The economic theory of harmonization of taxes on capital income

4.3.1 The economic theory of harmonization of taxes on capital income

Efficiency considerations are also at the heart of policy discussion relating to the intemational taxation of capital income. For efficiency to exist in international investments, two conditions must be met.12 First of all, the investment should be located in the área where production costs are the lowest.

Secondly, investments must be done by the company that could produce at minimum costs, i.e. by the company that is the lowest-cost producer. The first condition relates to the "where" of investments, the second to the "who" of investments. In the literature of intemational taxation of capital income, these two conditions have been translated into two different concepts of tax neutrality, viz. capital export neutrality (GEN) and capital import neutrality (CIN).

GEN is said to exist when an investor is faced with the same effective tax rate irrespective of the location of the investment. In other words, if tax rates between countries differ and companies are investing in a low-tax country, even if production costs in that country are higher than in the high-tax country, there is no capital export neutrality. GEN, therefore, relates to the decisión of where to invest and for GEN to obtain, a company must face the same effective tax rate everywhere. The following example illustrates the absence of GEN:

Country B

Production costs Price

Profit Profit tax After-tax profit

1000 2000 1000

800(80%) 200

1500 2000 500 100(20%) 400

In the absence of a tax, the company that produces the product from our example would choose to produce in country A. However, due to the existence of a differential profit tax, the company will instead choose to invest in country B, where it can achieve a higher after-tax profit. Thus, GEN is absent and the existence of corporate tax differences diverts investments from country A to

Tax Harmonization country B. From the perspective of productive efficiency, this investment implies a waste of productive resources and therefore reduces the overall level of welfare in the community of countries A and B. CEN could be established if both countries would have the same effective tax rates.

By contrast, CIN relates to the issue of who invests. One could also say that CEN concems the International allocation of investments, whereas CIN relates to the International allocation of savings. CIN is said to exist when all operations in one particular jurisdiction face the same effective tax rate. Thus, CIN primarily produces efficiency in exchange. An example may illustrate the meaning of CIN.

Firms from country: B

Price without tax Pnce with tax

100 120(10%)

110 110 (0%)

In the example it is assumed that firms from countries A and B supply a particular product to the market of country C. In the absence of a corporate tax, firms from country A would be the cheapest producers. However, as a result of the tax, ñrms from country A may decide to charge higher prices, as they will have to be able to make sufficient profit in order to provide their shareholders with an acceptable retum. As the less efficient firm from country B is not subjected to the tax (or to a lower tax) it will get most of the market of country C. This would be different in the case the tax rates were harmonized, as the artificial advantage for companies from country B would be eliminated.Thus, for CIN to obtain, all companies must be having the same effective tax rate irrespective of their nationality and location, so that taxation does not affect the relative competitive positions of the companies. Clearly, this harmonization would produce positive welfare effects in a tax unión of A andB.

The above example makes it clear that the benefits of tax harmonization can only be reaped if there are differences in productive efficiency and when the most efficient firm is facing the highest tax rates. In the case both firms would be equally efficient and firms from country B would be faced with lower tax rates, or in case the most efficient firms would face the lowest tax rates, harmonization would not produce the above mentioned welfare effects for the unión as a whole. Of course, when all countries are equally efficient, a higher tax in one country might result in a loss of production in that country and all production might subsequently take place in the other country, but this

would not lead to a waste of resources. At the same time, when all investment locations are equally efficient, the fact that taxes in country B are lower than in A, does not matter to anyone except the citizens of country A. Thus, if no country or location is more efficient than another, there can be no welfare loss for the unión as a whole if taxes encourage ñrms to favour one firm location or investment location over another.

CEN and CIN can be obtained by appropriate cholee of jurisdictional principies. Two altemative jurisdictional principies are at the disposal of the tax authorities as a basis for income taxes. The first principie is the residence or world-wide principie, according to which taxation is applied to the total income of residents irrespective of the place where the income was eamed.

This means that companies or groups of companies are taxed on their world- wide incomes. The second principie is the source or territorial principie, according to which the tax i s applied to all incomes eamed within the taxing jurisdiction, whether or not this income is enjoyed by residents or non- residents. As a general rule, CEN obtains if the residence principie were applied uniformly. CIN obtains in the case of uniform source taxation.

When governments tax at source in the capital importing country, CEN can be approached when governments would opérate a "credif system when taxing foreign source income. This implies that the resident country deduets all foreign-paid taxes which are levied on foreign incomes and that the (positive) difference must be paid to the govemment of the resident country.

Thus, companies would have no incentive to try to take advantage of the lax tax regime abroad. However, even under atax credit system, some distortions to CEN are still possible. Think, for instance, of a situation where the tax rate in the resident country is lower than abroad. When the tax authority does not reftind the excess tax which has been paid abroad, CEN will not apply as companies have an incentive to invest in low-tax jurisdictions. CEN may also not obtain in the case companies delay the repatriation of profits. Finally, CEN may be hard to achieve in the case of portfolio investments, as it is extremely difficult to ensure that foreign-source income is declared to the tax authorities of the capital exporting country. Usually, only source taxes are paid when this declaration does not take place.

CIN is in principie obtainable when taxation takes place at the source, i.e.

when taxes are levied on national profits. It can be approached when resident countries exempt all foreign source income which is eamed from capital exports. CIN may also not be approached for some reasons. Firstly, there could be withholding taxes on dividends. Secondly, as is well known (see furtheron), there is a bias against equity ñnancing and in favour of debt financing in most tax regimes as interest payments are usually tax deductible.

