Optimal Tax Policy when Firms are Internationally Mobile

1 Introduction

Standard optimal tax theory recommends that small open economies should not
impose source-based taxes on the normal return to capital if capital is internation-
ally mobile (Gordon (1986), Sinn (1990)). If capital is taxed at source, investment
is distorted and national welfare declines. The literature has therefore proposed a
whole class of investment-neutral tax systems in which (pure) profits can be taxed
without distorting the investment decision. These proposals are often summar-
ized under the label ‘consumption tax systems’. The main characteristic of these
investment-neutral corporate tax systems is that tax payments are zero if the pro-
ject return merely equals the cost of capital. In technical terms, the present value
of depreciation allowances (PVDA) is equal to 100% of the purchase price of the
capital good.

In 1982, the unweighted average of the PVDA for an investment in plant and
machinery across a large number of OECD countries¹ was 81%, the PVDA for
industrial buildings 48% (Devereux, Griffith & Klemm (2002))². With the excep-
tion of Ireland, no country allowed for immediate depreciation or an equivalent in
present value terms, i.e. a PVDA of 100% . Since then, the opening of capital
markets and increasing economic integration among these countries should have
increased the cost of distorting investment.³ In sum, we should have expected
countries to reform their tax system lowering the taxation of the normal return,
i.e. increasing the PVDA.

But, empirical observations do not support the view that governments pursued
this kind of tax policy strategy. Twenty-one years later, in 2003, the unweighted
average of the PVDA has dropped to 75% for plant and machinery and to 33%
for industrial buildings. This means that, on average, countries have taken the
opposite direction of what standard optimal tax theory suggests.

¹These countries are Australia, Austria, Belgium, Canada, Finland, France, Great Britain,
Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, Portugal, Spain, Sweden, Switzer-
land and the USA.

²We adopted the calculations with a fixed real interest rate (10%) and a fixed rate of inflation
(3,5%) in order to keep the numbers comparable across time and countries.

³Of course, source-based taxation is only one level of taxation. Taking into account
intermediate-level and household taxation, it is unclear whether the normal return to capital
is taxed or not, as Gordon, Kalambokidis, Rohaly & Slemrod (2004) show for the US, and
Becker & Fuest (2005) for Germany.

<<   1   2   3   4   5   6   >>

More intriguing information