Production location of multinational firms under transfer pricing: the impact of the arm’s length principle

  • Hayato KatoEmail author
  • Hirofumi Okoshi


When multinational enterprises (MNEs) separate the geographical location of affiliates, they can shift profits between the affiliates by manipulating intra-firm prices of inputs. We show that if the international tax difference between the parent and the host countries is large, MNEs choose to separately locate their affiliates in the two countries. We also investigate the impact of the arm’s length principle (ALP) on the location choice, which requires that the intra-firm price of inputs should be set equal to the price of similar inputs for the independent downstream firms. The ALP may change the location choice of MNEs, bringing smaller tax revenues to the host country, but greater revenues globally.


Multinational enterprises (MNEs) Transfer pricing Production location choice Intra-firm trade Arm’s length principle (ALP) 

JEL Classification

F12 F23 H25 H26 



We wish to acknowledge the valuable comments from two anonymous referees. Thanks are also due to David Agrawal, Jay Pil Choi, Dave Donaldson, Taiji Furusawa, Makoto Hasegawa, Andreas Haufler, Jota Ishikawa, Michael Keen, Kozo Kiyota, Yoshimasa Komoriya, Christopher Ludwig, Yasusada Murata, Ben Lockwood, Yukihiro Nishimura, Hikaru Ogawa, Toshihiro Okubo, Pascalis Raimondos, Yasuhiro Sato, Nicolas Schmitt, Yoichi Sugita, Kimiko Terai, Eiichi Tomiura, and Lorenzo Trimarchi for helpful suggestions. This paper was presented at HITS-MJT (Kanazawa Seiryo U), Hitotsubashi-Sogang Trade Workshop (Hitotsubashi U), Public Economics Workshop (U of Tokyo), Study Group on Spatial Economics (Kyushu Sangyo U), JSIE Kanto Meeting (Nihon U), International Symposium of Urban Economics and Public Economics (Osaka U), Applied Economics Workshop (Keio U), Australasian Trade Workshop (U of Auckland), 17th GEP/CEPR Annual Postgraduate Conference (U of Nottingham), Public Economics Seminar (LMU), and International Institute of Public Finance (U of Tampere). Financial support from the Japan Society for the Promotion of Science (Grant Number: JP16J01228), the MEXT-Supported Program for the Strategic Research Foundation at Private Universities (Grant Number: JPS1391003), the Obayashi Foundation, the Japan Legislatic Society Foundation, and the German Research Foundation through GRK are gratefully acknowledged. All remaining errors are our responsibility.


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Authors and Affiliations

  1. 1.Faculty of EconomicsKeio UniversityMinato-kuJapan
  2. 2.Munich Graduate School of Economics, Seminar for Economic PolicyUniversity of MunichMunichGermany

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