Do Tax Information Exchange Agreements Curb Transfer Pricing-Induced Tax Avoidance?

Abstract

We propose a game theoretical model where a multinational company and two governments interact with each other. Prior to an audit the true arm's length price of the multinational's product is unknown to the tax authorities. In equilibrium, tax evasion emerges in both countries, with both tax authorities conducting audits with a probability that depends on the multinational's transfer price reports. We find that introducing a Tax Information Exchange Agreement between the two tax authorities precludes tax evasion in the low-tax (“foreign”) country, while the degree of tax evasion in the high-tax (“domestic”) country remains unchanged. The volume of production increases, while the foreign tax authority discontinues its audit activities, and the domestic tax authority audits less often at least for sufficiently low arm's length prices. While the expected net tax revenues increase in the foreign country, they may decrease in the domestic country.