Sorting into Outsourcing: Are Profits Taxed at a Gorilla's Arm's Length?

37 Pages Posted: 31 Oct 2012  

Christian Bauer

Ludwig Maximilians University of Munich - Department of Economics

Dominika Langenmayr

Catholic University of Eichstaett-Ingolstadt; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: October 30, 2012

Abstract

This article analyzes profit taxation according to the arm’s length principle in a model where heterogeneous firms sort into foreign outsourcing. We show that multinational firms are able to shift profits abroad even if they fully comply with the tax code. This is because, in equilibrium, intra-firm transactions occur in firms that are better than the market at input production. Moreover, market input prices include a mark-up that arises from the bargaining between the firm and the independent supplier. Transfer prices set at market values following the arm’s length principle thus systematically exceed multinationals’ marginal costs, leading to a reduction of tax payments for each unit sold. The optimal organization of firms hence provides a new rationale for the empirically observed lower tax burden of multinational corporations.

Keywords: outsourcing, profit taxation, transfer pricing, arm’s length principle, multinational firms

JEL Classification: F230, L220, H250

Suggested Citation

Bauer, Christian and Langenmayr, Dominika, Sorting into Outsourcing: Are Profits Taxed at a Gorilla's Arm's Length? (October 30, 2012). CESifo Working Paper Series No. 3967. Available at SSRN: https://ssrn.com/abstract=2168630

Christian Josef Bauer (Contact Author)

Ludwig Maximilians University of Munich - Department of Economics ( email )

Geschwister-Scholl-Platz 1
Munich, Bavaria 80539
Germany

Dominika Irma Langenmayr

Catholic University of Eichstaett-Ingolstadt ( email )

Auf der Schanz 49
Ingolstadt, D-85049
Germany

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

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