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DDTC Working Paper 1416

                               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
                      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
                      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).
                      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
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