metadata: authors: 0: author: Conrad,Robert F
docna: 0: docna: Considerations for the development of tax
            policy when capital is internationally mobile
docty: Policy Research Working Paper
subtopic: Tax Administration,Macro-Fiscal Policy,Taxation & Subsidies,Investment and Investment Climate,Economic Adjustment and Lending,Social Policy,Human Rights,Legal Products,International Law,Tax Law,Judicial System Reform,Public Sector Economics,Tax Policy,Legal Reform,Treaties,Legislation,Regulatory Regimes,Public Finance Decentralization and
            Poverty Reduction
teratopic: Finance and Financial Sector Development
abstracts: cdata!: For tax policy to encourage maximum
            investment of capital (both foreign and domestic) it is
            necessary to take into account the potential mobility of
            capital across international borders. Economic analysis of
            investment incentives should therefore incorporate the
            effects of variables such as source rules, nexus rules,
            attribution rules, foreign tax credits, and so on, in
            addition to traditional variables such as legal tax rates
            and the revenue implications of the distribution of the tax base.
repnme: repnme: Considerations for the development of tax
            policy when capital is internationally mobile
display_title: Considerations for the development
            of tax policy when capital is internationally mobile
listing_relative_url: /research/1989/03/700546/considerations-development-tax-policy-capital-internationally-mobile
topicv3: Treaties m1327063 1026,Taxation m1327615 1121,Tax Policy m1327616 983,Investment Entry m1504647 2544,Discrimination m1505707 3379
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy Plan & Prog Review Dept
no_of_pages: 51
author_keys: 0: author_key: 428594
model_extractions: Poo, Ph-aidh To encourage investment and savings, policymakers cannot ignore capital mobility even in situations where domestic nationals do not invest abroad and foreign investors do not invest domesticaily. The potential for capital to move across intemational boundaries creates an opportunity cost for investment in a particular country and throughout the world. In determining marginal effective tax rates it is necessary in addition to traditional considerations, such as tax rates and the distribution of the tax base, to incorporate the following factors:

* Source rules (the basis for taxation).

* Nexus rules (which defie who must file and pay income taxes).

* Attribution rules (about accounting methods).

* The scope of bilateral accommodation between countries.

None of these factors i.' supetior economically to the others as a basis for determining tax policy. If tax policy is to encourage intemational capital flows, explicit tradeoffs may have to be made between increased tax revenues and incentives to invest.

In addition, tax policy should be evaluated with respect to _net,_ not gross, capital flows. Tax policy that increases foreign investments in a capital importing country by X percent is poorly designed if it increases the flow of domestic investments abroad by a larger percentage.

International capital mobility provides both costs and opportunides for developing tax policy within a country. Since investors tmat taxes as a cost of doing business, each country's tax price should reflect its opportunity cost of investment (either foreign or domestic). These tax prices will differ between countries. Uniformity of taxes across countries can therefore distort rather than improve investment. As long as there is reasonable competition among the suppliers of capital, tax competition among govemments may make distribution within the system more efficient. In such a context international cooperation may not be the best method for the develoment of tax policy for factors that are internationally mobile.

Equity across countries, however defined, should be measured by how the net benefits of capital investment (including tax revenues) are distributed - _not_ by how the tax base is distributed. In particular, tax treaties should not be evaluated solely on revenue potential nor should they be canceled unilaterally. Instead they should be evaluated on pragmatic grounds in terms of their effects on investor confidence and their administrative costs.

This is a background paper for the 1988 World Development ReporL Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Lupita Mattheisen, mom S13-067, extension 33757.

The PPR Working Paper Series disseminates the fidings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fuly polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.

Produced at the PPR Dissemination Center
# Considerations for the Development of Tax Policy When Capital **is** Internationally Mobile by Robert F. Conrad

# Table of Contents

|1.|Intr|oduction . . . . .<br>. . . . .<br>.|.|. .|. .|. .|.|.|.|1|
|---|---|---|---|---|---|---|---|---|---|---|
||1.1|The Imp3rtance of Internationa|l<br>Ca|pital|Flo|ws|||||
|||and Taxation.<br>.<br>.<br>.<br>.<br>.<br>.<br>.|.<br>.|.<br>.||. .|.||||
|2.|Motiv|es for Foreign Investment . . .|. .|. .|. .|.<br>.<br>|.|.|.|4|
||2.1|Portfolio Investments .. .<br>.<br>.|.|.<br>.|.<br>.|.<br>.<br>|.|.|.|5|
||2.2|Direct Investments . . . .<br>. .||.<br>|.<br>.|.<br>.<br>|.|.|.|6|
|||2.2.1 Horizontal International|In|vestm|ents|. .|.|.|.|6|
|||2.2.2 Vertical Direct Investme|nt|. .|.<br>.|.<br>.<br>|.|.|.|7|
||2.3|Government Induced Motivations|for|/aga|inst||||||
|||Foreign Investment . . . . . .|. .|. .|. .|. .|.|.|.|8|
||2.4|Summary..<br>.<br>.<br>.<br>.<br>.. . . . .|.|. . .|. .|. .||.|.|8|
|3.|Inco|me Taxation in an International E|nvir|onme|nt.|. .|.|.|.|9|
||3.1|Components of Tax Base and Defi|nit|ions|in a|n|||||
|||International<br>Environment. . .|. .|. .|. .|. .|.|.|.|10|
||3.2|Jurisdictional<br>Basis to Tax. .|. .|. .|. .|. .|.|.|.|10|
||3.3|Minimum Connection . . .|||..|.||.|.|11|
||3.4|Attribution Rules. . . . . . .|. .|. .|. .|. .|.|.|.|12|
||3.5|International Coordination.<br>.|.<br>.|. .|. .|. .|.|.|.|14|
|4.|<br>Ince|ntives and Consequences. . . . .|. .|. .|. .|. .|.|.|.|15|
||4.1|Traditional Economic Incentive|s. .|. .|. .|. .|.|.|.|15|
||4.2|Incentives Created by Administ|rat|ive<br>an|d Le|gal|||||
|||Concepts . . . . . . . . . . .|. .|. .|. .|. .<br>|.|.|.|16|
|5.|<br>Comm|ent and Perspective for Tax Polic|y D|evelo|pin|g in|||||
|||LDCs . . . . . . . . . . . . .|. .|. .|. .|. .|.|.|.|18|
||5.1|Lack of Coordination and Tax Co|mpet|itio|n .|.<br>.<br>|.|.|.|20|
||5.2|Discrimination . . . . . . . .|. .|. .|. .|. .|.|.|.|20|
||5.3|Tax Policy Implications<br>for Dev|elo|ping|Econ|omie|s|.|.|21|
||5.4|Options for Domestic Tax Policy|in|LDCs|. .|. .<br>|.|.|.|22|
|6|Summa|ry . . . . . . . . . . . . . .|.<br>.|.<br>.<br>|.<br>.|.<br>.<br>|.|.|.|26|
||Appen|dix . . . . . . . . . . . . . .|. .|. .<br>|.<br>.<br>|.<br>.<br>|.|.|.|30|
||Table|s...<br>.<br>.<br>.. . . . . . . ..<br>|..|. . .|.<br>|.<br>.<br>|.|.|.|35|
||Refer|ences.<br>.<br>.<br>.<br>.<br>.<br>.<br>.<br>. . . . .|. .|. .|. .|. .|.|.|.|41|

*Associate Professor of Public Policy, Duke University, rurham, North Carolina. Zmarak Shalizi provided many helpful comments on previous drafts. Appreciation is also expressed to Bela Balassa for his helpful comments. Jo Beth Mertens provdied valuable research assistance.
# 1 Introduction

The decrease in the relative prices of transportation and communications have been responsible, In part, for the growth in the international flow of goods and services. It is no longer unusua; for a resident of Singapore to phone the local office of a US stock broker to purchase equity in a US firm or bonds in a UK firm. In turn, the firms whose shares or debt are purchased by a Singaporean may have Investments in numerous countries, accounts maintained in different currencies, and financing from bank and insurance companies In Singapore. US residents may make depoqits n Canadiar. banks (a loan to the bank) which in turn may make loans to locail or foreign firms doing business in Canada or to firms in Brazil. Citizens of developed economies become employees of companies owned by tbe government of Zambia or offer short-term consulting services In Malawi either through private firms or through International organizations such as the World Bank.

