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JOURNAL OFPU LICECONOMICSEIASFNIER Jour nal of Pub lic Ec ono m ics 60 (199 6) 401 -422

r a n s f e r p r i c i n g r u l e s a n d c o r p o r a t e t a x c o m p e t i t i o nRamy El i tzur , Jack Mintz*

Faculty of Management University of Toronto 246 Blour Street West Toronto OntarioM5S 1V4 Canada

A b str a c t

A mu l t in a t io n a l p a ren t se ll s a n o n -m arke t ed co m mo d i t y t o a fo re ig n su b s id i a rythat uses the p roduct as an inpu t to p roduce a p roduct i t then se l l s . The subsid iary i sco n t ro l l ed b y a lo ca l man ag in g p a r t n e r w h o se co mp en sa t io n co n s i s t s o f a l u mp -su mp aymen t p lu s a sh a re o f t h e su b s id i a ry ' s p ro f i t . T h e p a ren t ch o o ses an o p t ima lt r an s fe r p r i ce t ak in g in t o acco u n t in cen t iv es fo r t h e su b s id i a ry ' s man ag in g p a r t n e ra n d t a x es . H o m e a n d h o s t g o v e r n m e n t s im p o s e c o r p o r a t e i n c o m e t a x e s o n t h e p a r e n tand subsid iary ' s respect ive p rof i t s sub ject to a t ransfer p r ic ing ru le (e .g . cost p lusp r i ce me t h o d o r co mp arab le p ro f i t me t h o d ) . A Nash eq u i l ib r iu m i s d e r iv ed fo re f fec t iv e t ax r a t e s ch o sen b y h o me an d h o s t g o v ern men t s . We t h en ex amin eh armo n iz a t io n an d su g g es t t h a t t ax r a t e s w o u ld b e r ed u ced .Keywords: Co rp o ra t e t ax a t io n ; T ran s fe r p r i c in g

I I n t r o d u c t i o n

R e c e n t l y , t h e r e h a v e b e e n c h a n g e s m a d e t o U . S . t r a n s f e r p r i c i n g r u l e s( S e c t i o n 4 8 2 o f t h e U . S . I n c o m e T a x A c t ) r e s u lt in g f r o m a n e x p r e s s e dc o n c e r n o v e r t h e l o w p a y m e n t o f c o r p o r a t e t ax b y f o r e ig n c o m p a n i e s in th eU n i t e d S t a t e s . S e v e r a l p a p e r s p o i n t i n g t o w a r d s l o w p r o f it s b e i n g e a r n e d int h e U n i t e d S t a t e s h a v e b e e n i n f l u e n t i a l i n p r o v i d i n g e m p i r i c a l s u p p o r t f o r at i g h t e n i n g u p o f tr a n s f e r p r i c i n g r u le s ( e . g . H a r r i s e t a l . , 1 99 3, a n d G r u b e r te t a l . , 1 9 93 ). M o r e o v e r , o t h e r h i g h t ax c o u n tr i e s h a v e a ls o b e c o m e m o r ec o n c e r n e d a b o u t t h e p o t e n t i a l s h i f t o f t a x a b l e i n c o m e o u t o f t h e i r ju r i s d ic -t io n ( s e e , f or e x a m p l e , Tax Notes International 6 ( 2 3 ) , 7 J u n e , 1 9 9 3, 1 3 5 9 ) .

* Corresponding author.0047-2727/96/$15.00 1996 Elsevier Science S.A . All rig hts reservedSSDI 0 0 4 7 - 2 7 2 7 ( 9 5 ) 0 1 5 5 8 - 2


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402 R. Elitzur, J. Mintz / Journal of Public Economics 60 1996) 401-422P o l i c y - m a k e r s o f t e n v i e w t r a n s f e r p r ic e s a s b e i n g m a n i p u l a t e d b y m u l t in a -t i o n a l s t o m i n i m i z e t a x e s . T r a n s f e r p r i c i n g r u l e s i n m a n y c o u n t r i e s a s s u m et h a t t h e c o r r e c t p r i c e t o a s s e s s f o r n o n - m a r k e t e d t r a n s a c t i o n s i s a c o m p a r -

a b l e p r i c e o f a s i m i l a r a r m ' s l e n g t h t r a n s a c t i o n a d j u s t e d f o r q u a l i t y a n d o t h e rd i f f e r e n t i a l a t t r i b u t e s s u c h a s b u s i n e s s r i s k ( s e e B e r n a r d a n d W e i n e r , 1 9 9 0 ;E d e n , 1 98 5) . T h e r u le s m a y re q u i r e t h e u s e o f a n u m b e r o f d i f f e r e n tm e t h o d s f o r c a l c u la t io n s . I n m a n y c a s e s t h e r e is n o s i m i la r tr a n s a c t e d p r ic e dt h a t c a n b e u s e d . I n s t e a d , a s i n t h e U n i t e d S t a t e s w h e r e t h e d e v e l o p m e n t o ft r a n s f e r p r i c i n g r u l e s h a s b e c o m e a n a r t , s e v e r a l a l t e r n a t i v e m e t h o d o l o g i e sh a v e b e e n p r e s c r i b e d w h e n t h e r e i s n o c o m p a r a b l e u n c o n t r o l l e d p r i c e : ( i )t h e r e s a l e p r i c e m e t h o d , ( i i ) t h e c o s t - p l u s p r i c e m e t h o d a n d , m o s t r e c e n t l y ,( ii i) t h e c o m p a r a b l e p r o fi t m e a s u r e . 1 T h e i m p l i c a ti o n o f t h e s e m e t h o d s u s e dt o m e a s u r e t r a n s f e r p ri c es i s t h a t t h e c o m p a n y c a n n o t u s e t h e a c t u a l t ra n s f e rp r i c e t o m e a s u r e s a l e s o r c o s t s . I n s t e a d , s o m e ' o b j e c t i v e ' m e a s u r e m u s t b eu s e d t h a t a d j u s t s t h e s a l es o r c o s t s o f t h e f ir m f o r a n t i c i p a t e d p r o f i le s e a r n e din t h e p a s t b y f i r m s in a s im i l a r l i n e o f b u s in e s s ac t i v i t y .T h i s v i e w , t h a t t r u e t r a n s f e r p r i c e s a r e e s s e n t i a l l y b a s e d o n s a l e s o r c o s tso f p r o d u c t i o n ( w i t h a n a d j u s t m e n t f o r a n a s s u m e d p r o f i t r a t e ) , f a i l s t or e c o g n i z e t h e r o l e o f tr a n s f e r p ri c e s i n i n f l u e n c i n g t h e b e h a v i o u r o fs u b s i d i a r i e s t h a t a r e c o n t r o l l e d b y t h e p a r e n t . 2 A s r e c e n t l y e m p h a s i z e d i n th ea c c o u n t i n g l i te r a t u r e ( R o n e n a n d B a l a c h a n d r a n , 1 98 8; J o r d a n , 19 89; A m e r -s h i a n d C h e n g , 1 9 9 0 ; H a l p e r i n a n d S r i n i d h i , 1 9 9 1 ; D a t a r a n d B a n k e r , 1 9 9 1 ) ,t h e t r a n s f e r p r i c e m a y b e u s e d a s p a r t o f a n i n c e n t i v e s c h e m e t o i n d u c ed i v i s i o n s to i m p r o v e t h e i r e f f i c ie n c y . If c o n t r o l i s a n i s s u e , t h e t r a n s f e r p r i c en e e d n o t b e e q u a l t o t h e m a r g i n a l c o s t o f p r o d u c t i o n s i n c e i t i n f l u e n c e s t h ea g e n c y c o s t s f a c e d b y t h e p a r e n t w h e n c o n t r o l l i n g s u b s i d i a r i e s . T h e r e f o r e ,t r a n s f e r p r ic i n g b y m u l t i n a t i o n a l s m a y b e u s e d n o t o n l y t o m i n i m i z e t ax e sb u t a l s o to i m p r o v e t h e e f f i c i e n c y o f w o r l d w i d e o p e r a t i o n s .I n t hi s p a p e r w e m o d e l a m u l t i n a t i o n a l p a r e n t o p e r a t i n g i n a h o m ec o u n t r y ( e .g . J a p a n ) t h a t s el ls a n o n - m a r k e t e d c o m m o d i t y o n l y t o as u b s i d ia r y o p e r a t i n g i n a f o r e i g n c o u n t r y . T h e s u b s id i a ry u s e s t h e c o m m o d i -t y a s a n i n p u t t o p r o d u c e a p r o d u c t t h a t i s o n l y s o ld in a c o m p e t i t i v e m a r k e to f a h o s t c o u n t r y ( e . g . t h e U n i t e d S t a t e s ) . T h e s u b s i d i a r y , w h i c h o p e r a t e su n d e r d e c r e a s i n g r e t u r n s t o s c a le , u s e s a f i xe d i n t a n g i b l e i n p u t p r o v i d e d b yt h e m u l t i n a t i o n a l p a r e n t . M o r e o v e r , t h e s u b s id i a ry is c o n t r o l l e d b y a lo c a lm a n a g i n g p a r t n e r w h o s e e f f o r t i n t h e s u b s i d i ar y is r e w a r d e d b y a p o r t io n o ft h e p r o f i ts e a r n e d b y t h e s u b s i d i a r y p l u s a l u m p - s u m t r a n s f e r . T h e p a r e n t

' See the review by H orst (1993) on the U .S. rules.2 For e xam ple, Granfield (1993, p. 100) has recently noted that: The vertically integratedMNC (mu ltinational corporation) can also ach ieve greater p rofits than two arm 's leng th firmsperforming similar functions simply by app ropriately structuring he internal, to MN C, transferprices.


