Office of Tax Analysis

U.S. Treasury Department

Washington, D. C. 20220 

Issued November, 1976 

Border Tax Adjustments on 

Comodities and Income 

M. B. Krauss 

New York University 

G. C. Hufbauer 

U. S. Treasury Department 

OTA Paper 18 September 1976 
I. 

11. 

111. 

IV . 

V. 

VI. 

TABLE OF CONTENTS 

Introduction 

The General Equilibrium Approach 

Commodity Border Tax Adjustments:

A Review 

Income Border Tax Adjustments

A. Worldwide Border Tax Adjustments

B. Foreign Tax Credit Limits 

Commodity BTAs and Income BTAs 

A. Heckscher-Ohlin-Samuelson Model 

B. Specific Factor Model 

C. Tradables and Home Goods 

Fiscal Sovereignty 

Page 

1 

2 

4 

6 

8 

15 

18 

18 

26 

29 

33 
I. INTRODUCTION 

Many of the major propositions in the literature on 

-11 

border tax adjustments have come to be widely known. 

What is not generally recognized, however, is that the 

border tax adjustment concept is as relevant to income taxa-

-2 /

tion as it is to commodity taxation. Income border tax 

adjustments, as distinct from commodity border tax adjustments, are not relevant unless there is international 

factor mobility. Most of the analysis of the border tax 

adjustment issue has been based on economic models in which 

factors of production are 

The general theme of 

border tax adjustments in 

only the free exchange of 

assumed to be immobile. 

this paper is the nature of 

an open economy which permits not 

goods, but also the free movement 

of factors between countries. Several topics will be investigated. The first is the role played by commodity 

border tax adjustments in determining the impact of taxation 

in an open economy. The second topic concerns alternative 

principles of income border tax adjustments. Third, the 

relationships between commodity border tax adjias tments and 

income border tax adjustments are considered. Finally, the 

implications for fiscal sovereignty are examined. 
-2-

11. THE GENERAL EQUILIBRIUM APPROACH 

The general equilibrium approach to public finance 

emphasizes the dual role of households in economic life: 

on the one hand, households buy goods and services from 

business firms in commodity markets; on the other, they 

sell or rent their services to business firms in factor 

markets. This is known as the'bircular flow of income" 

relationship. 

The fundamental insight provided by the circular 

flow of income concept is that taxation can affect households in two separate ways: either as consumers of products 

or as suppliers of factor services, Richard Musgrave, a 

pioneer in the application of general equilibrium analysis 

to questions of public finance, recognized this distinction 

and pointed out the two different economic flows upon which 

taxes can be imposed -- the "uses of income" flow and the 

-3 /

"sources of income" flow. Taxes imposed upon the "uses 

of income" affect the household in its role as a consumer, 

while taxes imposed upon the "sources of income" affect the 

household in its role as a supplier of factor services. 

Both "uses of income" and'bources of income" refer to 

the econamic position of the household, Whether taxes are 

iaposed on "uses" or "sources", general equilibrium theory 
-3-

assumes that households ultimately bear the burden of taxation, not business firms. 

The distinction between taxes on the "sources of income" and taxes on the "uses of income'' leads to another 

important distinction -- that between direct taxes and 

indirect taxes. The taxing authority candecide not only 

which flow to tax ("used'or "sources") but also how to 

impose the tax, The tax can be imposed directly on the 

household, or indirectly on the household via the intermediation of the business firm. If, for example, the 

government desires to tax the "sources of income" flow, it 

can levy either a direct income tax on households, or an 

indirect production tax that lowers the price offered by 

firms to households for their factor services. Similarly, 

if the government desires to tax the "uses of income" flow, 

it can impose either a direct expenditure tax on households, 

or an indirect consumption tax that raises the prices paid 

by households for commodities they consume. 
-4-

111. COMMODITY BORDER TAX ADJUSTMENTS: A REVIEW 

Commodity border tax adjustments (BTAs) are relevant 

whenever there is international trade and indirect taxes 

are imposed. If an indirect tax is designed to reach the 

uses of income flow, destination principle BTAs are necessary. 

Destination principle BTAs consist of import taxes and export rebates at a rate equal to the internal tax. On the 

other hand, if an indirect tax is designed to tax the 

sources of income flow, origin principle BTAs are required. 

Origin principle BTAs consist of the exemption of imports 

and the taxation of exports at a rate equal to the domestic 

tax. If an indirect tax is designed to reach both the uses 

of income and the sources of income flow, dual principle 

BTAs may be applied. Under the dual principle, the domestic 

tax would be imposed on imports, but not remitted on exports. 

-41 

In practice the dual principle is rarely, if ever, used. 

