International tax neutrality: reconsiderations.

The effects of taxation on labor supply are ambiguous. However, the argument that shifting the economic burden of source-based taxation to immobile factors results in labor-leisure distortions in the form of declining labor supply (67) which in turn leads firms to reduce their capital demand, (68) has its appeal. Nevertheless, to consider such ambiguously possible neutrality distortions by source-based taxation, consistency requires the application of the same logic to residence-based taxation by considering the saving-consumption distortions thereof. (69) The economic burden of residence-based taxation on capital falls on the investors and results in saving-consumption distortions in the form of declining capital supply (due to the substitution of consumption for saving). If labor-leisure distortions should affect the neutrality analysis of source-based taxation, the saving-consumption distortions should also affect the neutrality analysis of residence-based taxation. (70) The classic neutrality analysis disregards the saving-consumption distortions of residence-based taxation. Keeping within the framework, assumptions, and logic of the classic neutrality analysis, labor-leisure distortions of source-based taxation should be disregarded as well. (71) It should also be noted that the evidence provides that labor supply elasticity is lesser than saving elasticity, and that, in any event, both are close to zero. (72)

4. Practical Support: Gross-Up Provisions in Cross-Border Loan Agreements

The common practice of incorporating "gross-up" provisions in cross-border lending transactions provides practical support to the theoretical analysis suggested here. Gross-up provisions (sometimes referred to as "additional amounts" provisions) generally provide that the borrower should gross-up payments of the agreed interest by withholding taxes imposed by the borrowers' home jurisdiction. That way, lenders generally receive the same payments they would have received had no withholding taxes been imposed. Since principal amounts are not subject to changes (borrowers may not reduce the principal amount when withholding taxes are increased and grossed-up into the interest payment), gross-up provisions would be economically feasible either if the demand for capital is totally inelastic or if the withholding tax burden is shifted to immobile factors. The latter seems to be a better explanation.

B. Implications on the Other Neutrality Theories and the Simultaneous Implementation Thereof

This Part IV.B attempts to draw out the implications of the analysis in Part IV.A on the other neutrality theories, namely CIN, NN, CON, and NON, and argues that all theories may be best and simultaneously satisfied by pure source-based taxation.

1. Implications on Capital Import Neutrality (CIN) Theory

There are, as discussed in Part II, three different views of capital import neutrality. Musgrave views CIN as a policy seeking to achieve tax neutrality with respect to business competition and expansion opportunity within each capital importing country. (73) CIN is also believed to represent tax neutrality with respect to saving and result in an efficient allocation thereof. (74) As discussed in Part II, both views would be problematic under the classic analysis if CIN's assumed baseline is the non-tax world. Any income tax reduces expansion opportunity and results in a distortion with respect to the allocation of saving and consumption when compared to a non-tax world. Accordingly, Part II suggested that, for purposes of the classic analysis, theorists adopt a relative understanding of tax neutrality with respect to savings, business competition, and expansion opportunity. However, under the analysis suggested in Part IV.A, CIN may be viewed as representing full neutrality with respect to saving, business competition, and business expansion, using the non-tax world as its baseline. If immobile factors will bear the burden of source-based taxation, investors will receive net rates of return equal to those prevailing in the non-tax world. Therefore, no savings or expansion opportunity distortions are supposed to occur. Finally, CIN may represent neutrality with respect to the origins of imported capital. (75) Clearly, this feature of CIN is fully satisfied under the analysis suggested in Part IV.A.