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R . E l i t zu r , J . M i n t z / J o u r n a l o f P u b l ic E c o n o m i c s 6 0 1 9 9 6 ) 4 0 1 - 4 2 2 4 0 3

c a n n o t o b s e r v e t h e l e v el o f e f f o r t c h o s e n b y t h e m a n a g i n g p a r t n e r . T h em a n a g i n g p a r t n e r a ls o c o n t r o l s t h e a m o u n t o f i n p u t t o b e p u r c h a s e d f r o mt h e p a r e n t T h e p a r e n t , i n s t e a d , c o n t r o l s t h e tr a n s f e r p r ic e a n d c o n t r a c t u a lp a y m e n t m a d e t o th e m a n a g i n g p a r t n e r o f th e f o r e ig n s u b s id i ar y T h ep a r e n t a n d s u b s i d i a r y p a y a s o u r c e - b a s e d c o r p o r a t e p r o f i t s t a x t o t h e h o m e

a n d h o s t c o u n t r i e s , r e s p e c t w e l y : B o t h c o u n t r i e s u s e a t r a n s f e r p r i ci n g ru l e( e . g . a c o m p a r a b l e p r o f i t m e a s u r e o r a c o s t - p l u s p r i c e ) t o d e t e r m i n e h o wm u c h t a x is t o b e p a i d b y t h e m u l t i n a ti o n a l

U s i n g s o m e s p e c i a l a s s u m p t i o n s t o s i m p l i f y t h e m o d e l , w e d e r i v e a no p t i m a l p a y m e n t b a s e d o n a s h a r e o f p r o fi ts , t ra n s f e r p r ic e a n d l u m p - s u mt r a n s f e r t h a t is c h o s e n b y t h e m u l t i n a ti o n a l p a r e n t . T h e o p t i m a l p a y m e n td e p e n d s o n t h e c o st o f p r o d u c i n g t h e i n p u t i n t h e h o m e c o u n t r y , a g e n c yc o s t s ( t h e d e g r e e t o w h i c h t h e m a n a g i n g p a r t n c r d i s l i k e s e f f o r t ) a n d t h e' e f f e c t i v e t a x r a t e s ' a p p l i e d t o p r o f i ts 4 a s i m p o s e d b y t h e h o s t a n d h o m ec o u n t r i e s . W e s h o w t h a t t h e t r a n s f e r p r i ce o f g o o d s s o ld b y t h e p a r e n t t o t h es u b s i d i a r y i s e q u a l t o t h e m a r g i n a l c o s t o f p r o d u c i n g t h e g o o d , a d j u s t e d f o rt h e t a x r a t e o f t h e h o m e c o u n t r y , w h i l e a t r a n s f e r o f p r o f i t s is p a i d t o t h ep a r e n t f r o m t h e l o c al m a n a g i n g p a r t n e r . T a x e s i n t h e p r e s e n c e o f t r a n s f e rp r i c e r u l e s o p e r a t e a s a n e x c i s e t a x o n c o s t s o r a s a s a l e s t a x s i n c e t h et r a n s f e r p r i c i n g r u l e s r e q u i r e f i r m s t o u s e a p r i c e t h a t i g n o r e s t h e i r o w nt r a n s f e r p r i c e . W i t h o u t t r a n s f e r p r i c i n g r u l e s , a n i n c o m e t a x r e s u lt s in t h em a n i p u l a t i o n o f t h e t r a n s f e r p r ic e s o th a t a h i g h e r t a x r a te i n t h e h o m ec o u n t r y l e a d s t o a l o w e r t r a n s f e r p r i c e ( t o r e d u c e r e p o r t e d i n c o m e f o r h o m ec o u n t r y t a x p u r p o s e s ) a n d v i c e v e r s a f o r t h e h o s t c o u n t r y .

W e t h e n m o d e l a n o n - c o o p e r a t i v e g am e b e t w e e n t h e h o st a n d h o m eg o v e r n m e n t s w h o a r e s o l e ly i n t e r e s t e d in m a x i m i z i n g n a ti o n a l t a x r e v e n u e .T h e h o m e c o u n t r y o b s e r v e s t h e o u t p u t p r o d u c e d b y th e p a r e n t a n d its c o s to f p r o d u c t i o n . I t c a n n o t i n f er f r o m i n f o r m a t i o n t o th e g o v e r n m e n t t h e p r o f i tt r a n s f e r f r o m t h e f o r e i g n m a n a g i n g p a r t n e r t o t h e p a r e n t . T h e h o s t c o u n t r yc a n a ls o o b s e r v e o u t p u t s b u t c a n n o t d i r e c t l y o b s e r v e a ll o f t h e c o n t r a c tt e r m s b e t w e e n t h e p a r e n t a n d t h e l o c a l m a n a g i n g p a r t n e r , a n d t h e t r a n s f e rp r i c e f o r t h e s u b s i d i a r y . E a c h c o u n t r y p u r s u e s a N a s h s t r a t e g y i n t a x r a t e s( b u t t a k e s i n t o a c c o u n t t h e m u l t i n a t i o n a l ' s p r o d u c t i o n t h a t r e a c t s t o c h a n g e si n t a x r a t e s ) . W e s h o w h o w t h e e q u i l i b r i u m t a x r a t e s c h o s e n b y t h e h o s t a n dh o m e g o v e r n m e n t s a r e a f f e c t e d b y s hi ft s in e c o n o m i c fa c t o r s s u c h a s h o m e

3 T h e h o m e c o u n t r y u s e s t h e t e rr i to r ia l it y s y s t e m a n d e x e m p t s f o r e i g n - s o u r c e i n c o m e . F o rm a n y c o u n t r i e s t h i s is an e x p l ic it r u l e; f o r o t h e r s , m u c h o f f o r e i g n - s o u r c e i n c o m e m a y b ee x e m p t f r o m t a x a t i o n b y t h e h o m e c o u n t r y ( s ee A l t s h u l e r a n d N e w l o n . 1 99 3; H i n e s a n dH u b b a r d , 1 99 0 ; H o g g a n d M i n t z , 1 9 9 3 ). A m o r e g e n e r a l m o d e l w o u l d a ll o w f or t h e ta x a t i o n o ff o r e i g n i n c o m e r e m i t t e d t o t h e p a r e n t w i t h a c r e di t f o r c o r p o r a t e a n d w i t h h o l d i n g t a x e s o ni n c o m e . H o w e v e r , t h e s y s t e m is r a t h e r c o m p l e x ( s ee L e e c h o r a n d M i n t z , 1 9 93 ).

4 E f f e c t i v e t a x r a t e s a r e d e f i n e d b e l o w . W e n o t e h e r e t h a t t h e r a t e o f t a x d e p e n d s o n b o t h t h es t a t u t o r y t a x r a t e a n d t h e m a r g i n u s e d b y a u t h o r i t i e s t o d e f i n e t h e p r o f i t s o f t h e f i r m .


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404 R. El i tzur , J . M intz / Journal of Publ ic Economics 60 1996) 401 -422c o u n t r y p r o d u c t i o n c o s t s , a g e n c y c os t s a n d t h e p r o d u c t i v i t y o f t h e s u b -s i d i a r y .

A s n o t e d a b o v e , t h e i m p a c t o f t r a n s f e r p ri c in g r u l es is to t u r n t h ec o r p o r a t e i n c o m e t a x i n t o a n o ri g i n - b a se d c o m m o d i t y t a x . A s a r e s u l t,c o r p o r a t e t a x e s i m p o s e d i n e i t h e r c o u n t r y r e d u c e p r o d u c t i o n b y t h em u l t i n a t i o n a l a n d t h e t a x r e v e n u e s o f t h e o t h e r c o u n t r y . T h u s , i n a N a s he q u i l i b r i u m , g o v e r n m e n t s i m p o s e n e g a t i v e e x t e r n a l i t i e s o n t h e o t h e r i n t h ep r e s e n c e o f tr a n s f e r p r i ci n g r u le s . I f t a x d ec i s io n s w e r e h a r m o n i z e d , t h e ng o v e r n m e n t s w o u l d r e d u c e t h e i r l e v e l o f t a x r a t e s . T h i s i s c o n t r a r y t o t h eu s u a l r e s u l t t h a t c a p i t a l t a x r a t e s a r e s e t t o o l o w i n a N a s h e q u i l i b r i u m( W i l d a s i n , 1 9 8 6; M i e s z k o w s k i a n d Z o d r o w , 1 9 89 ).

2 D e s c r i p t i o n o f t h e m o d e lT h e m o d e l h a s f o u r p la y e rs :( 1 ) A p a r e n t c o m p a n y w i th a f o r e i g n s u b s i d ia r y .( 2 ) T h e m a n a g i n g p a r t n e r o f a s u b s i d ia r y .( 3 ) T h e t a x a u t h o r i t y i n t h e p a r e n t ' s c o u n t r y .( 4 ) T h e t a x a u t h o r i t y i n t h e s u b s i d i a r y 's c o u n t r y .A m u l t i n a ti o n a l o p e r a t e s a p a r e n t c o m p a n y in th e h o m e c o u n t r y ( d e n o t e d

a s ' h ' ) a n d a s u b s i d i a r y i n a f o r e i g n h o s t c o u n t r y ( d e n o t e d a s ' f ' ) . T h es u b s i d i a r y u s e s a l o c a t i o n - s p e c i f ic f i x e d f a c t o r a n d a f ix e d in t a n g i b l e f a c t o rp r o v i d e d b y t h e p a r e n t , b o t h o f w h i c h g e n e r a t e r e n t s ( d e c r e a s in g r e t u r n s t os c a le i n p r o d u c t i o n ) . E l e m e n t s o f t h e s e t - u p o f t h e p r o d u c t i o n f u n c t i o n a n dc o n t r a c t b e t w e e n t h e p a r e n t a n d l o c a l m a n a g i n g p a r t n e r o f t h e f o r e ig ns u b s i d i a r y i s s i m i l a r t o V a r i a n ( 1 9 9 2 , p p . 4 5 3 - 4 5 4 ) .

T h e p a r e n t p r o d u c e s a p r o d u c t o f q u a n t i t y x a t a c o n s t a n t m a r g i n a l c o s t o fc . T h e p r o d u c t is t h e n s o l d t o t h e s u b s i d ia r y i n a f o r e i g n c o u n t r y a s a n i n p u ti n t o p r o d u c t i o n o f a g o o d , Q f [ x , a ] , w h i c h a l so d e p e n d s o n t h e u s e o f t h em a n a g i n g p a r t n e r ' s e f f o r t . 5 T h e m a n a g i n g p a r t n e r s u p p l i e s e f f o r t , a , b u t i t i sa s s u m e d t h a t p r o d u c t i o n w i ll o n l y t a k e p l a c e i f a > 0 ( o t h e r w i s e Q = 0 ) . T od e r i v e r e s u l ts f o r a t a x c o m p e t i t i o n m o d e l , a v e r y s i m p l e p r o d u c t i o nf u n c t i o n f o r t h e s u b s i d i a r y i s u s e d :

dq ~ f = ~ a + b x - ~ x 2 f o r a > O , O < d < b0 , o t h e r w i s e . (1)

W e n o t e t h a t ~ is a r a n d o m v a r i a b l e w i t h m e a n , ~ = 1 , a n d ~ 1> 0 f o r s t a t e s o f

5 We c all the inp ut 'effort' although, m ore generally, the man aging partner can be a localbusiness that provides any unobservable factor of production at a cos t to the m anaging partner.


