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Do low corporate taxes always favor multinational production over economicintegration? We propose a two-country model in which multinationals choose thelocations of production plants and foreign distribution affiliates and shiftprofits between them through transfer prices. With high trade costs, plants areconcentrated in the low-tax country; surprisingly, this pattern reverses withlow trade costs. Indeed, economic integration has a non-monotonic impact:falling trade costs first decrease and then increase the plant share in thehigh-tax country, which we empirically confirm. Moreover, allowing for transferpricing makes tax competition tougher and international coordination ontransfer-pricing regulation can be beneficial.

Economic Integration and Agglomeration of Multinational Production with Transfer Pricing