Overseas production or domestic production? Impacts of tax disparity and market difference

Abstract

Overseas and domestic production are two commonly employed strategies for multinational firms (MNFs) to manage their global production operations. Recent tax-cutting initiatives have made domestic production an attractive option for MNFs. We aim to investigate whether such initiatives can effectively induce MNFs to produce domestically, especially when they cater to both domestic and foreign markets. In this study, we develop a game-theoretical model that considers an MNF with two subsidiaries - a production subsidiary and a retail subsidiary - located in different markets, and a third-party seller that resells the MNF's product in the domestic market. We take into account two important differences between the two markets, namely the tax disparity and the market potential difference. Our analysis reveals that a higher foreign market potential can strengthen the MNF's tax-saving incentive under the domestic production strategy. We find that a relatively lower domestic tax rate may not induce the MNF's domestic production even if the foreign market potential is low. On the other hand, when the domestic channel competition is intense, a higher domestic tax rate may still incentivize the MNF to produce domestically. These results depend on the tradeoffs among the tax-saving benefit, the third-party seller's free-riding, and the channel competition. We caution that promoting domestic production through a low tax rate may harm domestic consumer surplus, highlighting the need for policymakers to carefully consider the impact of tax policies on consumers.