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R. El i t zur , J . M in tz / Journal o f Publ ic Eco nom ics 60 1996) 401-4 22 405n a t u r e . T h e p a r e n t c a n n o t d i s c r im i n a t e b e t w e e n e f f o r t a n d r a n d o m t e c h-n o l o g i c a l s h o c k s a s s o u r c e s o f p r o f it a b i li t y .

T h e i m p l i c a t i o n s o f t h e a b o v e s p e c i a l p r o d u c t i o n f u n c t io n a r e t w o f o l d .F i r s t , w i th p o s i t iv e o u t p u t , e f f o r t a n d t h e p a r e n t ' s p r o d u c t a r e a d d i t i v e ,i m p l y i n g th a t t h e m a r g i n a l p r o d u c t o f th e p a r e n t ' s i n p u t a n d e f f o r t a rei n d e p e n d e n t ( a p r o p e r t y t o b e e x p l o it e d l a t e r f o r c o n t r a c t f o r m a t i o n ) .S e c o n d , t h e q u a d r a t i c f u n c t i o n i m p l i e s t h a t th e m a r g i n a l p r o d u c t o f t h ei n p u t , b - d x , d e c r e a s e s w i t h x ( a n d i s o n l y p o s i t i v e i f b > d x ) .

T h e m u l t i n a t i o n a l i s i n t e r e s t e d i n m a x i m i z i n g it s e x p e c t e d p r o f i ts . T h ep a r e n t ' s p r o f it i s 7r h = ( 0 - c ) x - T h , w i t h 0 a n d T h d e n o t i n g t h e t r a n s f e rp r i c e , c h a r g e d o n s a l es to t h e s u b s i di a r y a n d h o m e c o u n t r y t a x e s , r e s p e c t iv e -l y . T h e s u b s i d i a r y ' s e x p e c t e d p r o f i t i s 7 r f = O f - Ox - T f , w i t h T f d e n o t i n gt o t a l t a x e s p a i d t o t h e f o r e i g n g o v e r n m e n t . 6 T h e d e s c r i p t i o n o f th e t a xs y s t e m i n e a c h c o u n t r y i s d e s c r i b e d i n d e t a i l b e l o w ,

T h e m u l t i n a t i o n a l m u s t p a y a r e w a r d t o t h e m a n a g i n g p a r t n e r in t h es u b s i d i a ry a s c o m p e n s a t i o n f o r e ff o r t. W e a s s u m e , c o n s i s t e n t w i th t h el i t e r a t u r e a n d p r a c t i c e , 7 t h a t t h e m a n a g e r ' s r e w a r d is b a s e d o n a li n e a r s h a r eo f t h e f i r m ' s p r o f it s a n d a l u m p - s u m t r a n s f e r o f p r o f i ts . 8 L e t /3 d e n o t e t h es h a r e o f p r o fi ts p a i d to t h e m a n a g e r a n d W d e n o t e t h e t r a n s f e r p a i d b y t h em a n a g e r t o t h e p a r e n t ( W m a y b e n e g a t iv e , i m p l y i n g a p a y m e n t t o th em a n a g e r , o r p o si t i v e , im p l y i n g a p a y m e n t t o t h e p a r e n t ) .

W e n o t e t h a t t h e m u l t i n a t i o n a l e a r n s c o n s o l i d a t e d e x p e c t e d p r o f i t s , H =h1r + (1 - / 3 ) ~ ' f + W .T h e m a n a g i n g p a r t n e r o f th e s u b s i d ia r y c h o o s e s e f f o r t a n d t h e a m o u n t o fo u t p u t t o b e p r o d u c e d . S i m i la r t o t h e p a r e n t , t h e m a n a g e r i s a s s u m e d t o b er i s k - n e u t ra l . H o w e v e r , t h e l oc a l m a n a g e r p r o v i d e s e f f o r t (w h i c h is n o t f ix e di n s u p p l y ) a n d t h u s m a x i m i z e s th e f o l l o w i n g e x p e c t e d u t il it y f u n c t i o n d e f i n e do v e r i n c o m e a n d e f f o rt :

E u f = / 3 ~ f - W - tx a = / 3 ( Q r - Ox - T f) - W - t x a / > 0(w i t h 0


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406 R . E l i t z u r , J . M i n t z / J o u r n a l o f P u b l i c E c o n o m i c s 6 0 1 9 9 6 ) 4 0 1 - 4 2 2t h a t t h e m a n a g i n g p a r t n e r m a y e a r n l o ss e s e x p o s t (e v e n t h o u g h e x p e c t e du t i l i t y m u s t b e p o s i t iv e ) . I f t h e r e a r e l o s se s , it is a s s u m e d t h a t t h e m a n a g i n gp a r t n e r h a s o t h e r p r o j e c t s o r w e a l t h t o c o v e r t h e l o s s . 9

T h e t a x e s p a i d b y t h e m u l t i n a t i o n a l a r e b a s e d o n t h e c o r p o r a t e i n c o m e t a xw i t h a d j u s t m e n t s m a d e f o r tr a n s f e r p r ic i n g r u le s . T h e t a x a u t h o r it i e s i n e a c hc o u n t r y c a n n o t d i r e c t l y o b s e r v e t h e t r a n s f e r p r i c e , 0, e x c e p t b y w h a t isi n f e r r e d b y t h e a u t h o r i t i e s a n d t h e c o n t r a c t t e r m s : t h e s h a r e o f p r o f it s , /3,a n d t h e t r a n s f e r o f p r o f i t , W ( th e g o v e r n m e n t c a n n o t o b s e r v e d /x, w h i c hi m p o r t a n t i n d e t e r m i n i n g p r o f it d i s t r i b u ti o n s ) . 1 I n s t e a d , t h e y u s e i n f o r -m a t i o n t o a p p r o x i m a t e t h e t r a n s f e r o f p r o fi t a s p a r t o f t he t r a n s f e r p r i c e t od e t e r m i n e t a x l ia b il it ie s t h a t w o u l d b e o w i n g o n p r o f it s e a r n e d b y t h e p a r e n ta n d s u b s i d i a r y . T h i s i n f o r m a t i o n is b a s e d o n a n a n t i c i p a t e d p r o f i t r a t e f o rt h e i n d u s t r y t h a t w o u l d b e a m a r k - u p o v e r c o st o r a d e d u c t i o n f r o m t h er e c e i p t o f r e v e n u e s . A c c o r d i n g l y , i n t h e a b s e n c e o f a c o m p a r a b l e u n -c o n t r o l l e d p r i c e , t h e t r a n s f e r p r i c e s a r e b a s e d o n a c o m p a r a b l e p r o f i tm e a s u r e .

I n t h e h o m e c o u n t r y , t h e g o v e r n m e n t i m p o s e s a t ax o n p ro f it s at t h e r a t et h. H o w e v e r , s i n c e t h e t r a n s f e r p r i c e is n o t u s e d t o d e f i n e t h e v a l u e o f s al e s,t h e g o v e r n m e n t r e q u i r e s t h e f ir m t o u s e a ' f i c ti ti o u s p r i c e ' , 0 ' = ( 1 + k ) c ,w i t h k d e n o t i n g t h e m a r k - u p o n c o s ts as c o m p e n s a t i o n f o r a v e r a g e p r o f i t o no b s e r v e d i n d u s t r y - w i d e p r o f i ts e a r n e d o n s im i l a r ac t iv i ti e s. T a x e s p a i d t o t h eh o m e c o u n t r y a r e th u s e qu a l t o

T h ---- l h [ ( ] h - k ) c - c ] x = t h k c x( n o t e t h a t k > 0 f o r ta x r e v e n u e s t o b e p o s i t i v e ). W e d e n o t e b y ~b = t h k t h e' e f f e c ti v e ta x r a t e ' o n t h e c o s t o f p r o d u c t i o n . T h u s , i n c o m e t a x in t h e h o m ec o u n t r y b e c o m e s a n e x c i s e t a x o n c o s t s .

T h e h o s t c o u n t r y a l s o a pp l ie s a n ' i n c o m e ' t ax o n t h e p r of i t s o f t h es u b s i d i a r y a t t h e r a t e t f . H o w e v e r , t h e h o s t c o u n t r y d o e s n o t a l lo w t h es u b s i d i a ry t o d e d u c t t h e v a l u e o f sa le s p u r c h a s e d f r o m t h e p a r e n t ; i n s t ea d , at r a n s f e r p r i c i n g r u l e i s u s e d . 11 T h e a u t h o r i t i e s a s s e ss a r a t e o f p r o f i t m o ns a le s t h a t w o u l d b e t h e n o r m a l e x p e r i e n c e o f t h e i n d us t ry . T h e e x p e c t e d

9 It is com m on for parents to own subsidiaries that are joint ventures w ith local managingpartners. If the managing pa rtner has no outside resources to cov er losses, then the pare nt m ayneed to cover the losses.10 Profits can b e difficult to ob served if they are reflected in ass et values rem itted to foreignjurisdictions.it No deduction from the tax base is permitted for compensation paid to the manager. Thus,the corpo rate tax falls on both the multinational and the manager. If we allowed for managerialcompensation costs to be deducted from the taxable income of the firm and imposed on equalrate of tax on the m ana ger's salary at the personal level (i.e. a fully integrated tax system), thenthe results re por ted below wou ld not be significantly affected.


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R . E l i t zu r , J . Min t z / Jo u rn a l o f P u b l i c E co n o m ics 6 0 1 99 6 ) 4 0 1 - 4 2 2 407t a x e s p a i d t o t h e h o s t c o u n t r y are T f= t f m O ) 2 We le t ~ = t f m d e n o t e t h e' e f f e c t i v e t a x r a t e ' o n s a l e s . T h u s , t h e h o s t c o u n t r y ' s i n c o m e t a x b e c o m e s ap r o d u c t i o n t a x w h e n t h e c o s ts o f t h e i n p u t p u r c h a s e d f r o m t h e p a r e n t a r en o t d e d u c t i b l e .

3 . C h a r a c t e r i z a t i o n o f th e m a r k e t s e q u i l i b r i u mI n t h i s s e c t i o n w e d e s c r i b e t h e m a r k e t e q u i l i b r i u m b y f i r s t c o n s i d e r i n g t h em a n a g e r ' s d e c i s i o n . W e t h e n d e r i v e t h e o p t i m a l d e c i s i o n s f o r t h e m u l t i n a -

t i o n a l , e s p e c i a l l y i t s o p t i m a l t r a n s f e r p r i c e .

