Taxing multinationals in the presence of internal capital markets *

•Internal capital markets entail efficiency costs for MNEs, reflecting managerial disincentive effects.•The paper analyzes whether tax avoidance behavior of MNEs interacts with these costs.•The way the costs influence MNE and government behavior differs from the standard notion of fiscal competition.•The results are consistent with empirical findings.

There is ample evidence that internal capital markets incur efficiency costs for multinational enterprises (MNEs). This paper analyzes whether tax avoidance behavior interacts with these costs and how policies of competing governments respond to it. We show that the interaction in itself may lead to profit taxes that are inefficiently high (low), provided the costs are attenuated (magnified) by higher profit taxes. Further, internal efficiency costs might render infrastructure provision inefficiently low. We also clarify the implications of the decision to set up an internal capital market and of external finance for the behavior of competing governments. The results are consistent with empirical findings that are not inherently related to the notion of fiscal competition.