Balancing act: weighing the factors affecting the taxation of capital income in a small open economy

McKeehan, Margaret K and Zodrow, George R. (2016) Balancing act: weighing the factors affecting the taxation of capital income in a small open economy. Centre for Business Taxation Working Paper, Oxford.

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Alternative economic theories yield dramatically different prescriptions for optimal capital taxation in small open economies. On the one hand, foreign firms, including those with investments that yield firm-specific above-normal returns, have a large number of alternative investment opportunities; this suggests that the supply of foreign direct investment is highly elastic, which implies that small open economies should avoid imposing any source-based taxes on capital income. On the other hand, governments
invariably want to tax any above-normal returns earned by location-specific capital, especially if the returns accrue to foreigners, and to take full advantage of the potential revenue increase from any “treasury transfer” effect that arises due to residence-based tax
systems with foreign tax credits, such as that utilized by the United States. These factors suggest that investment is highly inelastic with respect to capital taxation, so that source-based capital income taxation is desirable; indeed, in one special case, the capital income tax rate for a small open economy should equal the relatively high US tax rate. Moreover, this difficult trade-off is in practice complicated by numerous additional factors: deferral
of unrepatriated profits and cross-crediting of foreign tax credits for US multinationals, foreign direct investment from firms from countries that, unlike the United States, operate territorial systems, and the existence of opportunities for both international capital
income shifting and labor income shifting. In this paper, we analyze optimal capital income taxation in a small open economy model that attempts to balance these conflicting factors.

Item Type: Other Working Paper
Keywords: Oxford University Centre for Business Taxation; Optimal Taxation; Open Economy; Income Shifting; Corporate Taxation
Subject(s): Taxation
Centre: Oxford University Centre for Business Taxation > CBT Working Papers
Date Deposited: 08 Feb 2019 12:52
Last Modified: 08 Feb 2019 12:52
Funders: n/a

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