draining development.pdf - Khazar University

118 Draining Development?in country A. The goods are exported to country B, where all three aresold at a price of 14 to consumers in country B.In this example, the aggregate corporate income tax base in country Ais equal to 12. Firm 1 shifts income out of country A, and firm 3 shiftsincome into country A. In the absence of trade mispricing, the tax basein country A would be the same. The tax revenue loss of country Abecause of mispricing is equal to 0. A method that only takes into accountfirm 1 and neglects the implications of mispricing by firm 3 is clearlymisleading. The same applies to the impact of income shifting on countryB. For illustrative purposes, one might, for instance, consider a developingcountry with a weak political system and a low corporate tax rate.While some firms may be willing to shift profits into that country toexploit the low corporate tax rate, others may consider it beneficial totransfer profits out of the country to hedge against expropriation risks.This might give rise to the heterogeneous transfer price distortions laidout above. While we do not necessarily want to suggest that income is, inreality, shifted into developing countries, we nonetheless consider thatan empirical identification approach should allow for the possibility thatthis might take place. This hypothesis could then be rejected as a resultof the analysis.What happens if other taxes are considered? For instance, one mightbe interested in measuring import duty revenue losses that arise becauseof avoidance or evasion. Assume that there is a proportional import dutyin country B. In this case, it is easy to check that tax revenue is the samein the two cases under consideration, and it is of key importance to takeinto account both under- and overpriced imports to country B. Notealso that, in this case, firms would have an incentive systematically tounderstate the import price. If this happens, income is shifted into thecountry. This is another reason why neglecting income shifting intodeveloping countries is not appropriate in the context of studies on taxavoidance and evasion. Depending on the question asked, it may bemeaningful to consider either net flows or gross flows, but reportingflows in one direction only and ignoring the flows in the other directionare not appropriate and may easily lead to misunderstandings.Pak (2007) defends his approach by claiming that the price filtermethod he uses is also applied by the U.S. Internal Revenue Service (IRSregulation 482) to deal with transfer pricing issues. This is not correct.