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

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  • Christian Josef Bauer
  • Dominika Langenmayr

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.

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3967.

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Date of creation: 2012
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Handle: RePEc:ces:ceswps:_3967

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

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References

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Citations

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Cited by:
  1. Thomas Gresik, 2013. "Allowing Firms to Choose Between Formula Apportionment and Separate Accounting Taxation," CESifo Working Paper Series 4560, CESifo Group Munich.
  2. Bauer, Christian J. & Langenmayr, Dominika, 2013. "Sorting into outsourcing: Are profits taxed at a gorilla’s arm’s length?," Munich Reprints in Economics 20122, University of Munich, Department of Economics.
  3. Langenmayr, Dominika & Haufler, Andreas & Bauer, Christian J., 2012. "Should tax policy favor high- or low-productivity firms?," Discussion Papers in Economics 14277, University of Munich, Department of Economics.

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