Tax Competition Overview

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Questions and Answers

Tax competition can lead to international tax divergence. This results in misallocation of capital if both countries use which type of taxation?

Source-based taxation (correct)

Territorial taxation

Destination-based taxation

International tax revenue

Tax competition is always bad.

False

What is the main issue addressed by papers by Feldstein and Hartman (1979) and Bond and Samuelson (1989)?

The relative merits of deductions and foreign tax credits in alleviating international double taxation of cross-border income flows.

Which of the following is NOT a main option to alleviate international double taxation?

Tax haven Signup and view all the answers

What does a multinational firm's production function in the model represent?

The relationship between the capital used at its domestic plant and the output produced. Signup and view all the answers

Match the following tax variables with their corresponding descriptions:

θ* = Foreign tax rate θs = Domestic tax rate applicable to foreign income after foreign taxes γ = Credit parameter: share of foreign taxes returned to the firm by the domestic tax authority in the form of a foreign tax credit θ = Domestic tax rate applicable to domestic income Signup and view all the answers

What is the main decision the domestic tax authority makes regarding international tax parameters?

Determining the domestic tax rate applicable to foreign income (θs) and the share of foreign taxes returned to the firm (γ). Signup and view all the answers

A deduction is implemented by setting θs = θ and γ = 0

True Signup and view all the answers

A foreign tax credit is implemented by setting θs and γ so that (1− θs)(1− θ) + γθ = 1− θ

True Signup and view all the answers

After-tax profit maximization by the firm implies that fk(K)= f(K) is a necessary condition for an efficient allocation of capital.

True Signup and view all the answers

A foreign tax credit is always optimal from the perspective of the domestic country?

False Signup and view all the answers

What is the domestic tax authority's objective in setting θs and γ?

Maximizing domestic national income. Signup and view all the answers

What is the expression used to represent domestic national income in the model?

N = f(K) + (1 - θ*)f*(K*) Signup and view all the answers

What does the domestic tax authority do to maximize N?

Chooses θs and γ while knowing K* is a function of these two tax parameters, represented as K* = K*(θs, γ), to maximize N. Signup and view all the answers

The first order condition of domestic national income is obtained by differentiating N with respect to the ______ to get[-fx(K) + (1− θ)fx (K)]dk*/dθs = 0.

domestic tax rate (θs) Signup and view all the answers

The first order conditions of the country and the firm together imply that (1 - θ) = ((1 - θs)(1- θ) + γθ*)/(1 - θ).

True Signup and view all the answers

The condition (1 - θ) = ((1 - θs)(1- θ) + γθ*)/(1 - θ) is met if θs = 0 and γ = 0.

True Signup and view all the answers

Allowing a deduction of foreign taxes from domestic taxable income is economically inefficient compared to allowing a foreign tax credit.

False Signup and view all the answers

What is the main difference between Feldstein and Hartman's model and Bond and Samuelson's model?

In Bond and Samuelson's model, both the domestic and foreign countries actively adjust their tax rates in response to the international capital flow, unlike Feldstein and Hartman's model where only the domestic country adjusts its tax rate. Signup and view all the answers

What is the order of events in the 2-stage game that the domestic and foreign tax authorities engage in?

First, the domestic country chooses between a deduction or a foreign tax credit to alleviate international double taxation. Then, both countries set their tax rates based on the chosen system. Signup and view all the answers

Bond and Samuelson's model is analyzed in the same order as Feldstein and Hartman's model.

False Signup and view all the answers

What are K and K* in the context of the model?

K represents the original capital stock in the home country, while K* represents the original capital stock in the foreign country. Signup and view all the answers

What does Z represent in the model?

Z represents the flow of capital from the home country to the foreign country. Signup and view all the answers

What is the impact of the capital flow Z on the capital amounts employed in the home and foreign countries?

The home country's capital stock decreases by Z, becoming K - Z, while the foreign country's capital stock increases by Z, becoming K* + Z. Signup and view all the answers

What is the return that the domestic owners of the capital flow Z obtain? Explain.