The fact that goods, services and factors of production have the potential to move across relatively fixed international boundaries raises difficulties for the rational development of tax policy both within and between countries. A government using principals of traditional optimal Income taxation, may find that tax revenues decrease because factors move to other countries which have distorted systems but lower effective tax rates (either total, marginal or average). This paper contains a review of the justification(s) for international factor mobility, a review of current perspectives on the income tax treatment of capital, and an alternative way of viewing the problem(s) of international tax coordination and competition. Income taxes will be the primary subject of analysis. Such emphasis does not imply that income taxes are the most Important aspect of international/local tax coordination or that income tax switches are the most effective means of attracting (controlling) investment. Income taxes may be neither.' However, there is now substantial debate over the appropriate use of income tax policy in an international environment.P

# 1.1 The Importance of International Capital Flows and Taxation

Changes in international capital flows can have numerous effects, including balance of payments effects, employment gains and losses, and tax revenue consequences to government. Foreign investment and international trade between related parties has also become increasingly important. For instance, It has been estimated that 36 to 45% of US imports and exports move between

1. Governments employ a host of methods to attract or deter both domestic and foreign investment including trade taxes, licensing, quotas and other restrictions. See Guisinger ( 1985).

2. See Musgrave (1987) for one perspective.
members of related partles.' The proportion may be higher for countries whose exports are natural resource based and who allow foreign Investment in this sector, e.g. Cameroon. Indonesia, Papua New Guinea, and Jamaica. International intrafrlm trade Is also significant in developed economies such as Canada and developing economies such as Korea.

Intrafirm trade of goods and services may benefit the current account balance In years when exports are significant. In turn these gains may be set by profit remittances in subsequent years, other things equal. Intrafirm International trade may respond differently or at a different rate to changes in nominal or real exchange rates relative to true arms-length transactions. Such differentials may complement or offset policy Initiatives by government. CapitQl Inflows (outflows) may be sufficient to change an economy's real exchange rate depending on the composition of investment and the rate at which Investments (remittances) are made.<sup>4</sup> Thus, governments coiacerned about terms of trade and the balance of payments may have to incorporate intrafirm trade effects into policy planning.

Employment effects of International capital movements have been recognized for some time, and governments have created numerous programs to attract such investment. For Instance, the "maquiladora" program in Mexico is claimed to have induced 722 "sister" plants of foreign investors which employ over two hundred thousand workers and produce electronic components, textiles, drugs and other goods.5 US firms are responsible for over half the people (35,000) employed In the electronics industry In Malaysia. Th se examples and the numerous incentives offered by almost all developing e; ies (Guisinger 1985) bear witness to the fact that countries are aware of tential impact of foreign Investment.

International capital flows may have a significant impact on government revenues. To the extent that foreign investment Increases intrafirm or armslength trade, export and import taxes may be affected. In addition, income taxes froin foreign investors may be significant. In 1983 over 70% of total income taxes, including oil related income taxes, in Indonesia were collected frsm foreign investors, while foreign investors accounted for almost 50% of nonoil related corporate income taxes.<sup>6</sup> Preliminary evidence suggests that a significant amount of total business income taxes are collected from foreign investors in Malawi which Implies that tax revenue from foreign investments can

# 3. Little (1986).

4. Such effects can be significant. For instance, Harberger (1986) suggests imposing a tax on capital imports to offset an externality created by changes in capital inflows in Chile.

5. Mongelluzo (1986) This program is designed for both exports and employment gains since products must be largely exported to qualify for the program.

6. Conrad (1986).

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**be** uignlfIcanto,n for small agricultural **based** economies.? This should not be a surprise. In a developing economy, tax collections will generally be significant in modern manufacturing relative to traditional sectors, and business Income taxes will generally be greater than personal taxes.0 Thus, to the extent that foreign investment is concentrated in the modern sector, the proportion of business related Income taxes paid by foreign investors should be significant.

Finally, countries are aware of the potential effect that interjuriedictional variation in taxation has on both domestic and international investment within each country. Tax sparing provisions have become more common in tax treaties between the capital exporters and importers.' The effect of such provisions is to preserve the tax incentives for foreign Investors which would be nullified in other circumstances. In addition, countries are increasir.gly aware of what has been labelled "tax induced capital flight", where tax incentives or low levels of taxation create an incentive for domestic nationals in one country to Invest in another.'<sup>0</sup> The recent controversy about the effect of US tax rules on "capital **flight"** from Latin America Is one example of this phenomenon." Under US tax rules non-residents are not subject to US tax on Interest from deposits held In US banks." Latin American countries, many of which use the source principal (see below), claim that this exemption has induced firms and individuals to 7. This statement is based on a sample of income tax returns collected as part of the Malawi tax reform effort.

8. This is true for a variety of reasons including the adoption of modern bookkeeping techniques in the modern sector, the relative ease of tracing transactions, the low level of personal income and the relative small number of taxpayers in the modern sector.

9. Tax sparing is a method where the home country of a foreign investors allows a credi for taxes computed without incentives. This allows the foreign country to provide effective incentives for foreign investments. In effect, the home country allows a credit for foreign taxes which are never paid. The United States is an exception to this trend since the United States does not allow tax sparing provisions in any of its treaties.

10. H. David Rosenbloom has suggested to me that "capital flight" is largely a pejorative term void of any meaningful content. What one country sees as "flight" is seen as increased investment in another. Whether such outcomes are the result of an efficiently operating market and or a cost may be one of perspective.

11. See McLure (1987) for further development and analysis. Also see Karzon(1983) for a detailed development of international tax evasion.

12. Under prior US law such income was defined to be non-US source. In 1986, such income was defined to be US source but was then explicitly exempted from taxation.

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Invest in the US at the expense of further capital tormation and tax revenues In these countries.1 An implication of the preceding discussion is that no country can ignore the potential for taxation to affect capital formatk.n within its boundaries and no countrY can ignore the potential effects of Income taxes Imposed by other countries on domest!c investment and revenue. The next sections are designed to examine the motives for foreign investment, to provide an outline of tax provisions which are relevant for international investment and to provide a general framework for how international tax considerations may be incorporated in developing tax design for a particular country.

# 2 Motives for Foreign Investment

International flows of factors and outputs, capital in particular, vary and can be conducted in numerous forms; e.g. corporations, banks. individuals, partnerships both domestic and non-domestic."4 The following definitions will be used in this paper to provide a consistent framework:

# Portfolio:

Investment[sl made by an economic agent [firm or Individuall who does not exercise direct control over operations. Portfolio investments can be in either debt or equity form.

# Direct:

Equity investments made by an economic agent who exercises substantial or complete control over operations.

The distinction between portfolio and direct Investment is sometimes clouded.1<sup>5</sup> Legal definitions of control may be arbitrary and may vary between countries.'<sup>6</sup> Nevertheless these definitions will serve for present purposes.

13. McLure (1987) has noted that if the Latin American countries employed the resident principal the consequences would be thp same since the administrative difficulties of findlng the tax base and collecting the tax are significant.

14. This section contains only a brief summary. More extensive discussions can be found in Caves (1982), Bergston, Horst and Moran (1979) and Kopits (1976) 16. For instance, a corporation which owns 26% of the equity of a firm may not have direct control but may be able to exercise substantial operational control via use of technology, patents and management services. See Smith and Wells (1976). Banks which make loans to foreign firms may exercise control over investment and operations should the firm find itself in financial difficulty.

16. Under US Law a "subsidiary" is defined to be a corporation for which the one agent owns 10% or more of the equity of a firm, while under Japanese law the minimum stock ownership is 26%.

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# 2.1 Portfolio Investments

Portfolio investments, either equity or debt, are a common means for capital to flow between countries. The basic economic motivation for this type of investment Is straight forward: maximization of risk adjusted returns from a portfolio of assets. Identical assets: e.g. oil wells, in two different countries may not have the same risk structure because of differexnces in markets or government policy within and between the jurisdictions. Risks may be country specific as well as Industry or market specific.<sup>17</sup> Returns<sup>from similar assets may</sup> be positively related acro3s jurisd _'t_ ns, but the relationship is not perfect, making diversification via internats 4l capital flows a potential strategy for 1 risk averse investors. 6 The optioni . ' any Investor to purchase shares or make loans in a country other than his coAntry of residence offers the<sup>potential for</sup> greater returns and/or greater diversification, given returns relative to restricting investments to a single country."' A second related motivation for portfolio Investments is to capture changes in exchange rates. That 15, Investors may invest In particular countries to hedge or to speculate in potential changes In relative exchange rates. Portfolio investments may be in the form of non-interest bearing deposits of foreign exchange, or in equity or debt instruments denominated In a foreign currency where the investor has the opportunity to earn a return from investments in addition to returns from changes in relative exchange rates.