3.1. The m anager s decisionsT h e m a n a g e r m a x i m i z e s e x p e c t e d u t i li ty d e f i n e d in ( 2 ) c h o o s i n g x a n d a

w i t h a E [ 0 , 1 ] . Th e r e s p ec t iv e f i r s t - o r d e r co n d i t i o n s a r e t h e f o l l o w in g :0 E u

O xOEu

- [ { b - d x } (1 - ~ - ) - 01/3 = 0 , (3 .1 )

Oa - /3 (1 - ~-) - / z ~ 0 . (3 .2 )T h e f i r s t- o r d e r c o n d i t i o n f o r x ( E q . ( 3 . 1 )) f o r / 3 > 0 s t a t e s t h a t t h e o p t i m a lc h o i c e o f x i s a t th e p o i n t w h e r e t h e b e n e f i t to t h e m a n a g e r o f a m a r g i n a lu n i t o f x , / 3 ( b - d x ) ( 1 - r ) , e q u a l s th e m a r g i n a l c o st o f x , / 3 0 . T h e f i r s t- o r d e r

c o n d i t i o n f o r a ( E q . ( 3 .2 ) ) s t a t e s t h a t e f f o r t i s e x e r t e d u p t o t h e p o i n t w h e r ei t s m a r g i n a l b e n e f i t f o r t h e m a n a g e r , / 3 ( 1 - ~ ' ) , e q u a l s t h e m a n a g e r ' s c o s t o fe f fo r t , /x .T h e f i r s t - o r d e r c o n d i t i o n fo r x ( E q . ( 3 . 1 ) ), f o r / 3 > 0 , i m p l i e s t h a t d e m a n df o r t h e i n p u t b y t h e s u b s i d i a r y i s i n v e r s e l y r e l a t e d t o t h e t r a n s f e r p r i c e a n dt h e t a x r a t e o f t h e h o s t g o v e r n m e n t :

x = {b - 0(1 - r ) - l } / d . (4)N o t e t h a t t h e m ar g in a l p r o d u c t o f x is eq u a l t o b - d x = 0 (1 - r ) - 1 , w h ich iso n ly p o s i t i v e i f t h e t r an s f e r p r i c e i s p o s i t i v e .T h e f i r s t - o r d e r c o n d i t i o n f o r e f f o r t i m p l i e s t h a t t h e m a n a g e r w i l l e i t h e rw o r k t o th e l i m i t , n o t w o r k a t a ll , o r j u s t b e i n d i f f e r e n t b e t w e e n w o r k i n ga n d n o t w o r k i n g . W e n o t e t h a t f o r t h e m a n a g e r t o w o r k w e l l e n o u g h f o r t h ef ir m t o p r o d u c e m a x i m u m p o s i ti v e o u t p u t ( a = 1 ), t h e f ir m m u s t p a y at2 If we think of the home and host countries as having multinationals that are identical in all

respects except for the realization of ~ , then the law of large numb ers would result in taxrevenues being non-random.


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408 R. Eli tzur, J . M intz / Journal of Public Economics 60 (1996) 401-422r e w a r d s u f f ic i e n t t o o f f s e t th e m a n g e r ' s d i s u ti l it y o f e ff o r t:

/3(1 - ~-) 1>/x .,3 (5 )N o t e t h a t i n t h e a b s e n c e o f c o n d i t i o n ( 5 ) h o ld i n g , t h e f i r m w i ll n o t p r o d u c eo u t p u t , g i v e n t h e p r o d u c t i o n f u n c t i o n a s s u m e d i n ( 1) .3 . 2 . T h e m u l t i n a t i o n a l s d e c is io n s

T h e m u l t i n a t i o n a l m a x i m i z e s e x p e c t e d p r o f i ts , c h o o s i n g t h e s h a r e o fp r o f i t s p a i d t o t h e m a n a g e r , /3, t h e l u m p - s u m t r a n s f e r o f p r o f i t, W , a n d t h et r a n s f e r p r i c e , 0 , s u b j e c t t o th e c o n s t r a i n t t h a t t h e m a n a g e r m u s t b ec o m p e n s a t e d w i th s u ff ic ie n t i n c o m e t o w o r k . T h e p r o g r a m m i n g p r o b l e m f o rt h e m u l t i n a t i o n a l c o m p a n y i s t h e r e f o r e t h e f ol lo w i n g:m a x H = 1r h + ( 1 - / 3 ) z r f + W( ts.w,o )

d z O x } += ( O - c ( l + 4 ) ) ) x + ( l - / 3 ) { ( a + b x - - ~ x ) ( 1 - ' r ) - W ,s .t . a r g m a x E u = / 3 ( 1 - ~ - ) a + b x - - ~ x - O x - W - t z a > ~ O .(a,x)

W e l e t A d e n o t e t h e L a g r a n g e m u l t i p l i e r f o r t h e c o n s t r a i n t .F o r t h i s p a r t i c u l a r p r o b l e m , t h e r e a r e o n l y tw o p o s s i b le s o l u ti o n s. W e n o t e

f ir s t t h a t f o r t h e r e t o b e a n y p o s i t i v e p r o f it s ( / / > 0 ) f o r t h e m u l t i n a t i o n a l ,t h e p a r e n t m u s t i n d u c e t h e m a n a g i n g p a r t n e r t o s u p p l y e f f o r t. T h i s re q u i r e sE q . ( 5 ) t o h o l d s o th a t t h e m a n a g e r ' s c h o i c e i m p l i e s a = 1 . S i n c e t h e r e i s n ov a l u e t o t h e f i rm i f t h e m a n a g i n g p a r t n e r is p a i d m o r e t h a n t h e d i s u ti li ty o fe f f o r t , t h e s o l u t i o n f o r t h e s h a r e o f p ro f i ts is /3 = / ~ / ( 1 - ~ - ) , w h i c h i m p l i e st h a t a = 1. S i n c e x i s c h o s e n o p t i m a l l y b y t h e m a n a g e r ( E q . ( 4 ) ) , t h ep r o g r a m m i n g p r o b l e m f o r t h e m u l t i n a t i o n a l m a y b e re w r i t t e n a s f o ll o w s s ot h a t o n l y 0 a n d W a r e c h o s e n t o m a x i m i z e p r o fi ts :

m a x ~ = (0 - c (1 + ~ b ))x(o,w)

+ A [ ( l~ -~ z ) { ( 1 - r ) ( l + b x - d x 2 ) - O x } - W - t x ] ,w i t h x = [b - 0 (1 - z ) - ~ ) / d a n d A E u = O . ( 6 ' )

13 In p rinciple, a c ondition of eq uality im plie s that the ma nager is ind ifferent betwe enworking or not w orking. It is assumed below that a paym ent to the m anager is only e m ore than13(1 - z ) , with e ~ 0 to induce one un it of effort if i t is at least equal to /z .


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R . E l i t zu r , J . M i n t z / J o u r n a l o f P u b l i c E c o n o m i c s 6 0 1 9 9 6 ) 4 0 1 - 4 2 2 41)9

G i v e n t h e c h o i ce o f tw o v a r i a b l e s (0 o r W ) w i th t h e e x i s te n c e o f o n eco n s t r a i n t , t h e s o l u t i o n fo r t h e p ro g ram m i n g p ro b l em i n (6 ' ) i s fo r t h eco n s t r a i n t t o b e b i n d i n g ( ;t ~ 0 ) . I f t h e co n s t r a i n t we re n o n -b i n d i n g (A = 0 ) ,t h en t h e m an ag i n g p a r tn e r wo u l d ea rn p o s i t i v e p ro f i t s , t h u s r ed u c i n g t h ev a l u e o f p ro f i ts e a rn ed b y t h e p a ren t . 14 Th e co n t r ac t w o u l d t h u s b eineff ic ient .

W i th th e co ns t ra in t b ind ing (A ~>0) , the f i r s t -o rder c ond i t ions a re thefo l l o wi n g to th e p ro b l em (6 ' ) , a f t e r ap p l i c a t i o n o f E q . (3 . 1 ) f ro m th em a n a g e r ' s p r o b l e m :a ~o w - 1 - a ) = o , 7 )

O0 - x 1 - A ) + 0 - c 1 + 0 5 ) ) - ~ = O . 8 )T h e s e c o n d i t i o n s t h e r e f o r e i m p l y

0 = c ( 1 + 0 5 ) , ( 7 ' )W = ~ d [ b - 0 (1 - 0 - ' ] 2 ( 8 ' )

wh e re (8 ' ) i s d e r i v ed f ro m th e co n s t r a i n t t o (6 ' ) .Th e in tu i t ion b eh in d (7 ' ) is tha t the in te rna l t ra ns fe r p r ice , 0 , i s equ a l toth e p a re n t ' s m a rg i n a l co s t , c , ad j u s t ed fo r (1 + 0 5) . Th i s w o u l d r e s u l t i n t h emos t e f f i c ien t p r ic ing o f the inpu t , x . The t rans fe r o f p ro f i t s , W, in Eq . (8 ) i seq u a l t o t h e m arg i n a l d i s u ti l it y o f t h e l o ca l m an a g e r ' s e f fo r t an d i s r e l a t ed t oth e p ro f i t s e a rn ed b y t h e s u b s i d i a ry ( s ee b e l o w) .T h e o p t i m a l t r a n s f e r p r i c e i n c r e a s e s w i t h t h e p a r e n t c o m p a n y ' s c o s t o fp ro d u c t i o n an d th e h o m e co u n t ry ' s t ax r a t e (wh i ch ac t s a s an ex c i s e t ax o nc o s t s ) . T h e l u m p - s u m p a y m e n t , W , f r o m t h e m a n a g i n g p a r t n e r t o t h e p a r e n td ec rea s e s w i th t h e t r an s fe r p r i c e an d th e h o s t co u n t ry ' s t ax r a t e an d

i n c rea s e s w i th t h e p ro d u c t i v i t y p a r am e te r o f t h e s u b s i d i a ry , b. A l s o , t h et r an s fe r p ay m en t i n c rea s e s w i th a d ec rea s e i n t h e co n cav i ty o f t h e p ro -d u c t i o n fu n c t i o n ( a l o wer v a l u e o f d i m p l i e s m o re r en t s b e i n g ea rn e d b y t h ef i rm , a s s h o wn i n ex p re s s i o n (9 ) b e l o w) . F i n a l l y , an i n c rea s e i n t h e co s t t o

~4 I f t h e t r a n s f e r o f p r o f i ts w e r e n o t p o s s i b l e ( W = 0 ), t h e n t h e o p t i m a l t r a n s f e r p r i c e w o u l db e e q u a l t o 0 = [ /x b + c ( 1 + & ) ] / [ 1 + / x ( 1 - ~ .)- 1] . In t h i s c a s e an i n e f f i c i en t co n t r ac t u s ed b y t h em u l t i n a t i o n a l w o u l d r e s ul t in e x c e s s p r o fi ts b e i n g e a r n e d b y t h e m a n a g i n g p a r t n e r . M o r e o v e r ,t h e o p t i m a l t r a n s f e r p r i c e w o u l d d e p e n d o n m o r e t h a n t h e c o s t o f p r o d u c t i o n a n d t h e h o m ec o u n t r y ' s t a x r a t e f a c e d b y t h e p a r e n t . I t a l s o w o u l d i n c r e a s e w i t h t h e s u b s i d i a r y ' s p r o d u c t i v i t yp a r a m e t e r , b , d e c r e a s e w i t h t h e h o s t c o u n t r y ' s ta x r a t e , a n d i n c r e a s e w i t h t h e c o s t o f e f f o r t fo rt h e m a n a g i n g p a r t n e r , / x.