They obtain the after-tax marginal product of capital in the foreign country, taking into account the taxes that may be imposed by both the domestic and foreign countries. Signup and view all the answers

The model assumes that initially, the marginal product of capital in the home country is higher than in the foreign country.

False Signup and view all the answers

Without any taxation, capital would flow from the foreign country to the home country.

False Signup and view all the answers

The capital flow continues until the marginal returns to capital in both countries are equal.

True Signup and view all the answers

What is the welfare consequence of this capital flow?

This capital flow increases welfare in both countries. Signup and view all the answers

What are t and t* in the model?

t represents the domestic tax rate applicable to the income generated from the capital flow Z, while t* represents the foreign tax rate applied to the same income. Signup and view all the answers

Why does an increase in either t or t* result in a decrease in the capital flow Z?

Higher tax rates reduce the after-tax return on investment, making capital flows less attractive and leading to a decrease in Z. Signup and view all the answers

The determination of the capital flow Z in a deduction system is represented by the equation FK(K - Z) = F(K* + Z)(1-t)(1 – t*).

True Signup and view all the answers

In a credit system, the determination of capital flow Z is represented by: FK(K - Z) = F(K* + Z)(1- t*).

False Signup and view all the answers

What are the two cases considered for the foreign tax credit in place?

Case 1: t > t*, where the domestic tax rate is higher than the foreign tax rate. Case 2: t ≤ t*, where the domestic tax rate is equal to or less than the foreign tax rate. Signup and view all the answers

In case 1 (t > t*), the tax payer pays a tax rate t in the foreign country.

False Signup and view all the answers

In case 1 (t > t*), the domestic tax authority provides a tax credit equal to the domestic tax t.

False Signup and view all the answers

In case 2 (t ≤ t), the tax payer effectively pays domestic tax at a rate of t - t = 0.

True Signup and view all the answers

The foreign tax credit case results in the same function Z(t, t*) as the deduction case.

False Signup and view all the answers

The credit system is more generous for the tax payer in comparison to the deduction system.

True Signup and view all the answers

Why is it important to consider combinations of t and t* that lead to Z > 0 when determining the effectiveness of deduction and credit systems?

This helps to understand which system is more conducive to a positive capital flow, which is beneficial for both the home and foreign countries. Signup and view all the answers

What is tm in the model?

tm represents the maximum single tax rate that allows for zero capital flow (Z = 0). Signup and view all the answers

With the deduction system, the capital flow Z will be zero when (1-t)(1 - t*) = (1 - tm).

True Signup and view all the answers

The expression t = (tm-t)/(1-t) represents the value of t for a given t* that would lead to a positive capital flow.

False Signup and view all the answers

The graphs representing the capital flow Z in case of deduction and credit systems are exactly the same.

False Signup and view all the answers

In the foreign tax credit system, the capital flow Z will be zero when max(t, t*) = tm.

True Signup and view all the answers

The foreign tax credit system always leads to a higher level of capital flow compared to the deduction system.

False Signup and view all the answers

What is the main objective of each country in the 2-stage game model?

Each country aims to maximize its national income. Signup and view all the answers

What does the domestic national income Y(t, t*) represent?

Y(t, t*) represents the domestic country's national income, taking into account the income from domestic production, the capital flow, and the foreign tax rate. Signup and view all the answers

What is the difference between the expressions for domestic national income and foreign national income?

The expression for foreign national income Y*(t, t*) considers the income from foreign production and the capital flow received from the domestic country, minus the payments made to the domestic country for the capital flow. Signup and view all the answers

(1− t)F(K + Z(t, t*)) represents the after-tax price that the foreign country pays for using the domestic capital.

True Signup and view all the answers

A Nash equilibrium is reached when both countries simultaneously maximize their national income.

False Signup and view all the answers

A Nash equilibrium is always the best outcome for both countries in a tax competition scenario.

