R&D, advertising, and profits: Economic theory, empirical evidence, and consequences for transfer pricing policy

This dissertation analyzes the effect of R&D and advertising on profitability from the perspective of transfer pricing analysis. After providing a review of the theoretical and economic literature on R&D and advertising, it examines the standard financial models applied to intangible asset valuation and finds them lacking. The dissertation then examines the empirical relationship between R&D, advertising, and profitability in greater detail using financial data for publicly-listed manufacturing firms over the period 1950–1998. As expected, the analysis confirms that current-period advertising and R&D have a significant impact on current-period profitability. For transfer pricing analysis, establishing the relative contribution of R&D and advertising to profitability is an important consideration. These results suggest that the impact of advertising on profitability is considerably closer to the impact of R&D than the literature review suggests. This dissertation also estimates various distributed lag models to determine the relative duration of advertising and R&D, although these models do not provide robust results. As an alternative, an estimate of the relative duration of advertising and R&D is derived from a financial market valuation approach. These results support the conclusion that the duration of advertising's effect on profitability is considerably closer to that of R&D than previous studies have suggested. Both the relative magnitude and the relative duration of advertising and R&D effects have important ramifications for transfer pricing policies. This dissertation then examines geographical segment data for manufacturing firms over the period 1991–1996, in order to determine whether there is evidence that is consistent with the hypothesis that MNCs use cross-border technology payments to minimize their overall tax burden. While the evidence is not conclusive, it does show that firms with greater R&D intensity have greater profitability differences between the parent companies and their foreign locations, and that these profitability differences are positively correlated with tax differentials. These results suggest the need for greater clarity and consistency in the development of international tax regulations on intercompany transactions involving intangible assets.