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410 R. Elitzur, J. M intz / Journal of Public Economics 60 (1996) 401-422t h e m a n a g i n g p a r t n e r i n s u p p l y i n g e f f o r t , ~ , i n c r e a s e s t h e t r a n s f e r p a i d t ot h e p a r e n t . T h e r e a s o n fo r t h is i s t h a t a h i g h e r v a l u e o f / x i n c r e a s e s t h e s h a reo f p ro f i ts p a i d to t h e m a n a g e r . T o k e e p e x p e c t e d u t i l it y c o n s t a n t ( a n d e q u a lt o z e ro ) , a l a rg e r l u m p - s u m t r a n s f e r i s m a d e t o t h e p a r e n t i f / 3 i s l a rg e r .T h e f o l l o w i n g p r o p o s i t i o n s u m m a r i z e s t h e r e s ul ts :Pro posi t ion 1 . The opt im al t ransfer pr ice ch arged by the pa ren t to it ssubs id iary is equa l to the marg ina l cos t o f produ ct ion ad jus ted fo r the hom ecou ntry s e f fect ive tax rate (c(1 + tb)) . The op t imal lump -sum t rans fer pa id bythe m anaging par tner to the paren t : ( i ) decreases wi th the transfer pr ice forthe inpu t (0 = c(1 + ~b)) charged to the subsidiary; ( i i ) decreases with the hostcou ntry s e f fect ive tax rate, r ; (i i i) increases wi th the prod uct ivi ty o f sub-s id iary product ion , b ; and ( iv) increases wi th the marginal d isut i l i ty o f e f for tby the manager , t z .

F i n a ll y , w e n o t e t h a t t h e e x p e c t e d p r o f i ts e a r n e d b y t h e p a r e n t , o n c e t h eo p t i m a l t r a n s f e r p r i c e a n d t r a n s f e r o f p ro f i t s a r e s e l e c t e d , a r e t h e fo l l o w i n g :

a n d

H = r r h + ( 1 - / 3 ) r r f + W , w i th r r h = O , (9 )rr f = (1 - r) + [ b( 1 - r ) - c ( 1 + $ ) ]22d[1 - r ]

( 1 - / 3 ) r r f + W = 1 - r - t * + [b( 1 - r) - c(1 + 4))] 22d[1 - r ]N o t e t h a t t h e p r i c i n g o f t h e i n p u t i s e f f ic i e n t ( a t t h e t a x -a d j u s t e d m a rg i n a l

c o s t ) , a s n o t e d a b o v e . T h i s r e s u l ts i n z e r o p r o f it s b e i n g e a r n e d b y th e p a r e n ta t h o m e ( if m o r e t h an o n e p r o d u c t w e r e p r o d u c e d u n d e r j o i n t c o st s f o r t h ed o m e s t i c m a r k e t , t h e n e f f i c ie n t p r ic i n g m a y n o t p r e v a il ) . T h e p r o f i t s e a r n e db y t h e s u b s i d i a ry (Tr t ) a r e a p a y m e n t fo r t h e l o c a l m a n a g e r ' s e f fo r t a n d t h er e n t s o b t a i n e d f r o m t h e l o c a t i o n - s p e c i f i c a n d i n t a n g i b l e f a c t o r s u p p l i e d b yt h e p a r e n t t o t h e s u b s i d i a ry . T h e c o n t r a c t r e s u l t s i n a l l t h e r e n t s a c c ru i n g t ot h e p a r e n t , s i nc e (1 - / 3 ) / + W = ~r f - / x , w i th /. ~ b e i n g th e u t il it y c o s t o f t h em a n a g e r ' s e f f o r t .

4 C o m p e t i t i o n i n e f f e c ti v e t a x r a t e sN o w t h a t w e h a v e sp e c i fi e d th e m a r k e t e q u i l i b r iu m , w e ca n d e r i v e t h eo p t i m a l t a x r a t e s f o r e a c h g o v e r n m e n t . T h e c h o i c e o f t h e o b j e c t i v e f o rg o v e r n m e n t d e c i s i o n - m a k i n g is i m p o r t a n t t o t h e a n a ly s is . A s a c h a r a c t e r iz a -


11/22

R . E l i t z u r, J . M i n t z / J o u r n a l o f P u b l i c E c o n o m i c s 6 0 1 9 9 6 ) 4 0 1 - 4 2 2 411t io n o f g o v e r n m e n t b e h a v i o u r , w e u s e t h e ' t a x r e v e n u e ' m a x i m i z a t io na s s u m p t i o n . 15 I n c h o o s i n g o p t i m a l t a x ra t e s, e a c h g o v e r n m e n t is a s s u m e d t op u r s u e a N a s h s t r a t e g y i n t a x ra t e s : n a m e l y , e a c h c h o o s e s it s b e s t s t r a t e g yg i v e n t h e s t r a te g y o f t h e o t h e r g o v e r n m e n t . F r o m t h e s tr a te g i c d e c i s i o n s o fe a c h g o v e r n m e n t , w e t h e n d e r i v e t h e p r o p e r t ie s o f t h e N a s h e q u i l i b r i u m i nt a x ra t es . F r o m t h e s e d e r i v a t io n s w e c a n d e v e l o p s e v e r al p r o p o s i t i o n s t h a ts h o w h o w t h e e q u i l i b r iu m in th e g a m e is s e n si ti v e t o e c o n o m i c v a r i ab l e ss u c h a s p r o d u c t i o n a n d a g e n c y c o st s.4 . I . O p t i m a l t a x ra t e s

G i v e n P r o p o s i t i o n 1 , e a c h g o v e r n m e n t ' s o p t i m a l t a x r a t e a ff e ct s t h ep r o d u c t i o n d e c i si o n s , t r a n s fe r p r i c e , a n d o p t i m a l c o n t r a c t c h o s e n b y t h em u l t i n a t i on a l . T h e g o v e r n m e n t c a n o b s e r v e c os ts an d k n o w s t h e p r o d u c t i o nf u n c t i o n o f t h e fi rm . I t c a n n o t d e t e r m i n e t h e c o n t r a c t p a r a m e t e r s , w h i c hi n c l u d e t h e s h a r e o f p r o f it s f o r t h e m a n a g e r , /3, a n d t h e t r a n s f e r o f p r o f it s ,W , w h i c h d e p e n d o n t h e u n o b s e r v a b l e v a l u e o f ~ . H o w e v e r , a s w i l l b es h o w n b e l o w , k n o w l e d g e o f t h e c o n t r a c t is n o t n e c e s s a r y to d e t e r m i n e t h eo p t i m a l s o l u t i o n f o r ta x r a te s , g i v e n t h e t r a n s f e r p r i c i n g ru l e s u s e d b y t h eg o v e r n m e n t .

T a x r e v e n u e f o r th e h o m e c o u n t r y is e q u a l t o t h e e ff e c t i v e t a x r a te , th,t i m e s t h e p a r e n t ' s c o st o f p r o d u c t i o n , c x , a n d , f o r th e h o s t c o u n t r y , is e q u a lt o t h e e f f e c t i v e t a x r a te , r , t im e s e x p e c t e d s a le s , Q , o f t h e s u b s i d i a r y . G i v e nt h e a s s u m p t i o n o f t a x r e v e n u e m a x i m i z a t i o n , t h e d e ci s io n f o r e a c h g o v e r n -m e n t i s t o c h o o s e i ts e f f e c t i v e t a x ra t e t a k i n g i n t o a c c o u n t t h e i m p a c t o f t h et a x o n t h e p r o d u c t i o n o f t h e in p u t ( h o m e c o u n t r y ) o r o u t p u t ( h o s t c o u n t r y ) .H o w m u c h i n p u t o r o u t p u t is a f f e c te d c a n b e e s t i m a t e d b y t h e g o v e r n m e n t ,w h i c h u l t i m a t e l y d e r i v e f r o m t h e e x p r e s s i o n s f o r x ( E q . ( 4 ) ) a n d 0 ( E q . ( 7 ) )a s o b t a i n e d a b o v e :

h o m e c o u n t r y : T h = ~ bc x - ~bc(b(1 - r ) - c (1 + th ) ) . (1 0 . 1 )

h o s t c o u n t r y Tf= TQ f=r+ - b2+ j . 10.2)~5 W elfare max imization which, in this mo del, w ould be th e sum of after-tax profits earn ed byresidents and tax revenue, sin ce consumers are unaffected, may also be considered as analternative objective for government policy. W e take th e view that governm ent politicians aresolely interested in tax revenue maximization, which is a common assumption in the literature(e.g. Kanbur and Keen, 1993). For a discussion on the impact of different objectives forgov ernm ent decision-making, see Mintz and Tulkens (19 86) and Trandel (1994).~6 No te that the game is specified in terms of effective tax rates, since these can b e derived by

values of the nom inal tax rates and the transfer p ricing limitations that determine the m ark-upover costs or profits as a percentage of sales.


