Production, Manufacturing, Transportation and Logistics
Competing multinationals’ backshoring decisions: Tax arbitrage versus production reliability tradeoff

https://doi.org/10.1016/j.ejor.2023.05.008Get rights and content

Highlights

  • Study competing MNFs’ backshoring decisions in the post-pandemic era.

  • Analyse tradeoff of tax arbitrage and production reliability improvement for MNFs.

  • Investigate impacts of backshoring on customer surplus and social welfare.

  • Study government's tax regulation design considering MNFs’ backshoring reactions.

Abstract

In the post-pandemic era, global supply chains are increasingly experiencing disruptions. To mitigate the effects of production disruptions, many multinational firms (MNFs) are centralising their supply chains by removing production subsidiaries back to the domestic countries (i.e. backshoring), at the expense of tax arbitrage benefits. This study conducts an analytical game-theoretical model to examine competing MNFs’ incentives to backshore, considering the trade-off between tax arbitrage and production reliability improvement. The MNFs’ equilibrium backshoring decisions, corresponding production quantities, and transferring prices are derived. We find that lower geographic tax differences and higher foreign country (or lower domestic country) disruption rates will jointly incentivise the MNFs to backshore; however, this does not guarantee higher expected profits for the two competing MNFs. The setting of symmetric MNFs could also result in the asymmetric equilibrium of backshoring strategy when the disruption risks in the same country are more correlated, which is induced by the competition mitigation incentives. Additionally, we find that backshoring always benefits customer surplus but may be detrimental to social welfare. Moreover, we endogenize the tax rate and investigate the government's tax regulation design problem. A main finding is that inducing MNFs’ backshoring by setting low tax rates would be unwise for the government under some conditions. To check the robustness of the main model, several extensions are also discussed.

Introduction

In the past few decades, many multinational firms (MNFs) in developed countries have transferred their manufacturing subsidiaries to foreign countries and have been selling products through their retailing subsidiaries in the domestic country (Wilson, 2010). This supply chain expansion is called offshoring, which is a prevalent practice for MNFs. Statistically, over 50 percent of the firms in the United States adopted offshoring strategy until 2008 (Minter, 2009). Tax arbitrage is one of the most important reasons for choosing offshoring strategy. As Webber (2011) points out, tax payment is one of the most important enterprise expenditures and strongly affects total profitability. Although the average tax rate is high, the tax differences by geography provide firms with opportunities for international tax arbitrage by reorganising their global supply chain structures (Hsu & Zhu, 2011). Therefore, many MNFs in developed countries have moved some of their subsidiaries from high-tax countries to low-tax ones.

Although offshoring is an effective way for MNFs to perform appropriate tax arbitrage and save operational costs, it geographically disperses MNFs’ supply chains, making their supply chains more vulnerable to disruptions (Moradlou et al., 2021). For example, the production activities of many hard drive manufacturers in Thailand were interrupted following a devastating flood, resulting in the lack of a hard drive supply to many companies, including large PC manufacturers of HP and Dell. However, Lenovo's was not affected by the production was not interrupted, as its component suppliers were positioned in China (Chao, 2012). Recently, with the outbreak of the COVID-19 disease in January 2020, MNFs’ global supply chain networks experienced severe disruptions in either production or transportation.1 For instance, the Chinese government frequently imposed transportation restrictions and regulations and restricted importation of various goods from highly pandemic-affected countries. This might have resulted in production disruptions due to the shortage of raw materials, especially for small manufacturers (Ivanov & Dolgui, 2021). Additionally, the government had to shut down factories located in pandemic-affected regions. Take Shanghai as an example: all manufacturing firms were shut down for over two months, which caused severe disruptions for supply chains in many industries. According to the Institute of Supply Management reports, in the first half of the year 2020, 75 percent of firms had experienced supply chain disruptions, while 62 percent of firms had suffered from severe delays in receiving goods (Magableh, 2021). In the post-pandemic era, global supply chain disruptions are occurring more frequently. For the IT industry, approximately 95 percent of the leading IT firms are increasingly suffering from supply chain disruptions.2

