New Evidence on Multinational Transfer Pricing

3 November 2006 at 11:54 am Peter G. Klein Leave a comment

| Peter Klein |

The economic theory of the firm is ultimately about the differences between inter- and intra-firm transactions. How, for example, are employment contracts different from arms-length transactions with independent contractors? (Alchian and Demsetz, in the famous passage in their 1972 article about “firing the grocer,” say there is no difference; Coase and Simon argue otherwise.)

We know little about how intra-firm purchase and supply arrangements differ from those between firms. However, thanks to a new dataset, the Linked/Longitudinal Firm Trade Transaction Database (LFTTD) from the US Census and Customs Bureaus, we now know something about how such transactions are priced. A new paper by Andrew Bernard, Bradford Jensen, and Peter Schott, “Transfer Pricing by U.S.-Based Multinational Firms,” uses the LFTTD data to compare export prices for “related-party” and “arms-length” transactions among US multinationals. Bernard, Jensen, and Schott find that intra-firm transactions are priced significantly lower than sales of the same good to arms-length customers.

After matching related-party sales by a firm to arm’s-length sales by the same firm for the same product to the same country in the same month using the same mode of transport, we find that the average arm’s-length price is 43 percent higher than the related-party price. Product characteristics are influential in determining this gap. While the wedge for commodities (i.e., undifferentiated goods) averages 8.8 percent, the gap for differentiated goods is 66.7 percent. Firm and market attributes are also influential: the difference between arm’s-length and related-party prices are higher for goods shipped by larger firms, by firms with higher export shares, and by firms in product-country markets served by fewer exporters.

Consistent with incentives to minimize taxation and import duties, we find that the wedge between arm’s-length and related-party prices is negatively associated with destination-country corporate tax rates and positively associated with destination-country import tariffs. . . .

We also examine the role of exchange rates in multinational pricing. . . . Here, we find that the price gap between firms’ arm’s length and related-party prices varies negatively with countries’ real exchange rates, suggesting that multinationals adjust their arm’s-length and related-party prices asymmetrically in response to exchange rate shocks.

The data are consistent with several managerial and financial motives for price discrimination between intra- and inter-firm transactions. The relationship between transfer pricing and other aspects of firm organization and strategy — e.g., as discussed by Holmstrom and Tirole 1991 — is not explored here, but is worthy of a follow-up paper IMHO.