The distorting arm’s length principle in international transfer pricing

Profit shifting due to manipulation of transfer prices erodes the corporate tax base in high tax countries. To protect tax revenues, governments typically apply the arm’s length principle to ‘correctly’ assess the value of intracompany trade and royalty income based on observed market transactions such as in comparable outsourcing relationships. We develop a model of heterogeneous firms which are subject to agency costs in external financing and choose between outsourcing and foreign direct investment. We show that the application of the arm’s length principle distorts financing and investment of multinational firms, the choice between outsourcing and direct investment, and leads to a reduction of world welfare.