Economic Integration and Agglomeration of Multinational Production with Transfer Pricing

Do low corporate taxes always favor multinational production in the course of economic integration? We propose a two-country model in which multinationals choose the locations of production plants and foreign distribution affiliates and shift profits between home plants and foreign affiliates by manipulating transfer prices in intra-firm trade. We show that when trade costs are high, plants are concentrated in the low-tax country, but surprisingly this location pattern reverses when they are low. Unlike existing models with single-plant firms, the impact of economic integration is non-monotonic, which we empirically confirm: a fall in trade costs first decreases and then increases the share of plants in the high-tax country. We also analyze tax competition and find that allowing for transfer pricing makes competition tougher, indicating a possibility of international coordination on transfer-pricing regulation making the world better off.