Companies that do not have an existing flow of profits in a foreign country are therefore usually obliged to take recourse to equity financing, and, as a result,

Tax Harmonization should eam higher pre-tax rates of retum, which prevenís CIN from being obtained.

Achieving CIN and CEN at the same time is normally only possible if all countries would face the same effective tax rate or would have a common tax regime (with common rates, tax bases, allowances etc.), of which intercountry compensation of losses is a feature. That normally not being the case, however, a cholee must be made between CIN and CEN as countries cannot at the same time opérate a credit system and an exemption system. In case the imposition of a common tax regime is impossible, which, CIN or CEN, would be preferable?

The starting point to this question could again be the Diamond and Mirrlees result that an optimal tax structure preserves productive efficiency.

That would lend support to the argument that CEN is to be preferred. In addition to that, deviations from CEN are usually considered to be more costly than deviations from CIN. Under the not unreasonable assumption that companies are more responsive to differences in the tax burdens when making decisions as to their investments than households are when making their decisions to save, variations in effective tax rates between countries can do more harm than do variations in effective tax rates within countries. That would be another argument in support of achieving CEN.

However, there are also costs involved in deviating from CIN. This is, for instance, the case if competition is imperfect and tax advantages enable high cost producers to drive out low cost competitors. That would result in a loss of productive efficiency, which could be an argument to doubt the residence principie. Also, applying the residence principie may be very difficult in practice, as it would require Consolidated corporate accounts. Furthermore, if parents were taxed according to residence, then a foreign subsidiary might have a different valué to different parents, i.e. parents in low-tax residence countries might have an inventive to own subsidiarles in high-tax countries.

That could lead to an undesirable amount of concentration of business.

Considerations of fairness or equity also would push in the direction of source-based taxation. In this connection, equity can be understood to have two dimensions. Firstly, there is intercountry equity, which implies an equitable distribution of tax revenues between capital exporting and capital importing countries. It could be argued, that source taxation is simply a compensation for the public services offered by the government of the capital importing country and that this country should be entitled to at least a part of the profits made by foreign business on its territory. Secondly, tax payer equity could imply that it is not f air that companies are taxed differently solely because they reside in different tax jurisdictions. Moreover, as foreign capital owners have better opportunities to conceal their foreign eamed income from their own tax authorities, application of residence taxation could result in an

erosión of the corporate tax base with the consequence that the burden of taxation would be shifted towards less mobile factors, such as labour, land, real estáte and consumers. Needless to say, this could result in less equitable personal income tax regimes.

Thus, although it seems that there are strong arguments in achieving CEN, a clear-cut case cannot be made as to its desirability in comparison to CIN. That is, however, not as disappointing as it might look at first sight. The reason for that is that many tax reform proposals can increase both CIN and CEN. This is, for instance, true for the abolition of withholding taxes on dividends. Other examples include the abolition or reduction of de facto tax incentives given to foreign direct investors.

Apart form the purely economic distortions caused by differences in corporate tax regimes, there are a number of other distortions which are worth mentioning.13 The most important of these distortions are administrative, organizational and fínancial distortions. Administrative distortions arise because tax planning, tax collection and tax avoidance have produced a large tax administration industry, both within government, and within companies.

Multinational companies nowadays employ huge tax departments whose job it is to minimize the tax bilí and to sort out how the company can deal with different intemational corporate tax provisions. In addition to that, large government tax bureaucracies have been set up in order to repair the loopholes that are created by differences in corporate tax regimes between countries and in order to make sure that companies comply with their tax obligations. From a strictly economic point of view, the activities of the tax administration industry, should be considered as a waste of resources and as socially useless forms of activity.

Organizational distortions arise because differences in International tax regimes change the way in which transnational firms organize themselves.

Different govemments usually give different tax incentives in order to encourage certain types of activity in jurisdictions. Thus, it may happen that companies lócate their R&D department in a certain country, their accounting department in another country and a holding company in yet another country.

If there are no sound commercial reasons to lócate these various different department in different countries, then responding to intemational differences in tax incentives implies that the organizational efficiency is reduced.

Financial distortions arise because International corporate differentials could change the fínancial structure of intemational firms. In this respect it should be noted that most tax systems favour debt financing over profit retention or the issuing of new equity. The reason why this is so is that interest payments are usually tax deductible whereas dividend payments are usually not. In the context of intemational business and transnational investments, we

Tax Harmonization also see that the tax systems usually favours debt finance over equity finance.

In many cases interest payments abroad attract a lower withholding tax than dividend payment abroad. As a result of this transnational companies are stimulated to use debt finance rather than equity finance. This problem is aggravated by the possibility of tax arbitrage between countries. Tax arbitrage occurs when allowances are given from low tax countries to high tax ones.

Companies operating in a country with high statutory tax rates may have an incentive to maximize the amount of interest of payments, particularly if these interest payments flow abroad to countries with low statutory tax rates. Thus, tax arbitrage causes companies towards using even more debt. It should be obvious that the encouragement of heavy reliance on debt finance and the concentration on interest payments in certain countries are two undesirable distortions which results from International differences in corporate taxes.

4.3.2 Direct tax harmonization in the EU: the case of capital income