International tax neutrality: reconsiderations.

The adoption of perfect residence-based tax systems by all countries may still be insufficient for satisfying CEN and global conformity with respect to tax rates is also necessary. Taxation on investment income results in saving distortions in terms of reductions in the saving stock. (56) Such reduction results in an increase in the pretax rates of return. (57) With different countries setting different tax rates, it is reasonable to assume that saving distortions in different countries differ too. Furthermore, with residence-based taxation, after-tax rates of return are a function of pre-tax rates of return prevailing in the source country and the tax rates prevailing in the country of residence. Because pre-tax rates of return at the source-country are distorted (increased) by the country's tax rate, after-tax rates of return on inbound foreign investments are in fact affected by an increase related to the source-country tax rate, followed by a reduction related to the residence-country tax rate. Such an increase bears no relationship, and is arbitrarily disproportionate, to the reduction. This combination may result in distortions in the after-tax rate of return differentials (i.e., in after-tax rate of return differentials not corresponding to pre-tax rate of return differentials). The final result is a distortion of investment decisions that violates CEN. Put differently, if saving distortions are affected by the source-country tax rate, without global conformity as to tax rates, saving distortions will affect different countries differently. Because saving distortions yield increased rates of return, pre-tax rates of return in different countries depart in varying proportions from the world rate of return ([r.sub.F]) and from the baseline of the non-tax world. With residence-based taxation, those distorted pre-tax rate of return differentials lead to distorted after-tax rate of return differentials that ultimately distort decisions about the location of investments.

4. The Problematic Aspects of the Unlimited Foreign Tax Credit (FTC) System

The unlimited FTC system suffers major problems. The first problem is that the tax on domestic source income might be reduced depending on foreign tax rates. If the tax rate of a foreign country is higher than the domestic rate, the excess foreign tax paid by a domestic taxpayer to this foreign country will be credited against the tax on the taxpayer's domestic source income. The same result occurs if the taxpayer has income from other foreign sources, the residual domestic tax on which is insufficient to offset the credit on the high-foreign-taxed foreign source income. For example, assume that a domestic taxpayer has domestic source income of $150 and foreign source income of $100 and that the domestic and foreign tax rates are, respectively, 40% and 50%. The taxpayer's domestic tax liability is $60 on the domestic source income and $40 on the foreign source income. Under an unlimited FTC system, the taxpayer will also be credited for the entire $50 tax paid to the foreign country. This credit not only will offset the $40 domestic tax liability on the taxpayer's foreign source income, but will also reduce the taxpayer's domestic tax liability on his domestic source income from $60 to $50.

This feature of the unlimited FTC system is undesirable for reasons related to sovereignty, equity, and efficiency concerns (which might also be considered political, philosophical, and economic concerns). On sovereignty grounds, it is implausible to hypothesize a country ceding taxing power over its own residents' domestic-source income to the laws and tax rates of other countries. (58) On equity grounds, it is undesirable that domestic taxpayers pay different taxes on equal amounts of domestic-source income (horizontal equity) simply because one taxpayer chose to invest in a high-tax foreign country. Likewise, it is undesirable that, as a result, domestic taxpayers pay the same amount of taxes on different amounts of domestic source income, or different amounts of taxes on inversely different amounts of domestic source income (vertical equity). On efficiency grounds, the reduction by an unlimited FTC system of domestic taxes on domestic source income of residents may be viewed as a subsidy by the residence country for outbound investments. It is generally accepted that subsidies have undesirable economic efficiency costs.

The unlimited FTC system's major theoretical shortcoming is that it allows, indeed encourages, other countries to raise taxes at the expense of the residence country by increasing their tax rates on the residence country's taxpayers and, in effect, transferring revenue from the residence country's fisc to their own while keeping the residence country's taxpayers indifferent.

It is not surprising, then, that unlimited FTC systems do not exist in practice. FTC systems, whenever adopted, are necessarily limited. The most common limitation is the general, or overall, limitation that limits the FTC to an amount equal to the product of the domestic tax rate and the foreign source income. This general limitation keeps the taxation of domestic source income of residents immune from reductions by FTCs and eliminates opportunities for foreign abuse. Obviously, the FTC limitations result in sensible departures from the objective residence-based taxation. If locational neutrality were to be achieved by unlimited FTC systems, it will no longer be so achieved with limited FTC systems.

5. Residence-Based Taxation and Tax Neutrality: Summary

The argument that residence-based taxation satisfies CEN suffers serious flaws as a matter of policy making. If the analysis presented here is correct, residence-based taxation at best satisfies CEN only when adopted by all countries in the world at an identical, harmonized, and universal tax rate. Under these limitations, CEN would also be satisfied by source-based taxation because capital would then (i.e., with harmonized tax systems and rates) be subject to the same tax rate wherever invested. Because of the practical unfeasibility of exercising full residence-based taxation, source-based taxation seems to be the superior means for satisfying CEN. Moreover, the adoption of limited, or unlimited, FTC systems by all countries in the world with a globally harmonized tax rate is meaningless. Such a harmonized system is de facto a globally harmonized source-based tax system. That is so because a residence country's tentative tax on foreign source income of its residents will be fully offset by the FTC granted, rendering the residence country taxing only by source. Part IV will ask whether CEN could be otherwise satisfied and whether it is possible to simultaneously satisfy CEN, CIN, CON, NN, and NON.

IV. INTERNATIONAL TAX NEUTRALITY BY SOURCE-BASED TAXATION

This part suggests that the general framework, logic, and assumptions of the classic neutrality analysis may lead to different results and understandings of international tax neutrality. It is argued here that if the tax burden on capital income falls on internationally immobile factors, source-based taxation, not necessarily with globally harmonized rates, best satisfies CEN as well as the other neutrality theories.

A. Should Source-Based Taxation Result in Movement of Capital?

The classic theory regarding the effects of source-based taxation on the allocation of investment capital is very straightforward. Due to the reduction in the after-tax rate of return from investments in the taxing jurisdiction as a result of the imposition of source-based taxation (t), capital starts flowing out of the taxing country to locations where the world rate of return ([r.sub.F]) may be reached. The outflow continues until the pre-tax rate of return in the taxing jurisdiction has been increased to r=[r.sub.F]/(1-t), allowing an after-tax rate of return of [r.sub.F]. Only then will investors in the taxing jurisdiction lack any incentive to relocate their investments. The crucial and decisive factor in locating investments is the net (after-tax) rate of return. The after-tax rate of return is determined by the pre-tax rate of return and the tax rate. Besides demand for capital, production and business expenses are among the factors determining the pre-tax rate of return. Immobile factors expenses, such as rents and wages, constitute the primary production and business expenses. What effects the imposition of source-based taxation, mainly the threat of capital outflow, has on these internationally immobile factors remains the crucial question.