A mechanism design approach to transfer pricing by the multinational firm

This paper is about how multinationals choose transfer prices and optimal production levels in the presence of differential corporate income tax rates and local ownership requirements. A key featrure of the model is that there is an asymmetric information problem between a parent and its foreign subsidiary. We examine the interaction between ownership structure, corporate taxes and bargaining power. Transfer prices induce underproduction compared to the full-information case when the parent has the bargaining ability. When bargaining is controlled by the subsidiary, overproduction obtains. The model is used to illustrate how governmental objectives can be accomplished without direct regulation of the transfer price.