International Taxation and Production Outsourcing

Abstract

This paper studies the effects of international taxation on multinational firms’ production outsourcing strategies, which has attracted recent attention from both practitioners and legislators. We formulate a stylized economic model with information asymmetry and find that under the territorial tax system, the presence of global tax disparity may result in subtle changes of a firm's production outsourcing strategy. In particular, the tax consideration can make a multinational firm more inclined to procure materials by its overseas subsidiary and then resell the materials to the contract manufacturer to retain profit in the low tax jurisdiction. Such an effect can not only cause the firm to choose a more expensive material supplier but also overproduce the products. Therefore, besides the general concern of income shifting, tax considerations can further lead to operational distortions. We show that to reduce tax disparity while preventing tax exemption for shifted foreign profit may lead to a win‐win outcome for the firm and the home country stakeholders. The firm will make more efficient operational decisions to obtain a higher after‐tax profit at a certain reduced tax rate, while the home country stakeholders can receive more tax income. Interestingly, the foreign contract manufacturer may also benefit from such a change.