Page 8 - Working Paper (Optimal Corporate Income Tax Policy for Large Developing Countries in an Integrated Economy)

P. 8

```
DDTC Working Paper 1416
8
Figure 2. Best Responses for Country 1 (Large Country) and Country 2 (Small Country)
Source: Kanbur and Keen (1993)
country keeps increasing, the small country can However, the equation above still assumes a
follow by increasing its tax rate with still gaining condition of commodity tax. Keen and Konrad
from the capital inflow. Continuously by doing (2014) proves that a model of profit shifting
so, the small country will be advantageous will lead to a similar structure. Suppose a
from the capital inflow coming from the large multinational earns “true” profits in each of
countries. the two countries. However, the declared profit
to be taxed is different from the “true” profit,
By assuming that country 2 initially set t depending on how intensive the company uses
2
above , the best response for each country transfer pricing and other instruments of profit
are then sequentially shifting from country 2 to country 1 (remind
that t <t ). In other words, there is s fraction of
1 2
real profit in country 2 that is shifted to country
1. Assuming there is cost of profit shifting which
Equation (16) implies that if the larger
takes form of so the firms’s net profit is
country (for example, country 2) lowers its tax
rate, country 1, as the smaller country, would
set a very low rate in order to attract consumer
from country 2. It would be the best option
Maximizing (16) with respect to will
for country 1 since the revenue lost could be
provide us an equation exactly the same as (12),
(or probably, more than) offset by the revenue
while the amount of the revenues received by
gained from abroad. Conversely, if country 2
each country is equal to (13). The proportion
increases its tax rate, there will be a point where
of profit shifted from country 2 to country 1
country 1 prefer to stop following to increase
thus depends on the difference of the tax base
its tax rate, which by means, implementing
(t –t ) and the cost of implementing such
2
1
the strategy of undercutting. The sequential
shifting. Accordingly, the amount of proportion
responses however will be unending, since
of shifted profit can be shown again on (17). For
each country will always respond each other.
the revenues in the two countries, the equation
Nevertheless, Kanbur and Keen (1993) shows
can be rewritten by replacing the tax base,
that there is Nash equilibrium under this
population (h ) to � as well, as shown in (18).
i
i
relationship, which is as following equation.
It enlighten us the idea that smaller
countries has more chance in taking advantage The smaller country – in a sense that it can
in whichever rates the larger countries choose. only yield lower profits from real economic
Practically, the smaller ones will set lower tax activities–, will set lower tax in equilibrium.
rates. This is because there is major asymmetry The reason is that this type of country loses
between the responses of small country and the relatively small tax revenue from its own tax
large country. base, so that it is much better for the country
```