Most portfolio investments are made by firms and banks. That is, individual investors do not directly participate in international portfolio investments to a significant degree. Rather, individual investors participate via equity or debt in firms which funnel individual savings to various<sup>parts of the</sup> world.2<sup>0</sup> Firms and banks may have a comparative advantage in evaluating and investing in foreign markets. Also, transaction costs of foreign portfolio investments may be higher than similar domestic Investments because of currency exchange cost, administrative costs of holding assets in more than one ___________ 17. See Lessard (1982) for attempts to measure country specific<sup>risks. It Is now</sup> common for banks and large corporations to employ experts in country risk analysis.

18. For instance, oil wells in Indonesia and Ecuador made be subject to the same International price risks, but the exchange rate risks of the two countries could be quite different.

19. Whether investors wish to invest in another country is a different issue. Clearly, an investor is no worse-off with the option<sup>to invest in a foreign</sup> country than she would be with a prohibition on international flows of factors.

20. Exceptions to this general statement are apparent. Muuh "capital flight" In developing countries may be in the form of individual<sup>diversification.</sup>

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country, etc. These costs may make **fims** and banks efficient Intermediaries for the International transfer of capital.n

# 2.2 Direct Investments

Direct Investments are generally made by "multinational corporations" (hereafter MNC). Direct investment Involves substantial control over operations and use of returns from the foreign Investment. In addition, direct Investment often involves some type of non-market trade (e.g. either goods or services) between the domestic ftirm and the foreign operation. Direct investments generally take one of two forms. Foreign subsidiaries are "separate' legal entities and are generally resident In the country where the Investment is made." Direct Investment may aiso be made through an unincorporated branch where the Investment is an extension of the operations of the foreign firm.2 The decision to form a forc1gn subsidJary rather than a branch is a function of segregating risks (if a foreign subsidiary becomes bankrupt then the parent is liable only for the total equity Investment), organization convenience, and government policy (e.g. tax effects and foreign Investment laws). Regardless of the organizational method, foreign Investment is economically speaking, a multiplant operation which might be multiple output as well. Two general types of multiplant operations have been Identified: horizontal and vertical.H

# 2.2.1 Horizontal International Investments

Horizontal International investments are replications, to various degrees, of operations by firms; e.g. beverage plants In various countries held by the same firm. This type of investment is justified by greater use of Intangible assets, scale economies, and economies of scope. A firm may hold a patent, a brand name, or some production process which may exhibit the characteristics of a public good. If thes-s processes were generally known then the firm would lo:e its comparative advantage In a pariAcular product. Thus, firms may engage in 21. Portfolio diversification on the part of frms has been subject to criticism on the grounds that well diversified individual Investors can change their personal portfolios in response to changes in firm policy. It is argued that firm (or bank) managers should not attempt to diversify for stockholders and treat investments in a risk neutral manner. This criticism breaks down in the presence of comparative advantage and transaction costs. In these situations, investors may self-select firms which offer portfolios In accord with their own preferences and these individuals may do so at lower total and marginal cost.

22. Dual resldent corporations are also common.

23. Branches have been common in natural resource projects and in some types of banking.

24. The discussion which follows is based extensively on Caves (1982).

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direct foreign Investment to use thl knowledge **while** maintaining control over **the** intvrnal public good. These lnternal public goods may create scale economlea and economies of scope which enable profitable foreign investment.3 The decision to engage In direct foreign Investment relative to export or to engage in licensing agreements may depend on many non-government policy parameters. Transport cost of exports relative to local production Is clearly a factor. There may also be decreasing returns to scale after some point for any particular plant. Thus, expansion Into foreign markets may be cheaper with two plants of optimal size relative to one In the home country which would have higher marginal cost. Licensing may be arranged when property rights are well established and/or the owner of the patent or technique is not concerned about reputation effects regarding others' use of a particular process. When quality control is Important and firms are concerned about access to confidential intormation, direct investment may be the preferred alternative.

# 2.2.2 Vertical Direct Investment

Natural resource projects are the traditional example of vertical direct foreign Investment. Integrated petroleum producers operate In many countries with operations which vary from exploration to distribution. However, vertical direct Investment In natural resource projects must be the result of another motivation or economic process since it Is possible for there to be separate production, exploration and distrtbution firms. One justification for the vertical direct Investment is related to "transactional" gains. According to Caves (1982). "The vertically integrated firm internalizes the market for an intermediate product, just as the horizontal MNC Internalizes markets for intangible assets." Complete contracts between Independent parties are impossible to write and administer In the presence of uncertainty.<sup>2</sup> ' Thus, firms may find It in their interest to control sources of supply via integration if the costs of such int-rnal operations are lower than the risk adjusted costs of entering contracts. Natural resource projects are not the only example of vertical direct investment. Firms may design production techniques for various lntermediate products to take advantage of wage differentials across countries. Computer components are often produced in relative low %age countries and used to produce computers In high wage countries. Such policies may enable the nrm to operate an integrated operation where costs of producing the final product are a minimum.

25. See Rollinson (19886) for the development of a model where internal public goods have International investment effects.

28. See Williamson (1971) for further discussion of the Internal organization of firms.

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# **2.8** Government Induced Motivations for/against Foreign Investment

Government policy (or Intergovernmental policy) may affect the pattern of foreign Investment. A standard example is the use of Import tariffs or quantity restrictions to foster domestic production. For Instance, Indonesia has an Import ban of assembled automobiles. This policy has created a number of Indonesian Investments by foreign firms In auto assembly.27 Other governmernt policies also affect the motivation for or against foreign Investment. These policy Instruments include: policy regarding access to foreign exchange and remittances, "Incentives" such as cash grants, perfomrnance requirements, restrictions (or Inducements) regarding foreign Investment In particular sectors, and Income taxes. Examples include domestic ownership requirements oI participation (e.g. Indonesia), access to government financing (e.g. shale oil In Canada), export licensing rules and duty drawback systems (e.g. Malawi), subsidized prices for inputs (e.g. electricity).0 Income tax policy has often been used as an Incentive for or a:-ainst partivular investments. These Incentives have included tax holidays -. Indc esla under prior law), export incentive schemes where lnvestori allowed additional income tax deductions or credits for exports (e.g. Malawi), lower (higi0r) rates for particular industries (e.g. Zambia), and accelerated depreciption (sometimes negotiated on a case by case basis).

## 2.4 Summary

The types of and motivations for foreign Investment discussed above are extensions of standard economic models of domestic investment. That Is, domestic firms may engage In multiplant operations, either horizontally or vertically, a single government can discriminate for or against certain investments, and investors can create diversified portfolios of various assets. The true distinguishing feature of foreign Investment of any form is that factors move across international boundaries. This may be obvious but it has important consequences for investment and the role of public policy, tax policy in particular. First, international boundaries may artificially create different markets for the same product which would not be present in their absence. These boundaries and the different cultural and political distinctions they reflect may increase the cost of investment for foreigners relative to domestic nationals who know the language, the traditions, and the policies of the country. However, domestic Investors may not have access to brand names, patents, and other factors which create a cost advantage for the foreign investor. Such differences imply that the supply elasticity of investment funds 27. It has been estimated that the f ilue added of Indonesian assembly Is negative when valued at world prices since the import cost of the kits used to assemble the car is greater than the cost of a complete imported car.

28. For a complete description of the nature of non-tax Incentives see Guisinger (1985)

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or the elasticity of demand tor **investments** within **a** particular cour tV may be diffe.-ent for foreign Investors relative to domestic Investors.

Second, government may be able to Identify Investment according to ownership (domestic - foreign) which It may use In the development of policy. That is, government may use the ownership of factors by nation of origin as a tool in developing policy and to discriminate for or against foreign relative to domestic owners. The tact that governments use this distinction is clearly obvious, and in the International taxation field has created calls for coordination and other policies to limit government use of this information. However, the need for coordination and limits on government use of information to discriminate may not be completely justified. Economic discrimination does not necessarily imply ineMciencies either within a particular country or globally. In addiOon, discrimination based on reasonable economic criteria may have desirabli dib.ribution consequences. If foreign investors are "wealthier" than domestic Investors and foreign investors' demand for investment in a particular country is relatively inelastic, then higher taxes on the foreign investor could have both desirable eMfcency and equity consequences.<sup>2</sup> 9

# 3 Income Taxation In an International Environment

Traditional public nnance has concentrated on two aspects of tax policy: the rate(s) and the computation of taxable income relative to real economic income.3<sup>0</sup> More complexity and more degrees of freedom are Introduced when factors are free to move internationally. Some of these issues are discussed In this section.<sup>31</sup> 29. Furthermore, governments constantly discriminate, in an economic sense, In their use of tax policy. Non-neutral depreciation methods, progressive rate structures, credits for particular activities, and the double taxation of corporate income are common examples of such discrimination. Discrimination is also inevitable in a second best world and where distributional considerations may enter. Whether discrimination for or against foreign investment is any worse than the types cited in this note is an empirical and/or a normative question. However, from an economic perspective the issue is whether governments, Individually or collectively, can use additional information to create efficient policies which coincide with distributional objectives.

