Page 11 - Working Paper (Optimal Corporate Income Tax Policy for Large Developing Countries in an Integrated Economy)
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DDTC Working Paper 1416

                   uniformly, regardless of the source of the income.   have three different  tax  rates applying to capital
                   Non-residents are not taxed by the home country   income: (i) t , which is the tax rate levied on res
                   on their income originating on that country. While   idents on their  domestic-source income;  (ii)  t ,
                   under the source principle, income originating in   which is effective tax rate levied on residents on
                   the home country is uniformly taxed, regardless of   their foreign-source income in addition to the tax
                   the residency of the income recipient.           already levied in the foreign country; (iii) t , which
                                                                    is the tax  rate levied on non-residents  on their
                      The  collision of  the method  applied between   capital income originating in the home country.
                   countries involve double taxation of the same tax
                   base.  This  issue  is  frequently eliminated  by a   With the same intuition, the foreign country
                   system of domestic tax credits for foreign taxes or   may also have  three  tax  rates  which  we denote
                   double taxation agreement. For instance, suppose   by  t* , t* , t* and  respectively. With complete
                   that the home country adopts the source principle   integration of capital  markets between the two
                   and that the foreign country adopts the residence   countries,  capital  will  flow  until  this  condition  is
                   principle. Suppose further that the foreign country   reached, where
                   allows  a credit  against taxes  paid in the home
                                                                            r(1 – t ) = r*(1 – t* – t* )    (19)
                   country. In this case, if the home country’s tax rate         rD         rN    rF
                   does not exceed the foreign country’s rate, then the
                                                                       This  right, then the residents  of  the home
                   resident of the foreign country receives at home full
                                                                    country will  move its capital  abroad until  the
                   credit against taxes  paid abroad. In other  words,
                                                                    equation balanced again. Conversely, if the left is
                   the foreign country resident pay the same tax rate
                                                                    bigger than the right, there will be capital inflow
                   on domestic-source and foreign-source income.
                                                                    from  foreign  country’s  residence,  since  the  firms
                      However, if the home country’s tax rate exceed   in world  economy perceive  that investing in the
                   the foreign country’s tax rate, the foreign residence   home  country  is  more  profitableequation  holds
                   pays higher tax for income generated in the home   the principle on the perspective of  the residents
                   country than in the foreign country. And in the   in the home country. It implies that in equilibrium
                   most case, the foreign residence does not receive   state, these  residents  are indifferent between
                   refund from the foreign country. In result, in this   investing at home or abroad, meaning that there is
                   kind of situation, tax credit does not fully restore an   no incentive to change the place for investment. If
                   effective residence principle in the foreign country,   the left section is smaller than the.
                   while on the contrary, it fully restores an effective
                                                                       The same principle can be settled for the foreign
                   source principle of the home country. Hence, in this
                                                                    countries  to examine similar capital  movement,
                   context, tax credit – which in this case is applied by
                                                                    which is
                   foreign country – gives benefit for home country’s
                   welfare in two ways: home country gains tax              r(1 – t –  t* ) = r* (1 – t* )    (20)
                   revenue generated from foreign capital inflow and
                   immobile capital rent which is paid to the domestic   If we are to take interest rate as constant, we
                   labor.                                           can  safely  remove  temporarily  the  influence  of
                                                                    capital  return.  In  such condition, tax  rate is the
                      This  kind of  situation can appeared  in many   only factor for capital owners in considering where
                   ways, and thus affect the capital owners’ decision   to put  his capital.  Then, tax  rate should hold the
                   on  where  to  invest.  Such  flows  have  significant   following equilibrium:
                   effect toward its way to achieve the viability  of
                   equilibrium in the world capital  markets (world   (1 – t )(1 – t* ) = (1 – t* – t )(1 – t – t* )   (21)
                                                                                          rN     rF
                   saving = world investment), under which countries
                                                                       This  constraint  implies that  despite the two
                   are competing each other to catch capital.
                                                                    countries arrange  each of their own  tax  system
                      To thoroughly examine the capital  movement   independently,  and  do not  explicitly coordinate
                   decision, using the model built up for tax arbitrage   their  tax  systems  between  them, each  one
                   by  Frenkel,  Razid  and  Sadka  (1992)  is  very   nevertheless must take into account the tax system
                   informative.  Consider again the standard of two-  of the other. Now consider first the case in which
                   country economy – for simplicity – with  perfect   both  countries  adopt  the  source  principle.  Since
                   capital  mobility and denote interest rates in the   that principle implies that  income  is  taxed  only
                   home country and  foreign country with  r  and   according to its source, regardless of residency, in
                   r*  respectively. Generally, the home country may   equilibrium it follows that
                                                                           t  = t ,t* = t* ,andt = t*     (22)
                   31. Jacob Frenkel, Assaf Razin, and Efraim Sadka, “International Taxation
                   In An Integrated World,” NBER Working Paper Series, No. 23266 (1992).  In the  second  possibility, let  us consider  the
                   32.            Ibid.                             case in which both countries adopt the residence
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