It is generally understood that the distortionary effects of capital income taxation are magnified in open economies. For example, the standard theoretical model suggests that the optimal effective marginal tax rate of a source-based capital income tax in a small open economy is zero (see Gordon, 1986). Raising this tax rate increases the required pre-tax rate of return in that location; this reduces the quantity of capital located there, which in turn creates an excess burden which could be avoided by taxing immobile factors directly.
One alternative to income taxation is consumption-type taxation. This paper investigates the effects of different types of consumption-type taxation on factor allocation, production and consumption in a two-country framework. Our particular interest is in the three versions of the business cash-flow tax levied on business profit. The latter three taxes differ in how the profit is allocated across the two countries. We analyze the case where aggregate profit is allocated by an apportionment factor based on the location of sales; a “destination” tax akin to VAT where exports are tax exempt, but imports are taxed; and a conventional source-based tax. We explore and compare the efficiency properties of each of these forms of taxation. We show that there are many potential distortions even when capital income is excluded from the tax base, so that the tax is based only on profit or economic rent. We also examine a game played between the two countries to consider what the non-cooperative outcome would be if the two countries chose their tax systems independently. In particular, starting from the most common form of taxation, the source-based tax, we analyze whether countries have an incentive to switch at least part of their tax system to one of the other forms.
We model a single company which has a plant in each country, which supplies a representative consumer in each country, and which is owned equally by the two consumers. The company generates profit in three ways. First, it has the use of a fixed factor in each production location, which implies that there are decreasing returns to scale in the other two factors, capital and managerial skill. The existence of the fixed factor generates profit in the country of production. Second, the company can allocate both capital and managerial skill freely between the two countries. The profit generated from access to managerial skill, assumed to be owned by the company, is therefore mobile between the two countries. Third, in our base case, the company is a monopolist that can exploit its market power in each of the two markets. This component of profit is therefore located in the destination country, where the consumer is resident.
Within this framework, even taxes on business profits can affect economic behavior. For example, consider the effects of a source-based cash-flow tax applied to the company in each country, where the home country has a higher tax rate, and the only cross border trade in the final good is an export from the foreign country to the home country. In this case, marginal domestic sales are supplied from the foreign country, but existing sales are supplied in part from the home country and taxed at a higher rate. With market power, the firm earns profits. Hence, even under a cash-flow tax, it will have an incentive to shift production to the foreign country, where the tax rate is lower.
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Consumption and Cash-Flow Taxes in an International Setting