30. A description and analysis of these economic incentives is beyond the scope of this paper. Tax incentives in essentially closed economies has been studied extensively. For instance, see Atkinson and Stiglitz (1980), Boadway and W31dinsen (1984) and the particular studies cited in these books.

31. A number of studies contain an analysis of taxation in an international envir .-ment including: Boskin and Gale (1986), Bovenberg (1986), Caves (1982,. Dieter (1982), Dutton (1986), Hartman (1984, 1986), Horst (1978), Kopits (1976a,b. 1980, 1981). and Mutti and Grubert (1985, 1987).

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# 3.1 Components of Tax Base and Definitions In an International

# Environment

Government must determine a minimum of four factors In addition to the rate(s) and the computation of the base to determine taxes due within a particular jurisdiction: the jurisdictional basis to tax, a determination of a minimum presence below which an economic activity Is not taxable, attribution rules for the base, and the degree of coordination with other countries via explicit tax rules or treaties.

# 3.2 Jurisdictional Basis to Tax

The jurisdictional basis to tax may be either "residence" or 'source" or a combination of the two.32 axation based on country of residence Implies that all economic activities carried or, by a legal (or tax) resident of a particular ,.ountry will be subject to tax. If the residence principal were used exclusively then a government would tax all income of residents regardless of the location of the activity and non-residents who carry on economic activity in the country would be exempt from local taxation. T iis would Imply that foreign Investment carried out by a non-resident firm would be taxed only In the country of residence and not in the country where the activity Is located.

A second basis of taxation i_ the source principal. Under this principal economic activities carried on within a particular country would be subject to income taxation regardless of residence. If this principal were consistently applied by all countries then income "sourced' in a particular country would be taxed only once In the country where the income is attributed.33 Most developed countries tax both on residence and source. For instance, the United States taxes the "world-wide" income of US citizens and residents, while taxing only "US source" income of non-residences. France generally taxes the domestic income of residents and non-residents, but may exempt the "foreign source" income of either. Developing countries also vary with respect to the use of source and residence principals. For Instance, Malawi employed the source principal exclusively until 1987 and Indt;nesla employs both the source and residence principals.<sup>3</sup> ' If countries vary with respect to the jurisdictional basis of taxation, as they do, then there exists the potential for so-called "over-Lhpping" (double) or 32. Taxes may also be based on the destination principal. Destination principal taxes include import and export taxes. The use of the destination principal in the income tax area is limited. It Is sometimes used In formulary methods such as the three factor formula used by some states In the United States. See Conrad (1985, 1988b).

33. See below for a discussion of attribution rules.

34. See Table 2 for a comparison of different sources of variation.

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under-lapping taxation In the absence of International coordination. For Instance, a resident of a country which taxed exclusively on the source principal could invest In a country which exclusively employed the residence principal and escape taxation all together." Alternatively, a citizen of the country which taxed exclusively on residence would be taxed twice on the income from any activities undertaken in the source country. Whether such a result Is "fair" is a legal issue which may be completely separate from the economic issues of equity and efficiency. For instance, if the person who was taxed twice was a discriminating monopolist and the person not taxed at all was perfectly competitive operating with zero economic profit then no efficiency consequences would result from this pattern of taxation if the combined effective tax rate on the discriminating monopolist was 100% of economic income in both countries. Alternatively the person subject to potential double taxation could be placed at a competitive disadvantage relative to the person not taxed at all. Depending on the particular facts and circumstances, lack of international coordination with respect to the Jurisdictional basis to tax can create economic incentives for the flow of goods and factors.

Positive economic analysis has little or nothing to offer with respect to the appropriate Jurisdictional basis for taxation. From an economic perspective, income is attributable to people and not to places or things." Normative economics may also have little to say with respect to the appropriate jurisdictional basis. From a normative perspective the Issue may be the distribution of the tax burden between individuals or perhaps countries. Whether source is preferred to residence will depend on the resulting distribution of tax burdens within and between individuals and countries, and not on the abstract principals per se.

# 3.3 Minimum Connection

Nexus rules define the conditions under which a potential taxpayer becomes liable for filing and paying income taxes. For instance, many countries grant personal exemptions which enable low income persons to escape taxation. In the international environment nexus rules determine when an activity of an economic agent is sufficient to make that agent taxable in a particular jurisdiction. Concepts generally applied in this area are location of services (e.g. labor services by a IJK resident for the Government of Malawi performed in Malawi may be subject to tax in Malawi while labor services for the 35. The same result would hold for a worker of the source country working in the residence country.

36. The residence principal might be preferred on this basis but the justification Is tenuous at best.

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Government of Malawi performed in the UK are not subject to Malawi tax"), and the concept of "permanent establishment" for business enterprise." The presence of nexus rules and variation across countries in their application gives factor owners a second degree of freedom with respect to tax regime choice; i.e. factor owners may be able to decide whether to be subject to taxation in one or more countries simultaneously. This decision will be based on the combined effective tax rate of the activity under each alternative tax regime.<sup>3</sup> " Government may also use nexus rules to discriminate in favor of (against) foreign Investors: e.g. a country could establish a high threshold for minimum connection and effectively exempt foreign investors from tax while requiring all domestic residents to file and to pay income tax.

Nexus rules have been a source of controversy between capital exporting and importing countries. Some capital importing countries have sought a comprehensive low standard for determining minimum connection, while some capital exporting countries (and the agents they represent) have sought more restrictive nexus reules for capital Importing countries via treaties. 40 The incentives of capital importing countries are clear: the low cost of administration (usually assumed) relative to collections Is sufficient to induce capital importing countries to expand the tax net for foreign investors as wide as possible.

# 3.4 Attribution Rules

A country which applied the residence principal on a world wide basis exclusively would have to develop attribution rules solely on the basis of the legal owner of the income.<sup>41</sup> Countries which employ the source principal must attribute the income to particular political jurisdictions. The traditional standard has employed separate accounting where each permanent establishment 37. Note that the UK resident might be subject to income tax in the UK on the total income, both Malawi and UK source 38. Permanent establishment is a legal concept relative to the source principal and is based on the so-called "force of attraction theory" where there is a presumed level of economic activity sufficient for the firm to attract economic income to a particular location.

39. That is, the optimal regime choice will be determined by a discrete comparison of the after tax returns from being taxed In one country exclusively or in both.

40. Concerns regarding comprehensive and expanded nexus rules are reflected in model tax treaties such as the UN Model Treaty.

41. The attribution of income between residents of a particular country may not be as transparent as it appears when applied in the corporate tax area. For instance, if separate corporate reporting of two related domestic corporations were required then inter firm allocations may be required.

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(or group) in a particular country is treated under the arms-length standard. That is. an attempt is made to compute income for related parties with International investments as if they were separate businesses doing business exclusively In each country. Under separate accounting, f.o.b. prices of outputs are used to attribute revenues to the location of production or distribution and c.l.f. pricing of inputs are used to attribute factor coSts.'2 The use of separate accounting may be difficult to administer, and this technique has been subject to some debate.43 The difficulties with separate accounting involve the ability to determine arms-length prices for goods and services traded between related parties. Arms-length prices may not be known and/or could be different across firms because of different valuations of identical goods and services due to variation in risk preferences or differences in willingness to pay. Attribution of items such as interest expense, corporate overhead, research and development, and the pricing of intermediate outputs are examples of the difficulties of separate accounting.

Related to these examples are the technological phenomena of economies of scale and scope. Attribution of the economic income (positive or negative) from these technological advantages using separate accounting may be difficult or impossible to establish. The difficulty of attributing income (even within the firm) combined with variation in other aspects of income tax law across countries have given rise to transfer pricing problems. Transfer pricing Is a legitimate concern of government, but transfer pricing must be placed in perspective for two reasons.

First, there will always be an Incentive to under report income, regardless of the method of attribution. Investors will always have an Incentive to under report income if the probability of strict enforcement Is low. No method of attribution will solve this problem.

