International tax neutrality: reconsiderations.

Capital outflow has significant implications on the economy. The outflow of direct investment capital is associated with the movement of the underlying business and economic activity from the territory of the taxing jurisdiction elsewhere. The outflow of portfolio investment capital may be associated with the contraction of the underlying business and economic activity. In both situations, internationally immobile factors are the most harmed. Real estate is vacated, and employees lose their jobs. Such is the logical and possible consequence when capital outflow is reduced from K to K', decreasing the amount of capital invested in the taxing jurisdiction as described in Figures 2 and 3 above. (59) Theoretically, this description makes sense, but the question is whether land owners, employees, and other immobile factors do in fact allow such an outcome to occur or whether they react differently by, for example, agreeing to lower rents and salaries. Put differently, would immobile factors be better off unemployed or would they be best served by economically bearing the tax burdens simply by lowering their rents and salaries? By shifting the tax burden to immobile factors by having lower immobile factors expenses, investors enjoy a higher pre-tax rate of return and an after-tax rate of return equal to the world rate of return. They would no longer have incentives to relocate their capital and CEN would be satisfied.

1. Supply and Demand

The critical question here concerns the effects that source-based taxation on investment capital income has on the supply of immobile factors when compared to the non-tax world. The classic CEN analysis assumes that the supply curve of internationally immobile factors remains unaffected by the imposition of source-based taxation on investment capital income. Immobile factors, as with all other economic factors, seek to maximize their profits and set their supply patterns accordingly given alternative investment opportunities presented by any other relevant economic factors. The bargaining position of immobile factors in the non-tax world, or with residence-based taxation on investment capital, effectively differs from their bargaining position in a world where investment capital is subject to source-based taxation. Capital owners (investors) need economic activities in order to earn returns on their investments. The supply of immobile factors is crucial for economic activities to operate. On the other hand, immobile factors need economic activities, and therefore capital, in order to be employed and generate returns. In the non-tax world, equilibrium is reached because all factors seek profit maximization consistent with their mutual needs and available alternatives. Immobile factors depend on the world rate of return and their compensation requirements vary accordingly. When residence-based taxation is imposed on investment capital, the net marginal product of capital, wherever invested, is reduced by the tax rate (t) from the world rate of return ([r.sub.F]) to [r.sub.F](1-t). Investors and immobile factors realize that under residence-based taxation the mobility feature of capital has no advantage--income from investment capital will be subject to the same tax rate wherever invested. Accordingly, the compensation requirements of immobile factors remain unaffected. On the other hand, lacking better alternatives, capital owners assume the entire tax burden and their net rate of return requirements fall from [r.sub.F] to [r.sub.F](1-t).

Following the same logic, the economic burden of source-based taxation should eventually be borne by immobile factors. With source-based taxation in effect, investors and immobile factors are aware of the fact that locating the investment outside of the taxing jurisdiction would allow investors to earn the world rate of return ([r.sub.F]), while investing inside the taxing jurisdiction would generate an after-tax rate of return equal to [r.sub.F](1-t). Given the inherent advantages of capital's mobility, immobile factors must reduce their compensation requirements and bear the burden of source-based taxation. Otherwise, a capital outflow will occur, (60) leaving immobile factors unemployed. Therefore, capital owners' world rate of return requirements remain, compared to the non-tax world, unaffected. On the other hand, having no other alternatives or choices, (61) immobile factors in the taxing jurisdiction are forced to bear the burden of source-based taxation on investment capital by lowering their compensation requirements. By so doing, immobile factors reduce the business expenses of the economic activities underlying the investments, increase the pre-tax rate of return to investors to [r.sub.F]/(1-t), and allow those investors to earn a net (after-tax) return on their investment equal to the world rate of return ([r.sub.F]). Figure 5 illustrates this process in a capital-exporting country where the pre-tax marginal product of capital curve shifts upwards from the demand for capital curve as a result of reduced immobile factors expenses stemming from both the imposition of source-based taxation and the threat of capital outflow.

[FIGURE 5 OMITTED]

The curve representing the pre-tax marginal product of capital (pre-tax rates of return) demonstrates the shifting of the economic burden of source-based taxation (t) from mobile factors (capital) to immobile factors (land, labor, etc.). The "grossed-up" pre-tax rate of return (r=[r.sub.F]/(1-t)) allows an after-tax rate of return equal to the world rate of return ([r.sub.F]). Therefore, the curve representing the after-tax marginal product of capital (after-tax rates of return) is identical to the demand for capital curve. (62) In these circumstances no capital outflow occurs as a result of the imposition of source-based taxation and CEN is satisfied. (63) A similar process occurs when source-based taxation is imposed by a capital-importing country.

2. Substitutions

The analysis presented above relies to a great extent on the unavailability of substitutions for the employment of immobile factors. If substituting employment of immobile factors is available, the threat of capital outflow as a result of the imposition of source-based taxation may not result in any shift in tax burdens from mobile to immobile factors. This condition (the unavailability of substitutions) certainly prevails with a Leontief production function in effect. According to the Leontief production function, Q = min(aK, bL), where Q is the output (or production), a and b are constants, K is capital, and L is labor. (64) Under this function there is no possibility of substitution between capital and labor. That is, capital and labor must be used in fixed, constant proportion. Adding an additional worker without a proportionate increase in capital (e.g., machines, facilities, etc.) will not result in increased output. Neither will output increase simply by adding capital alone without a proportionate increase in labor. If one worker is needed to operate one machine, adding an extra worker without adding an additional machine, or adding an extra machine without adding an additional worker to operate it, will be meaningless in terms of production. Therefore, capital outflow will necessarily result in a proportionate unemployment of immobile factors. Since any potential substituting employer of immobile factors would be subject to the same source-based taxation, such substituting employment, if at all, would not be for more than the compensation the original employer threatening to relocate its investment would be willing to pay in order to stay. Otherwise, the substituting employer would have outbid the original marginal employer in the non-tax world in the first place. Immobile factors will then have no choice but to reduce their compensation and bear the economic burden of source-based taxation on investment capital.

The 1971 study of Diamond and Mirrlees, (65) which found that tax competition between jurisdictions leads countries to find it in their interest not to impose any taxation on income from investment capital but instead impose it directly on immobile factors, (66) does not seem to be applicable under the framework described above. Possibly, the adoption of a neoclassical production function, under which labor may be substituted for capital, is a prerequisite for the Diamond and Mirrlees conclusions to apply. This interesting issue is beyond the scope of this article. Additional scholarship should analyze the extent to which this article's argument is applicable.

3. Labor-Leisure and Saving-Consumption Distortions