisingly, this pattern reverses with low trade costs. Indeed, economic integration has a non-monotonic impact: falling trade costs first decrease and then increase the plant share in the high-tax country, which we empirically confirm. Moreover, allowing for transfer pricing makes tax competition tougher and international coordination on transfer-pricing regulation can be beneficial.

Keywords: Profit shifting; Multinational firms; Intra-firm trade; Trade costs; Foreign direct investment (FDI)

JEL Classification: F12; F23; H25; H26