42. The use of f.o.b. and c.i.f. prices may themselves be arbitrary definitions of income attribution. It is clear that firms desiring to determine economic performance of profit centers would use such pricing. However, there is no economic reason to use such rules for tax purposes. Attribution rules where the destination principal is used to attribute revenues and f.o.b. prices are used to attribute costs would work just as well from an efficiency perspective if all other aspects of the income tax laws of all countries were the same and neutral. The distribution of the tax revenue may be different but the distribution of investment might not change.

43. Alternatives to separate accounting include specific allocation (i.e. the allocation of particular components to specific locations; e.g. Interest Income Is allocated to location of commercial domicile), and formulary apportionment used by some states in the United States. Formulary apportionment attributes total income of a "unitary business" (another vague concept) based on one or more ratios. For instance, a formula could consist, in part, of the ratio of sales attributed to Zaire to total world wide sales. This fraction would be multiplied by total income to compute income attributable to Zaire.

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Second, the economic Incentive to transfer price arises In the first instance because of variation in other aspects of the tax laws within and between countries and not because of the detects of separate accounting. If an Investor's objective is to maximize after tax profits of combined operations, transfer pricing is of little value if a dollar reduction in taxes in Columbia results In a dollar increase In taxes somewhere else. Thus, the difficulties created by separate accounting may not create marginal incentives in a world with equal marginal effective rates.<sup>44</sup>

# 3.5 International Coordination

International coordination (or lack thereof) for a single country may take two forms: 1. domestic definitions and administration, and 2. development of an explicit treaty network. Domestic definitions relate to the computation of the base, the rates, and the presence of accommodation for income taxes paid to other countries. A country can coordinate Its policies with international practice by using internationally accepted norms (if present) for nexus rules, attril ktion, and computation of the base. If a country employs the source prir..&pal exclusively (and the system can be administered) then these policies may be sufficient to ensure international tax coordination. This is true since any foreign investment of domestic nationals will not be taxed by the country of residence limiting the potential for overlapping taxation.

If a country employs the residence principal or a combination of residence and source then that country may have to address the problem of overlapping taxation with respect to the potential investments within its boundaries and investments of its residents orerseas. International standards have evolved which enable the "country of source" to tax the income of all economic activity within its borders (both resident and non-resident). This implies that a country may not have to develop specific rules for foreign investment within the country (attribution rule exempted), but government might have to address the problems of the foreign source income of its residents. Such recognition under international convention can come for domestic tax purposes in the form of a deduction or a credit for income taxes paid to foreign governments, or government may exempt foreign source Income completely from the domestic base.

Tax treaty development is a second method for international coordination. This coordination is bilateral in nature and affords the opportunity for a country to coordinate tax policy with major (or potential) trading partners. In general, tax treaties override the statutory law. This implies that items such as withholding tax rates and certain definitions can be included in a treaty. Treaties also include provisions for the tax status of government personnel, students, etc. operating in the foreign country. Finally, treaties generally 44. The problem of distributing the tax revenues remains. However, this is precisely the pcint. From rn economic perspective separate accounting is one method, among many, of distributing revenue between jurisdictions. Thus to the extent that one method is superior to another must be determined on revenue distributional criteria and not on the distribution of the base.

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contain exchange **of** Information agreements which enable tax authorities to request information relating to particular tax payers **and** competent authority provisions which provide a means for the settlement of disputes.

# 4 Incentives and Consequences

# 4.1 Traditional Economic Incentives

The fact that income taxes vary across jurisdictions is hardly surprising. Some standard indicators of lnterjurisdictional differences are presented in Tables 1-3. As shown, business income taxes vary across countries with respect to rates (Table 1), computation of the base (Table 2). special incentives such as cash grants (Table 2), and principles employed to determine the basis for taxation (Table 3). If these and other sources of variation combine to create non-neutral tax wedges both within and between countries then allocative Incentives for factor flows are created.<sup>4</sup> ' These Incentives can affect the levtl of savings and investment within and between sectors as well as within and between countries. Capital-labor ratios, real wage differentials (after accounting for immigration restrictions), and risk exposure can differ between countries as a result. Some of these Incentives are outlined below. Positive effective domestic capital tax rates Increase the cost of capital to firms and decrease the returns to domestic savers. Other things equal such wedges may lower the capital stock withln a particular jurisdiction. If the economy is closed then the decrease in the capital stock is accomplished via a 46. The analysis presented below Is descriptive. For more analytical treatments of allocative Incentives see Fullerton and King (1985) who examine Intersectoral incentives and Conrad (1985, 1988b) who examines incentives created by interjurisdictional non-neutralities. The conditional clause In the text should be emphasized for two reasons. First, it is possible, though unlikely, that all the non-neutralities cancel out leaving a neutral system (Conrad 1985, 1988b). For Instance, non-neutral depreciation In one country could be offset by attribution rules in that or another country. The distribution of the revenues between jurisdictions may be different relative to a transparently neutral system but the allocation of capital may be the same. Second, to the extent that "tax competition" between jurisdictions is efficient then allocative incentives may be a minimum. Such effects may not be apparent in a comparison of tax laws since non-neutralities may be negotiated away on a case by case basis. For instance, the US state of Kentucky has reportedly granted (US)125 million in concessions to attract a foreign assembly plant from Toyota. If (US) 125 million is sufficient to put Toyota in a zero tax (in present value terms) position then the investment could be neutral. It could be argued that foreign investors should pay positive taxes because of the benefits received by the jurisdiction (e.g. public services). Powever, income related charges are ability to pay taxes and thus by definition have little or no relationship to benefits received. Thus, a country which desires to recoup the cost of public service delivery should impose user charges, etc. where possible.

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decrease In aggregate savings following the fall in net-of-tax returns assuming a positive savings elasticity. If the economy is open the fall in the domestic capital stock may result from a reallocation of International portfolios of both domestic and foreign investors. Domestic investors will now invest outside the country while foreign investors will invest in their home or some other foreign country until net of tax returns are equalized. Thus, savings by domestic nationals, as opposed to domestic investment made by domestic nationals, need not fall when the economy is open. Rather, domestic nationals may respond to Increased domestic taxes by reallocating a fixed quantity of savings toward foreign investment.

Differential taxation across sectors within the domestic economy can create allocative effects across sectors given a particular level of total Investment and savings. For instance, many developing countries offer significant investment incentives in modern manufacturing (e.g. Malawi offers an investment allowance restricted to the modern sector manufacturing). Such investments can increase manufacturing investment relative to other sectors for which the economy has a comparative advantage (e.g. agriculture).<sup>4</sup> The incentive for debt finance is a third type of incentive created by application of t,.Lditional income tax approaches. The cost of debt may be dedi Atible at the corporate level while firms are generally not allowed a dedu tion for the cost of equity. Thus, there Is an incentive for firms to increase their debt-asset ratios. This incentive can contribute to an increase In an open economy's level of external debt. If marginal financing Is biased toward debt by a tax wedge then firms might seek external loans relative to either domestic or external equity which might increase the economy's exposure to various shocks.4'

# 4.2 Incentives Created by Administrative and Legal Concepts

Differential incentives are also created by variation in administration and legal rules. The factors discussed in the last section (e.g. nexus rules, etc.) can complement or offset more traditional tax incentives. For instance, administrative policies could affect the degree of discrimination between foreign 46. Traditional agriculture, including large estates which are taxable, may suffer because land is generally not depreciable. Diversification of an economy's asset base may be a legitimate concern of government. However, the issue is whether differential taxation is the cost effective means of obtaining such diversification.

47. It could be argued that external equity can increase an open economy's external obligations in a general sense. However, the difference lies in the obligation to repay. For instance, if an economy suffers from an adverse external shock which decreases profitability, foreign equity holders do not have to be repaid while holders of external debt will demand payment on a current basis, if possible. Thus, external debt, as opposed to equity, can impose short term. and perhaps long term, adjustments necessary to accommodate lenders.

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and domestic Investors. Developing countries have been accused of practices such as stricter audits and enforcement of foreign relative to domestic investors.4 Legal rulings and administration In one country can also complement or offset policy In another. For instance, differences in attribution rules may create situations where income is characterized inconsistently. Other differences include transfer pricing rules, definitions of debt, dividends, etc., source rules for particular transactiona (e.g. loans), and treatment of foreign exchange gains and losses. Such inconsistent treatment can create situations where the effective tax rate differs from traditional economic measures. The extent to which traditional economic measures over or under estimate the true effective rate will depend on the particular facts and circumstances of the investor making generalizations difficult. For Instance, inconsistently administered transfer prices (including transport) can change both the total taxes paid by a MNC and the distribution of the revenue.

