Arm's-length transfer pricing and national welfare

Abstract

While some countries coordinate their tax policies for multinationals with their commercial trade policies, the practice is not universal. Many countries, including the United States, formulate tax policies solely to mitigate tax avoidance practices like strategic transfer pricing. In this chapter, I consider an environment in which a host country has incomplete information about a multinational's foreign operations. I show that a policy that seeks to achieve arm's-length transfer prices is consistent with broader welfare objectives when the multinational's home country adopts a commensurate-with-income standard (ruling out repatriated losses) and when the multinational prefers pre-tax operating profit over post-tax transfer price profit. This result is based on a previously unidentified externality created by the opportunity for multinationals to engage in strategic transfer pricing.