Tariff Elimination versus Tax Avoidance: Free Trade Agreements and Transfer Pricing

Free trade agreements (FTAs) entail rules of origin (ROO), which require exporters to identify the origin of exports to prove eligibility for preferential tariff rates. This paper investigated how a multinational enterprise (MNE) in an international oligopoly model reacts to an FTA with ROO when it can manipulate its transfer price for intra-firm trade. Before the formation of an FTA, the MNE uses the transfer price to avoid a high corporate tax or to shift profits from the rival firm in the final-goods market. After the FTA formation, ROO can force the MNE to set the transfer price such that it meets the value-added requirement of ROO, or to change the location of its input production. We show that an FTA with ROO may decrease the profits of both the MNE and the local firm, even when they comply with ROO and take advantage of the tariff elimination provided for in the FTA. Furthermore, there is a case where ROO increase the consumer's gains from an FTA and transform a welfare-reducing FTA into a welfare-improving FTA.

Published: Mukunoki, Hiroshi, and Hirofumi Okoshi, 2021. "Tariff elimination versus tax avoidance: Free trade agreements and transfer pricing," International Tax and Public Finance, Volume 28, Issue 5, 1188–1210.
https://link.springer.com/article/10.1007/s10797-021-09689-8