One Set or Two Sets of Books: The Impact of a Strategic Tax Auditor
37 Pages Posted: 1 Sep 2017
Date Written: July 1, 2017
Using a game theoretical setting, this paper studies how a multinational company’s (MNC) choice of using one set (OSB) or two sets of books (TSB) is affected by a strategically acting tax auditor (TA). First, a divisionalized MNC with a producing division in a low tax country and a selling division in a high tax country chooses either OSB or TSB. With OSB, the unique transfer price coordinates the quantity decision and determines the tax payments. With TSB, two transfer prices are used for both tasks. Second, a TA may audit the MNC’s transfer prices.
It turns out that the TA’s bargaining power and his personal audit costs critically inﬂuence the MNC’s transfer pricing decision. For a low bargaining power and low audit costs, the MNC keeps OSB with positive probability. When the TA’s bargaining power is high, the negotiation beneﬁts from using a single transfer price are outweighed by the costs of a reduced ﬂexibility. Then, the MNC keeps TSB with either tax aggressive or compliant reported transfer prices. In addition, a raise in the tax difference induces less tax aggressive behavior. Intuitively, tax aggressiveness should be even more attractive in this case. This intuition is not true in our setting since the TA’s audit probability increases and, thus, makes proﬁt shifting less attractive.
Keywords: transfer pricing, two sets of books, one set of books, strategic tax auditor
JEL Classification: H26, H87, M42
Suggested Citation: Suggested Citation