International tax neutrality: reconsiderations.

Following the classic tax neutrality analysis, it is assumed here that no economy is large enough to affect the world rate of return. (36) Because the capital movement from capital-exporting to capital-importing countries occurs in the non-tax world, the final allocation of capital is considered to be economically efficient and serves as the baseline in the following tax neutrality analysis.

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B. The Effects of Source-Based Taxation on the Allocation of Capital: The Classic Theory

The imposition of source-based taxation (37) by a country at the rate of t forces the rate of return on capital invested to rise from [r.sub.F] to r=[r.sub.F]/(1-t) in order to allow investors to earn an after-tax rate of return equal at least to the world rate of return, [r.sub.F]. Figure 2 illustrates the effects of the imposition of source-based taxation by a capital-importing country on the allocation of capital and rates of return therein.

[FIGURE 2 OMITTED]

As described in Figure 1, in a world without taxation capital flows into the capital-importing country, reducing the rate of return on capital invested there from the initial rate of return, [r.sub.0], to the world rate of return, [r.sub.F], and equilibrium is reached. The capital inflow stops when the rate of return in the capital-importing country reaches [r.sub.F]. However, if the capital-importing country imposes source-based taxation at the rate of t, the capital inflow stops when the rate of return on domestically invested capital reaches r=[r.sub.F]/(1-t). (39) At that point, the after-tax rate of return will be equal to the world rate of return, [r.sub.F], and any further investments in this country will yield an after-tax rate of return lower than [r.sub.F], Therefore, it will be more profitable for investors to invest elsewhere and earn returns that are at least equal to the world rate of return. The overall result of the imposition of source-based taxation by a capital-importing country is that net rates of return on domestically invested capital are unaffected, but the amount of capital invested there is reduced when compared to the non-tax world (from K to K'). Therefore, the segmented curve represents the marginal net returns on capital invested in the capital-importing country after the imposition of source-based taxation, (40) according to which the same net rates of return (as compared to the demand for capital curve) are reached if less capital is invested.

The effects of the imposition of source-based taxation by a capital-exporting country on the rates of return on capital invested (Figure 3) are similar to those in a capital-importing country, but from an opposite direction.

In a non-tax world, capital flows out of a capital-exporting country until the rate of return on capital invested has risen from the initial rate of return, [r.sub.0], to the world rate of return, [r.sub.F], at which point the outflow stops (Figure 1). When source-based taxation (t) is imposed by the capital-exporting country, the capital outflow does not stop at the point where r=[r.sub.F], but continues further and stops at a point where r=[r.sub.F]/(1-t). Only then will investors be unable to invest elsewhere to earn greater net returns. As in the case of the capital-importing country, the result of the imposition of source-based taxation by a capital-exporting country is that net rates of return on domestically invested capital are unaffected, but the amount of capital invested there is reduced (from K, in a non-tax world, to K').

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According to the classic neutrality analysis, it seems undisputable that the imposition of source-based taxation by both capital-exporting and capital-importing countries theoretically results in locational distortions when compared to the non-tax world. That is why source-based taxation is so widely perceived to violate CEN.

C. Residence-Based Taxation and Tax Neutrality

A pure residence-based tax system is a tax system where the home-country imposes taxation on the worldwide income of its residents. Ideally, the home-country tax should be the only tax imposed on any income of its residents regardless of the source of such income. (42)

1. The Theoretical Premise of the Classic Analysis of Capital Export Neutrality (CEN)

The classic analysis of CEN rests on the theoretical premise that the imposition of pure residence-based taxation by a capital-exporting country (43) will not distort the investment behavior compared to the non-tax world. The idea underlying the classic analysis is that under residence-based taxation, the residents of a capital-exporting country will be subject to the same tax burden regardless of the locations of their investments. (44) Therefore, pure residence-based taxation will have no effect on decisions as to the location of investments. Locational tax neutrality (CEN) will thus be achieved. This notion is illustrated in Figure 4, which shows how the imposition of residence-based taxation affects the non-tax world equilibrium of Figure 1.

In Figure 4, the tax rate imposed by the capital-exporting country is t, while [r.sub.0], [r.sub.F], W, and K denote the same values as in Figure 1. Because income from both domestic and foreign investments is subject to the same tax, domestic investors have no tax incentives to shift the location of their investments. As a result, the new equilibrium differs from the non-tax world equilibrium only in that the net return to domestic investors falls from [r.sub.F] to [r.sub.F](1-t) and the balance is the tax revenue. (46) Distortions regarding capital stock and its location are believed not to occur and CEN is satisfied.

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2. The Need for Global Systems Uniformity

Because generally countries will not be willing to forego taxation by source, even with respect to foreign taxpayers, the best and perhaps only feasible way to accomplish taxation by residence is to adopt an unlimited FTC extraterritorial system. The overall tax rate that taxpayers would bear under such an unlimited FTC system would be equal to the tax rate imposed by the country of residence, regardless of what other countries do. (47) The prevailing belief in the context of international tax neutrality analysis is that exercising residence-based taxation by adopting an unlimited FTC system enables a country to achieve CEN regardless of the tax policies other countries might adopt. (48) This supposed feature of CEN is considered superior, as a policy matter, to CIN, which requires that all countries adopt source-based taxation. (49) It is argued here, against the prevailing belief, that CEN also suffers from this same shortcoming and that for CEN to be satisfied, all countries in the world must adopt residence-based taxation.

Due to the effect of source-based taxation on the rates of return offered for investment capital in the source-based taxing country, (50) it is enough for one country to adopt source-based taxation to result in the locational distortion of investment capital. When a country imposes source-based taxation (t), capital (51) will flow out of the country, resulting in an increase in the rates of return from [r.sub.F] to [r.sub.F]/(1-t). Such an increase distorts the international pre-tax rate of return differentials and affects investors' decisions regarding where to invest. For example, consider two countries, A and B, in a non-tax world both offering a rate of return of 12%, which is the world rate of return. Now assume that Country A imposes extraterritorial taxation at a rate of 50% with an unlimited FTC system, while Country B adopts a source-based tax system at a rate of 40%. The pre-tax rate of return in Country A remains 12%, (52) but the rate of return in Country B rises to 20% (12/(1-0.4)). (53) For residents of Country A, the after-tax rate of return on investment in Country A is 6% (12X(1-0.5)), and the after-tax rate of return on investment in Country B is 10% (20X(1-0.5)). (54) Therefore, investors from Country A will prefer to relocate their investments to Country B where their after-tax rate of return is higher. CEN is satisfied when the decision where to invest is tax neutral. The baseline of CEN is the non-tax world. Investments by residents of Country A in our example that would have been located in Country A in the non-tax world are relocated to Country B because it adopted a source-based tax system. The result is that CEN is not indeed satisfied, not even by Country A, despite the fact that Country A adopted an unlimited FTC system. Only when all countries adopt pure residence-based systems or full FTC systems can CEN be achieved. (55)

3. The Need for Global Tax Rate Harmonization