Abusive Transfer Pricing and Economic Activity

This paper investigates how concealment costs of transfer pricing and the probability of detection affect transfer pricing and firm behavior. We find that transfer pricing in intermediate production factors does not affect real activity of a multinational firm if the firm’s concealment effort as well as the probability of being audited by tax authorities are conditioned on the amount of shifted profits. If tax authorities rely on the standard OECD arm’s-length principle instead by reacting to a deviation of the transfer price from the market price, the multinational will for tax reasons adjust its production structure. A policy implication of the paper is that it should be preferable to condition audits on the amount of income shifted rather than on the distortion of the transfer price proper. Another policy finding is that improving the quality of tax law might be superior to higher detection effort. The former reduces profit shifting and concealment effort, whereas the latter leads to more wasteful use of resources on concealment and has an ambiguous effect on profits shifted.