Duopolistic Competition, Taxes, and the Arm’s-Length Principle∗

Numerous (high-tax) countries presume that multinational firms use their transferpricing policies to shift profits into countries with lower tax rates. To avoid the corresponding loss in tax revenues, tax authorities develop constantly tightening rules to curb transfer-price distortions. Affected firms include the decision of compliance to these rules into their strategic considerations. In a scenario with arm’slength regulation in two countries, we analyze the transfer-pricing policy of a firm that uses the same transfer price for tax and managerial incentive purposes. Thus, the transfer-pricing policy is driven by three issues: interaction with competitors, minimization of tax burden, and avoidance of punishments. The model shows that tighter transfer-pricing rules may help firms to mitigate competition and to increase their profits and that non-compliance to the arm’s-length principle is part of their equilibrium strategy. ∗We acknowledge helpful comments by Stefan Homburg, Wolfgang Leininger, Ralf Maiterth, Björn Walker, Alfons Weichenrieder, participants of the annual meetings of the German Economic Association of Business Administration (2003) and the Verein für Socialpolitik (2003) as well as seminar participants at Eberhard Karls Universität Tübingen and University of Hannover. JEL-Classification: H25, L22, M40. †Evelyn Korn: Philipps-Universität Marburg, email: [email protected], Stephan Lengsfeld: University of Hannover, [email protected] Duopolistic Competition, Taxes, and the Arm’sLength Principle