Income Shifting and Management Incentives

Abstract

Existing literature shows that income shifting via transfer pricing within multinational enterprises collides with optimal incentivization of managers in subsidiaries. Against this background, however, internal debt shifting has not been investigated so far. We investigate how both income-shifting channels impact management incentivization when the widely used profit metrics EBIT(DA) is applied as performance measure. Different from most other studies, we focus on endogenous, unobservable managerial effort and the firm's optimal design of the compensation contract. We find that internal debt shifting does not have a direct effect on management incentives, but has some ambiguous repercussion via its positive effect on investment. In contrast, transfer pricing in royalty payments has a clearly negative incentive effect that is fully neutralized, however, by an higher compensation rate. Hence, the adjustment of the compensation payment one-to-one mirrors the transfer-pricing strategy of the firm. There is no confounding indirect effect from this channel because abusive royalty payments do not affect investment.