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DDTC Working Paper 1416

                      Considering in case all countries raise their tax   tax. But, later in this section, by the work done
                   rates some common and small amount dt  = dt, then   by Keen and Konrad (2014) , we can see that
                   it holds that from equation (1), this simply reduces   the generated result can also logically apply for
                   the common net return ρ by the same amount and      profit shifting interpretation. Assume there are
                   leaves the allocation of capital unchanged, so that   two countries (i = 1,2), where the population is
                   the welfare of  country i is  dWi =  –k dt  + G 'k dt ;   uniformly distributed  in each, but  population
                   Evaluating  this  from  Nash  equilibrium,  ’s  first-  sizes  h  differs  in a way that  h  >  h . In each
                   order condition (7) then implies                    country,  there is only one unit  of some good.
                                                                       Suppose  that  t  >  t , then the  consumers  in
                                                                       country 2 find it worth to purchase abroad in
                                                                       country 1 if t  + �s < t , or
                      By assuming all countries are identical (k  = k ),
                                                                          In consequence, revenues of the two
                                                                       countries are:
                      Given the positive sign, it shows that the Nash
                   equilibrium is Pareto inefficient: all countries would
                   benefit  from  a  small,  uniform  increase  in  all  tax
                   rates. This does not hold if the tax-rate increasing   It appears that  because of  the movement,
                   actions are not followed by the related countries.   an  amount  of       move from country 2
                   If there are only one or few  countries take such   to buy the good in country 1. In effect, the tax base
                   actions,  capital  will  simply  move away  from the   of country 2 is  only  as  many  as   .
                   countries and enter the other countries who do not   Accordingly,  assuming that  each government
                   increase the tax rate. This then becomes the central   wants to maximize  its tax  revenue, taking  as
                   argument against unconstrained international tax    given the tax set of the other, then maximizing
                   competition.                                        the r heavily depends on its relative size. After
                                                                       mathematical routine done by Kanbur and Keen
                   3.  Moving toward  More Realistic                   (1991), the best response of each t ( t ) and  t (
                   Assumption                                          t ) are
                      3.1. Incorporating Profit-Shifting Practices
                         Despite  the  insightful  information  that
                      ZMW  model  can  give,  its  assumption  is  too    And, for t
                      simplistic and general.  It is  thus inherently
                      limited  to comprehend  the complex practices
                      of international tax competition. For instance,
                      moving capital  does  not necessarily mean a
                      multinational  move its subsidiary  from one
                      to another country, but it can just move away
                      its  earning  through  profit  shifting  practices  –   The  described  responses  revealed in (14)
                      mostly by transfer price and thin capitalization   and  (15) shows that  there are mismatched
                      instruments.  UNCTAD  has  recently  estimated   responses  between country 1 and  country 2.
                      that, every  10% increase  of  investment from   This is visually depicted in Figure 2.
                      certain countries  will  impact to the reduce
                                                                          As  depicted  in the illustration, when  the
                      of the rate of return of the related companies
                      in  developing  countries by  1%.   Thus, it  is   large country set low  t ,  it  is  optimal  for the
                                                                       small country to set  t  above t . Some citizen
                      necessary  to make more realistic  assumption                        1       2
                                                                       of the small  country are moving to the large
                      underlying the model.
                                                                       country, but  the tax  rate in the large country
                         How does profit-shifting activities affect the   is so low that this condition will not hold long
                      way in which strategic aspects of international   for them. But, as the large country increases its
                      competition works? To get the answer, we can     tax rate beyond   , it becomes gainful for the
                      start with Kanbur and Keen (1993) model. This    small country to set a lower tax (discontinued
                      model  is  actually constructed  for  commodity   from the path of � + t /2. As the tax rate of large
                   20.  UNCTAD, “FDI,  Tax,  and Development: The  Fiscal Role  of   21. Michael Keen and Kai A. Konrad, “The Theory of International Tax
                   Multinational Enterprise  towards Guidelines for  Coherent International   Competition and Coordination,” Max Planck Institute for Tax Law and Public
                   Tax and Investment Policies”, UNCTAD Working Paper, (2015).  Finance Working Paper, No. 06 (2014).
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