Strategic Trade Policy Through the Tax System

10 Pages Posted: 23 Sep 2014

Date Written: September 2014

Abstract

If conventional instruments of strategic trade policy are unavailable, the system of foreign profit taxation and transfer price guidelines may serve as surrogate policy instruments. In this paper, I consider a model where firms from two countries compete with each other on a market in a third country. Both firms have affiliates in the third country where (part of) the production takes place. I analyse optimal policy choices of the firms' residence countries aiming at strategically manipulating the competitiveness of their firms. I show that, first, countries prefer the tax exemption system over the tax credit system if there is no intra‚Äźfirm trade. Second, if the headquarters provide inputs for production in the affiliate, countries prefer the tax exemption system if the transfer price for these inputs is close to the headquarters' variable cost and if the residence country's tax rate is high. However, if transfer prices are high and the residence country's tax rate is low, I show that the tax credit system is an optimal tax policy choice for both countries. From a policy perspective, the view that the tax exemption system is generally the best policy response if domestic firms' competitiveness is a policy goal has to be qualified.

Suggested Citation

Becker, Johannes, Strategic Trade Policy Through the Tax System (September 2014). The World Economy, Vol. 37, Issue 9, pp. 1237-1246, 2014. Available at SSRN: https://ssrn.com/abstract=2499949 or http://dx.doi.org/10.1111/twec.12143

Johannes Becker (Contact Author)

University of Muenster

Schlossplatz 2
Muenster, D-48149
Germany

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