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412 R . E l i tzu r , J . Min t z / Jo u rn a l o f P u b l i c E co n o m ics 6 0 1 99 6 ) 4 0 1 - 4 2 2T a x r a t e s a r e c o n s t r a i n e d t o b e n o n - n e g a t i v e a n d , i n t h e c a s e o f t h e h o s tc o u n t r y ' s ta x r a t e , r < 1 , t o p r e v e n t t a x ra t e s t h a t c o n f i s c a te o u t p u t f r o m t h es u b s i d i a r y .

T h e h o m e c o u n t r y ' s o p t im a l ta x r a t e , ~ , is d e r i v e d b y m a x i m i z i n g th e t a xr e v e n u e a s s p e c i f i e d i n ( 1 0 . 1 ) a b o v e . T h e s o l u t i o n f o r t h e o p t i m a l t a x r a t e i st h e f o l l o w in g ( w i t h ~ i> 0 ) :

~ [ r ] - (1 - r )b - c (11 .1 )2 cW e n o t e t h a t t h e h o m e c o u n t r y ' s c h o ic e o f its e ff e c ti v e t a x r a te m o n o t o n i -

c a l l y d e c r e a s e s w i t h t h e h o s t c o u n t r y ' s t a x r a t e s i n c e04~ bO r 2 c

W e a l s o p r o v i d e t h e f o l l o w i n g p r o p o s i t i o n , w h i c h is t ri v i al to p r o v e b u tu s e f u l f o r l a t e r r e f e r e n c e .P r o p o s i t i o n 2 . F o r a g i v e n z , th e o p t i m a l t a x ra te o f t h e h o m e c o u n t r y , ok, i s( i ) i n c r e a s i n g i n b a n d ( i i ) d e c r e a s i n g i n c .

T h e h o m e c o u n t r y c a n i m p o s e a h i g h e r t a x ra t e i f t h e s u b s i d ia r y is m o r e' p r o d u c t i v e ' , a s c a p t u r e d b y t h e p a r a m e t e r , b , o f if t h e p a r e n t ' s c o s t o fp r o d u c t i o n f o r g o o d x d e c r e a s e s , a s c a p t u r e d b y t h e p a r a m e t e r c . In t u i ti v e l y ,t h e s e s e e m t o b e r e a s o n a b l e r e s u l t s .F o r t h e h o s t c o u n t r y , t h e o p t i m a l t a x r a t e i s c h o s e n b y m a x i m i z i n g t h eo b j e c t i v e f u n c t i o n p r o v i d e d i n E q . ( 1 0 . 2 ) . T h e o p t i m a l t a x r a t e f o r t h e h o s tc o u n t r y ( r / > 0 ) c a n b e c h a r a c t e r i z e d b y th e f o l l o w i n g :

- - O fr [ r , 4a] - O Q f / O r , ( 1 1 .2 )

w h i c h i m p l i e s(1 + r ) 2d + b 2(1 - c2(1 + 40 2

T h e r e a c t i o n f u n c t io n f o r r m o n o t o n i c a l l y d e c r e a s e s w i th ~ b e c a u s e i t c a nb e s h o w n t h a t


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R. Elitzur, J. M intz / Journal of Public Econom ics 60 (1996) 401-422 413O r - 2 ( 1 + ) c 2 ( 1 + r )&b c2(1 + ~b)2 + ( 1 - r ) 2 3 ( b 2 + 2 d ) < 0 .

A s in t h e a b o v e a n a l y si s o f t h e h o m e c o u n t r y ' s r e a c t i o n f u n c t i o n , t h ef o l l o w i n g p r o p o s i t i o n p r o v i d e s s o m e u s e f u l r e s u l t s f o r l a t e r r e f e r e n c e .

P r o p o s i t i o n 3 . F o r a g i v e n (a , t h e h o s t c o u n t r y s e f f e c ti v e t a x r a t e, r , is ( i )i n c r e a s i n g i n d , ( i i ) i n c r e a s i n g b , a n d ( i i i ) d e c r e a s i n g i n c .

T h e i m p l i c a t i o n o f P r o p o s i t i o n 3 is t h a t t h e h o s t c o u n t r y w i ll i n c r e a s e i tst a x r a t e i f t h e c o s t o f p r o d u c t i o n i n th e h o m e c o u n t r y f a ll s , t h e s u b s i d i a r y ' sp r o d u c t i v i t y i n c re a s e s ( b ) , o r t h e p r o d u c t i o n f u n c t i o n o f t h e s u b s i d i a ry ism o r e c o n c a v e . T h e i m p a c t o f d o n t h e o p t i m a l t a x r a t e , r , is e x p l a i n e d a sf o l lo w s . A l t h o u g h a n i n c r e a s e i n d r e d u c e s r e n t s , a s s h o w n i n E q . ( 9 ) a b o v e ,i n t h e e x p r e s s i o n f o r 7r f , t h e i n c r e a s e d c o n c a v i t y o f t h e p r o d u c t i o n f u n c t i o nd m a k e s i t e a s i e r t o i n c r e a s e t h e t a x r a t e w i t h o u t r e d u c i n g o u t p u t .

E q s . ( 1 1 . 1 ) a n d ( 1 1 .2 ) a r e a l s o t h e r e a c t i o n f u n c t io n s o f t h e h o m e a n dh o s t g o v e r n m e n t s ' s t r a te g i c c h o ic e s as f u n c t io n o f t h e t a x r a t e c h o s e n b y t h eo t h e r g o v e r n m e n t . F o r t h e h o m e g o v e r n m e n t , t h e c h o i c e o f 4~ ( E q . ( 1 0 )) isa u n i q u e a n d d e c r e a s i n g f u n c t i o n o f r s in c e & b / a t = - b / 2 c .

F o r t h e h o s t g o v e r n m e n t , t h e c h o i c e o f r is n o t n e c e s s a r il y u n i q u e , wa l t h o u g h o n l y o n e s o lu t io n m a y b e b o u n d e d b e t w e e n 0 an d 1. TM F o r t h ep u r p o s e o f i ll u s tr a ti n g t h e e q u i l i b r iu m , w e a s s u m e u n i q u e n e s s in o u rd i s c u s s i o n b e l o w s o t h a t w e c a n d e a l w i t h f u n c t i o n s r a t h e r t h a n c o r r e -s p o n d e n c e s .

F i g . 1 i l l u s tr a t e s th e N a s h e q u i l i b r i u m f o r t a x r a te s . A u n i q u e e q u i l i b r i u mm a y n o t b e o b t a i n e d , a s d i s c u s s e d a b o v e , b u t , a s r e p o r t e d i n F i g . 2 ( a ) - ( c ) ,w e f i n d a u n i q u e so l u t i o n f o r 0 ~< r < 1 a n d 4 ~ / > 0 ( s e e t h e a p p e n d i x f o rd e t a i l s r e g a r d i n g t h e s i m u l a t i o n s ) .

T h e i n t e r c e p t s s h o w n i n F ig . 1 a r e d e r i v e d f o r th e m o n o t o n i c a l l yd e c r e a s i n g r e a c t i o n f u n c t i o n s b y u si n g E q s . ( 1 1 . 1 ) a n d ( 1 1 . 2 ) . W e n o t e t h a t ,w h e n r = 0 , t h e i n t e r c e p t o f th e r e a c t i o n f u n c t i o n f o r r[ 4~ ], w h i c h is e q u a l t o{ ( 2 d + b 2 ) ' 5 - c } / c is u n a m b i g u o u s l y t o t h e r i gh t o f th e i n t e r c e p t o f t h er e a c t i o n f o r ~ b [ r ] , w h i c h i s e q u a l t o ( b - c ) / 2 c , s i n c e b < ( 2 d + b 2 ) s a n d2 c > c . A s f o r th e i n t e r c e p t s w h e n 4) = 0, w e n o t e t h a t t h e i n t e r c e p t f o r t h eh o m e c o u n t r y ' s r e a c t i o n f u n c t i o n , 4 ~ [ r ] , i s e q u a l t o (b - c ) / b l e s s t h a n o n e .F o r a n e q u i l i b r i u m t o e x is t , t h e i n t e r c e p t f o r t h e h o s t c o u n t r y ' s r e a c t i o n

t7 Eq. (11 .2) is cubic in r.~8 We find this to be the c ase for the simulations reported below.


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414 R . E l i t z u r , J . M i n t z / J o u r n a l o f P u b l i c E c o n o m i c s 6 0 ( 1 9 9 6 ) 4 0 1 - 4 2 2

. . . . . . . . >

~ , , , , , , ( I )X' I ~ ii1'= b-e ~ = (2d+b') ',cb 2c

F ig . 1 . r = ( b - c ) / b ; ~ = ( b - c ) / 2 c ; an d ~b - - [ (2d + be) 1/2 - c ] / c .

f u n c t i o n , r [~ b ], m u s t b e b e l o w t h e i n t er c e p t o f t h e h o m e c o u n t r y s r e a c t io nf u n c t i o n a n d , t h e r e f o r e , l e s s th a n o n e i n v a l u e .

T h e N a s h e q u i l i b r i u m i n t a x ra t e s , w h i c h m a y e x i s t a n d b e s ta b l e i n t h i sm o d e l , ~9 i s o b t a i n e d a t t h e p o i n t a w h e r e t h e t w o r e a c t i o n f u n c t i o n s m e e t .

19 A s i l l u s t ra t e d i n F i g . 1 , s t a b i li t y c a n b e s h o w n a s l o n g a s t h e s l o p e o f t h e h o s t c o u n t r y ' sr e a c t i o n f u n c t i o n i s g r e a t e r i n a b s o l u t e v a l ue t h a n t h e s l o p e o f th e h o m e c o u n t r y ' s r e a c t i o nf u n c t i o n ( i . e . [ a r / O ~ l > I { a ~ / a r } - ~ l ) . U s i n g t h e e x p r e s s i o n s fo r s l o p e s o b t a i n e d a b o v e , s t a b i li t yw i l l h o l d i f

b < (1 + (b? + (1 - r )23 (b 2 + 2d )c ~ + ~ c ~ + - ~ S

N o t e t h a t b > c , i m p l y i n g t h a t t h e l e f t - h a n d s i d e o f t h e e x p r e s s i o n i s g r e a t e r t h a n o n e i n v a l u e .T h e r i g h t - h a n d s i d e w i l l a l s o b e g r e a t e r t h a n o n e p r o v i d e d i s n o t t o o l a r g e . T h u s , s t a b i l i t yc a n n o t b e g u a r a n t e e d , a l t h o u g h f o r t h e s im u l a t io n s r e p o r t e d b e l o w , w e g e n e r a ll y o b t a i n s ta b l es o l u t i o n s .


