Tariff elimination versus tax avoidance: free trade agreements and transfer pricing

International Tax and Public Finance https://doi.org/10.1007/s10797-021-09689-8 Tariff elimination versus tax avoidance: free trade agreements and transfer pricing Hiroshi Mukunoki1 · Hirofumi Okoshi2 Accepted: 20 July 2021 © The Author(s) 2021 Abstract We explore the new roles of rules of origin (ROO) when multinational enterprises (MNEs) manipulate their transfer prices to avoid a high corporate tax. The ROO under a free trade agreement (FTA) require exporters to identify the origin of exports to be eligible for a preferential tariff rate. We find that a value-added criterion of ROO restricts abusive transfer pricing by MNEs. Interestingly, an FTA with ROO can induce MNEs to shift profits from a low- to high-tax country. Because the ROO augment tax revenues inside FTA countries, they can transform a welfarereducing FTA into a welfare-improving one. Keywords Rules of origin · Free trade agreement · Transfer pricing · Profit shifting JEL classification codes F13 · F15 · F23 · H26 This study was conducted as a part of the Project “Analyses of Offshoring” undertaken at the Research Institute of Economy, Trade, and Industry (RIETI). We wish to thank two anonymous referees, Jay Pil Choi, Ruud Aloysius de Mooij, Carsten Eckel, Clemens Fuest, Taiji Furusawa, Andreas Haufler, Jung Hur, Jota Ishikawa, Hiro Kasahara, Yoshimasa Komoriya, Ngo Van Long, Kiyoshi Matsubara, Kaz Miyagiwa, Monika Mrazova, Martin Richardson, Kensuke Teshima, and the participants of the Canadian Economic Association meeting, RIETI, 58th congress of ERSA, Microeconomics Workshop at the University of Tokyo, Summer Workshop on Economic Theory at Otaru University of Commerce, and 21st annual conference of ETSG, Workshop on International Economics at Osaka University, 76th Annual Congress of IIPF. Hiroshi Mukunoki acknowledges financial support from JSPS KAKENHI (Grant Numbers JP19H00594 and JP20K01659). Hirofumi Okoshi acknowledges the financial support from Deutsche Forschungsgemeinschaft. (German Science Foundation GRK1928). The usual disclaimer applies. Conflict of interest: The authors declare that they have no confict of interest. * Hirofumi Okoshi Hiroshi Mukunoki 1 Faculty of Economics, Gakushuin University, Mejiro 1‑5‑1, Toshima‑ku, Tokyo 171‑8588, Japan 2 Faculty of Economics, Okayama University, 3‑1‑1 Tsushima‑naka, Kita‑ku, Okayama‑shi, Okayama 700‑8530, Japan 13 Vol.:(0123456789) H. Mukunoki, H. Okoshi 1 Introduction Tax avoidance by multinational enterprises (MNEs) has become controversial in the last two decades of rapid globalization. The Organisation for Economic Co-operation and Development (OECD) estimates that countries lose 4–10% of corporate income tax revenue annually because of profit shifting.1 One way to shift profits across countries is to manipulate the price of intra-firm trade (transfer price), which is known as abusive transfer pricing. Because MNEs determine the prices of transactions among related companies, they manipulate these prices to decrease profits in high-tax countries and conversely increase profits in low-tax countries. Some empirical research has provided evidence of transfer pricing being used to save tax payments.2 Because the taxes paid by firms are one of the main sources of government revenues, tax avoidance by MNEs has become a serious issue, as trade liberalization and the creation of global value chains increase intra-firm trade and provide MNEs with greater opportunities to redistribute their tax base to low-tax countries. Our primary focus is on how such losses of tax revenues are linked to trade liberalization driven by trade agreements. Trade agreements among countries facilitate firms’ exports and imports. They also influence firm behaviors in other respects including transfer pricing and generate more complicated welfare effects. In particular, the specific rules needed to implement trade agreements complicate the effects of trade liberalization. We focus on the rules of origin (ROO) of a free trade agreement (FTA), which require exporters in member countries making tariff-free exports to other member countries to prove that the exported products originated within the FTA.3 To meet the ROO, firms may change their strategies such as their input procurement. Conconi et al. (2018) concludes that the ROO of the North American Free Trade Agreement (NAFTA) reduce imports of inputs from non-member countries, suggesting that such rules cause inefficiency in input procurement. Considering tax avoidance, this also implies that the ROO can hinder MNEs from shifting profits within the firm because they may need to consider whether their intra-firm transactions satisfy the requirements of the ROO. 1 See http://www.oecd.org/tax/beps/, accessed on March 11, 2020. For instance, Swenson (2001), Clausing (2003), Cristea and Nguyen (2016) and Davies et al. (2018) provided empirical evidence of the transfer price manipulation. Blouin et al. (2018) found that MNEs have conflicting motives for using transfer pricing to lower corporate tax and tariff payments. 3 Regional trade agreements in goods are classified into FTAs and customs unions. Unlike customs unions, member countries of an FTA can set their own tariff schedule against non-member countries. This offers an opportunity for firms producing outside the FTA to save tariff payments by choosing as a transit country the member country whose tariff against non-member countries is low, and then reexporting from that country to other FTA member countries whose tariffs against non-member countries are higher. Stoyanov (2012) presents evidence of firms’ incentive to transship a good through FTA members. To forestall firms from tariff avoidance, FTA members stipulate ROO. 2 13 Tariff elimination versus tax avoidance: free trade agreements… One way to prove the origin is to satisfy the value-added (VA) criterion, which is closely related to transfer price manipulation.4 The VA criterion requires firms to add a sufficient value inside FTA member countries. Specifically, let p denote the export price of the product and r denote the value of the input materials, which are used per unit of final good production and do not originate in the FTA. The VA criterion typically requires that the VA ratio (p − r)∕p is above the specified level. This method of calculating the VA content is called the “transaction value method.” The value of the input materials depends on the transfer price if MNEs procure inputs from related companies outside FTA countries, and, hence, a VA criterion can constrain MNEs from engaging in tax avoidance through abusive transfer pricing. However, a VA criterion allows the MNE an option to meet the ROO without changing its input sources. This violates the principal purpose of the ROO to increase local procurement of inputs. Although this possibility has been overlooked in the economic literature on transfer pricing and FTA, it has been noted by some policy researchers. LaNasa (1996) stated tha (...truncated)