Tax motivated vertical FDI and transfer pricing

We examine a domestic downstream producer that acquires a foreign input supplier with the aim of manipulating the transfer price and shifting profits from a high-tax to a low-tax country. The multinational enterprise faces a trade-off: insourcing the input at a high transfer price reduces the corporate tax burden but at the cost of increasing the input cost of its downstream division, which reduces domestic sales and profits. The optimal transfer price balances this trade-off. Regulation under the arm’s length principle is shown to reduce the transfer price, which reduces distortion in the domestic production and expands the region in which vertical FDI benefits consumers and social welfare in the home country. We also show that promoting downstream competition could help align private and social incentives, reinforcing the positive effects of regulation.