False Signup and view all the answers

In a tax competition scenario with a deduction system, the domestic country always sets a tax rate of zero to maximize its income.

False Signup and view all the answers

The domestic country's optimal tax rate in the deduction system is equal to the maximum tax rate (tm) that would lead to zero capital flow.

False Signup and view all the answers

When the domestic country provides a foreign tax credit, the domestic country's optimal tax rate in the case of t* = 0 is still to.

True Signup and view all the answers

When the domestic country provides a foreign tax credit, the foreign country's optimal tax rate in the case of t ≤ t* is higher than t*.

False Signup and view all the answers

In a Nash equilibrium with a deduction system, there is always zero capital flow.

False Signup and view all the answers

In a Nash equilibrium with a foreign tax credit system, there is always a positive capital flow.

False Signup and view all the answers

The domestic country always prefers a deduction system over a credit system.

True Signup and view all the answers

Study Notes

Tax Competition

Countries often set tax rates without cooperation, leading to tax competition
This can be good or bad, depending on the effects

Is Tax Competition Good or Bad?

Bad:
- Leads to tax divergence internationally, creating misallocation of capital, particularly apparent in low tax rates in smaller countries. Source-based taxation exacerbates this issue if adopted by both countries.
- Results in relatively high combined tax rates on cross-border activity. This leads to misallocation of production factors. In practice, this tends to lead to the reduction of international double taxation
- Can result in insufficient tax revenue, which hinders financing of adequate public goods. This can threaten wealth redistribution and welfare state systems.
Good:
- Prevents tax revenue from becoming excessively high, as political waste of tax revenues by politicians is common

Papers by Feldstein and Hartman (1979) and Bond and Samuelson (1989)

These papers investigate methods to mitigate international double taxation, specifically focusing on deductions and foreign tax credits.

Paper by Feldstein and Hartman (1979)

Two primary methods to alleviate international double taxation:
- Foreign tax credit: Foreign taxes are deducted from the domestic tax liability.
- Deduction: Foreign taxes are deducted from the domestic taxable income.
For comparable tax rates, the foreign tax credit offers more generosity to taxpayers.

The Model

A single multinational firm operates domestic and foreign plants, allocating its overall capital (K) between domestic (K) and foreign (K*) capital.
Production functions at domestic and foreign plants are given, showcasing decreasing marginal capital products.

Tax Variables

θ*: Foreign tax rate
θ_s: Domestic tax rate applicable to foreign income after foreign taxes
γ: Share of foreign taxes returned to the firm as a foreign tax credit
θ: Domestic tax rate applicable to domestic income

The Domestic Tax Authority

The domestic tax authority determines international tax parameters (θ_s and γ) based on the provided domestic (θ) and foreign (θ*) tax rates.

Allocating Capital

To maximize after-tax worldwide profits, the firm equalizes the after-tax marginal products of domestic and foreign capital.

Deduction vs. Foreign Tax Credit

Deduction: Setting θ=θ_s and γ = 0
Foreign Tax Credit: Setting θ_s and γ values to satisfy (1-θ_s)(1-θ*)+γθ* = 1 − θ

Foreign Tax Credit Implications

Necessary condition for efficient capital allocation: fk(K) = f(K*)
Maximizes worldwide output: f(K) + f*(K*)

Model Details

K and K*: Initial capital stocks in home and foreign countries, owned by residents.
Z: Flow of capital from home to foreign.
Capital flow changes the capital employed: K – Z (home), K* + Z (foreign).
The return to domestic owners of Z is dependent on the after-tax marginal product of capital in the foreign country, factoring in possible taxation by both domestic and foreign countries.

Marginal Product of Capital

Initially, the marginal product of capital is lower in the home country (FK(K) < F(K*)).
Without tax, capital flow from home to foreign.
Capital flow continues until marginal returns are equal: FK(K – Z) = F(K* + Z).
This increase welfare in both countries

Determination of Z (No Taxes)

Figure showing the marginal product of capital (MPK) and how Z (capital flow) is determined without taxes.

