DISCUSSION PAPER SERIES
No. 2753
CORPORATE TAXATION,
MULTINATIONAL ENTERPRISES
AND ECONOMIC INTEGRATION
Hans Jarle Kind, Karen Helene Midelfart
Knarvik and Guttorm Schjelderup
INTERNATIONAL TRADE
ZZZFHSURUJ
Available online at: www.cepr.org/pubs/dps/DP2753.asp and http://papers.ssrn.com/paper.taf?abstract_id=267149
www.ssrn.com/xxx/xxx/xxx
ISSN 0265-8003
CORPORATE TAXATION,
MULTINATIONAL ENTERPRISES
AND ECONOMIC INTEGRATION
Hans Jarle Kind, Norwegian School of Economics and Business Administration
Karen-Helene Midelfart Knarvik, Norwegian School of Economics and Business
Administration, and CEPR
Guttorm Schjelderup, Norwegian School of Economics and Business
Administration
Discussion Paper No. 2753
March 2001
Centre for Economic Policy Research
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This Discussion Paper is issued under the auspices of the Centre’s research
programme in International Trade. Any opinions expressed here are those
of the author(s) and not those of the Centre for Economic Policy Research.
Research disseminated by CEPR may include views on policy, but the
Centre itself takes no institutional policy positions.
The Centre for Economic Policy Research was established in 1983 as a
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discussion of open economies and the relations among them. It is pluralist
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These Discussion Papers often represent preliminary or incomplete work,
circulated to encourage discussion and comment. Citation and use of such a
paper should take account of its provisional character.
Copyright: Hans Jarle Kind, Karen Helene Midelfart Knarvik and Guttorm
Schjelderup
CEPR Discussion Paper No. 2753
March 2001
ABSTRACT
Corporate Taxation, Multinational
Enterprise and Economic Integration*
This Paper addresses the outcome of international tax competition in the
presence of multinationals that use transfer pricing for strategic purposes as
well as to reduce their tax burden. We examine how economic integration
affects tax levels, transfer pricing behaviour and national welfare. We show
that the tax elasticity of the transfer price depends on the tax system and on
the extent of economic integration. Under separate accounting, the
conventional wisdom that increased economic integration forces governments
to reduce tax rates is supported by our findings. This is not true under formula
apportionment, however, where increased integration reduces the tax
elasticity of the transfer prices and indeed allows governments to levy higher
tax rates.
JEL Classification: F15, F23, H25, H87
Keywords: economic integration, international tax competition, multinational
enterprises, tax regimes
Hans Jarle Kind
Norwegian School of Economics and
Business Administration
Helleveien 30
N-5045 Bergen
NORWAY
Tel: (47 55) 583 890
Fax: (47 55) 583 901
Email: hans.kind@nhh.no
Karen Helene Midelfart Knarvik
Norwegian School of Economics and
Business Administration
Helleveien 30
N-5045 Bergen
Norway
Tel: (47 55) 959 510
Fax: (47 55) 959 350
Email: karenhelene.knarvik@snf.no
For further Discussion Papers by this author see:
For further Discussion Papers by this author
see:www.cepr.org/pubs/new-dps/dplist.asp?authorid=117878
www.cepr.org/pubs/new-dps/dplist.asp?authorid=137967
Guttorm Schjelderup
Norwegian School of Economics and
Business Administration
Helleveien 30
N-5045 Bergen
NORWAY
Tel: (47 55) 959 238
Fax: (47 55) 959 350
Email: guttorm.schjelderup@nhh.no
For further Discussion Papers by this author see:
www.cepr.org/pubs/new-dps/dplist.asp?authorid=117379
*This Paper is produced as part of a CEPR Research Network on Foreign
Direct Investment and the Multinational Corporation: New Theories and
Evidence, funded by the European Commission under the Training and
Mobility of Researchers Programme (Contract No. ERBFMRX-CT98-0215).
