Some economists argue that by adopting a policy of low corporate
taxation, developing countries may actually boost their tax revenues.
According to this argument, low rates will attract multinational enterprises
(MNEs) to set up affiliates in the country and through transfer pricing
attribute their global profits to these affiliates. The Dominican Republic,
Panama, and the Bahamas have made themselves tax havens and have even
induced MNEs to relocate their headquarters. However, other developing
countries are victimized by the transfer pricing game when MNEs inflate
the price of inputs and lower the price of their subsidiaries' output.
To avoid this scenario, governments employ the arm's length principle of
price regulation. By definition, an arm's length price is the price negotiated
between unrelated parties under similar conditions. The arm's length price
can be determined by the market price or the cost of production.
Unfortunately, tax administrations in developing countries often lack the
information and technical expertise to calculate arm's length prices.
An additional complicating factor is that many transactions in
developing countries take the form of licensing fees, payment for
consulting and management services, or royalties. Determining the fair
price of these transactions is difficult. In fact, it is in the service sector that
price inflation is most prevalent. The under-invoicing of imported goods
can be another method of tax evasion by MNEs in high-tariff jurisdictions.
Finally, MNEs may manipulate transfer pricing to circumvent restrictions
on foreign exchange or capital repatriation.
Research suggests that manipulation of transfer pricing is not substantial.
Still, it can significantly erode the tax base of poor countries dependent on
foreign investment. To guard tax revenues, governments of developing
countries are often advised to improve their tax administration systems,
adopt international standards of accounting and transfer pricing regulation,
and participate in cross-border transfer pricing agreements.
