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``````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`````` 3   4   5   6   7   8   9   10   11   12   13 