Incentive effects of tax transparency: Does country-by-country reporting call for arbitration?

Abstract

The OECD proposes mandatory fiscal arbitration as a means of dispute resolution between tax authorities to avoid double taxation of multinational enterprises' profits. We investigate the effects of mandatory fiscal arbitration on tax-audit qualities in a two-country setting with country-by-country reporting (CbCR) and a tax rate differential. Our analytical model shows that tax-audit quality in the high-tax country increases under CbCR because finer information raises tax-audit effectiveness. In contrast, the low-tax country refrains from auditing as it benefits from profit shifting. While arbitration resolves double taxation, its effects on tax-audit quality depend on the procedure in place. An approach based on exogenous negotiation powers lowers audit quality, a final-offer arbitration preserves audit quality, and an independent-opinion arbitration with minimum-quality requirement offers the strongest audit incentives: even the low-tax country engages in auditing. Our findings contribute to the policy debate about interdependencies between firm-level tax policies, national fiscal enforcement, and international fiscal cooperation.