The economic effects of EU-reforms in corporate income tax systems

capital requires that the marginal product of capital increases. In light of decreasing returns to
scale with respect to capital in production, a smaller capital stock is required to achieve this.
Consequently, a higher cost of capital induced by a higher corporate tax rate will reduce
investment.
If part of investment is financed by debt (d b > 0), (A.15) is modified as the financial cost of
investment is now a weighted average of the cost of debt and the cost of equity. We see that the
cost of debt is reduced by the deductibility of nominal interest costs. The interest deductibility
thus reduces the cost of capital, perhaps even below the level obtained in the absence of tax.
Profit shifting behaviour
In producing output, subsidiaries use intermediate inputs that are supplied by their parent
company. The arms-length price for this intermediate input is equal to the market price of the
numeraire good, but the parent company can manipulate this transfer price for intra-company
deliveries. In particular, the benefit from marginally changing the transfer price is measured by
the difference in the statutory corporate tax rate that applies to the subsidiary (τ f ) and the rate
that applies to the parent (τ m ). This benefit needs to be weighed against the cost of transfer
pricing. We adopt the following cost function for manipulating transfer pricing (i.e. the price
that the headquarter charges for goods supplied to its subsidiary):
c
q
=
+ εq
pq
−1 1 (A.17)
1+
ε
q
Hence, deviating the transfer price (p q ) from its arms-length price (equal to one) creates a cost
for the multinational, which is convex if ε q > 0. In the optimum, the marginal cost from transfer
price manipulation is set equal to marginal benefit, which is determined by the corporate tax
differential between the foreign subsidiary and the multinational headquarter, i.e.:
∂cq
∂pq
εq
f m
= sign( pq
−1)
pq
−1
= τ −τ
(A.18)
Expression (A.18) shows that the headquarter company has an incentive to set an artificially
low (high) transfer price for supplies to subsidiaries in countries that feature a lower (higher)
statutory corporate tax rate. In this way, it shifts profits from high to low-tax countries, thereby
reducing its overall tax payment. The marginal cost of this manipulation depends on the initial
deviation of the transfer price from its arms-length price. The speed at which transfer prices
increase is determined by the parameter ε q. In the model, we set its value so as to replicate
empirical evidence on profit shifting.
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