Tax Variables (with Taxes)

t and t*: Domestic and foreign tax rates on income from capital flow (Z).
Z is a function of t and t*: Z(t, t*)

Determination of Z (Deduction System)

FK(K – Z) = F(K* + Z)(1-t)(1 – t*) Equation for Z

Maximum Single Tax Rate (tm)

tm represents the highest single tax rate that can maintain a zero capital flow (Z = 0).

Optimal Tax Rate (t) with Deduction

Equation for t as a function of t': t = (tm − t*)/(1 − t*)

Foreign Tax Credit: Z=0

Graph representing conditions under which Z = 0 with a foreign tax credit.

Two-Stage Game

Country 1 can choose deduction or tax credit at stage 1.
Country 2 sets its tax rates at stage 2, knowing the choice of country 1.

National Income Maximization

Each country aims to maximize its national income during the 2-stage game.

Nash Equilibrium

Equilibrium occurs when each country's tax rate maximizes its national income, given the other country's tax rate.
Graph representing the Nash equilibrium points for the two countries.

Nash Equilibrium (Foreign Tax Credit)

In Nash equilibrium, there's no capital flow (ZN = 0).
Deduction system produces higher welfare for both countries compared to the foreign tax credit system.

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Description

This quiz explores the complex dynamics of tax competition among countries and its potential benefits and drawbacks. Dive into the arguments for and against tax competition, examining its impact on international tax rates, capital allocation, and public goods financing. Through this, you'll understand how tax policies can shape economies on a global scale.

Tax Competition Overview

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Podcast

Questions and Answers

Tax competition can lead to international tax divergence. This results in misallocation of capital if both countries use which type of taxation?

Tax competition is always bad.

What is the main issue addressed by papers by Feldstein and Hartman (1979) and Bond and Samuelson (1989)?

Which of the following is NOT a main option to alleviate international double taxation?

What does a multinational firm's production function in the model represent?

Match the following tax variables with their corresponding descriptions:

What is the main decision the domestic tax authority makes regarding international tax parameters?

A deduction is implemented by setting θs = θ and γ = 0

A foreign tax credit is implemented by setting θs and γ so that (1− θs)(1− θ*) + γθ* = 1− θ

After-tax profit maximization by the firm implies that fk(K)= f*(K*) is a necessary condition for an efficient allocation of capital.

A foreign tax credit is always optimal from the perspective of the domestic country?

What is the domestic tax authority's objective in setting θs and γ?

What is the expression used to represent domestic national income in the model?

What does the domestic tax authority do to maximize N?

The first order condition of domestic national income is obtained by differentiating N with respect to the ______ to get[-fx(K) + (1− θ*)fx (K*)]dk*/dθs = 0.

The first order conditions of the country and the firm together imply that (1 - θ*) = ((1 - θs)(1- θ*) + γθ*)/(1 - θ).

The condition (1 - θ*) = ((1 - θs)(1- θ*) + γθ*)/(1 - θ) is met if θs = 0 and γ = 0.

Allowing a deduction of foreign taxes from domestic taxable income is economically inefficient compared to allowing a foreign tax credit.

What is the main difference between Feldstein and Hartman's model and Bond and Samuelson's model?

What is the order of events in the 2-stage game that the domestic and foreign tax authorities engage in?

Bond and Samuelson's model is analyzed in the same order as Feldstein and Hartman's model.

What are K and K* in the context of the model?

What does Z represent in the model?

What is the impact of the capital flow Z on the capital amounts employed in the home and foreign countries?

What is the return that the domestic owners of the capital flow Z obtain? Explain.

The model assumes that initially, the marginal product of capital in the home country is higher than in the foreign country.

Without any taxation, capital would flow from the foreign country to the home country.

The capital flow continues until the marginal returns to capital in both countries are equal.

What is the welfare consequence of this capital flow?

What are t and t* in the model?

Why does an increase in either t or t* result in a decrease in the capital flow Z?