A major proposition to emerge from the border tax 

adjustment literature is that, if the indirect tax is a 

truly general tax levied at the same rate on all final goods, 

there is no basic difference between destination principle 

BTAs and origin principle BTAs. But when the indirect tax 

varies between commodities, there is indeed a difference 

between the two principles, Destination principle BTAs 
-- 

-- 

-5-

ensure that domestic taxation does not disturb the structure 

of world prices facing producers -- all the distortion is 

shifted to consumption. Conversely, origin principle BTAs 

ensure that domestic taxation does not disturb the structure 

of world prices facing consumers -- all the distortion is 

shifted to production. Finally, dual principle BTAs cause 

domestic taxation to distort both consumption and production. 

Thus destination and origin principle BTAs can exert 

dramatically different effects on the composition of com-

-

5 1 -

modity trade. For example: 

A shift from the origin to the destination 

principle will reduce consumption and increase production of heavily taxed goods.

Correspondingly, imports of these goods will 

fall, and exports rise, 

A shift from the origin to the destination 

principle will increase consumption and 

decrease production of lightly taxed goods.

Correspondingly, imports o rise and exports decline. -61these goods will 
-6-

IV. INCOME BORDER TAX ADJUSTMENTS 

In a world in which factors of production are immobile 

between countries, the distinction between a tax on the 

consumption of income (an expenditure tax) and a tax on the 

-7 1 production of income (an income tax) is almost meaningless. 

The location of the consumption of income is the same as 

the location of the production of income and the two taxes 

are, more or less, the same. This is analogous to the 

closed-economy analysis of commodity taxation where a tax 

on the consumption of goods is identical to a tax on the 

production of goods, since the location of consumption is 

necessarily the same as the location of production. 

The distinction between a tax on the consumption of 

income and a tax on the production of income has relevance 

only if the location of consumption differs from the location of production. This is only possible when there is 

international factor mobility. If, for example, a country 

wants to tax only the consumption of income, then income 

produced abroad but consumed at home by residents must be 

taxed, while income produced at home but consumed abroad by 

nonresidents must be tax-free. Taxation imposed on the consumption of income would require border tax adjustments to 

tax the foreign source income of residents and exempt the 

domestic source income of nonresidents. On the other hand, 
-7-

if a country wants to tax only the domestic production of 

income, then the foreign source income of residents must be 

tax-free, while the domestic source income of nonresidents 

must bear the tax. 

Thus, there are three types of income border tax adjustments for direct taxes that correspond exactly to the 

three types of commodity border tax adjustments for indirect taxes. The combination of taxes on "imported" 

foreign source income plus exemptions for "exported" I 

domestic source income can be called residence principle 

BTAs. The combination of exemptions for ''imported" foreign 

source income plus taxes on "exported" domestic source income can be called source principle BTAs. The combination 

of taxes on both "imported" foreign source income and on 

"exported" domestic source income can be called worldwide 

BTAs. 

Both destination and residence principle border tax 

adjustments implement taxes on the uses of income flow --

the destination principle with respect to indirect commodity 

taxes, the residence principle with respect to direct income 

taxes, Both origin and source principle border tax adjustments implement taxes on the sources of income flow -- the 

origin principle with respect to indirect taxes, the source 

I 
-8-

principle with respect to direct taxes, Dual and worldwide 

border tax adjustments reach both the uses of income flow 

and the sources of income flow. 

In the real world,a mixture of residence and source 

principle BTAs are used in connection with the direct taxation of income. Some countries, such as France and the 

Netherlands, impose their income taxes on a territorial 

basis by domestic statute, while other countries, such as 

West Germany, reach much the same result by tax treaty, 

using the so-called "exemption" method to relieve double 

taxation. Under a pure territorial or exemption system, income imported by residents from foreign sources is exempt 

from domestic taxation while income exported to nonresidents 

from domestic sources is subject to domestic taxation. The 

territorial or exemption system of taxation, if applied on 

a multilateral basis, would explicitly result in source 

principle border tax adjustments. 

Residence principle border tax adjustments are not 

applied in the same explicit way. However, worldwide border 

tax adjustments, coupled with the foreign tax credit, will 

sometimes implement the residence principle. 

A. Worldwide Border Tax Adjustments. Worldwide BTAs 

consist of taxes on domestically-produced income sent abroad 

by nonresidents plus taxes on foreign-produced income 
-9-

repatriated by residents. When supported by worldwide BTAs, 

the income tax imposes a burden both on the uses of income 

and on the sources of income. 