The presence of factor mobility combined with variation in tax rules Increases the administrative and enforcement efforts of government. Transfer pricing and thin capitalization are two obvious examples of the problems encountered. Such diMculties have been one factor in the call for more International cooperation. There has been the perception that international convention may favor capital exporting countries; e.g. lcwer withholding tax rates, strict definitions of nexus. etc. Attribution rules and administration employed by capital exporting countries can be complex and perhaps cannot be administered by the tax administrations in most developed countries.<sup>4</sup> 9 These costs are offset to a degree by the International convention which generally allows the country of "source" the right to tax the income first with the country of "residence" recognizing this right via a deduction or credit for foreign income taxes paid if the home country taxes worldwide income or by an exemption If the capital exporter employs the source principal. Developing countries have recognized this advantage via attempts to incorporate tax sparing into various treaties.

The Incentive for cooperation both bilaterally and worldwide has been counterbalanced by the self-interest of various governments and the interest groups they represent. Competition for foreign investment has led to development of incentive packages for particular investors which clearly discriminate. Capital exporting countries have also been under pressure to decrease the Incentives to invest abroad. For example, legislation such as Subpart F in the US and tax haven rules have been attempts to restrict the advantages offered by the foreign tax credit for particular sectors and investments.

In summary, traditional types of incentives such as variation in depreciation rules, rates, etc. combined with variation in source and other legal/administrative concepts make the analysis of the net incentive to invest 48. In countries where this author has worked, it is common for foreign Investors to claim that they are "easy targets" for the tax administration.

49. The UN Model Treaty is one example of efforts to address these issues.

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domestically rather than abroad difficult. This complexity has also increased the degrees of freedom which both Investors and governments have in manipulating Income and or attracting (or otherwise discriminating against and in favor of) particular investors either foreign or domestic. The benefits of international cooperation are tempered by the self-interest of each government. All of these factors combine to increase the complexity of capital taxation within and between countries with a corresponding increase in administrative cost and effort.

# 5 Comment and Perspective for Tax Policy Developing in LDC's

The situation implied by the discussion in previous sections raises a number of issues for the development of rational tax policy within a particular country and to the degree of international coordination. A discussion of these two issues is contained in this section. The implications for development of tax rules in an LDC may depend on the extent to which international cooperation is either necessary or desirable. For that reason the issue of international cooperation will be discussed first.

# 5.1 Lack of Coordination and Tax Competition

Three consequences resulting from lack of uniformity and international coordination are capital reallocations, the potential for double or less than full taxation, and tax competition between countries. These three consequences are interrelated. The effective tax rates by investor, by country will determine the extent to which capital is reallocated across borders. Thus, double and less than full taxation may affect the amount of capital investment within and between countries (e.g. the recent claims by Latin American governments about the effects of exempt interest for deposits in US banks held by non-residents). In addition, tax competition can affect the revenues collected, both within and between countries. Thus, tax competition or coordination can affect the tax wedge.

Tax competition between countries has been claimed to be inefficient5, resulting in higher tax burdens on domestic factors, revenue losses, and other inefficiencies. These effects may be offset or complimented by international rules such as tax credits, tax sparing, inconsistent attribution rules, and measures of the base. Increased uniformity and consistent treatment has been advocated as the preferred path for the resolution for these problems.

Three points should be noted with respect to the benefits of international uniformity. First, "tax competition" may not be inefficient. From an economic perspective it is unusual to hear claims for the efficiency of private markets and then to hear claims of destructive economic competition between countries. Unless some market failure is relevant at the margin then there is no reason to 50. See Musgrave (1987) for one perspective of the potential costs of tax competition.

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conclude **a** priori that tax competition is necessarily bad. That is, trom both **an** efficiency and equity perspective the net benefits (gains less all losses) of tax competition may be higher relative to coordination and less than complete uniformity. Tax competition and lack of uniformity may be the preferred uolution as factor mobllity Increases. Competition between countries may place .oounds on the level of effective taxation. In addition competition, combined with the potential for discrimination, can enable countries to determine whether particular investments or investors can bear more tax. Site specific rents and other factors may be present which enable countries to collect a greater share of revenue from particular investments. This would not be the case If uniformity were present. That is, lack of uniformity and competition simultaneously restrict and increase the ability of particular governments. Taxes cannot be too high in a competitive environment or investment will fall. However, government is allowed to develop policies more consistent with custom, preferences, objectives, and administrative constraints in such an environment.

Second, competition may force governments to evaluate policy based on true costs and not relative to some standard which may be either arbitrary or in the interest of other parties. International tax conventions were developed for capital exporting countries and at a time when few countries had substantial economic power. The rules developed at that time in that situation may not be appropriate for small developing countries seeking to attract investment which is socially profitable. In addition, the world economic situation is changing and will continue to change in the direction of greater factor mobility, absent controls, where traditional capital exporters may not be the major source of investment funds.<sup>6</sup> ' Thus, competition in the tax area may be more appropriate in a situation where the economic influence of a few capital exporters is declining with respect to the determination of the world price of capital.

Third, coordination, unless uniform and complete, may make the problems of overlapping taxation and capital misallocation worse.n<sup>2</sup> Coordination with respect to source rules, attribution rules, and even with respect to the computation of the base does not completely restrict government from creating offsetting incentivee. Governments can always give cash or other incentives as well as use indirect and trade tax policy to offset revenue losses or loss of control over particular policy instruments. To the extent that such instruments 51. For Instance, the United States has become a net capital importer. Regardless of the underlying cause (deficits, terms of trade effects, capital flight from unstable economies, etc.) this fact may indicate that the US may be more open to trade than in the past. Increased openness by major capital exporters necessarily implies less control over international factor movements and interest rates. Tax competition in this case may be more appropriate than coordination, where parties losing economic control may be able to influence the development of harmonized rules.

62. Since any contemplated practical tax on capital Is distortionary, tax coordination and competition must be evaluated in a second best context. Thus, even a completely uniform capital tax system adopted by the entire world can be less efficient and less equitable relative tax competition.

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are less than perfect substitutes for Income **tax** policy, the welfare **effects** of the distortions could increase."

# 6.2 Discrimination

Uniformity and coordination may affect the ability of government to discriminate for or against particular Investors or sectors (e.g. foreign relative to domestic). Tax treaties and other efforts at coordination have been attempts to limit the amount of discrimination In certain areas. However, efficiency and perhaps equity considerations Indicate that discrimination may be appropriate. For Instance, optimal tax theory in a closed economy Is based on the ability of government to behave like a monopolist and discriminate relative to the compensated own and cross price elasticities of demand. Thus appropriate use of discrimination may Increase revenues, welfare, and depending on the distributional objectives, equity.0<sup>4</sup> It was stated in Section I that factor mobility across borders may provide useful linformation for the design of tax policy. If the elasticity of supply (or demand) for Investments to different between foreign and domestic Investors then this lnformation might be productively employed.

Three Issues arise with respect to the ability to effectively discriminate. First, discrimination may be costly. Recent tax reform efforts In de"'eloping countries (e.g. Indonesia and Malawi) have noted the high cost of negotiating investment packages and taxes on an Investor specific basis. However, If the social benefits are greater than the cost there Is no economic justification for their elimination.<sup>55</sup> Second, capital exporting countries, the United States in particular, have been strong In their opposition to discrimination in the Income tax area.<sup>5</sup> 6 This opposition may represent the self-interest of capital exporters 53. These comments imply that notions such as overlapping taxation may not be as much of a problem as they might appear. From an economic perspective, the issue is the combined effective tax rate, not how many tlimes the same income is taxed. Investors would clearly prefer to be taxed twice on the same real economic Income and pay $5.00 In tax than to be taxed once and pay $10. {See Conrad(1985) for situations where this can occur.) If competition leads to more equality of effective tax rates between countries then the additional efficiency cost of sectoral or interjurisdictional misallocations are reduced. (The welfare cost of a capital tax could still be positive.) Issues of overlapping taxation and equity are then related to the distribution of the tax revenue between countries and not the distribution of the tax base or the number of times the same base is taxed.

54. See Atkinson and Stiglitz (1980) for cases where distribution and equity are enhanced or offset by discriminatory eMcient second best taxes.

65. Political considerations and the potential for bribery, etc. may be sufficient justification for the elimination of such negotiations.

