International tax neutrality: reconsiderations.

The concept of neutrality contextually changes with the different objectives of the tax neutrality theories. The objective of NN and NON is to maximize national efficiency. The baseline of NN therefore is a non-tax national economy. (17) The neutrality feature of NN should then refer only to the national tax--the national income tax system of a nation seeking to maintain NN should not affect the locational allocation of national businesses. (18) In this context, foreign taxes are considered as regular expenses of doing business abroad. Hence, the classic analysis concludes that NN is satisfied when foreign-source income of nationals is also subjected to the national tax, while a deduction for foreign taxes paid is provided. (19) Perhaps intuitively, the same logic should apply to NON, but that does not seem to be the case. Following the classic analysis, NON may not be seen as a neutrality theory in the first place. The classic analysis of NON utilizes, even exploits, tax differentials as a means to promote national efficiency. NON assumes that foreign inbound investments will substitute for any national outbound investment and therefore compensate, in terms of national tax revenue, for the loss on national outbound investments. (20) Therefore, viewing the national wealth as comprised of the national tax revenue and the net income of nationals, NON encourages nationals to make outbound investments the after-foreign-tax return of which is higher than the after-tax return on alternative domestic investments. (21) Such comparison between after-tax returns is not considered neutral by the classic analysis. NON is satisfied by source-based taxation (exempting foreign source income from home country taxation). (22)

Classically, CIN seeks tax neutrality with respect to business competition and expansion opportunity within each capital importing country and calls on all countries in the world to adopt source-based taxation. (23) The logic behind classic CIN is simple. If all investors in a certain jurisdiction are taxed only by source and only by that jurisdiction, regardless of their residency, then the taxation will have no effect on business competition and expansion opportunity within each jurisdiction. (24) In this respect the concept of neutrality is slightly different and is closer to the meaning of tax-equality (though not as a value) between investors in each jurisdiction. Accordingly, taxes will have no effect on business competition and expansion opportunity differences and comparisons within each jurisdiction. However, under classic CIN, expansion opportunity is distorted if the non-tax world is used as a baseline, since the mere imposition of taxation reduces net profitability and, therefore, reduces the funds available for business expansion. But with all businesses within the same jurisdiction suffering from the same reduction in expansion opportunity, the relative neutrality is kept.

Of course, this does not mean that all businesses within one jurisdiction will have a similar expansion opportunity. Nor does it mean that different businesses will not have different competitive advantages or disadvantages. But the assumption is that, if such differences exist, they exist completely independent of the tax system. CIN is also believed to provide tax neutrality as to saving and result in an efficient allocation thereof. Under a CIN tax system all savers in one jurisdiction receive the same after-tax returns, regardless of their residency status. Therefore, intertemporal marginal rates of substitution in the jurisdiction balance (i.e., all savers in one country will receive the same prices for future and present consumption). (25) If all countries adopt source-based taxation, after-tax rates of return, and therefore intertemporal marginal rates of substitution, will be globally balanced, resulting theoretically in an efficient allocation of world saving. (26) This argument too would be problematic under the classic analysis if the baseline of CIN with respect to saving neutrality is the non-tax world. Any income tax imposition distorts the allocation of saving and consumption. (27) Therefore, it seems more reasonable under the classic neutrality analysis to adopt a relative understanding of tax neutrality with respect to saving that is similar to the one with respect to business competition and expansion opportunity.

However, CIN may be viewed as a non-tax world based neutrality theory representing neutrality with respect to the location of the investors, assuming the location of the investment is fixed (i.e., in the taxing jurisdiction). Therefore, a tax system would satisfy CIN if, with respect to investments in the taxing jurisdiction, the location of investors (where capital comes from) is not distorted by the imposition of the tax. In this view, CIN is the flip side of CEN, which represents neutrality with respect to the location of the investment, assuming the location of the investor is fixed (i.e., in the taxing jurisdiction). CEN theory keeps tax neutral the question as to where capital from the taxing jurisdiction should be exported to ("capital export neutrality"). In contrast, the concern of CIN is keeping tax neutral the question as to where capital invested in the taxing jurisdiction should be imported from ("capital import neutrality"). If all countries adopt source-based taxation, CIN will definitely be satisfied because all investors in the taxing jurisdiction will be subject to, and only to, the same tax regardless of their residency. The imposition of source-based taxation does not distort the non-tax world profitability differentials between investors because the investment returns in the taxing jurisdiction will be reduced in the same proportion (the tax rate) in rem. Following this view, the only difference between CIN and CON is that the latter represents neutrality with respect to the identity of the investor (owner), while the former is indifferent to the identity of investors from the same location. (28)

It is accepted in the literature that, unlike CEN, for CIN to be satisfied all countries in the world must adopt source-based taxation. (29) This is so because CIN is satisfied only when investment income is taxed solely by source. (30) The literature also confirms that CEN and CIN may not be simultaneously satisfied unless tax rates are internationally harmonized. Only then will investors be subject to the same tax regardless of the location of investments (CEN) or the residency of investors (CIN). Graetz offers an interesting way of making this point, and it seems best to put the argument in his words:

My favorite way of making this point is in terms of an irreconcilable

conflict among the following three simple principles:

Principle 1: People should pay equal taxes on their income

regardless of the country that is the source of that income. In

particular, U.S. taxpayers should be treated equally regardless of

the source of their income.

Principle 2: All investments in the United States should face the

same burden regardless of whether a U.S. person or a foreign person

makes the investment. In other words, U.S. and foreign-owned

investments and businesses should be treated equally.

Principle 3: Sovereign countries should be free to set their own tax

rates and to vary them as their domestic economic situations demand.

The essential difficulty is that the first two principles can hold

simultaneously only when capital income is taxed at the same rate in

all countries. This requires identical tax systems, including

identical tax rates, tax bases, and choices between source- and

residence-based taxation. That has never happened, and it never will.

Moreover, there would be no way to keep such a system in place without

violating Principle 3.... This difficulty makes compromise between

these principles inevitable.

Principle 1 states a requirement of capital export neutrality.

Principle 2 states a version of capital import neutrality, although it

also expresses a desire for nondiscrimination either in favor of or

against foreign-owned businesses and investment. (31)

The logical aspect of Graetz's argument is clear. (32)

III. RECONSIDERING THE CLASSIC TAX NEUTRALITY ANALYSIS

A. The Non-Tax World

In an open economy with capital mobility and no taxation, marginal rates of return on capital in all countries will eventually settle at the world rate of return ([r.sub.F]). (33) This is illustrated graphically in Figure 1 below. If capital were immobile, the prevailing rates of return absent taxation in each country in Figure 1 are represented by [r.sub.0e] in the capital-exporting country and [r.sub.0i] in the capital-importing country, resulting from the intersection between the curves presenting each country's wealth ([W.sub.e] or [W.sub.i]) and the demand for capital. (34) Since capital is mobile, if [r.sub.F] is higher than the rate of return of the domestic country ([r.sub.0e]), capital will flow out of this capital-exporting country until the rate of return increases to [r.sub.F]. If [r.sub.F] is lower than the rate of return of the domestic country ([r.sub.0i]), capital will flow into this capital-importing country until the rate of return decreases to [r.sub.F]. (35)