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R . E f i tz u r , J. M i n t z / J o u r n a l o f P u b l i c E c o n o m i c s 6 0 1 9 9 6 ) 4 0 1 - 4 2 2 415

0 .00 .6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .0 .7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .0 .6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i0 . 5 . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .0 .4....................................................................................................0 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .0 . 2 . . . . . . . . . . . .. . . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . .. . .0.1 "" --

0 0 3 5 0 4 0 5 0 5 5 0 6 0 6 5 0 7 0 7 5 0 8 0 8 5 0 9 0 9 5 1 1 1 1 5 1 2 1 2 5C0 .90.85.0.8'0.75.0 . 70 . 6 50 . 60 . 5 50 . 50 .45 0 .5 0 .6 0 .7 0 .8 0 .9 1 1 .1 1 .2 1 .3 1 .4 1 .5 1 .6 1 .7 1 .8 1 .9d

0.50.60.70.8.0.9.ii iii ii ii i i iiiiii iiiiiiii iiiiii iiiiiiii iiiiiiiii iiiii i i i . ~..................................................................................................

0 . . . . . . . . . . . . . . . . .1 .1 1 .2 1 .3 1 .4 1 .5 1 .6 1 .7 1 .8 1 .9 2 2 .1 2 .2 2 .3 2 .4 2 .5 2 .6 2 .7bF i g . 2 . ( a ) E f f ec t s o f ch an g es i n c ; ( b ) e f f ec t s o f ch an g es i n d ; an d ( c ) e f f ec t s o f ch an g es i n b( ~ , ~ - ; - - - , ,~ ) .


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416 R. E fitzur, J . M intz / Journal o f Public Economics 60 (1996) 401 -4224 . 2 . S o m e c o m p a r a t i v e s ta t ic s

U s i n g t h e r e a c t i o n f u n c t i o n s i l l u s t r a t e d i n F i g . 1 , a n d P r o p o s i t i o n s 2 a n d3 , w e c a n i l l u s t r a t e s o m e c o m p a r a t i v e r e s u l t s s h o w i n g t h e s e n s i t i v i t y o f t h eo p t i m a l t a x r a t e s t o v a r i o u s s o l u t i o n s .

F i g . 3 (a ) s h o w s t h e i m p a c t o f a n i n c r e a s e i n th e p a r e n t ' s c o s t o f p r o d u c t i o nin t h e h o m e c o u n t r y . B y P r o p o s i t i o n 2 , t h e r e ac t i o n f u n c t io n 4 ~[~'] s h i f t s t ot h e l e f t a s 0 4 > / 0 c < 0 . B y P r o p o s i t i o n 3 , t h e r e a c t i o n f u n c t i o n a l s o s h i f t s t ot h e l e f t a s O~ /Oc < 0 . T h e e q u i l i b r i u m c h a n g e s f r o m p o i n t a t o b , i n d i c a t i n g

F IG U R E A;

F IG U R E B

F I G U R E C1;

Fig. 3.


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R . E l i tz u r , J. M i n t z / J o u r n a l o f P u b l i c E c o n o m i c s 6 0 1 9 9 6 ) 4 0 1 - 4 2 2 417

t h a t a t l e a s t o n e o f th e t a x r a t e s , i f n o t b o t h , d e c l i n e . T h e s e r e s u l t s a r ec o n s i s t e n t w i t h t h e s i m u l a t i o n s r e p o r t e d i n F i g . 2 ( a ) , w h i c h s h o w t h a t b o t h ~ -a n d ~ d e c l i n e w i t h i n c r e a s e s i n c .

F i g . 3 ( b ) s h o w s t h e i m p a c t o f a c h a n g e i n th e c o n c a v i t y o f th e s u b s i d i a r y ' sp r o d u c t i o n f u n c t i o n ( as d is c u s se d a b o v e , d i n c re a s e s th e d e g r e e o f c o n c a v i t yi n t h e p r o d u c t i o n f u n c t i o n ) . B y P r o p o s i t i o n 2 , t h e r e a c t i o n f u n c t i o n 4 ~[ 7] isu n a f f e c t e d w h i l e , b y P r o p o s i t i o n 3 , t h e r e a c t i o n f u n c t i o n T [ ~ ] s h i f t s t o t h er i g h t . A s a r e s u l t o f a s h if t i n d , t h e h o s t c o u n t r y ' s e f f e c t i v e t a x r a t e , r ,i n c r e a s e s a n d t h e h o m e c o u n t r y ' s e f fe c t i v e t a x r a t e , 05, d e c r e a s e s . I n o t h e rw o r d s , t h e i n c r e a s e d c o n c a v it y o f t h e p r o d u c t i o n f u n c t i o n ( t h r o u g h h i g h e rd ) a l lo w s t h e h o s t c o u n t r y t o e x p l o i t f u r t h e r t h e s e r e n ts . T h e s e r e s u lt s a r ec o n f i r m e d b y t h e s i m u l a t i o n s r e p o r t e d i n F i g . 2 ( b ) .

F i g. 3 ( c) c o n s i d e r s t h e i m p a c t o f a n i n c r e a s e i n t h e p r o d u c t i v i t y p a r a m e t e rb o n t h e e q u i l i b r i u m . F r o m P r o p o s i t i o n 2 , a n i n c r e a s e i n b c a u s e s t h er e a c t i o n f u n c t i o n & [ T ] t o s h i f t t o t h e r i g h t . F r o m P r o p o s i t i o n 3 , t h e r e a c t i o nf u n c t i o n ~ '[d ~] a l so sh i f ts t o t h e r i g h t . T h u s , a t l e a s t o n e o f t h e e f f e c t i v e t a xr a t e s , ~- o r ~ , m u s t r i s e i n v a l u e , I n t h e s i m u l a t i o n s r e p o r t e d i n F i g . 2 (c ) w ef in d t h a t ~ i n c r e a s e s s u b s t a n t ia l l y , a l t h o u g h r r e m a i n s a l m o s t t h e s a m e i nv a l u e ( i n f a c t, d e c r e a s e s s l i g h tl y w h e n b r i s es ) . T h i s r e fl e c ts th e n a t u r e o ft a x c o m p e t i t i o n i n th i s m o d e l ; t h e h o m e c o u n t r y i n c r e a s e s i ts ta x r a t e , 05, s or a p i d l y w h e n b r i s e s t h a t t h e h o s t c o u n t r y h a s n o r o o m t o r a i s e ~ - .

5 T a x h a r m o n i z a t io n

I n t h e m o d e l p r e s e n t e d s o f a r w e f i n d t h a t c o r p o r a t e t a x c o m p e t i t i o n i nt h e p r e s e n c e o f t r a n s f e r p r ic i n g ru l e s r e s ul ts i n m o n o t o n i c a l l y d e c r e a s i n gr e a c t i o n f u n c t i o n s . I n o t h e r w o r d s , w h e n o n e c o u n t r y r a is e s it s e f f e c ti v e t a xr a t e , t h e o t h e r w i l l s t r a t e g i c a ll y lo w e r i ts o w n . A q u e s t i o n t h a t n a t u r a l l ya r i s e s f r o m t h i s t y p e o f a n a l y s i s i s t h e f o l l o w i n g : W e r e t h e c o u n t r i e s t oh a r m o n i z e t a x r a t e s , w o u l d t h e y r a is e o r l o w e r t h e i r r at e s o f t a x a t i o n ?

F o l l o w i n g M i n t z a n d T u l k e n s ( 1 9 8 6 ) , w e d e f i n e h a r m o n i z a t i o n a s t h ep r o c e s s t h a t r e s u l t s i n c o u n t r i e s r e d u c i n g t h e f i s c a l e x t e r n a l i t i e s t h a t r e s u l tf r o m n o n - c o o p e r a t i v e s t r a te g i c d e ci s io n s . A f is ca l e x t e r n a l i t y m a y b e d e f i n e da s th e u n c o m p e n s a t e d e f f e c t o f a n i n cr e a s e in o n e c o u n t r y ' s ta x r a t e o n t h ew e l f a r e o f t h e o t h e r ( i n t h i s c a s e t a x r e v e n u e s ) . I f t h e e x t e r n a l i t y is ap o s i t i v e ( n e g a t i v e ) o n e , t h e n a c o u n t r y c h o o s e s a t a x r a t e t h a t i s t o o l o w( h i g h ) s i n c e it d o e s n o t t a k e i n t o a c c o u n t t h e b e n e f i t ( h a r m ) o f i ts d e c i s i o no n t h e w e l f a r e o f t h e o t h e r c o u n t r y . W i t h h a r m o n i z a t i o n , a c o u n t r y w o u l dr a i s e ( l o w e r ) i ts t ax r a t e i f t h e f i s ca l e x t e r n a l i t y in t h e n o n - c o o p e r a t i v e g a m ei s p o s i t i v e ( n e g a t i v e ) .

I n t e r m s o f t h e p r o b l e m e s t a b li s h e d h e r e , w e c a n p r o v e t h e f o ll o w i n gr e s u l t w i t h r e g a r d t o f i s c a l e x t e r n a l i t i e s :


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4 1 8 R. Elitzur, J. Mintz / Journal of Public Economics 60 1996) 401-422

P r o p o s i t i o n 4 . I n a N a s h e q u i l i b r i u m e a c h c o u n t r y c h o o s e s a t a x r a te t h a tc a u s e s a n e g a t iv e f i s c a l e x t e r n a l it y i n t h a t t h e t a x r e v e n u e s o f t h e o t h e r c o u n t r yd e c r e a s e w i t h a h i g h e r v a l u e o f i t s o w n t a x r a t e .P r o o f . The fiscal externalities can be derived by di fferentiat ing the taxrevenue function of each country with respect to the tax rate of the other.Using the envelope theorem, we obtain the following:From Eq. (9.1),

O T h -~bc2(1 + ~b)BOr d(1 -- r) 2 < 0 .

From Eq. (9.2),O T f --rC2(1+ ~)0th d(1 - r) 2 < 0 .