56. For instance, US rules disallow a foreign tax credit on so-called "sop-up" taxes by foreign governments.

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**with** respect to the preservation of their revenue **base in** addition to **concerns** about fairness. Third, tax competition could reduce discrimination relative to uniformity and coordination. The ability of countries to discriminate against particular sectors or Investors Is limited by competitive pressure from other governments In attracting the same type of investments. In summary, Increased coordination and uniformity may not be the best method nor even result in desirable outcomes for the problems related to the taxation of International capital flows.

# 6.3 Tax Policy Implications for Developlng Economies

A developing economy faces numerous constraints in the construction of capital tax policy Including: the distortions introduced by capital taxation in other countries, capital mobility, administrative abilities, and administrative resources. In general, a country would like to attract investment on the country's terms, simultaneously accruing both taxes and the other economic benefits of an increase in the domestic capital stock. However, trade-offs may exist and governments must determine whether incentives in favor of or against particular investments are worth the economic cost relative to budgetary and other constraints.

A developing economy should take into account the following considerations in order to develop a reasonable tax policy:

1. Most countries cannot individually affect the international opportunity cost of capital either for foreign investors or domestic nationals. A change in relative world returns over which the country has no control can change the relative incentive to invest in its jurisdiction.

2. The International cost of capital may not be uniform. The risk adjusted opportunity cost of investment may differ by the residence of the investor and/or the current tax situation of the investor.

3. Governments should be concerned about the intersectoral effects of taxation as well as the ownership and size of the aggregate capital stock. To the extent that differential tax wedges are created between sectors which are inconsistent with the diversification objectives of the economy, efficiency and distributional objectives are hampered.

Flexibility and accommodation are also by these constraints. However, accommodation to international standards should be made only when it is in the self-interest of the country to do so. Finally, neutral internal taxation does not necessarily imply efficient taxation. It the effective tax rate Is uniformly high then capital will have an incentive to move out of the country. Alternatively, uniformly low domestic effective taxes can be offset in part by distortions in the tax law of other countries or by revenue transfers to home countries if the neutral tax is imposed on foreign investors via the foreign tax credit.

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# 6.4 Options for Domestic Tax Pol'cy In LDC's

A simple model for capital taxation Is presented in this section. No unique uniform tax system for all countries Is Implied by the preceding analysis. Thus this model is intended to serve as a framework for analysis rather than as a proposal. The model contains four elements: cash-flow taxes at the business level, uniform withholding taxes on all distributions, adoption of the residence principal, and tax treaties. Tax treaties may be optional depending on the particular circumstances. It should be emphasized that a combination of cashflow and withholding taxes on distributions can be consistent with either consumption or comprehensive income tax principals. (See below.) Cash Flow Taxation at the Business Level Cash flow taxation at the business level includes the following elements:

- Immediate expensing of all assets

- No deduction for Interest payments

- No tax Incentives

- Treatment of all accounts on purely a cash basis

A number of administrative difficulties are eliminated by this type of business taxation. First, ad hoc or point estimates of real economic depreciation are not necessary since all assets are Immediately expensed. Second, the bias toward debt finance is eliminated since interest is not deductible. Third, the system is automatically indexed 'or inflation. Fourth, capital gains are automatically Included in the system since asset sales are positive cash flows and thus are included in the base. The last two factors have two benefits for a developing economy. There is no need to make any adjustment for foreign exchange gains or losses. In addition, separate computations and schedules for capital gains and losses are not necessary.<sup>57</sup> Cash flow business taxes are generally easier to administer than traditional income taxes, but difficulties remain. For instance, transfer prices for Inputs and products would still have to be deterr.iined; however thin capitalization rules, etc. would not be necessary. In addition, from an economic perspective a cash-flow tax is a tax on economic rent and not a tax on the return to invested capital. Thus countries could suffer both a revenue loss and 57. Capital gains taxation is particularly difficult to administer in developing countries. In addition, countries which exempt certain capital gains (e.g. Malawi) risk revenue losses by having otherwise ordinary income artiftically recharacterized as capital gains as well as the revenue losses from the absence of the tax in the first instance.

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**additional oeonotlc inefficiencies due to the lack** of **capital taxation.** This cost can be **offset, In** part, by the **second** component of the proposed system.

# Un4ivereal ythholdint

The second component Is the application of universal withholding on all payments made by the business sector. Withholding would be Imposed on distributions of dividends, Interest, royalties, directors' fees, and other corporate distributions In addition to wages IndeDendent of the residence of the reciDient." Many countries impose withholding on wages, and this proposal would merely expand withholding to all corporate distributions.

The fact that withholding is lmposed on all distributions would eliminate the need for border withholding taxes on non-residents which Is now common. This would eliminate the need to determine the residence of the recipients before application of tax. In addition, to the extent that withholding taxes paid by non-residents Is eligible for foreign tax credits, the 'ost government may preserve some revenue with no additional allocative incentives." The treatment of withholding taxes at the domestic Individual level will be determined by the overall policy objectives of government. If government desires to have no taxation on capital then dividends and Interest would not be Included In personal Income, and the withholding tax would be claimed as a credit (with provision for refund) for non-capital income taxes. This would ensure that no ta --s on capital would be paid. Alternatively, withholding tax Inclusive corporate iistributions could be included at the personal level and a credit claimed for tne withholding taxes paid. In this case, capital Income is taxed at the individual level with the withholding tax serving as a prepayment.<sup>6</sup> ' Thus, cash flow taxation at the corporate level cum withholding 58. The additional distortions could arise because there is no theoretical superiority of one particular type of taxation in a second best world. Given rever.ue constraints, the absence of a capital tax will Increase the taxes on other factors. This increased taxation could reduce welfare relative to capital and labor taxation with lower rates.

59. To the extent that the personal income tax is part of an overall tax system, uniform withholding of wages would be desirable. This would enable government to collect taxes from a smaller number of taxpayers and would decrease the incentive to recharacterize corporate distributions.

60. In theory, a host government could collect 100% of the tax payments on foreign source income which accrues to the home government. In practice, such efforts would involve Investor by investor discrimination based on resident and tax position. It is doubtful that such a policy could be Implemented given anti-discrimination policies of most capital investors.

61. Capital gains at the personal level would still be difficult to administer, unless government moved to consumption taxation. The difficulty arises in part because of the general lack of accounting for inflation in the basis for a capital gain.

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taxes can be Instruments of either consumption or comprehensive income taxation systems.

If cash-flow taxes are Imposed at the corporate level then there is no n_ed to gro8isu crporate distributions for the tax paid at the corDorate level. If there are zero economic profits then a gross-up would be redundant since the present value of taxes are zero. Alternatively, if the present value of taxes is positive then the government is getting a share of any economic rent and there is no need to impute rent to the individual level.62

# Residence PrinciDal

Consideration should be given to taxing domestic nationals on their worldwide income and taxing non-residents based on source. Two justifications are offered for adopting the residence principal; one symbolic and one practical. Taxing domestic nationals on worldwide Income may not be administratively feasible for some countries.<sup>6 3</sup> However, administrative difficulties should not force government to provide a signal to domestic nationals that they should invest in other countries.'<sup>4</sup> Exclusive use of the source principal is in effect stating that government Is indifferent between investing at home or in some other country where taxes are lower.<sup>6 5</sup> Second. to the extent that the tax admilnistration can obtain information, some taxes can be collected. The practical issue here is revenue collections relative to the cost."

# Tax Treaties

Tax treaties can be viewed as a form of bi-lateral discrimination. Treaties can override certain general provisions of tax law including withholding rates and certain definitions such as source. To the extent that tax treaties are in the interest of the developing economy a treaty network should be considered. However, the following points should be noted with respect to treaties: 62. To the extent that investors accrue rent this system would not be totally neutral as long as the rent tax was less than 100%. Some rent will still flow through to the individual level and the overall return net of tax would still be higher relative to an investment with zero rent. The extent to which this is a problem will depend on the size of real economic income and the efficiency of the markets in each country.

63. McLure (1987) discusses the difficulties with residence principal taxation In a developing country.

64. H. David Rosenbloom noted this type of effect to me.

65. There may be a risk of double taxation unless the country allows a foreign tax credit.

66. The symbolic value of the principal may be important enough to warrant some expenditure of resources on administration.

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1. A treaty network may not be needed it effeetlve tax rates, definitions, and administration are comparable to international standards.

2. A developing economy should not enter into treaties with the expectation of significant revenue gains.

3. Exchange of Information terms usually benenit the capital exporting country,67 4. Tax sparing may be included in a treaty and its inclusion may have some economic effect. However, all parties must realize that tax sparing is a type of foreign aid for which the developing country might pay either by increased dependence on one country for its source of funds or by granting other concessions in the tax treaty or other agreements.

