Effects of Differential Tax Rates on Transfer Pricing

The purpose of this paper is to study transfer pricing under asymmetric information and taxation. In accordance with the empirical evidence documented in accounting literature, this paper assumes that the firm uses one pricing system instead of two pricing systems'one for the tax purposes and the other for internal control. We provide a closed-form solution for the optimal mechanism under a dual-price system, which allows for the price credited to the manufacturing division to not equal the price charged to the distribution division. The equilibrium outcomes of the analysis suggest several interesting findings. Under a dual-price system, both divisional accounting profits at equilibrium change in the same direction with respect to the change of tax rate. However, the direct effect is larger than the indirect effect. Under a dual-price system, the division with the lower tax rate should be credited more profits than the division with the higher tax rate, but it would not fully bear all the profits.