Many studies have shown that the activities of multinational corporations are quite sensitive to differences in income tax rates across countries. In this paper, I explore the interaction between multinational taxation and abatement activities under an international emissions permit trading scheme. Four types of plans are considered: (1) a single domestic permit system with international offsets; (2) separate national permit systems without trade; (3) separate national permit systems with limited offsets; and (4) an international permit trading system. For each plan, I model the incentives for the multinational firm to choose abatement activities at home and abroad and to transfer emissions credits between parent and subsidiary.
Limits on trading across countries restrict efficiency gains from abatement, as is well known. But I show furthermore that if available offset opportunities are limited to actual abatement activities, those activities are more susceptible to distortions from incentives to shift taxable income. Transfer pricing rules can limit but not always eliminate these distortions. In a system of unlimited international trading, abatement is efficiently allocated across countries, but tax shifting can still be achieved through intra-firm transfer pricing. From the basis of efficiency for both environmental and tax policies, the best design is an international permit trading system with transparent, enforceable transfer pricing rules.