Transfer pricing rules and competing governments

The literature on the regulation of multinationals' transfer prices has not considered the possibility that governments may use transfer pricing rules strategically when they compete with other governments. The present paper analyses this case and shows that, even in the absence of agency considerations, a non-cooperative equilibrium is characterised by above-optimal levels of effective taxation. We then derive conditions under which harmonization of transfer pricing rules lead to a Pareto improvement, and show that harmonization according to the 'arm's length' principle-the form of harmonization advocated by the OECD-may not be Pareto improving.