International tax neutrality: reconsiderations.

Tax policy in general and international income tax policy in particular has long been a subject of discussion and argument by tax philosophers, economists, and lawyers. Theories have often been introduced to support the establishment of new tax systems, to justify existing ones, or to call for changes. Economists introduced "economic efficiency" as a criterion for evaluating tax systems. At the international level, tax neutrality theories were introduced as criteria for achieving economic efficiency. Different tax neutrality theories supported different theoretical international income tax systems. Some theories called for compromise, jeopardizing coherence, and increasing complexity. While reconsidering the classic tax neutrality analysis, this article argues that residence-based taxation has, at best, no advantages over source-based taxation in satisfying capital export neutrality. This article then introduces the idea of best satisfying capital export neutrality, simultaneously with the other tax neutrality theories, simply by source-based taxation (not necessarily with globally harmonized rates) that effectively cures the distortions resulted by its imposition.

"Save your reproach, reproach makes temptation increase, You'd better heal me with the very cause of my disease" (1)

I. INTRODUCTION

Since Peggy Musgrave's 1963 and 1969 works, (2) and their reformulation and restatement by Horst in 1980, (3) the economics and legal literature has broadly discussed international tax neutrality theories and introduced new ones seeking to enhance economic efficiency. The development of the discussions was, historically, fairly limited because Musgrave's conclusions, rather than the basic definitions, served as the undisputed baseline. This article reconsiders the international tax neutrality theories by referring to the basic definitions, questioning the accepted conclusions, and suggesting different ones.

Five international tax neutrality theories have been introduced: (1) capital export neutrality (CEN), (2) capital import neutrality (CIN), (3) national neutrality (NN), (4) capital ownership neutrality (CON), and (5) national ownership neutrality (NON). It is undisputed in the tax literature that CEN can only be achieved through residence-based taxation or once all countries adopt source-based taxation with identical tax rates; CIN through source-based taxation; NN if home countries tax foreign source income and allow deductions for foreign taxes; CON through either residence- or source-based taxation; and NON through source-based taxation. The main idea of this article is that CEN, as well as the other neutrality theories, is best and simultaneously satisfied by source-based taxation, not necessarily with globally harmonized tax rates.

After the introduction in this Part I, Part II presents and discusses the classic international tax neutrality theories and analysis. Part III next reconsiders the classic analysis of tax neutrality, especially CEN, and its conclusions. Part III argues that pure residence-based taxation satisfies CEN only when global uniformity with respect to tax systems is achieved. Furthermore, if the saving-consumption distortions of taxation are to be considered, global uniformity with respect to tax rates is also needed. Given such limitations, source-based taxation seems to be a theoretically, practically, and politically superior means for achieving CEN. Part IV follows the classic framework and analysis of international tax neutrality by disregarding the saving-consumption distortions of taxation, consistently disregarding the labor-leisure distortions of taxation, and showing how the burden of source-based taxation will be borne by immobile factors (labor, land, etc.) rather than mobile factors (capital). This allows source-based taxation to fully satisfy CEN simultaneously with NN, CIN, CON, and NON. Part IV also calls for additional work in this respect. Part V is reserved for conclusion.

II. ECONOMIC EFFICIENCY AND THE CONCEPT OF TAX NEUTRALITY

Economic efficiency is fundamentally associated with economic costs and benefits. Maximizing economic efficiency requires, to the extent possible, maximizing economic benefits and minimizing economic costs. Maximizing economic efficiency is thought to result in maximum wellbeing in overall terms. It logically follows that economic efficiency disregards distributive considerations: insofar as benefits are maximized and costs are minimized in overall terms, economic efficiency is satisfied regardless of how wealth is distributed. From a national perspective, economic efficiency is concerned with maximizing the excess of overall economic benefits over overall economic costs within the nation. From a global perspective, worldwide economic efficiency is thought to be concerned with maximizing overall wealth in worldwide terms. (4)

International tax neutrality policies are economic theories believed to enhance economic efficiency as an international tax policy matter. The basic assumption of all international tax neutrality theories is that capital is perfectly mobile and that labor and land are perfectly immobile. The baseline of the classic tax neutrality analysis seeking to maximize global economic efficiency is a non-tax world in which investment and other business decisions are considered economically most efficient. (5) Tax neutrality theories strive to keep such investment and business decisions tax neutral--that is, to keep investment and business decisions unaffected and undistorted, compared to a non-tax world, by the imposition of tax and tax consideration. All international tax neutrality theories will be generally introduced in this part, but each will also be discussed in greater detail in the following parts.

Taking the non-tax world as its baseline, CEN seeks a tax system that does not distort the locational allocation of investment capital in an "ideally efficient" non-tax world. For a tax system to satisfy CEN, capital should be invested in the same locations where such capital would have been invested had there been no taxes. (6) Only then will the decision as to the location of investment be tax neutral. Under the classic tax neutrality analysis, only pure residence-based tax systems would satisfy CEN. (7) International tax differentials might distort such allocation by resulting in higher after-tax rates not necessarily associated with the higher pre-tax rates of return. The distortion in capital allocation occurs because investors seek to maximize their net profits, and ergo invest where after-tax rates of return are higher. Hence it is thought that source-based taxation is economically inefficient from a global perspective. (8) On the other hand, under residence-based taxation (implemented by full and unlimited foreign tax credit (FTC) systems), a taxpayer will be subject to the same total tax rate (equal to the domestic tax rate) regardless of the investment's location. (9) Since investors under such circumstances have no tax incentives to relocate their investments, Musgrave concludes that only a full and unlimited FTC system would satisfy CEN. (10) While frequently criticizing her assumptions, the subsequent economic literature generally accepted Musgrave's logic and conclusions. (11) When referring to CEN policy matters, the legal literature usually, perhaps naturally, adopted the economic classic analysis as a given. Nevertheless, one of the most explicit attacks on CEN economic analysis was Michael Graetz's article describing CEN analyses as employing "inadequate principles, outdated concepts and unsatisfactory policy." (12)

The non-tax world is, as well, the baseline of CON, which requires ownership patterns, rather than locational allocation of capital, to be free of tax distortions. (13) CON is believed to maximize global efficiency when the productivity of capital depends on, and varies with, the identities of its owners. (14) The logic behind CON analysis is simple. An efficient allocation of capital maximizes productivity; therefore, if productivity depends on, and varies with, the ownership of capital, then an efficient tax system is one that encourages the most productive ownership of capital. (15) CON analysis follows the CEN classic analysis and concludes that, for CON to be satisfied, conformity among tax systems is necessary, either by all countries adopting source-based taxation, or by all countries adopting residence-based taxation. (16)