Multilateral use of worldwide BTAs leads to the problem 

of international double taxation. The foreign tax credit is 

often used to deal with this problem. Among other countries, 

the United States, the United Kingdom, and Japan presently 

use the foreign tax credit to avoid international double 

taxation. If country A gives an unlimited -a/ 

foreign tax 

credit for income taxes paid to foreign countries on income 

arising there, income produced in foreign countries but 

consumed in A will not be subject to double taxation. Instead, 

such income will be taxed only once, at the same rate applied 

to domestically-produced income. If country B also gives an 

unlimited foreign tax credit, then income produced in country 

A but repatriated by residents of country B will bear no net 

income tax burden in country A, since the government of B will 

provide a credit to its own residents for those taxes paid 

to the government of A. Hence, the effect of worldwide border 

tax adjustments with unlimited foreign tax credits given by 

the governments of both countries is equivalent to residence 

principle border tax adjustments: There is a domestic tax 

in each country on domestically-consumed income produced 

abroad, and there is no domestic tax on domestically-produced 

income consumed abroad. It should be stressed, however, that 
-10-

this equivalence applies -not with respect to the tax revenue

that accrues to each government but rather with respect to 

the domestic tax rates levied on residents who receive income from foreign sources. 

Figure 1 illustrates the relationship between ''true" 

residence principle border tax adjustments and "equivalent" 

residence principle border tax adjustments (that is, worldwide border tax adjustments combined with unlimited foreign 

tax credits). TT represents the domestic transformation 

curve between goods X and Y. The international price ratio is 

given by the slope of LP and the production point is P. The 

value of the production bundle P at prices LP is OL in terms 

of good Y, the numeraire good. OL,therefore, represents 

gross domestic product or domestically-produced income, 

The world portrayed in Figure 1 is a world of international factor mobility. Some of the domestically-produced 

income is owned by foreigners while some of the income produced abroad is owned by residents. In Figure 1, it is 

assumed that an amount LM of domestically-produced income is 

exported to its foreign owners, to be consumed abroad, while 

an amount MN of foreign-produced income is imported by its 

domestic owners to be consumed at home. Hence, domesticallyconsumed income equals ON (OL minus LM plus MN). 

Let R equal the domestic tax rate and F equal the foreign 

tax rate. If the domestic income tax at rate R is appi: -il 
- 11 -

Geed Y 

L 

N 

M 

C 

Good X 

Figure 1 
- 12 -

only to the consumption of income, then the total tax paid 

by resident consumers would be Tc: 

Tc = R(0L) - R(LM) t R(MN) = R(0N) (1) 

Note that "truef1residence principle border tax adj.ustmenbs 

are R(MN) - R(LM). R(LM) of tax is rebated on domesticallyproduced income repatriated for foreigners, while R(MN) of 

tax is imposed on foreign-produced income repatriated to 

residents. 

On the other hand, an income tax at rate R imposed only 

on the domestic production of income would result in a total 

tax of Tp: 

TP = R(0L) = R (OM) t R(LM) (2) 

A tax on the domestic production of income implies 

source principle border tax adjustments, since R(LM) is 

included within R(0L) and no tax is imposed on MN. As 

explained earlier, the territorial or exemption system of 

taxation implements the source principle. 

With respect to domestically-consumed income, equation 

(1) specifies only the domestic taxes on the relevant income 

flows. To represent total taxation by both countries on 

these flows, equation (1) must be modified to take into 

account F(LN), the foreign tax on net income exported from 

the home country (LM less MN). It is assumed that the 

foreign country also applies its income tax as a consumption 

tax and employs "true" residence principle border tax adjustments. The total taxation imposed by boXh countries is given by 

Tc t Tc*: 
- 13 -

T, t Tc* = R(0N) t F(LN) (3) 

The domestic country would collect net tax revenue of R(0N) 

and the foreign country would collect net tax revenue of 

F(LN) on domestically-produced income. 

These consequences of a "true" residenoe principle 

may be contrasted with the consequences of an "equivalent" 

residence principle. An income tax supported by worldwide 

border tax adjustments and an unlimited foreign tax credit 

in both foreign and domestic countries would lead to a total 

tax of Tww + Tww* on income produced or consumed in the home 

country: 

Tww TwwX- = [R(OL) + R(MN) - F(MN)] i- [F(LM) - R(LM)] 

= R(0N) + F(LN) (4) 

The foreign tax credit in the domestic country is represented 

by - F(MN), while the foreign tax credit allowed by the foreign 

country is shown by - R(LM). The domestic country would 

collect net tax revenue of [R(OL) t R(MN) - F(MN)] while the 

foreign country would collect net tax revenue of [F(LM) - R(LM)] 

on domestically-produced income. 

Equation (4) is identical to equation (3) with respect 

to the overall tax burden. In other words, the total tax 

paid by consumers in both countries is the same if both 

countries follow a residence principle or if both adopt 

a system of worldwide border tax adjustments and an unlimited 

foreign tax credit. Thus, if each country in the world economy 
- 14 - supports its income tax with worldwide border tax adjustments

* 

and offers an unlimited foreign tax credit, the result, so far 

as taxpayers are concerned, is equivalent to each country 

imposing a tax solely on the consumption of income. 

