Page 13 - Working Paper (Optimal Corporate Income Tax Policy for Large Developing Countries in an Integrated Economy)
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DDTC Working Paper 1416

                   home country. The level of incentive here is solely   It appears that in determining which tax regime
                   determined by how much tax they have to pay if   to be used, there is trade-off between maximizing
                   they are to invest at home country. I divide the level   public  goods  or private goods  consumption.
                   into three categories. First, if they are certainly pay   Unsurprisingly,  nowadays,  countries  tend  to
                   lower  tax  investing at  home  country, the level of   shift to source principle. With this principle, the
                   incentive  is  high.  Second,  if  the  amount  of  tax  to   governments will  just  whether losing capital
                   pay at home  country can possibly lower, higher,   inflow  but  sustaining  tax  revenue  (when  foreign
                   or equal, then the level of incentive is at moderate   countries uses residence principle), or potentially
                   level. Third, if they are certain that they have to pay   gaining capital inflow with increasing tax revenue
                   higher tax at home country, the level of incentive   as well due to the increasing tax base (when foreign
                   is low.                                          countries uses source principle). On the other side,
                                                                    if  the home  country prefer  residence  principle,
                      In short, the table above implies that residence   capital  will  possibly  attracted  to  flow  inside  –
                   principle has clearly bigger opportunity to attract   depends on foreign countries’ tax regime, but the
                   capital  inflow.  If,  say,  the  foreign  country  holds   tax revenue will certainly not increase.
                   source principle,  the home country would have
                   absolute advantage in attracting foreign residents   5. Policy Implication
                   to move their investment inside, since the foreign
                   residents  will  not  be  obliged  to pay any taxes.
                                                                       The provided results inform us that in deciding
                   Next, suppose the foreign country holds residence
                                                                    optimal  corporate income  tax  policy, there are
                   principle, making the foreign residence  compare
                                                                    two factors  that  should  be of  consideration:
                   the tax rate imposed by both country. In such case,
                                                                    consumption on  private goods and  consumption
                   if t  = t* , the expected return of investing such
                   capital   of home and  foreign country will  be  the   on public goods. In maximizing these  two, the
                                                                    government  tries  to  attract  capital  inflow,  which
                   consideration of the capital owner deciding where
                                                                    can be perceived as both tax base and job creator.
                   to put  the capital.  In  this scenario, the incentive
                                                                    In considering optimal tax policy, the government
                   is to invest at home country is at moderate level,
                                                                    tries to seek the best option of corporate income
                   certainly below the previous scenario.
                                                                    tax, whether in terms of its rate or its regime, in
                      Now, suppose the home country holds source    which  public  goods  consumption and private
                   principle, while the foreign country also  uses   goods  consumption could be trade-off.  Hence,  in
                   source  principle.  Similarly,  foreign  residents  will   effort  to  maximize  the society’s welfare,  several
                   compare the home country’s tax rate and foreign   policy implications can be inferred as follows:
                   country’s tax rate to make investment decision. It   a.  Lowering corporate income tax rate?
                   becomes direct tax rate competition between home
                   country and foreign country. Again, in this case, the
                                                                          It clearly appears that capital are attracted
                   level of  incentive  is  at moderate  level. But  if  the
                                                                       to move to countries with lower income tax rate,
                   foreign country implements residence  principle,
                                                                       so that in tax competition, the winner is the one
                   the foreign residents will have to pay tax two times.
                                                                       who can manage to apply low corporate income
                   This  certainly  discourages  capital  to  flow  inside
                                                                       tax  rate.  Does  it  mean,  for  large  developing
                   the home country, making the incentive to invest
                                                                       countries, lowering corporate income tax rate
                   at home country is low. If the home country holds
                                                                       increases economic welfare?  To enlighten  the
                   residence  principle, on the contrary, the foreign
                                                                       answer, the government should consider with
                   residents will only have to pay t*  no matter where   broad perspective.
                   they decide  to put  their  capital.  The  incentive to
                   invest in home  country will  be still  at  moderate   Recall  that  through  ZMW  model  equated
                   level, nevertheless.                                in (5), country’s welfare is  function of
                                                                       consumption on public  and private goods.
                      These   scenarios  provide  us  insightful
                                                                       Suppose  a  large  developing  country  lowers
                   information not only about the relation between tax
                                                                       its tax rate. The effect to the country’s welfare
                   regimes and the incentive level to attract capital, but
                                                                       then can be breakdown as follows. First, remind
                   also about improving welfare as general. Remind
                                                                       that public goods consumption is reflected by
                   that  from (5), the  welfare is maximized through
                                                                       tax revenue, which is equal to . By lowering the
                   private goods  and public  goods  consumption.
                                                                       corporate income tax rate, it simply means that
                   By  attracting  capital  inflow  through  residence
                                                                       is reduced. The impact to , however, is uncertain.
                   principle, we should note that while private good
                                                                       Despite through KK framework lower tax rate
                   consumption increases, the government revenue is
                                                                       incentivize  capital  inflow,  such  occurring  will
                   reduced, since the foreign residents pay zero tax to
                                                                       also depend to the tax regime hold by the home
                   the home country’s government.
                                                                       country and its competitors.
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