Submitted 22 February 2001
NON-TECHNICAL SUMMARY
This Paper addresses the outcome of international tax competition in the
presence of multinationals that use transfer pricing for strategic purposes as
well as to reduce their tax burden. In particular, we examine how economic
integration affects tax levels, transfer pricing behaviour and national welfare
under different corporate taxation regimes.
It is well known in the literature on multinationals that firms may use transfer
pricing as a strategic device to increase profits in foreign markets. To see the
strategic motive for transfer pricing, consider a multinational enterprise (MNE)
that has a foreign subsidiary, which is active in markets with Cournot
competition. Essential intermediates are supplied by the headquarters to the
foreign affiliate. If the MNE sets low prices, the foreign affiliate becomes a low
cost firm that behaves aggressively by selling a large quantity. Such
aggressive behaviour under Cournot competition induces its local rival to
behave softly by setting a low quantity. The soft response from the rival is
beneficial and leads to higher profits in the foreign market as well as to
increased profits for the multinational enterprise as a whole.
It is also well known from the literature that MNEs may use transfer pricing as
a means of shifting profits to low tax countries. From a policy point of view
transfer pricing to shift profits to low tax countries is worrisome, since the profit
shifting activities threaten to undermine the fiscal autonomy of high tax
countries. At least two policy options exist to curb transfer pricing. The first
measure is to enforce arm’s-length prices on intra-firm transactions. Not only
is this difficult to achieve, but the administrative costs are also considerable.
The second solution pertains to the choice of tax system. If, by choosing the
‘right’ system for corporate taxation, one can reduce the disparities in
countries’ tax bases and tax rates, incentives to shift profits would be
diminished. Currently, most OECD countries use separate accounting as a
foundation for their corporate tax system. Under this system accountants and
tax authorities try to identify the exact receipts and expenditures attributable to
the corporation’s activities in each country. A problem with the separate
accounting system is that the globalization of the world economy has made it
ever more difficult to disentangle individual operations of multinational
corporations. The alternative corporate tax system is formula apportionment,
where the total income of a corporation is apportioned on the basis of a
weighted formula, where the weights are, say, sales, payroll or property.
Variants of formula apportionment are used in Canada, Switzerland and the
US.
In our analysis we explore the interaction between corporate taxation, transfer
pricing and welfare. We show that the relationship between these factors
depends on the degree of economic integration and the choice of tax regime.
We show that the transfer price of a multinational is actually independent of
the prevailing tax regime, separate accounting or formula apportionment.
Nonetheless, the tax elasticity of the transfer price depends on the tax system
and on the extent of economic integration. One important result that emerges
is that the effect of increased economic integration on equilibrium taxes
depends crucially on the tax regime in force. We show that the transfer price is
relatively tax elastic for a high degree of economic integration under a
separate accounting (SA) regime, while the opposite is true under a formula
apportionment (FA) regime. As a consequence, the impact of economic
integration on welfare and on the intensity of tax competition depends crucially
on the choice of tax scheme. While under SA, increased economic integration
leads to lower tax revenue, the opposite is true under FA.
To make a full welfare assessment it should be noted that economic
integration under any tax regime affects consumer surplus positively due to
enhanced competition leading to lower prices and larger quantities sold. Thus,
under SA we have two opposing effects of increased integration; rising
consumer surplus and falling tax rates. In contrast, with FA, consumer surplus
and tax rates rise. Figure 4 indicates that an SA regime provides the highest
welfare level for a low degree of integration (high trade costs), while the FA
regime becomes more attractive as integration proceeds. Thus, for a high
degree of economic integration, the FA regime may come to dominate the SA
regime from a welfare perspective.
We find that the impact of increased economic integration on the intensity of
international tax competition hinges on the choice of tax regime. Under
separate accounting increased integration leads to intensified tax competition,
while under formula apportionment increased integration actually reduces the
intensity of tax competition. These relationships are mirrored in the
relationship between economic integration and welfare under the two different
tax regimes. In terms of national welfare, the SA system dominates for low
degrees of integration, while the FA system becomes dominant as an
integration process proceeds. Hence, our results support the view brought
forward by many other economists that increased economic integration may
call for a substantial reform of the corporate tax system.
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