There is, however, a significant difference between 

tltruelt and tlequivalentlt residence principle border tax

adjustments. This difference relates to the distribution 

of the tax revenues. Under a true residence principle, the 

domestic government collects the revenues on imported income 

and rebates the revenues on exported income. Under an 

ttequivalenttlresidence principle (worldwide border adjustments 

with unlimited foreign tax credits), the foreign government 

collects the revenues on income imported by the domestic 

country and rebates the revenues on income exported from 

the domestic country. In terms of Figure 1 and equation 

(4), the home government loses F(MN) but gains R(LM) with 

ttequivalent'lresidence principle border tax adjustments by 

comparison with tttruetlresidence principle adjustments. 

Whether a given country would gain or lose tax revenues 

upon switching from "equivalentt1to Ittrue"residence principle 

border tax adjustments depends on the quantitative difference 

between R and F on the one hand, and MN and LM on the other. 

Any shift of tax revenue between governments attending 

a change from llequivalenttlto "truettresidence principle border 

tax adjustments can be expected to have economic effects 
- 15 - over and above the intergovernmental shift of purchasing 

power. The additional effect reflects the so-called 

"transfer problem". If the domestic and foreign governments have different spending patterns as between domestic 

and foreign goods, a transfer of real resources from one to 

the other, measured at constant terms of trade, will change 

the pattern of world demand, and thus the equilibrium of 

the world economy. The terms of trade of the domestic 

country will improve if the shift of tax revenue increases 

the world demand for its products, and vice versa. 

A country which loses tax revenue can possibly gain 

from a terms of trade improvement, but the more likely 

outcome is that a country which loses tax revenue will also 

experience an adverse terms of trade effect. Governments 

tend to concentrate their expenditures on nontraded goods 

and services, and when they purchase traded goods, they 

tend to discriminate in favor of domestic firms. Ordinarily, 

then, one country will experience a double dose of welfare 

loss, and the other country a double dose of welfare gain, 

as a result of changing from "equivalent" to "true" residence 

principle border tax adjustments. For this reason, such 

a shift is unlikely in the real world. ~ 

-_ 

B. Foreign Tax Credit Limits. The correspondence, 

from the taxpayer's view, between the "equivalenttfresidence 

principle and the tltruet'residence principle holds so long 
- 16 - as foreign tax credits are not sub3ect to a limit. This 

is not the usual case in the real world; instead foreign 

tax credits are often subject to a limit set with reference 

to the domestic tax rate. 

Consider the consequences of a foreign tax credit 

limit when the domestic tax rate is greater than the 

foreign tax rate. In this case, with "equivalent1' 

residence principle border,tax adjustments and a foreign tax 

credit limited by the domestic tax rate, imported income 

will bear the same tax rate as domestically-produced 

income. But domestic taxes on exported income will not 

be fully compensated by the foreign government. An analogous 

distortion occurs when the domestic tax rate is less than 

the foreign tax rate. Here, imported income will not be 

fully compensated by the domestic government, so that 

imported income will be taxed at a higher rate than 

domestically-produced income. 

A foreign tax credit limit thus ensures that income 

flows from the high-tax country to the low-tax country are 

taxed under the source principle rather than the residence 

principle. If R > F, there will be a ''source tax" on exported 

income equal to (R-F). If R < F, there will be "source taxVt 

on imported income equal to (F-R). A tlsourcetax" on exported 

income is equivalent to a tax on factor inflows. The result 

will be lower factor inflows than would have occurred without 
-17-

the foreign tax credit limit. Similarly, a "source tax" on 

imported income is equivalent to a tax on factor outflows 

The result will be lower factor outflows than otherwise 

91 

would have occurred. 
-18-

V. COMMODITY BTAs AND INCOME BTAs 

A. Heckscher-Ohlin-Samuelsonmodel. The HeckscherOhlin-Samuelson model may be used to illustrate the relationship between commodity BTAs and income BTAs. This model 

assumes two goods each produced by two different and fullyemployed productive factors, labor and capital, under perfectly competitive conditions. The production functions 

exhibit constant returns to scale; technology is identical 

in the two countries; and one of the goods is unambiguously 

capital-intensive while the other is unambiguously laborintensive. In addition, assume that factor services but not 

factor owners are mobile between countries, and to simplify 

matters even further, that only capital moves across international borders. The home country is assumed to be small 

so that it has a negligible impact on world prices of goods 

and factors. Finally, to keep the analysis simple, assume 

that taxes are spent on defense and other public goods in a 

way that does not directly affect the productivity of factors 

or their after-tax incomes. 

The initial situation of the economy is illustrated in 

Figure 2. At the world price ratio for goods, indicated by 

the slope of LP, home production is at point P and home consumption is at point C. The trade triangle is PBC. Commodity 
-19-

price equalization leads to factor price equalization in 

the model and initially there is no incentive for factor 

movement . 

