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

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  • Christian J. Bauer
  • Dominika Langenmayr

Abstract

This article analyzes profit taxation according to the arm's length principle in a new 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. Transfer prices set at market values following the arm's length principle thus systematically exceed multinationals' marginal costs. This allows for a reduction of tax payments with each unit sold. The optimal organization of firms hence provides a new rationale for the empirically observed lower tax burden of multinational corporations.

Suggested Citation

  • Christian J. Bauer & Dominika Langenmayr, 2011. "Sorting into Outsourcing: Are Profits Taxed at a Gorilla's Arm's Lenght?," Working Papers 104, Bavarian Graduate Program in Economics (BGPE).
  • Handle: RePEc:bav:wpaper:104_bauerlangenmayr
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    Cited by:

    1. Bodo Knoll & Nadine Riedel, 2015. "Transfer Pricing Laws," ifo DICE Report, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 12(4), pages 22-26, 01.
    2. Bauer, Christian J. & Langenmayr, Dominika, 2013. "Sorting into outsourcing: Are profits taxed at a gorilla's arm's length?," Journal of International Economics, Elsevier, vol. 90(2), pages 326-336.
    3. Irlacher, Michael & Unger, Florian, 2018. "Effective tax rates, endogenous mark-ups and heterogeneous firms," Discussion Papers in Economics 49717, University of Munich, Department of Economics.
    4. Langenmayr, Dominika & Haufler, Andreas & Bauer, Christian J., 2015. "Should tax policy favor high- or low-productivity firms?," European Economic Review, Elsevier, vol. 73(C), pages 18-34.
    5. repec:ces:ifodic:v:12:y:2015:i:4:p:19149986 is not listed on IDEAS
    6. Johannes Becker & Ronald B Davies, 2014. "A negotiation-based model of tax-induced transfer pricing," Working Papers 1409, Oxford University Centre for Business Taxation.
    7. Cyril Chalendard, 2016. "Shifting-Profits through Tax Loopholes. Evidence from Ecuador," CESifo Working Paper Series 6240, CESifo Group Munich.
    8. Sotiris Blanas & Adnan Seric, 2017. "Determinants of Intra-Firm Trade," Working Papers 178118175, Lancaster University Management School, Economics Department.
    9. Thomas Gresik, 2013. "Allowing Firms to Choose Between Formula Apportionment and Separate Accounting Taxation," CESifo Working Paper Series 4560, CESifo Group Munich.
    10. Sotiris Blanas & Adnan Seric, 2017. "Knowledge Transfer and Intra-Firm Trade," Working Papers 178612931, Lancaster University Management School, Economics Department.
    11. V. Vicard, 2015. "Profit shifting through transfer pricing: evidence from French firm level trade data," Working papers 555, Banque de France.
    12. Anca D. Cristea & Daniel X. Nguyen, 2016. "Transfer Pricing by Multinational Firms: New Evidence from Foreign Firm Ownerships," American Economic Journal: Economic Policy, American Economic Association, vol. 8(3), pages 170-202, August.
    13. Holzmann, Carolin Maria, 2016. "Transfer pricing as tax avoidance under different legislative schemes," Annual Conference 2016 (Augsburg): Demographic Change 145929, Verein für Socialpolitik / German Economic Association.
    14. Nielsen, Søren Bo & Schindler, Dirk & Schjelderup, Guttorm, 2014. "Abusive Transfer Pricing and Economic Activity," Discussion Papers 2014/21, Norwegian School of Economics, Department of Business and Management Science.
    15. Gresik, Thomas A., 2016. "Allowing firms to choose between separate accounting and formula apportionment taxation," Journal of Public Economics, Elsevier, vol. 138(C), pages 32-42.
    16. Hayato Kato & Hirofumi Okoshi, 2017. "Production Location of Multinational Firms under Transfer Pricing: The Impact of the Arm's Length Principle," Keio-IES Discussion Paper Series 2017-016, Institute for Economics Studies, Keio University.

    More about this item

    Keywords

    outsourcing; profit taxation; transfer pricing; arm's length principle; multinational firms;

    JEL classification:

    • F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business
    • F22 - International Economics - - International Factor Movements and International Business - - - International Migration
    • H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies

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