Game Theory and Institutional Entrepreneurship: Transfer Pricing and the Search for Coordination in International Tax Policy

Radaelli, Claudio M., Policy Studies Journal

Deep economic integration has internationalized tax policy problems (Tanzi, 1995), yet there is a fundamental difficulty in building cooperation in international tax policy. There are various reasons for this, including the fact that both policymakers and experts disagree about what an international tax regime should consist of and what international organizations should do, but the problem of coordination in international tax policy cannot be reduced to the fact that policymakers and experts do not know what to do. Indeed, political action often takes place even when there is fundamental uncertainty and social sciences do not provide solid recommendations (Lindblom, 1990). Thus one has to explain poor cooperation by considering the strategic structure of international tax policy.

Turning to game theory for this type of explanation, the conventional argument is that international tax policy suffers from the prisoner's dilemma syndrome (Hallerberg, 1996). With capital movement liberalization and free trade - this is the starting point of the argument - states compete for attracting capital and nonlocation-specific activities of multinationals by lowering tax rates and offering special tax regimes. The race to the bottom cannot be avoided because there are substantial incentives to free-ride.(1) Even if collective action could be attained among a limited number of countries, the remaining noncooperative countries would enjoy increasing returns, especially if they are small tax havens (Frenkel, Razin, & Sadka, 1991; Kanbur & Keen, 1993).

Put differently, the more cooperation proceeds, the more likely are reluctant countries to find themselves in a favorable position. Cooperation in tax policy is self-limiting, not self-stimulating (Genschel & Plumper, 1997). This is consistent with the standard game theoretical propositions that in a prisoner's dilemma large numbers of players inhibit cooperation and asymmetries favor small players. Although business tax rates have not fallen to zero, there are signs that unbridled tax competition(2) already has produced undesirable effects such as the degradation of the international tax system (Organization for Economic Cooperation and Development, 1998) and the shift of the tax burden on unskilled labor in the European Union (European Commission, 1996).

The prisoner's dilemma, however, makes cooperation difficult to achieve but not impossible.(3) The literature on international policy regimes shows that collective action can overcome the prisoner's dilemma (Martin, 1993). Further, competition does not necessarily end with the race to the bottom (Vogel, 1995). This raises doubts over the usefulness of the prisoner's dilemma for interpreting all international tax policy issues. I present three points in this article. First, international tax policy should be examined on an issue-by-issue basis. The characteristics of the policy process depend on the issues involved (Hocking, 1993; Krasner, 1991). The downside of this choice is that interdependencies between different issues cannot be taken into account. Definitively, there is a trade-off between accounting for issue interdependence and analyzing the dilemma of cooperation on an issue-by-issue basis. One even could raise the objection that by looking at transfer pricing in isolation the whole picture of international tax policy is missed. The point is well taken, but transfer pricing policy is characterized by specific policy instruments, distinctive patterns of institutionalization, and most importantly by a strategic structure of interaction different from the one that can be found in other tax issues, such as the taxation of portfolio investment. Thus, the choice of investigating tax policy on an issue-by-issue basis can be defended.

Elaborating upon the first point, the second point is that the most appropriate model should be chosen on the basis of the specific tax issue under consideration. Transfer pricing, accordingly, should be analyzed by taking into account the structure of strategic interaction in this issue area. For transfer pricing the best model is not a cooperation game, but a coordination game.(4)

Third, game theoretic models provide the initial conceptual framework, but they must be supplemented by forms of analysis more sensitive to the contextual aspects of the policy process. Accordingly, I draw upon the insights of new institutionalism in organization theory (Powell & DiMaggio, 1991; Zucker, 1988). The latter shows how institutional entrepreneurs lead the policy process toward conflictual institutionalization. The article is organized as follows. I review the policy problem of transfer pricing and provide the conceptual framework for analysis, before empirical evidence is introduced (by considering the U.S. arena and then the wider Organization for Economic Cooperation and Development [OECD] arena). Finally, I present some concluding thoughts.

An Overview of the Transfer Pricing Problem

What Transfer Pricing Is All About

The search for international tax cooperation started a long time ago, first with agreements between states for the taxation of diplomats at the turn of the century, followed by the work of the League of Nations. More recently, the OECD has developed models for bilateral tax treaties and guidelines for transfer pricing policy. Broadly speaking, today the main components of the international tax system are the tax treaty network, the classification of types of income (in international tax policy the right to tax is allocated either to the source or to the resident country, depending on the type of income), the residence principle (which stipulates that a state shall tax residents comprehensively, that is by including the income produced by residents abroad, although in practice this principle encounters serious limitations), and tax rules for transfer pricing. As 60% of world trade is accounted for by multinationals, transfer pricing rules are one of the most important elements of the international tax system (Organization for Economic Cooperation and Development, 1995).

The essence of transfer pricing tax rules is to establish how transactions within a multinational (the price that a subsidiary, for example, charges to the parent company for specific components of a product) should be accounted for tax purposes. The OECD, the major forum for international tax policy, always has recommended the so-called arm's length method as a standard for transfer pricing. The essence of this method can be articulated as follows: For tax purposes, related enterprises within a multinational company are treated as if they were separate businesses. Consequently, multinational companies must account for transactions (of goods and services) between their subsidiaries at transfer prices identical to the ones charged to unrelated companies.

The pressure points on this method boil down to the fact that the arm's length is extremely difficult to employ when sophisticated transactions occur. Sometimes it is impossible to refer a cross-border transaction within a multinational to a similar transaction between unrelated companies because the product exchanged is unique. If there is not a market for a particular product it is impossible to establish the market value of a transaction. Moreover, the proliferation of transactions involving intangibles, research and development (R&D), and central services makes the arm's length method less manageable. Finally, by postulating that enterprises within a transnational group are separate entities, the method goes against the essence of a transnational company. Indeed, the latter is established for the very purpose of dealing with a unitary business.

These pressure points have spawned criticisms of the arm's length. One alternative to the arm's length is worldwide unitary taxation (this is the alternative supported by a few American states, but not by the U.S. government); another is profit methods (more popular at the U.S. Department of the Treasury). Let us start with unitary taxation first. The idea of the unitary tax method is to substitute complicated calculations and almost endless tax disputes with a formula for distributing taxable income in different jurisdictions. According to the unitary method, a company's taxable income in …

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Publication information: Article title: Game Theory and Institutional Entrepreneurship: Transfer Pricing and the Search for Coordination in International Tax Policy. Contributors: Radaelli, Claudio M. - Author. Journal title: Policy Studies Journal. Volume: 26. Issue: 4 Publication date: Winter 1998. Page number: 603. © 1999 Policy Studies Organization. COPYRIGHT 1998 Gale Group.

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