Starting from this position, the home country imposes 

a tax,levied under the source principle, only on capital in 

the corporate sector. One way corporate capital can escape 

the tax is to flee abroad. In the frictionless HeckscherOhlin-Samuelson world, the flight of corporate capital into 

foreign investment must eventually result in a shutdown of 

the domestic corporate sector. With goods and factor prices 

given, a corporate income tax, no matter how small, is inconsistent with positive corporate sector output. Domestic 

production of the corporate good ceases because, with the 

price ratio for goods fixed by world markets, the corporate 

sector cannot afford to match the after-tax returns to 

capital available from foreign sources. 

This result is illustrated in Figure 2. The corporate -IO/

good is assumed to be capital-intensive. The production 

point moves along the Rybczynski line MR which depicts the 

change in production, at constant commodity prices, as 

capital enters or leaves the domestic economy. Capital 

leaves until the production point M on the vertical axis is 

reached. This implies complete product specialization of 

the noncorporaEe good. OM represents gross domestic product 
- 20 -

NonCorporate

Good 

L 

Corporate Good 

Figure 2 
-21-

in terms of the noncorporate good, but national income remains at OL, since interest and dividend receipts from the 

exported capital services equal LM under factor-price equalization assumptions. With constant national income, unchanged 

commodity prices, and no alteration in consumer preferences, 

consumption is unaffected by the tax and remains at point C. 

LM of income from capital plus MN of the noncorporate good 

are traded for NC of the corporate good. The only effect of 

the tax has been to change international exchange from a 

pattern of ''goods for goods" to a welfare-equivalent pattern 

of "capital services (plus goods) for goods". 

A combination of residence and destination principle 

BTAs could prevent the dislocation implied by the shift in 

production from P to M. If the corporate tax is imposed 

according to the residence of the ccxporation, there is no 

tax reason for corporate capital to flee to the foreign 

country. The location of corporate production is irrelevant 

for corporate tax purposes. But domestic shareholders will 

shift their capital from the corporate sector to the domestic 

noncorporate sector so as to equalize net of tax returns. 

Equalization of net of tax returns between the two sectors 

of the economy requires a higher before-tax return on capital 

in the corporate sector than in the noncorporate sector. 

This in turn requires a destination principle adjustment for 

trade in corporate goods so that the corporate tax can be 
-22-

passed forward as a consumption tax. With a combination of 

residence and destination principle BTAs, the tax raises 

revenue and the exchange pattern of ''goods for goods" persists. 

On the other hand, if origin principle BTAs were applied 

to goods trade, corporate sector output would disappear. 

Under the origin principle, the corporate tax cannot be 

passed forward to consumers. The equalization of net of 

tax factor prices would lead to capital inflow or outflow, 

depending upon whether the shrinking corporate sector was 

labor-intensive or capital intensive in comparison to the 

noncorporate sector. 

This is the essential symmetry between source principle 

income BTAs and origin principle commodity BTAs in the 

Keckscher-Ohlin-Samuelsonmodel with capital mobility. 

Under either border tax adjustment principle, the corporate 

tax has no effect other than to switch the pattern of international exchange from that of "goods for goods'' to a welfareequivalent pattern of'kapital services (plus goods) for goods.11-

11/ 

A corollary of this symmetry is that, in a world of factor price 

equalization and capital mobility, the corporate income tax 

will be effective in the sense of raising tax revenue only 

if it is supported by both -destination principle commodity 

BTAs and residence principle income BTAs. Neither principle 

of border tax adjustment, by itself, is sufficient for this 

purpose. 
-23-

The same analysis can be extended to any income tax 

that le imposed at a differentially higher rate on particular uses of a factor. Consider an equal ad valorem tax on 

labor and capital in one sector only, say sector X. Assume 

that X is capital-intensive and that capital services are 

mobile. Under both source principle income and origin 

principle goods BTAs, capital leaves the country until sector 7121

X closes down. This outcome is illustrated in Figure 3 

which portrays factor endowments on the axes and commodity 

output by isoquants (deleted to simplify the illustration). 

At the world factor-price ratio of O( and the initial factor 

endowment E, the corresponding factor-intensity ratios are 

0% and 05, and the factor allocation points are Px and Py. 

If capital alone is mobile, capital leaves the country until 

the factor endowment point becomes P

Y I. Output of X falls 

from Px to zero and output of Y rises from Py to P

Y

'. Some 

capital migrates from sector X to sector Y, and some capital 

leaves the country. With the disappearance of sector X, no 

tax is collected on either internationally mobile capital or 

internationally immobile labor. The situation, similar to 

that in Figure 2,.isthat an exchange pattern of "factor 

services (plus goods) for goods'' replaces a welfare-equivalent 

pattern of "goods for goods.'' For the tax on labor and 
24 -

1 

L Labor 0 

Figure 3 
-25-

capital in X to be effective, it too must be supported by 

both residence principle and destination principle BTAs. 