6. There is symbolic value to tax treaties. Competent authority provisions are signals to international investors that the country is serious about the desire to attract international Investment and to abide by internationally established norms.

6. In the context of the current framework the following points deserve nute:

- Tax sparing may not be an issue since there are no direct Investment incentives in the system."

- The developing country can discriminate by treaty with respect to items such as withholding rates. Withholding rates are generally part of a treaty. This implies that withholding rates can vary across investors depending on the country of residence in a treaty context. In effect, a developing country can use withholding rates as a form of "sop-up" tax.<sup>6</sup> 9 The ability to take full advantage of

67. Exceptions do occur, but in general the capital exporter will seek information regarding its residents investing In the developing country.

68. Abolition of tax incentives can be perceived as a loss of an Instrument for attracting foreign capital. However, as long as investors make decisions relative to net of tax, risk adjusted returns then it is the effective tax rate that matters not the incentives. Purthermore, the efficiency cost of particular incentives can be high and thus It may be possible for countries to move to a more neutral system with lower effective tax rates for all investors while preserving revenues.

69. Legally speaking this may not be the case since withholding taxes are defined to be a tax paid by the foreign firm on behalf of the non-resident. However, economically speaking, to the extent that foreign invtestment is controlled by non-residents both corporate and withholding taxes are paid by the non-resident. Thus, the ability to adjust withholding rates by country offers the opportunity for the developing country to adjust marginal effective rates by country of residence.

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this benefit is offset by the ability of nrms to "treaty shop" which may Incur a revenue loss for the country."<sup>0</sup> A pragmatic approach to treaties is Indicated by these points. A country with few or no treaties must weigh the benefits against the signifcant cost of negotiating and administering a treaty. Developing countries with existing treaties should not unilaterally cancel them, however, because of the adverse perceptions such moves generate.<sup>7</sup> ' For these reasons, treaty development should be based on the particular circumstances and goals of the country.

# 6 Summary

Several issues have been discussed in the preceding sections.

# Tax Switches in an International Environment are More Numerous

Four factors (nexus rules, jurisdictional basis to tax, attribution rules, and the degree of International coordination) were discussed in Section 2. These factors increase the degrees of freedom available to a government in developing tax policy relative to more traditional components of tax policy (e.g. rates and definition of the base). From a positive economic perspective, these factors should be included In the analysis of tax policy to examine how each factor Interacts to determine the net incentives for investment and savings."

# More Constraints are Present

The increase in the choice set for government tax policy is not free. Additional constraints are imposed as well. First government will be constrained by the ability of capital to move across international borders in response to changes in tax policy. That is, investors have an increase in the number of degrees of freedom as well. Economic agents can only respond to changes in tax policy by changing the supply of factors in a closed economy (e.g. savings can 70. If transactions costs were low then it is possible for the effective tax rate for foreign investment to be the lowest withholding treaty rate plus the corporate tax rate, absent control by the other party to the treaty. See Rosenbloom (1984) and Kozon (1983) for further development.

71. When Nigeria canceled its treaties, it was generally agreed that the country was not prepared to develop reasonable alternatives. The cancellation generated significant negative publicity for Nigeria and to date the country has been unable to complete a new treaty network.

72. See McLure (1987), Mieskowski (1986), Gordon and Smith (1986) and Conrad (1985, 1988a) for some initial development of how the factors discussed in Section 2 interact with more traditional tax switches. No comprehensive analysis of the Interaction between all components has been done to date which includes both Incentives to investment domestically and across jurisdictions. However, the works cited here can be considered a foundation for subsequent work.

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change In response to net rates of return). When factors can move across boundaries economic agents can change both the quantity and the location of Investment. Furthermore changes in location are not necessarily a one way street from capital exportsrs to capital Importers. Tax policy can affect the decisions of residents of capital importers to invest outside as well as the incentive for foreigners to invest within the borders of a developing economy. Thus domestic tax policy, given policy in other countries, can be a factor in the decision for domestic investors to become international Itivestors. This implies that government should be concerned with a policy with regard to "net" as opposed to gross capital flows. Issues of dependence on foreign investment and the desire for ownership of domestic investment by domestic nationals may be legitimate political or policy concerns. However, government needs to understand how each policy instrument combines to create incentives to invest, In general, and how these incentives are realized In particular investments before polican be successfully Implemented.

A second constraint faced by government is the ability of other governments to change their tax policies. Policy changes made by other governments may be a benefit or a cost to a particular economy. That is, tax competition places a clear constraint on a government's ability to act unilaterally with respect to changes in tax policy. However, policy changes In other countries can provide incentives (or even subsidies) for investors to move capital to one's own country via changes in rates, base computations, and other rules.

# Income Tax Policy Should Placed in Context

Income tax policy is only one tool in government's toolbox for reaching particular objectives. The effectiveness of income tax policy will be determined by how this instrument is used in the context of overall policy implementation. For instance, trade tax policy, pricing policy, exchange rate policy and other tools affect how investors will respond to income tax initiatives. Income tax policy can be offsetting (e.g. trade barriers to induce foreign investment combined with high Income taxes can create offsetting incentives) or complimentary (e.g. accelerated depreciation with subsidized prices).

This implies that income tax policy should be used when It is the most effective (or can be combined with other instruments to be the most effective) tool to reach a particular objective. Thus, income tax policy cannot and should not be evaluated in isolation.

# International Coordination maY be Neither Necessary or Desirable

The call for international coordination in international taxation appears to be based on notions of interjurisdictional equity and destructive tax competition. Equity considerations may be a legitimate concern, but interjurisdictional equity may be more appropriately applied to the distribution of the revenues from the taxation of capital and not to the distribution of the base. This implies that unless all aspects of capital income taxation, including rates, etc., are somehow uniform then there is no necessary correlation between the attribution of the

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base and the distribution of the revenues." Even equity with respect to the distribution of the base does not necessarily Imply utiform tax treatment. For instance, real economic depriciation may vary across countries (i.e. the real depreciation of a truck may be higher In Malawi than In the US). Thus, in order to have an "equitable" distribution of the base then the computation of the base must necessarily be non-uniform. Thus, untformity of attribution rules, nexus rules, etc. must be placed in the context of overall policy.

The negative connotations of tax competition must be weighed against competition's potential benefits. The information gained by the competitive process enables countries to learn where it can and cannot be flexible. Investors examine other factors in addition to taxation in determining investments. Thus, competition between countries can aid in learning the comparative advantages of a particular location and enable a country to Identify site specinc rents and other factors which may Increase both revenues and the rate of growth.

Investors treat taxes as a cost of doing business and competition between countries may aid in making this cost as low as possible. That is. each country's tax price will reflect the opportunity cost of investment (either foreign or domestic). There Is no reason to believe that these tax prices are the same across countries, given the variety of factors (location, education, cultural differences, initial stocks, etc.) which influence the reservation price (both total and marginal) of investment. Thus, uniformity (in effect monopoly power) may distort rather than enhance investment. As long as the international capital market (the suppliers of capital) Is reasonably competitive, then competition by governments may enhance both the distribution and efficiency of the system.

In summary, the potential for capital to move across international boundaries may be one of the most important factors in tax policy design.74 Thus, tax policy development (and tax reform efforts) should incorporate this factor in order to be successful. Successful incorporation of international factor flows requires both evaluation and flexibility. A government must evaluate the opportunity cost of investment in terms of both development objectives and revenue constraints. This implies that explicit trade-offs may have to be made between revenues and incentives to invest. Where trade-offs are small or nonexistent (site specific rents, etc.) then government should be In position to take full advantage of them.

Flexibility is necessary because exogenous changes in world prices (including interest rates) and policy changes in other countries can affect both 73. For example, countries can have identical attribution rules but different tax rates.

74. The current stock of foreign investment within a country or the stock of investment held by domestic nationals in foreign countries is not an indicator of the influence of international capital markets on the incentive for investors to respond to changes in policy since the potential for change always exists.

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incentives to Invest and revenues in a partieular country. This **Implies** that the opportunity cost of Investment, In general, or in specific sectors may change, and tax policy should be flexible enough to respond to these changes. Finally. flexibility requires a clear determination of a country's objectives. The evaluation of tax treaties, foreign Investment agreements, and general policy must be made relative to the development policies and constraints of a particular economy. In this context flexibility will enable a country to respond to changing conditions with informed self interest.

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