The determination of the capital flow Z in a deduction system is represented by the equation FK(K - Z) = F(K* + Z)(1-t)(1 – t*).

In a credit system, the determination of capital flow Z is represented by: FK(K - Z) = F(K* + Z)(1- t*).

What are the two cases considered for the foreign tax credit in place?

In case 1 (t > t*), the tax payer pays a tax rate t in the foreign country.

In case 1 (t > t*), the domestic tax authority provides a tax credit equal to the domestic tax t.

In case 2 (t ≤ t*), the tax payer effectively pays domestic tax at a rate of t - t* = 0.

The foreign tax credit case results in the same function Z(t, t*) as the deduction case.

The credit system is more generous for the tax payer in comparison to the deduction system.

Why is it important to consider combinations of t and t* that lead to Z > 0 when determining the effectiveness of deduction and credit systems?

What is tm in the model?

With the deduction system, the capital flow Z will be zero when (1-t)(1 - t*) = (1 - tm).

The expression t = (tm-t*)/(1-t*) represents the value of t for a given t* that would lead to a positive capital flow.

The graphs representing the capital flow Z in case of deduction and credit systems are exactly the same.

In the foreign tax credit system, the capital flow Z will be zero when max(t, t*) = tm.

The foreign tax credit system always leads to a higher level of capital flow compared to the deduction system.

What is the main objective of each country in the 2-stage game model?

What does the domestic national income Y(t, t*) represent?

What is the difference between the expressions for domestic national income and foreign national income?

(1− t*)F(K* + Z(t, t*)) represents the after-tax price that the foreign country pays for using the domestic capital.

A Nash equilibrium is reached when both countries simultaneously maximize their national income.

A Nash equilibrium is always the best outcome for both countries in a tax competition scenario.

In a tax competition scenario with a deduction system, the domestic country always sets a tax rate of zero to maximize its income.

The domestic country's optimal tax rate in the deduction system is equal to the maximum tax rate (tm) that would lead to zero capital flow.

When the domestic country provides a foreign tax credit, the domestic country's optimal tax rate in the case of t* = 0 is still to.

When the domestic country provides a foreign tax credit, the foreign country's optimal tax rate in the case of t ≤ t* is higher than t*.

In a Nash equilibrium with a deduction system, there is always zero capital flow.

In a Nash equilibrium with a foreign tax credit system, there is always a positive capital flow.

The domestic country always prefers a deduction system over a credit system.

Study Notes

Tax Competition

Is Tax Competition Good or Bad?

Papers by Feldstein and Hartman (1979) and Bond and Samuelson (1989)

Paper by Feldstein and Hartman (1979)

The Model

Tax Variables

The Domestic Tax Authority

Allocating Capital

Deduction vs. Foreign Tax Credit

Foreign Tax Credit Implications

Model Details

Marginal Product of Capital

Determination of Z (No Taxes)

Tax Variables (with Taxes)

Determination of Z (Deduction System)

Maximum Single Tax Rate (tm)

A foreign tax credit is implemented by setting θs and γ so that (1− θs)(1− θ) + γθ = 1− θ

After-tax profit maximization by the firm implies that fk(K)= f(K) is a necessary condition for an efficient allocation of capital.

The first order condition of domestic national income is obtained by differentiating N with respect to the ______ to get[-fx(K) + (1− θ)fx (K)]dk*/dθs = 0.

The first order conditions of the country and the firm together imply that (1 - θ) = ((1 - θs)(1- θ) + γθ*)/(1 - θ).

The condition (1 - θ) = ((1 - θs)(1- θ) + γθ*)/(1 - θ) is met if θs = 0 and γ = 0.

In case 2 (t ≤ t), the tax payer effectively pays domestic tax at a rate of t - t = 0.

The expression t = (tm-t)/(1-t) represents the value of t for a given t* that would lead to a positive capital flow.

(1− t)F(K + Z(t, t*)) represents the after-tax price that the foreign country pays for using the domestic capital.