Finally, consider an equal ad valorem tax on capital 

in both sectors. With residence principle BTAs, capital 

will have no reason to leave the country; nor will it have 

any reason to shift from one sector to another. Hence, 

with a uniform tax on capital, residence principle income 

BTAs alone are sufficient to ensure that neither industry 

shuts down and that the tax base does not disappear. The 

tax, in fact, does not disturb the economy's initial equilibrium. With source principle BTAs, however, capital does 

have an incentive to leave the country. If labor is internationally immobile, the ensuing unemployment will drive 

down the relative wage until the after-tax return on capital 

is restored to the world level. This implies an increase in 

the pre-tax return on capital in both industries which requires an increase in the relative price of the capitalintensive good. But given fixed world commodity prices, 

the required price change is impossible, and hence the 

capital-intensive sector must close down. Full employment 

is thus inconsistent with positive output of the capital 

intensive industry when capital is internationally mobile. 

In this way, the burden of the income tax on capital is 

transferred to labor. 
-26-

B. Specific Factor Model. It seems extreme that a 

corporate income tax, however small, would shut down the 

corporate sector when applied under either source principle 

income BTAs or origin principle goods BTAs,as asserted in 

the Heckscher-Ohlin-Samuelson model. The corporate income 

tax is widely applied by various nations under these same 

principles and the corporate sector persists in spite of 

substantial international capital mobility. This may be 

explained by the presence of specific factors. 

Consider a neo-Ricardian model with two goods, corporate and noncorporate, and with labor specific to the 

corporate good and land specific to the noncorporate good. 

A third factor, capital, is used in the production of both 

goods and can move freely between the two sectors. The 

economy in question is small and open to both commodity 

trade and capital mobility. 

The initial supply of domestic capital is given by 00' 

in Figure 4. The value of the marginal product of capital 

schedule in the corporate sector is shown'by AB, and the 

value of the marginal product of capital schedule in the 

noncorporate sector is shown by DC. The initial equilibrium 

is at point E, with OT capital employed in the noncorporate 

sector and O'T capital employed in the corporate sector. 

The equilibrium return to capital is equalized at OK in 

both sectors. 
NonCorporate

Good 

D 

K 

Corporate

Good 

A' 

A 

I

_-----

I 

T 0" 

Cap it a1 

Figure 4 
-28-

The home country now imposes a tax at an ad valorem 

rate of K'K/O'K on capital in the corporate sector only. If 

source principle BTAs apply to this corporate tax, corporate 

capital will flee the taxing country. Capital goes abroad 

until the net of tax price of capital in the corporate 

sector again is restored to OK. This implies that the gross 

of tax price of capita_l is O'K' in the corporate sector, 

and to achieve this result, 0'0" units of capital must leave 

the home country. As a result, OT units of capital are employed in the noncorporate sector at a net (equal to gross) 

return of OK; and 0"T units of capital are employed in the 

domestic corporate sector at a net of tax price of OK and a 

gross of tax return of O'K'. 

Given international capital mobility, the corporate 

income tax has reduced the size of the corporate sector but 

it has not completely eliminated it. Only at the tax rate 

AK/O'K would the corporate sector close down. Corporate tax 

revenues are E'N'NE, which is clearly less than E'K'KE--the 

initial tax base times the tax rate. Who pays this tax? 

Clearly corporate capital does not, since the net of tax 

price of corporate capital has not changed. Instead the 

tax is paid by labor, the specific factor in the corporate 

sector, out of its Ricardian rent, MHL, which is reduced to 

a post-tax level of MN'E'. Indeed, because of the existence 

of this rent, the tax affects neither the price received 
-29-

producers nor the price paid by consumers for the corporate 

good. It is borne fully by the specific factor of production in the corporate sector. 

The same result emerges if instead of source principle 

BTAs, the corporate tax is levied with residence principle 

income BTAs. The equilibrium conditions that the net of tax 

return of capital be OK in both sectors and the gross of tax 

return of corporate capital be OK' imply that 0'0" units of 

corporate capital are sent abroad, presumably by erstwhile 

domestic shareholders. Labor pays the full tax in this case 

as with source principle BTAs, Indeed the general conclusion that emerges from the specific factor model is that all 

taxes imposed on a given sector will be borne by the factor 

of production specific to that sector as if the tax had been 

placed directly on the rent of the specific factor. 

