International Taxation and Production Outsourcing

Abstract

This paper studies the effects of international taxation on multinational firms' production outsourcing strategies, which has attracted recent attention from both practitioners and legislators. We find that under the territorial tax system, the presence of global tax disparity may result in subtle changes of a firm's production outsourcing strategy. In particular, the tax consideration can make the firm more inclined to keep material procurement in house and use buy-sell arrangement to retain profit in low tax jurisdictions. Such an effect can not only cause the firm to choose a more expensive material supplier but also overproduce the products. Therefore, besides the general concern of income shifting, tax considerations can further lead to operational distortions. We show that to reduce tax disparity while preventing tax exemption for shifted foreign profit may lead to a win-win outcome for the firm and the stakeholders. The firm will make more efficient operational decisions to obtain a higher after-tax profit at certain reduced tax rate, while the home country stakeholders can receive more tax income. Interestingly, the foreign contract manufacturer may also benefit from such a change.