Thus, both fiscal externalities are negative. []If both governments were to harmonize their taxes by reducing the impact

of the negative externalities, they would choose lower tax rates. Theintuition underlying this result is that the taxes selected by either the homeor host country either increase the supply cost of the input produced by theparent or reduce the net revenues received by the subsidiary. Both of theseeffects result in a reduction in the amount of output sold and input used inproduction. For either case, an increase in ~b or r will cause the revenues ofthe other country to decline. This result is illustrated by Fig. 4 where weshow that the indifference curves for each government are concave to theaxes. Thus, both countries could choose lower tax rates, which would resultin greater revenues for both countries.The above results apply to the impact of tax competition and harmoniza-tion on tax revenues that governments seek to maximize. We could, instead,concentrate on how harmonization might improve social welfare. Eventhough both governments seek to maximize tax revenues, we could con-sider, instead, how harmonization might improve the allocation of resourcesin the international economy.Social welfare in this model is the aggregate of the multinational safter-tax expected profits and tax revenues earned by both governments, netof the cost of the managing partner s effort. It can be shown, as below, thatthis implies that aggregate social welfare is equal to expected profits gross ofthe payment of taxes in each country:

: ~ h q_ ~-~f : O f -- CX -- t x a


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R. Elitzur, J. Mintz / Journal of Public Economics 60 1996) 401-422T,

419

o [ q

\ \ T

Fig. 4.

w i t h~ h _-- ( 0 -- C (1 + ) ) X + ( 1 - - / 3 ) ( ( 1 - - z ) ( Q f - Ox) + W + 4acx,a f = / 3 1 - r)0 f- Ox - w - I ~ a ~ Q f - Ox

S o c i a l w e l f a r e w i ll b e m a x i m i z e d i n t h e a b s e n c e o f t a x e s ( i . e . ~ - = ~b = 0 )s i n c e t h e P a r e t o - o p t i m a l s o l u t i o n is f o r a = 1 a n d b - d x = c . T h u s , t a xh a r m o n i z a t i o n u n d e r t a k e n b y g o v e r n m e n t s s e e k i n g to m a x i m i z e t a x re -v e n u e s w i l l a l s o i m p r o v e s o c i a l w e l f a r e s i n c e t a x r a t e s w o u l d b e c l o s e r t oz e r o .

6 C o n c l u s i o n s

T h e a b o v e m o d e l , w h i le s i m p l e in c h a r a c te r i z i n g th e b e h a v i o u r o f t h em u l t i n a t i o n a l a n d t h e m a n a g i n g p a r t n e r , p r o v i d e s a r ic h s e t o f r e s u lt s o n t h er o l e o f t h e t r a n s f e r p ri c in g r ul e s o n ta x c o m p e t i t io n b e t w e e n h o m e a n d h o s tg o v e r n m e n t s . A p r i m a r y re s u l t is t o s h o w h o w t h e o p t i m a l c o n t r a c t b e t w e e nt h e p a r e n t a n d s u b s i d i a r y w i ll b e a f f e c t e d b y ta x r a t e s in th e p r e s e n c e o ft r a n s f e r p r i c i n g r u l e s. F r o m t h is r e s u l t w e s p e c i f y a t a x c o m p e t i t i o ne q u i l i b r i u m i n w h i c h e a c h g o v e r n m e n t c h o o s e s o p t i m a l t a x r a t e s t o m a x i -


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420 R . E l i tz u r , J. M i n t z / J o u r n a l o f P u b l i c E c o n o m i c s 6 0 1 9 9 6) 4 0 1 - 4 2 2mize tax revenue. From this equilibrium we derive comparative static resultsthat suggest that host countries could increase their rates of taxation onforeign firms if changes in productivity and costs induce higher profitsearned by the multinational. We also find that harmonization would result inlower effective corporate tax rates. This would not only improve taxrevenues for both governments but also improve aggregate social welfare.Our work is being extended in a number of directions. In a companionpaper we compare the impact of the regular corporate income tax and acorporate income tax with transfer pricing rules on the transfer price ofmultinationals for a more general case. Another area of research is toconsider a richer economic environment such as the introduction of capitalor other inputs that may not be subject to transfer pricing rules. We couldalso consider the impact of apportionment rules for corporate taxationpurposes that result in an allocation of income across jurisdictions accordingto shares of sales, payroll or capital.

A c k n o w l e d g e m e n t sThis paper was presented at the International Seminar on Public Econ-omics held in Linz, Austria, August 1993. We wish to thank participants inthe seminar as well as our two discussants, Frans van Winden and

Hannelore Weck-Hannemann, for their detailed comments that helpedimprove this paper. We gratefully acknowledge the detailed comments oftwo anonymous referees, Beverly Lapham, David De Meza and participantsin sessions held at Tel Aviv University, The Hebrew University, theCanadian Economics Association and Warwick University.

A p p e n d i xThe simulations reported in the text were conducted by using expression

(11.1) and (11.2) in the text:( 1 - r ) b - c~b[z] - 2c (A.1)

(1 + ~-) 2d + b E(1 - ~ .) 3 c 2 ( 1 + ~ b ) 2 . ( A . 2 )

The simulations, using the Maple Symbolic Processor in MATHCAD 4.0,were developed as follows:(1) Substitution of (A.1) into (A.2) for ~b resulting in a value to beobtained for z.


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R . E l i t z u r , J . M i n t z / J o u r n a l o f P u b l ic E c o n o m i c s 60 1 9 9 6 ) 4 0 1 - 4 2 2 421( 2 ) C a l c u l a t i o n s f o r e a c h s i m u l a t i o n f o r ~- w e r e d o n e s e p a r a t e l y a s

f o l l o w s :( a) U s e o f b = 2 a n d d = 1 a n d c s ta r t i n g f r o m 0 . 3 5 a n d i n c r e a s i n g e a c h

t i m e b y 0 .0 5 . T h i s s i m u l a t i o n r e s u l t e d i n F i g . 2( a ) .( b ) U s e o f b = 2 , c = 0 . 5 a n d d s t a r t i n g f r o m 0 . 5 a n d i n c r e a s i n g e a c h b y0 . 1 . T h i s s i m u l a t i o n r e s u l t e d i n F i g . 2 (b ) .

( c) U s e o f c = 0 . 5 , d = 1 a n d b s t a r t i n g f r o m 1 a n d i n c r e a s i n g e a c h t i m e b y0 . 1 . T h i s s i m u l a t i o n r e s u l t e d i n F i g . 2 ( c ).

e f erences

Alt hsu le r R . and T .S . New lon , 1993 , The e f f ec ts o f U .S . t ax po li cy on t he incom e r epa t r i a t ionpa t t e rns o f mu l t ina t iona l co rpo ra t ions , in : A . G iov ann in i , G . H ubbard and J . S lemrod , eds . ,S t ud ies in in t e rna t iona l t axa t ion (Un iver s i t y o f C h icago P res s , C h icago , IL ) 77 -115 .Am ersh i , A .H . and P . C heng , 1990 , In t ra f i rm resource a l loca tion : The econom ics o f tr ans fe rp r i c ing and cos t a l loca t ions in accoun t ing , C on t empora ry Accoun t ing R esea rch 7 , no . 1 ,61 -99 .Bern ard , J . -T . and R . Weiner , 1990 , Mul t ina t iona l co rpo ra t ions , t r ans fe r p r i ces , and t axes:Ev idence f rom t he U .S . pe t ro leum indus t ry , in : A . R az in and J . S lemrod , eds . , Taxa t ion in aglobal economy (Univers i ty of Chicago Press , Chicago, IL) 123-154.D a t a r , S .M. and R .D . Bank er , 1991 , Op t ima l tr ans fe r p ri c ing under pos t con t r ac t in fo rmat ion ,C on t empora ry Accoun t ing R esea rch 8 , no . 2 , 329-352 .Ede n , L . , 1995, The mic roeconom ics o f t r ans fe r pr i c ing , in : A .M . R ugm an and L . Eden , eds . ,Mult inat ionals and t ransfer pr ic ing (St . Mar t in ' s Press , New York) .G ran f le ld , M .E . , 1993 , An econom ic analysi s o f the do cum en t a t ion and f inanc ia l imp l ica t ionso f t he new Sec t ion 482 r egu la t ions , Tax No t es In t e rna t iona l 7 , no . 2 .G ru ber t , H . , J . Mut t i and D . Sw enson , 1993 , Exp la in ing t he low taxab le income o f fo re ign -con t ro l l ed compan ies in t he Un i t ed S t a t es , in : A . G iovann in i , G . H ubbard and J . S lemrod ,eds . , Studies in in ternat ional t axat ion (Univers i ty of Chicago Press , Chicago, IL) 237-270.H a lpe r in , R .M . and B . S r in idh i , 1991 , U .S . income t ax tr ans fe r -p r i c ing ru les and r esourcea l loca t ion : The case o f decen t r a l i z ed mul t ina t iona l fi rms , The Accou n t ing R ev iew 66 , no . l ,141-157.H ar r i s , D . , R . M orck , J . S lem rod and B . Yeung , 1993 , Incom e sh if ting in U .S . m u l t ina tiona lcompan ies , in : A . G iovann in i , G . H ubbard and J . S lemrod , eds . , S t ud ies in in t e rna t iona l

t axa t ion (Un iver s i t y o f C h icago P res s , C h icago , IL ) 277-302 .H ines , J .R . and G . H ubbard , 1990 , C oming home t o Amer ica : D iv idend r epa t r i a t ions by U.S .mul t ina t iona l s , in : A . R az in and J . S lemrod , eds . , Taxa t ion in a g loba l economy (Un iver i s t yof Chicago Press , Chicago, IL) 123-154.H ogg , R . and J . Min t z , 1993 , Impac t s o f C anad ian and U.S . t ax r e fo rm on t he f inanc ing o fC anad ian subs id ia ri e s o f U .S . p a ren t s , in : A . G iovann in i , G . H ubba rd and J . S lem rod , eds . ,S t ud ies in in t e rna t iona l t axa t ion (Un iver s i t y o f C h icago P res s . C h icago , IL ) 47 -74 .Ho rs t , T. , 1993, Th e com para ble prof i t s m ethod , Tax Notes In ternat ion al , 14 Jun e, 1443-1458,Jo rda n , J .S . , 1989 , Accou n t ing -based d iv i siona l pe r fo rma nce m easu rem en t : Incen t ives fo rp ro f i t max imiz a t ion , C on t empora ry Accoun t ing R esea rch 6 , no . 2 , 903-921 .K anbur , R . and M. K een , 1993 , J eux s ans f ron t i e r es : Tax compet i t ion and t ax coord ina t ionw hen coun t r i e s d i f f e r in s i z e , Amer ican Economic R ev iew 83 , 877-892 .K P M G , 1994 , Execu t ive compensa t ion p rac t i ces in t he TSE 300 compan ies , mim eo . , Toro n t o .


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