The proximity-concentration trade-off with profit shifting

We study a firm which serves two unequally-sized jurisdictions and must choose where to locate its first production plant, and whether to open a second plant to serve the other market through local sales rather than exports. An exporter pays taxes only to the region where it locates its single production plant. A double-plant multi-regional firm pays taxes in both regions, but may shift taxable profits across them, at a cost. We show that the standard trade-off between fixed and trade costs is modified, depending on both the average tax of, and the tax difference between, the two regions. We also find that increased market size asymmetry may make it more likely that the firm builds a second production plant. From a total-welfare viewpoint, it is always desirable to control the firm's tax avoidance ability when the double-plant structure is given. However, the fact that the firm may react to corporate taxation by changing its production structure may be a reason not to curb profit-shifting activities. (C) 2010 Elsevier Inc. All rights reserved.