How Transfer Pricing Hurts the Middle Class

One of the basic building blocs for understanding the effect of tax havens is the mechanism by which profits show up in the havens rather than the countries where they are really earned. This tool is known as “transfer pricing,” which at its most basic is simply the centralized setting of prices for transactions between two subsidiaries of the same company. The fact that intra-corporate sales make up much of world trade (estimates range between 33% and 60%) means that how the prices are set can have a huge economic impact.

When one subsidiary of a multinational company sells something to another one, the price for the good or service is not set in a market. A Ford transmission will not work in a Chevrolet, so there is no independent buyer for products like that. But for Ford Motor Company to know how well its various entities are doing, it has to have prices attached to intra-corporate sales. The pricing system is centralized, and can be used for multiple purposes; the most interesting for our purposes is shifting profits into lower tax jurisdictions. The charts below show how this works. In the example, it is the price of the transmission that is set via transfer pricing for the sale of French-made transmissions for use in final assembly in the U.K. All numbers are arbitrary.

	Ford France		Ford UK
		Price of car	15000
Price of transmission	1000	Price of transmission	1000
Cost of production	500	All other costs	12000
Pre-tax profit	500	Pre-tax profit	2000
Tax at 40%	200	Tax at 20%	400
Post-tax profit	300	Post-tax profit	1600

Total post-tax profit: $1900

	Ford France		Ford UK
		Price of car	15000
Price of transmission	600	Price of transmission	600
Cost of production	500	All other costs	12000
Pre-tax profit	100	Pre-tax profit	2400
Tax at 40%	40	Tax at 20%	480
Post-tax profit	60	Post-tax profit	1920

Total post-tax profit: $1980

We have the same car, the same final selling price, the same cost of production, the same pre-tax profit. But by reducing how much Ford France charged Ford UK for the transmission, profit was shifted into the lower tax country (in this example, the UK). Post-tax profit increased by the change in sales price ($400) times the difference in the tax rate (20%).

Of course, it is not like tax authorities don't know that shenanigans like this can arise. But it can be hard to detect it even if you're looking for it. Richard Caves' Multinational Enterprise and Economic Analysis provides a good overview of many research studies, which have found that it easier to get away with abusive transfer pricing when there is no real arm's length market for the good. For example, there is obviously a large market for spark plugs, so it's relatively easy to see if the price a company assigns for their sale between subsidiaries makes sense. On the other hand, there is frequently no market for a company's patents, because it often does not want to license them to other firms because they are a source of competitive advantage. That explains why Microsoft put patents in an Irish subsidiary where the royalties are untaxed: there is no good way to determine if the prices charged to other subsidiaries for their use is a reasonable one or not.

We see, then, that by a relatively simple mechanism a company can make its profits show up in lower tax jurisdictions. As previous columns discussed, most multinationals have a substantial network of subsidiaries in tax havens to reduce the taxes they pay in the U.S. and other developed countries. Their reduction, of course, means higher taxes for us, higher deficits, program cuts, or some combination of the three.

My next post will deal with how to combat tax havens.