Confronting such severe global supply chain disruptions, MNFs are rethinking moving their overseas subsidiaries back to their domestic countries.3 This phenomenon is the opposite of offshoring, is defined as backshoring (or reshoring), and has gained much attention from governments of developed countries and many industries in the past ten years (Jung, 2020). A consensus between academia and industry is that backshoring is mainly motivated by the significant rise in labour costs in some developing countries (Yang et al., 2021). The impact of costs on MNFs’ backshoring decisions has also been discussed in previous papers. However, after the outbreak of the COVID-19 disease, we have witnessed many MNFs’ have accelerated backshoring activities when facing the increasingly destructive impacts of supply chain disruptions.4 This clearly shows that apart from rising costs in developing countries, global supply chain disruption also behaves as an important factor that motivates MNFs’ backshoring in this post-pandemic era.

In a complex global environment, the choice to backshore or not is a difficult one for MNFs. On the one hand, global tax arbitrage requires that MNFs should locate their subsidiaries in different countries to take advantage of geographical tax rate differences, which motivates MNFs’ offshoring. On the other hand, while facing severe global supply chain disruption risks, MNFs should centralize their supply chains and locate their subsidiaries in the same countries to ensure supply-side reliability. Therefore, they become entangled in a troublesome trade-off: either choosing backshoring (to ensure supply reliability but bear additional tax payments) or choosing offshoring (to save tax payments but bear more supply disruption risks) to maximise their total after-tax profits.

Moreover, competition is also a crucial factor that MNFs need to consider (Wu & Zhang, 2014). Under competition, MNFs’ backshoring problem becomes more complex in two ways. First, competing MNFs’ decisions regarding global supply chain structures (i.e. backshoring or not), prices, and sales quantities are grossly affected. Then, some important research questions arise: How does competition affect firms’ backshoring decisions and their corresponding operational decisions? How does competition alter the balance of tax arbitrage and supply reliability? Second, disruption risks are often contagious in practice, which is also modelled as a ripple effect by Ivanov & Dolgui (2021) and Li et al. (2021). Under the ripple effect, the two competing MNFs’ disruption risks are correlated. Therefore, other research questions arise: How do firms’ disruption risk levels and risk correlations affect their operational decisions and the corresponding industrial revenue? How will the risks affect customer surplus and the total utility of government?

To answer the above questions, we establish a game-theoretical model involving two competing MNFs that strategically choose to backshore (or not), considering the balance of tax arbitrage and production reliability improvement. The two MNFs are assumed to be symmetric in market share and production disruption risks. The global transportation and production costs are assumed to be zero, which enables us to focus on the main research goals related to tax arbitrage and production disruptions. The two MNFs’ backshoring (or not) decisions constitute several scenarios (i.e. both backshoring, both offshoring, and one backshoring and the other offshoring). For each scenario, the two MNFs are involved in Cournot competition in the domestic market and simultaneously determine the respective sales quantities. Additionally, for a certain MNF that adopts backshoring strategy, another important decision is transferring price. Considering the setting of arm's length regulations (ALR), the transferring price is determined as though the MNF's retail and production subsidiaries are independent entities (Kim et al., 2018). We then derive the equilibrium backshoring decisions for the two MNFs by comparing the expected profits for the four scenarios. The effects of critical factors (i.e. tax rate, disruption risks, and competition intensity) on industrial revenue, customer surplus, and social welfare are examined.

