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Strategic Trade Policy through the Tax System

  • Johannes Becker

If conventional instruments of strategic trade policy are unavailable, the system of foreign profit taxation and transfer price guidelines may serve as surrogate policy instruments. In this paper, I consider a model where firms from two countries compete with each other on a third market. I analyze optimal policy choices of the firms’ residence countries aiming at strategically manipulating the competitivity of their firms on the third market. I show that, as has recently been claimed, countries prefer the tax exemption system over the tax credit system if transfer prices for headquarter services to the affiliate are close to the headquarter’s variable cost and if the third country’s tax rate is low (i.e., if there is a large tax differential between both locations within the firm). However, if transfer prices are high and the tax rate in the third market country is sufficiently close to the residence country’s tax rate, I show that the tax credit system is an optimal tax policy choice for both countries. From a policy perspective, the view that the tax exemption system is generally the best policy response if domestic firms’ competitiveness is a policy goal has to be qualified.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3066.

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Date of creation: 2010
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Handle: RePEc:ces:ceswps:_3066
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  1. Joel Slemrod, 1998. "A General Model of the Behavioral Response to Taxation," NBER Working Papers 6582, National Bureau of Economic Research, Inc.
  2. Brander, James A. & Spencer, Barbara J., 1985. "Export subsidies and international market share rivalry," Journal of International Economics, Elsevier, vol. 18(1-2), pages 83-100, February.
  3. Michael P. Devereux, 2008. "Taxation of outbound direct investment: economic principles and tax policy considerations," Oxford Review of Economic Policy, Oxford University Press, vol. 24(4), pages 698-719, winter.
  4. Desai, Mihir A. & Hines, James R. Jr., 2004. "Old Rules and New Realities: Corporate Tax Policy in a Global Setting," National Tax Journal, National Tax Association, vol. 57(4), pages 937-60, December.
  5. Andrew Bernard & J. Bradford Jensen & Peter Schott, 2008. "Transfer Pricing by U.S.-Based Multinational Firms," Working Papers 08-29, Center for Economic Studies, U.S. Census Bureau.
  6. Holmstrom, Bengt & Tirole, Jean, 1991. "Transfer Pricing and Organizational Form," Journal of Law, Economics and Organization, Oxford University Press, vol. 7(2), pages 201-28, Fall.
  7. Johannes Becker & Clemens Fuest, 2010. "Taxing Foreign Profits With International Mergers And Acquisitions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 51(1), pages 171-186, 02.
  8. Clausing, Kimberly A., 2003. "Tax-motivated transfer pricing and US intrafirm trade prices," Journal of Public Economics, Elsevier, vol. 87(9-10), pages 2207-2223, September.
  9. Michael P Devereux, 2007. "The Impact of Taxation on the Location of Capital, Firms and Profit: a Survey of Empirical Evidence," Working Papers 0702, Oxford University Centre for Business Taxation.
  10. Bond, Eric W & Samuelson, Larry, 1989. "Strategic Behaviour and the Rules for International Taxation of Capital," Economic Journal, Royal Economic Society, vol. 99(398), pages 1099-1111, December.
  11. Johannes Becker, 2013. "Taxation of Foreign Profits with Heterogeneous Multinational Firms," The World Economy, Wiley Blackwell, vol. 36(1), pages 76-92, 01.
  12. Huizinga, Harry & Laeven, Luc, 2007. "International Profit Shifting within European Multinationals," CEPR Discussion Papers 6048, C.E.P.R. Discussion Papers.
  13. Elitzur, Ramy & Mintz, Jack, 1996. "Transfer pricing rules and corporate tax competition," Journal of Public Economics, Elsevier, vol. 60(3), pages 401-422, June.
  14. Gene M. Grossman & Esteban Rossi-Hansberg, 2008. "Trading Tasks: A Simple Theory of Offshoring," American Economic Review, American Economic Association, vol. 98(5), pages 1978-97, December.
  15. Becker, Johannes & Fuest, Clemens, 2012. "Transfer pricing policy and the intensity of tax rate competition," Economics Letters, Elsevier, vol. 117(1), pages 146-148.
  16. Mintz, Jack & Tulkens, Henry, 1996. "Optimality properties of alternative systems of taxation of foreign capital income," Journal of Public Economics, Elsevier, vol. 60(3), pages 373-399, June.
  17. Harry Grubert & Joel Slemrod, 1994. "The Effect of Taxes on Investment and Income Shifting to Puerto Rico," NBER Working Papers 4869, National Bureau of Economic Research, Inc.
  18. Overesch, Michael, 2006. "Transfer pricing of intrafirm sales as a profit shifting channel: evidence from German firm data," ZEW Discussion Papers 06-84, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
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