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International Tax and Public Finance

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30.06.2018

Incentives to tax foreign investors

verfasst von: Rishi R. Sharma

Erschienen in: International Tax and Public Finance | Ausgabe 2/2019

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Abstract

This paper shows that a small country can have an incentive to tax inbound FDI even in a setting with perfect competition and free entry that is compatible with the Diamond–Mirrlees (Am Econ Rev 61(1):8–27, 1971) framework. While firms make no aggregate profits worldwide due to free entry in this setting, they make taxable profits in foreign production locations because their costs are partly incurred in their home countries. These profits are not perfectly mobile because firm productivity varies across locations. Consequently, the host country does not bear the entire burden of a tax on foreign firms, giving rise to an incentive to tax foreign investors. The standard zero optimal tax result can be recovered in this model under an apportionment system that ensures zero economic profits in each location.

Vorheriger Artikel Inter vivos transfers of ownership in family firms

Nächster Artikel Tax policy and economic growth: does it really matter?

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See also Dixit (1985), Razin and Sadka (1991) and Gordon and Hines (2002) for alternative formulations of this result.

The compatibility of a heterogeneous firms setting featuring perfect competition and free entry with Diamond–Mirrlees has been noted by Dharmapala et al. (2011), who study optimal taxation with administrative costs in a closed economy.

Several papers that study monopolistically competitive settings also have the property that households receive pure profits, either because of the absence of a free entry condition (e.g., Haufler and Stähler 2013) or due to a free entry condition that allows for such profits (e.g., Davies and Eckel 2010).

Section 4.4 extends this analysis to the multi-country case.

Note that there are no profits that enter into the household’s budget; the free entry condition that guarantees this will be discussed in Sect. 2.4.

This differs from Helpman et al. (2004), where a firm draws a single productivity parameter for both countries. Hence, in their framework, differences in profitability across locations are due to aggregate factors such as wages or market sizes, whereas in the current paper, firms will also have idiosyncratic differences in profitability across locations.

What is essential for the main result in the paper is that firms receive some signal of their productivity in both countries before choosing where to produce. The main result would still hold if there is some additional uncertainty that is only resolved following location choice.

In this setting, each firm will only produce in one location. The most natural way of accommodating firms that produce in multiple locations within this framework would be to follow some of the heterogeneous firms literature in international trade in interpreting the basic unit of production as a “project” rather than a “firm” so that multiple projects can be thought of as nested within a firm.

See Dharmapala et al. (2011) for more on the connection between this type of setup and Diamond–Mirrlees.

A more formal justification for this small country equilibrium can be obtained by assuming that \(L_{1}=\epsilon L_{2}\) and \(K_{1}=\epsilon K_{2}\) and considering what happens as \(\epsilon \rightarrow 0\). This argument is presented in Appendix A.2.

More broadly, these small country results would also hold qualitatively for a country that is not technically a small country but is sufficiently small so as to have a relatively limited effect on foreign prices and the foreign mass of entrants.

The positive optimal tax result, however, would still hold even with multiple immobile factors.

See Davies and Gresik (2003) for a more extensive discussion of the conditions under which factor prices will be fixed with respect to tax rate changes, and the implications of this for tax policy.

Formally, this is because the unit normal vectors point in opposite directions (i.e., \(u_{1}=-\,u_{2}\)).

Note also that this proof holds even if the measure of country 1 firms locating at home was zero, so that \(\intop _{\Theta _{11}}l_{11}\left( w_{1},r,z_{1} \right) g(z)\hbox {d}z=0\). This is because domestic entry is always connected to domestic labor since a portion of the fixed entry costs is paid in terms of labor.

A more detailed analysis of the implicit apportionment system would require an examination of the royalty regime that is in place, since royalties often serve as a means of apportioning profits across countries. Such an analysis would be beyond the scope of the current paper.

If country 1 firms all located in their home country, the profits net of all fixed costs would be equal to zero. This means that if fixed costs were deductible, no tax revenue could be raised on domestic firms. Since some firms locate abroad and so are not subject to domestic taxation, the net profits at home after fixed costs will actually be negative. Since the purpose of this extension is to consider what happens when domestic firms are subject to actual taxation, I assume that the fixed costs are not deductible.

The case with domestic firms also in operation (Case II in Sect. 3.2) is identical to Sect. 3.2 since the factor price insensitivity still holds and so the host country would again have an incentive to maximize revenue.

As with the two-country case, we can more formally justify the small country concept here by assuming \(L_{i}=\epsilon \sum _{j\ne i}L_{j}\) and \(K_{i}=\epsilon \sum _{j\ne i}K_{j}\) and considering the equilibrium as \(\epsilon \rightarrow 0\). The formal argument would then be of essentially the same nature as the one presented for two countries in Appendix A.2, i.e., that as \(\epsilon \rightarrow 0\), the wage in each foreign country, the mass of entrants in each foreign country and the factor price for capital would be determined by foreign equilibrium conditions that hold independently of any country i variables. As in the two-country case, the results derived here would again be qualitatively true of a country that is not technically a small country but is sufficiently small so as to have a limited effect on foreign variables.

Note that owing to Walras’ Law, we could have equivalently used the goods market clearing condition, (2.3), which also becomes independent of country 1 variables as \(\epsilon \rightarrow 0\), in place of either the capital market clearing condition or country 2’s labor market clearing condition.

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Titel: Incentives to tax foreign investors
verfasst von: Rishi R. Sharma
Publikationsdatum: 30.06.2018
Verlag: Springer US
Erschienen in: International Tax and Public Finance / Ausgabe 2/2019
Print ISSN: 0927-5940
Elektronische ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-018-9506-3

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