Multinational Firms’ Heterogeneity in Tax Responsiveness: The Role of Transfer Pricing


The authors thank the University of Waseda (Tokyo) for its hospitality. They also gratefully acknowledge helpful comments and discussions from Andrew Delios, Rodolphe Desbordes, Mihir Desai, Peter Egger, Karolina Ekholm, Lionel Fontagné, Shinji Hasegawa, Peter Neary, Armando Pires, Olivier Poindron, Dirk Schindler, Guttorm Schjelderup, Doina Radulescu, Hylke Vandenbussche, Rodrigo Wagner and Ian Wooton, as well as seminar participants at the Kennedy School of Government, the University of Strathclyde, NHH, the Paris School of Economics, the CESifo Workshop on the Taxation of Multinationals (Venice), the EEA conference (Vienna), the NOITS workshop (Bergen), the RIEF workshop (Barcelona) and the University of Waseda. The usual disclaimer applies.


In this paper we show that the ability of multinational firms to manipulate transfer prices affects the tax sensitivity of foreign direct investment (FDI). We offer a model of international capital allocation where firms are heterogeneous in their ability to manipulate transfer prices. Perhaps paradoxically, we show that the ability to shift profits can make parent companies’ investment more sensitive to host-country tax rates, as long as investors expect fiscal authorities to use price and profit detection methods. We then offer a comprehensive empirical study to test our predictions in the case of Japanese FDI. We exploit the finding that the unobservable ability to manipulate transfer prices is correlated with whole ownership of affiliates and R&D expenditure. Based on country, parent firm and sector characteristics, we estimate an investment equation on a sample of 3,614 Japanese affiliates in 49 emerging countries. We obtain a greater semi-elasticity of investment to the statutory tax rate in affiliates that are wholly-owned and that have R&D-intensive parents. We interpret these results as indirect evidence that abusive transfer pricing is one of the determinants of FDI activity.