2. Implications on National Neutrality (NN) Analysis

National neutrality is a tax policy maintained by a country seeking to maximize its own national, rather than global, economic efficiency. The classic NN analysis is straightforward and its explanation is briefly recounted in this paragraph. (76) The national income from domestic investments consists of the gross returns that are distributed between nationals in the form of net returns and the domestic government in the form of taxes. On the other hand, the national income from outbound investments consists of net-of-foreign-taxes returns that are distributed between nationals in the form of net-net-returns (of foreign and domestic taxes) and the domestic government in the form of domestic taxes. It follows then that from a national perspective, an efficient outbound investment is one whose net-of-foreign-tax return equals or exceeds the gross return on an alternative domestic investment. Nevertheless, for a private investor, an outbound investment continues to be efficient beyond the national efficient point insofar as its net-net-return equals or exceeds the net, not gross, return on an alternative domestic investment. Therefore, in order to maximize national efficiency, a country should encourage outbound investments with net-of-foreign-tax returns equal to, or higher than, the domestic gross return and discourage outbound investments with net-of-foreign-tax returns lower than the domestic gross return. According to the classic NN analysis, the best way to achieve this goal is to match the private efficient point with the national efficient point, primarily by taxing foreign source income while providing a deduction for foreign taxes. (77)

The analysis presented in Part IV.A above has interesting implications on NN and leads to a different conclusion than the one reached by the classic NN analysis. The fundamental objective of NN is to match the private efficient point with the national efficient point. It is suggested here that this matching is best achieved when all countries adopt source-based taxation. If [r.sub.D] and [r.sub.Fn] are, respectively, the domestic and foreign rates of return in the non-tax world, and [t.sub.Fn] and [t.sub.D] are, respectively, the tax rates imposed by the home and foreign countries, then the pre-tax rates of return at these countries will respectively be [r.sub.D]/(1 - [t.sub.D]) and [r.sub.Fn]/(1 - [t.sub.Fn]). The after tax rates of return on investments in the home and foreign countries will respectively be [r.sub.D] and [r.sub.D]. Clearly, the private efficient point is achieved when [r.sub.D] = [r.sub.Fn]. Determining the national efficient point is more complex.

From a national perspective, [r.sub.Fn] (the net-of-foreign-tax return) represents the productivity of the outbound investment (by a national investor). The remaining question seeks to establish the national productivity of a domestic investment by a national investor. According to the classic NN analysis, the answer is [r.sub.D]/(1 - [t.sub.D]) (i.e., the pre-tax rate of return). The reasoning of the classic NN analysis is that the pre-tax rate of return on a domestic investment is the total national income that is distributed between the national investor in the form of after-tax return and the domestic government in the form of taxes. But, if the domestic pre-tax rate of return ([r.sub.D]/(1 - [t.sub.D])) is the product of shifting the economic tax burden to domestic immobile factors, then the national productivity from a domestic investment is not [r.sub.D]/(1 - [t.sub.D]), but only [r.sub.D]. In the non-tax world a domestic investor would earn [r.sub.D], and immobile factors employed by the underlying business activity would presumably earn X. When source-based taxation is imposed on investment capital, its burden is economically shifted to immobile factors which no longer earn X, but only X - [[[r.sub.D][t.sub.D]]/[1 - [t.sub.D]]]. (78) The value [[r.sub.D][t.sub.D]]/[1 - [t.sub.D]] is shifted to the return on capital and is added to [r.sub.D], yielding a pre-tax rate of return of [r.sub.D]/(1 - [t.sub.D]). The earnings of domestic immobile factors are also part of the national income. Therefore, by "grossing-up" the domestic rate of return due to the imposition of source-based taxation from [r.sub.D] to [r.sub.D]/(1-tD), the national productivity from domestic investment was not increased.

The only economic incident came from shifting the value [[r.sub.D][t.sub.D]]/[1 - [t.sub.D]] from one component of national income (immobile factors) to another (capital). Hence, from a NN perspective the national productivity of a domestic investment is only [r.sub.D], and not [r.sub.D]/(1 - [t.sub.D]). When the national productivity of a domestic investment is [r.sub.D] and the national productivity of an outbound investment is [r.sub.Fn], then the national efficient point is achieved when [r.sub.D] = [r.sub.Fn]. This is also the private efficient point.

In conclusion, if all countries adopt source-based taxation, the private efficient allocation of domestic and foreign investments would match the national one and NN would be achieved.

3. Implications on Capital Ownership Neutrality (CON) Analysis