The key research findings can be summarised as follows. First, we find that tax rate differences, disruption risk levels, and competition intensity jointly shape the equilibrium backshoring decisions for the MNFs. For example, each MNF, when facing lower tax rate differences and disruption risks in the domestic country or higher disruption risks in the foreign country, will be more likely to backshore. Otherwise, it will be less willing to backshore. Although lower tax rate differences or lower disruption risks incentivises MNFs to backshore, they do not guarantee higher expected profits for them under competition. Second, we find that an asymmetric equilibrium (i.e. one MNF offshoring and the other backshoring) exists for the symmetric MNFs under competition. The equilibrium exists only if the competition intensity is relatively weak, tax rate difference is moderate, or risk correlations in both markets are relatively high. Third, by investigating the properties of customer surplus and social welfare, we find that backshoring always benefits customers in the domestic country. However, backshoring has been found to harm social welfare in the domestic country when the government is less concerned about tax income or when the foreign country (or domestic country) disruption level is low (or high). Finally, with a further discussion about the government's tax design, we provide results regarding the optimal tax rate and social welfare with respect to the critical parameters. For example, we find that when the weight for tax income is relatively low, domestic countries’ governments should set a low tax rate that incentivises both MNFs to backshore; however, when the weight is sufficiently high, the governments should set a moderate level of the tax rate that only incentivises one MNF to backshore. The findings indicate that inducing MNFs’ backshoring by setting a low tax rate does not always contribute to the social welfare under some conditions. To investigate the robustness of the main model, we make three extensions and show that the key results still hold.

The remainder of this paper is organised as follows. The literature review is presented in Section 2. Model formulations are presented in Section 3. The equilibrium results for the game-theoretical models are discussed in Section 4. The effects of backshoring on industrial profit, customer surplus, and social welfare are shown in Section 5. The government's tax regulation design regarding backshoring are discussed in Section 6. Three extensions are presented in Section 7. Section 8 concludes the paper and provides future research directions. The proofs are presented in the Online Appendix.

Section snippets

Literature review

This study focuses on the problem of competing MNFs’ global sourcing decisions considering the impact of global taxation and production disruptions. This work contributes to three streams of literature: (1) MNFs’ offshoring or onshoring decisions, (2) supply disruption management, and (3) competitive supply chain structure design.

Model description

In this section, we introduce the formulation of the game model, including the supply chain structurers, production disruptions, demands, profits, and decision sequences. Table 2 contains the notations used in this study.

Equilibrium analysis

In this section, we use backward induction to solve the problems. We first solve the competition problems for the four scenarios. Then, we obtain the equilibrium shoring strategies by comparing the outcomes of the four scenarios.

Impact of backshoring on industry profit, customer surplus, and social welfare

In this section, we study how production backshoring affects industry profit (Π^D), customer surplus (CS) and social welfare (SW). We model the industry profit as a sum of after-tax profits for all the divisions of the two MNFs that are located in the domestic country, which can be expressed asΠ^DI1I2={EΠ1BB+EΠ2BB,I1=B,I2=B,EΠ1BO+EΠR2BO,I1=B,I2=O,EΠR1OB+EΠ2OB,I1=O,I2=B,EΠR1OO+EΠR2OO,I1=O,I2=O.

Following Bian and Zhao (2020) and considering the expected sales quantities and the competition

Government's tax regulation design: SW maximization

In practice, many governments induce MNFs’ backshoring by reducing the corporate tax rate. For example, the US has already lowered the corporate tax rate for reshoring firms from 35% to 21% to induce more MNFs’ reshoring since 2017.8 However, how to set an optimal level of tax rate remains unknown in literature. In this section, we endogenizing the tax rate and study the

Cross-border risk correlations

In the main model, we assume that when the two MNFs’ production divisions are located in different countries, their production disruption risks are not corelated. In this section, we consider an extension of the basic model in which the risks in the domestic country and the foreign country are also correlated. This occurs when the geographical locations of the two countries are not significantly distant or the regional isolation regulations are not well adopted, so the risks will also spread

Conclusions

MNFs often locate their production and retail subsidiaries in different countries with tax differences to gain tax arbitrage benefits. However, in recent years, MNFs have started to move their overseas subsidiaries back to their domestic countries (backshoring). Evidence shows that one of the reasons for MNFs’ backshoring is to combat the increasing threats of global supply chain disruptions, especially in the post-pandemic era. By adopting backshoring, MNFs can jointly manage their dispersed

Declarations of Competing Interest

None.

Acknowledgements

This work is supported by the National Natural Science Foundation of China (Nos. 72101117, 72171047, 72001113 and 71771053) and the Natural Science Foundation of Jiangsu Province (Nos. BK20200485 and BK20201144). It is also partly sponsored by EC H2020-MSCA-RISE-2017 (Project 777742).

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