Strategic Trade Policy through the Tax System

• Author: Johannes Becker
• Published date: 01 September 2014
• DOI: http://doi.org/10.1111/twec.12143
• Date: 01 September 2014

Strategic Trade Policy through the Tax

System

Johannes Becker

Institute of Public Economics, University of M€

unster, M€

unster, Germany

1 INTRODUCTION

IN recent decades, international trade agreements such as GATT and supranational institu-

tions such as the WTO and the EU have successfully reduced the level of tariffs and pro-

duction subsidies. Today, if countries want to strategically manipulate the terms of trade of

their trade-oriented firms, they have to choose different and subtler means than outright subsi-

dies or tariffs. One potential means to do so is the tax system, especially the set of taxes on

multinational firms.

In this paper, I analyse the tax system’s scope and potential for strategic trade purposes. I

concentrate on two features of the tax system, the regime of foreign profit taxation and trans-

fer price guidelines. The OECD recommends to its members to choose between two regimes

of foreign business income taxation, the tax credit system where foreign income is taxed and

foreign taxes are credited against the domestic tax liability, and the tax exemption system

where foreign income is not taxed by the residence country. As the regime choice is likely to

affect the cost of production, it is relevant as a means of indirect strategic trade policy. The

same may be true for transfer price guidelines which are required to determine locational

income for tax purposes. The choice of transfer price guidelines may serve the goal of effi-

ciency

1

(not distort production choices) and fairness (ensure a fair share of taxable income in

all locations), but it may also be used as an instrument for indirect strategic trade policy. If

the two jurisdictions under consideration differ in tax rates, changing the transfer price affects

the firm’s variable cost and, thus, its competitiveness.

The implications of the tax regime choice for the domestic firms’ competitiveness have

recently been in the focus of a lively debate.

2

Several countries, among them the United

States and the United Kingdom, have reviewed their system of foreign income taxation. The

UK has already switched from the tax credit system to the exemption system. The main argu-

ment in favour of exemption has been –both in the UK and the US –that a tax on foreign

I thank the Editor, Zhihong Yu, an anonymous referee as well as Pascalis Raimondos-Møller and partici-

pants at the CESifo Area Conference on Public Sector Economics for helpful comments. All errors are

my own.

1

The efficiency-related objective implies that transfer prices among related parties should not be dif-

ferent from market prices in transactions between unrelated parties. This arm’s length principle is,

however, often hard to apply, for example, if such market transactions do not exist, and its efficiency

properties crucially depend on the assumption of competitive markets. Moreover, even if an arm’s

length benchmark exists, its use may lead to distorted incentives within the firm, as Devereux and

Keuschnigg (2013) point out.

2

Recent contributions include Desai and Hines (2003, 2004), Devereux (2008), Desai (2009), Hines

(2009), Becker and Fuest (2010). There is an extensive literature on the optimal taxation of foreign prof-

its building on the seminal work by Peggy Musgrave (n

ee Richman, 1963; Musgrave, 1969). For a short

overview and discussion, the reader may refer to Mintz and Tulkens (1996) or Becker (2013).

©2014 John Wiley & Sons Ltd 1237

The World Economy (2014)

doi: 10.1111/twec.12143

The World Economy