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Separate Accounting vs. Formula Apportionment: A Private Information Perspective

Should countries calculate tax liabilities for multinational firms using separate accounting methods or apportionment formulas? Separate accounting methods initiate distortions through transfer pricing decisions. Apportionment formulas initiate distortions through production decisions. Both types of distortions are due to asymmetric information between the multinational and the relevant tax authorities over the value of cross-border transfers. In this paper, I explicitly model the role of private information in two tax competition games: one in which tax liabilities are calculated under separate accounting and transfer prices are audited and one in which tax liabilities are calculated under formula apportionment. I show that differences in after-tax firm profit and tax revenues depend on the accuracy of the governments' auditing technology and non-monotonically on the firms' private information.