Duopolistic Competition, Taxes, and the Arm¶s-Length Principle

Numerous (high-tax) countries presume that multinational ¯rms use their transfer-pricing policies to shift pro¯ts into countries with lower tax rates. To avoid the corresponding loss in tax revenues, tax authorities develop constant-ly tightening rules which limit the scope of transfer-price distortions. A®ected ¯rms include the decision of compliance to these rules into their strategic consi-derations. Within a game-theoretic model we show that ¯rms's transfer-pricing policies are driven by three issues: interaction with competitors, minimization of tax burden, and avoidance of punishments. It shows that tighter transfer-pricing rules may help ¯rms to defuse competition and to increase their pro¯ts and that non-compliance to the arm's length principle is part of their equilibrium strategy