C. Tradables and Home Goods. So far the discussion has 

concerned models in which both goods are tradables. Another 

outcome is reached when the country specialize6 in the production of one tradable and produces a home or nontraded 

good as well. The assumption of a nontraded good prohibits 

"goods for goods" trade, and instead compels a pattern of 

"factor services for goods" trade. Consider the situation 

illustrated in Figure 5. The commodity price ratio MN corresponds to equalized factor prices, the production point is 

P on the transformation curve TT, and the consumption point 

is C on the national income budget constraint line M'N! 
- 30 -

Tradable 

Good 

R 

P’ rl ” 

Home Good 

Figure 5 
-31-

Consumption is sustained by an outflow of capital services 

that reconciles the production and consumption points by 

producing an inflow of interest payments equal to CP in 

terms of the tradable good. 

From this initial equilibrium position, the government 

imposes an equal ad valorem tax on labor and capital employed in producing the tradable good only. With source 

principle BTAs, capital flees the home country to the extent 

necessary to shut down the tradable good industry. The production points from P to P' on the Rybczynski line RP' and 

interest payments equal C'P'. Butthis cannot be a position 

of final equilibrium since at the commodity prices given by 

the slope of M'N', the desired consumption point is C, not C'. 

The shut down of the tradable sector by capital flight implies an excess demand for the tradable good (excess supply 

of the home good) at prices M'N'. The consequent increase 

in the output of the tradable good and decrease in the output 

of the home good raises the after-tax price of capital, so 

that capital returns until the after-tax price of capital is 

equalized in both countries. Such equalization implies that 

the tax is passed forward to consumers through a higher 

relative price for the tradable good. With a higher price 

of the tradable, the homothetic consumption vector shifts 

from OZ to OZ' indicating C" as the equilibrium consumption 

point. Interest receipts are C"P" in terms of the tradable, 
-32-

and the increase in the capital stock employed abroad by 

comparison with the initial equilibrium is measured by PP" 

along the Rybczynski line, 

In terms of its implications for border tax adjustment 

policy, the analysis of a tradable and nontradable in a twosector general equilibrium model gives the result that neither 

the principle of commodity nor income border tax adjustments

la1

-

LJI 

is important. There is only -one general equilibrium 

outcome possible, and this outcome is consistent only with 

the taxation of the uses of income stream. By contrast, 

there are two different general equilibrium outcomes possible 

in the Heckscher-Ohlin-Samuelson model with two tradables, 

and which result emerges depends upon whether the uses of 

income or the sources of income stream is taxed. 
-33-

VI. FISCAL SOVEREIGNTY 

“Fiscal Sovereignty” implies national control over budget 

size. Fiscal sovereignty problems are most likely to appear 

in a Heckscher-Ohlin-Samuelson world of traded goods and 

mobile goods. If factor services but not factor owners are 

mobile, a country can exercise control over the size of its 

budget only if it taxes the uses of income flow. A tax on 

the sources of income would be frustrated by the exportation 

of factor services and the consequent importation of factor 

income from abroad. But since the location of production is 

irrelevant if the tax base is income owned by residents, a 

uses” tax can be avoided only if the factor owners themselves 

move. Assuming that movement is precluded by the national 

allegiance of factor owners, fiscal sovereignty over budget 

size requires either a tax on residents’ income (a direct 

tax coupled with residence principle BTAs) or a tax on their 

consumption of goods (an indirect tax coupled with destination 

principle BTAs). 

The concludion that source taxation at different rates 

in different countries is not possible when factor services 

are mobile depends on the assumption that the marginal productivity of mobile factors is the same everywhere. This may 

not be the case for three reasons: first, technology may not 

be the same everywhere; second, even if technology is iden-

-

1.41 - .. tical, full factor price equalization may not occur; and 

third, high-productivity may be a result of high taxation 

11 
-34-

(this can happen if the government spends the revenue in a 

way to increase factor productivity). High-productivity 

countries can exploit their advantage by charging higher 

source taxes than low-productivity countries without neces­ -15/

sarily prompting factor service movement, 

We have already noted that fiscal sovereignty is consistent with taxing the uses of income, This consistency 

rests upon the assumption that factor owners are immobile; 

however, if factor owners are mobile, border tax adjustments 

will have little effect in preserving a country's fiscal 

sovereignty. Unless the level of taxes is associated with 

a comparable level of fiscal benefits, taxpayers will be encouraged to seek a more hospitable fiscal environment. The 

only border "solution" to this problem involves restrictions 

on the mobility of capital and labor. A better solution would 

involve reexamination and modification of the domestic fiscal 

regime. The emigration of factor owners should be regarded 

as a symptom not a cause, of economic illness, 

The potential. mobility of factor owners is, of course, 

an empirical question that can only be settled by empirical 

analysis. But some speculation may be worthwhile. Suppose 

that most individuals have a special affinity for a particular 

culture, usually the culture of their birth, but perhaps 

another culture as well. If this "cultural affinity" is not 

an inferior good, the demand for it should be greater in 

richer countries than in poorer ones. This in turn implies 
- 35 -

that factor owners in rich countries are likely to be less 

mobile in response to an inhospitable fiscal climate-an 

implication consistent with the combination of exceedingly 

high tax rates in certain wealthy countries, such as Sweden 

and the Netherlands, without the significant emigration of 

factor owners. This speculation suggests that redistributive 

tax policies can be most successfully pursued by a wealthy 

country with a specific cultural experience, and least 

successfully pursued (unless reinforced by strict capital 

controls and repressive emigration policies) by a poor 

country with a cultural experience that can be duplicated 

elsewhere. 
FOOTNOTES 

The authors are associated, respectively, with New York 

Uriversity and the U.S. Treasury Department. The views expressed are -

the opinions of the authors, and do not reflect 

views of the associated institutions. 

