Will tax deal end transfer pricing?

Today many firms are multinationals and operate around the world. This has brought many benefits and the effect of globalization on living standards has been considerable.  (This is actually the continuation of specialisation and trade you learn about in the first weeks of any economics course).

One of the drawbacks of this globalisation has been that multinationals have developed ways to pay their tax in countries where the profit taxes (corporate taxes) are lowest. This is, of course, rational behaviour for after-tax profit maximizing firms.

Transfer pricing works like this. Say you are a publisher and sell a really excellent economics textbook in the UK. The profit tax in the UK is 30%. Schools in Malaysia want to buy the book. Rather than sell them the book from the UK at £33 the publisher sells the books to their subsidiary in Singapore for £6, just over the cost of production. The subsidiary then sells the books to the Malaysian schools making all the profit in Singapore where the profit tax rate is just 10%.

I'm not bitter, but that's what Simon and Schuster did with my textbook, paying royalties only on the £6 earned in the UK.

This is perfectly legal. Firms such as Starbucks have bought their coffee from their Swiss subsidiary for the whole of Europe at high prices so the profit is declared in low tax Switzerland. Google have paid just £130m tax in ten years in the UK.

Now the OECD (The Organization for Economic Cooperation and Development - the 'rich countries club') have signed a deal to make multinational firms pay tax where they really earn it. This means they should pay profit tax on all the operations in the country where their activities take place.

It will be difficult to police, and only 31 countries have signed. This means firms might just start declaring their profits in a country which has not signed. However the system they hope to implement should allow countries to demand tax on the amount of tax the firm would have made if declared correctly.

The BBC covers the story here

This issue has direct relevance to IB Paper 2 and for taxation policy. For VCE this is a topic that is relevant to trade and budgetary policy.