Wake Not a Sleeping Lion: Free Trade Agreements and Decision Rights in Multinationals

Free trade agreements with rules of origin affect the location of input production for vertically integrated multinational enterprises. The relocation induced by a free trade agreement changes the allocation of decision rights within multinational enterprises and the purpose of transfer pricing from avoiding high taxes to strengthening their product market competitiveness. This study shows that a free trade agreement with rules of origin may hurt both a multinational enterprise and a local firm, despite tariff elimination, when the relocation occurs and the decision rights change from centralization to decentralization. Moreover, such a free trade agreement can hurt consumers. Nevertheless, rules of origin increase the feasibility of free trade agreements due to larger tax revenues.