See, for example,Harry Johnson and Me1 Krauss, "Border 

Taxes, Border Tax Adjustments, Comparative Advantage and 

the Balance of Payments," Canadian Journal of Economics, 

v. 3, n. 4, November 1970; and James E. Meade, "A Note 

on Border-Tax Adjustments," Journal of Political Economy, 

v. 82, n. 6, SeptemberIOctober 1974. 

Income and commodity border tax adjustment principles 

are also examined by Carl S. Shoup, Public Finance,

Chicago, Aldine Publishing Co,, 1969, and Dieter Biehl,

Ausfuhrland-Prinzip Einfuhrland-Prinzip und GemeinsamerMarkt-Prinzip, Koln, Carl Heymanns Verlag, 1969. 

Richard A. Musgrave, The Theory of Public Finance, New 

York, McGraw-Hill, 1958. 

In fact, the dual principle amounts to the origin principle plus an import tariff, or the destination principle plus an export tax. A reverse dual principle, conceptually bizarre because it extends an open invitation 

to fiscal evasion, would exempt both imports and exports

from domestic taxation. 

Associated with the differing trade effects of border 

tax policies are differing consequences for national 

welfare. The choice between destination and origin

principles is the choice between departing from an 

optimum consumption pattern and departing from an 

optimum production Dattern. 

These results reflect the shift in relative prices facing

producers and consumers. A shift from the origin to the 

destination principle increases the relative price received by producers and paid by consumers for heavily

taxed goods by comparison with lightly taxed goods. 

For present purposes, consumption of income is broadly

defined to encompass any disposition of income by residents of the state, including the purchase of both 

consumption and investment goods. 
-8/ In fact, countries generally impose a limit on the foreign

tax credit which is related to the domestic tax rate. The 

effect of these limitations is discussed later. 

-9/ A tax on capital inflows or outflows does not necessarily

reduce potential welfare in the taxing country. Indeed, 

as R.W. Jones has demonstrated, such interference with 

factor service flows, when combined with an optimal

tariff, can be a necessary condition for potential welfare maximization. This consideration, however, does 

not amount to a convincing argument for the limitation 

of foreign tax credits. The limitation of foreign tax 

credits may not correspond with the needs of an optimal

interference policy, and, even if it does, the whole 

policy can only be supported on beggar-my-neighbor

principles. R.W. Jones,"International Capital Movements 

and the Theory of Tariffs and Trade", Quarterly Journal 

of Economics, v. 81, n. 1, February 1957. 

-10/ If the corporate good was instead labor-intensive, the

Rybczynski line would intersect TT from above, and a 

tax on capital in the corporate sector would paradoxically cause an inflow of capital from abroad to work in 

the noncorporate sector. 

-11/ The pioneering work of Robert Mundell should be mentioned at this point. Mundell demonstrated that,

under the assumption of full factor price equalization

and the mobility of capital services, a tax on commodity

imports (a tariff) can have no effect on potential welfare in the tariff imposing country because imports

completely dry up and the tax base disappears. By extension, though Mundell did not consider this case, a 

production tax on a given sector, or a partial factor 

tax in a given sector, closes down that sector but does 

not affect potential welfare in the tax-imposing country.

See Robert Mundell, "International Trade and Factor 

Mobility," American Economic Review, v. 47, n. 3, June 1957. 

-12/ If good X were labor-intensive, capital would have to

flow into the taxing country for sector X to shut down. 

This seemingly paradoxical result can be understood by

noticing that capital would flow into production of 

untaxed good Y. 
-

13/ The result is the same, but the reason is different in

the specific factor model. There, the tax falls on the 

immobile resource under either the source or the origin

principle, 

-14/ This has been the consistent position of Bertil Ohlin.

See Bertil Ohlin, "Some Aspects of the Relationship

Between International Movement of Comrnodities, Factors 

or Production and Technology," Nobel Symposium, The 

International Allocation of Economic Activity, Stockholm,

June 1976. 

-15/ Conversely, low-productivity countries may be able to 

tax payments for the use of ''atmospheric''factor services, such as technical expertise and patents imported

from abroad, without chasing the indefinitely extensible 

"atmosphere" to another country.