The golden rule in transfer pricing regulation

In this paper we analyze the optimal regulation of an internationally integrated monopolist, producing in one country and selling in another country. The monopolist’s pricing policy is constrained by transfer pricing regulations, and is subject to different tax rates on profits in the two countries. The governments of the two countries can use their tax rates as regulatory instruments, and they also determine an arm’s length interval of acceptable transfer prices. The two governments can cooperate in order to maximize world welfare, or they can each try to maximize their own country welfare. It is shown that in several of the solutions governments apply a golden rule. This rule requires that the firm realizes all profits in the manufacturing country, while no profits are made in the retailing country. This can be obtained by choosing a sufficiently high (low) tax rate in the retailing (manufacturing) country, or by appropriately fixing the transfer price.