US tax reform of 1986 was considered to be a success in historic dimensions and
could have triggered similar reforms in other countries (see diagram 1).
The second approach is the attempt to explain tax rate cut cum base broad-
ening policy as an optimal response to a changing economic environment. Haufler
& Schjelderup (2000) show that, if multinational firms earn supernormal profits
and if they may shift these profits to low tax countries via transfer pricing, it is
optimal to reduce tax rates and broaden tax bases, despite the distortion of in-
vestment caused by this policy. Fuest & Hemmelgarn (2005) show that a tax rate
cut cum base broadening policy may be optimal in the presence of income shifting
through thin capitalization even if there are no pure profits. Another argument
is provided by Bond (2000) who observes that “the increase in the importance of
foreign direct investment flows over the last fifteen years or so has been accompan-
ied by corporate tax reforms of this [tax rate cut cum base broadening] type. This
coincidence does not establish any causal Iinkfrom globalization to tax changes, but
other explanations (...) appear to be scarce” (p. 173). He proposes to interpret
the tax rate cut cum base broadening to be the optimal tax policy reaction to the
existence of mobile and highly profitable firms. Without using a formal model,
he suggests a setting in which multinational companies are assumed to be very
sensitive to the effective average tax rate whereas investment by immobile firms
is relatively insensitive to the effective marginal tax rate. Bond concludes that
a government then might increase domestic investment by lowering the statutory
tax rate and accepting a broader tax base, even though this results in a higher
cost of capital.
In this paper, we contribute to the second approach to explain the trend towards
low tax rates and broad tax bases. Surprisingly, the question of how optimal
corporate tax policy looks like in the presence of internationally mobile firms,
has not been investigated yet in a formal model.7 Of course, firm mobility as
such has been extensively analyzed in the literature on foreign direct investment
(Lipsey (2001)) and the new economic geography (see Ottaviano & Thisse (2003)
firms. When the US lowered the tax rates fundamentally, other countries were forced to do the
same if they did not want to push the US firms out of the country (Slemrod (2004)).
7As Devereux, Lockwood & Redoano (2004) put it, existing models do not account for the
fact that governments have two instruments, the tax rate and the tax base. Second, these models
ignore other forms of mobility than capital mobility.