International tax neutrality: reconsiderations.

(4) See MUSGRAVE, supra note 2, at 109; RICHMAN, supra note 2, at 5; Michael Graetz, The David R. Tillinghast Lecture, Taxing International Income: Inadequate Principles, Outdated Concepts, and Unsatisfactory Policies, 54 TAX L. REV. 261, 285 (2001). The dominant argument in the legal and economic literature as well as in government analyses is that the proper goal for U.S. international tax policy should be advancing worldwide economic efficiency, rather than national economic efficiency or national economic welfare. See TREASURY DEPARTMENT, THE DEFERRAL OF INCOME EARNED THROUGH U.S. CONTROLLED FOREIGN CORPORATIONS: A POLICY STUDY 25-26 (2000) [hereinafter TREASURY SUBPART F STUDY]; see also Graetz, supra, at 280. The notion is that maximized worldwide economic efficiency leads to maximized global welfare which in turn leads to maximized national economic welfare. The assumption is often made that it is possible to separate efficiency from distributive issues, so that one can address the latter separately, through transfer payments. From this perspective the best outcome is the one that maximizes social wealth, since that leaves more for the government to redistribute to satisfy equity concerns. Query whether it is feasible to separate the two sets of issues in this way. Nevertheless, this approach is not undisputed. Based mainly on economic, fairness, and political grounds, Graetz argues for rejecting the worldwide perspective of economic efficiency as well as economic efficiency as a sole value in international tax policy. Id. at 277-315. This issue is beyond the scope of this article, as is an inquiry in to what extent economic efficiency should be considered to underlie international tax policy.

(5) Id.

(6) See MUSGRAVE, supra note 2, at 109; RICHMAN, supra note 2, at 5; Graetz, supra note 4, at 285.

(7) See MUSGRAVE, supra note 2, at 121, 146-48.

(8) To illustrate, consider the following example as to the tax and rate of return differentials of Countries A and B with source-based tax systems and respectively with pre-tax rates of return of 10% and 12% and tax rates of 30% and 50%. The after-tax rates of return will therefore be 7% in Country A and 6% in Country B. In this situation, investors of both countries would invest in Country A following the higher after-tax rates of return, while it is argued that from a global economic efficiency perspective investment should have been located in Country B following the higher pre-tax rates of return.

(9) MUSGRAVE, supra note 2, at 121, 146-48.

(10) Id. To illustrate consider the same example of note 8 while changing the tax systems in both countries from source- to residence-based systems. Investors from Country A will be subject to a total tax rate of 30% on investments in both Country A and Country B (due to the entitlement to a full foreign tax credit (FTC) from Country A on investments in Country B) and will have after-tax rates of return of 7% in Country A and 8.4% in Country B. The investors from Country B will be subject to a total tax rate of 50% on investments in both Country B and Country A (due to the residual taxation by Country B on investments in Country A) and will have after-tax rates of return of 5% in Country A and 6% in Country B. Both investors will prefer to invest in Country B and the locational allocation of investments will not be distorted.

Obviously, the same result would be reached and capital export neutrality (CEN) would therefore be satisfied under source-based taxation if all countries were to tax only by source with globally identical tax rates. With globally harmonized source-based tax rates investments will be subject to the same tax rates regardless of their location.

(11) For a review of this literature, see, e.g., TREASURY SUBPART F STUDY, supra note 4, at 23-36; James R. Hines Jr., The Case Against Deferral: A Deferential Reconsideration, 52 NAT'L TAX J. 385, 395-96 (1999); Donald Rousslang, Deferral and the Optimal Taxation of International Investment Income, 53 NAT'L TAX J. 589 (2000).

(12) Graetz, supra note 4.

(13) Mihir A. Desai & James R. Hines Jr., Evaluating International Tax Reform, 56 NAT'L TAX J. 487, 495 (2003) [hereinafter International Tax Reform].

(14) Desai & Hines believe that there is considerable reason to think that the productivity of capital does depend on, and vary with, its owners' identities. Id. at 494.

(15) Id.

(16) Id. at 495. The argument that capital ownership neutrality (CON) may be satisfied by all countries taxing foreign income while providing full FTCs is based on the notion that "ownership would be determined by productivity differences and not tax differences, thereby meeting the requirements for CON." Id. at 494. It seems that this argument assumes that the demand for capital in the source country is totally elastic. Without this assumption, FTC systems may face difficulties satisfying CON in some situations. Consider for instance the situation in which Countries A, B, and C tax foreign income while providing full FTCs. Assume that the tax rates in these countries are 50%, 30%, and 40% respectively. Further assume that the expected pretax rate of return from an investment in Country C is 12% if owned by a resident of Country A, 10% if owned by a resident of Country B and 8% if owned by a resident of Country C. The after-tax returns for these investors will be 6%, 7%, and 4.8% respectively. Hence, the tax systems will result in a distortion in the allocation of capital. Global efficiency requires that the investment be owned by the investor from Country A, with whom the investment is most productive (highest pre-tax rate of return). If the three investors are competing over the investment, it will end up with the investor from Country B who has the highest after-tax return, and as such will be willing to pay the highest price for the investment.

(17) MUSGRAVE, supra note 2, at 134; International Tax Reform, supra note 13, at 496-97.

(18) George Mundstock, Section 902 Is Too Generous, 48 TAX L. REV. 281, 295 (1993); see also MUSGRAVE, supra note 2, at 133-34 (referring to national neutrality policy as an "intended departure from tax neutrality" for the sake of promoting national efficiency).

(19) MUSGRAVE, supra note 2, at 133-34. For a review of the subsequent literature, see TREASURY SUBPART F STUDY, supra note 4, at 36-42; Hines, supra note 11, at 395-96; Rousslang, supra note 11.

(20) International Tax Reform, supra note 13, at 496-97.

(21) Id.

(22) Id.

(23) MUSGRAVE, supra note 2, at 119; RICHMAN, supra note 2, at 8.

(24) Id.

(25) See Assaf Razin & Efraim Sadka, International Tax Competition and Gains from Tax Harmonization, 37 ECON. LETTERS 69, 69-70 (1991); see also Reuven S. Avi-Yonah, Globalization, Tax Competition, and the Fiscal Crisis of the Welfare State, 113 HARV. L. REV. 1573, 1605-06 (2000); Graetz, supra note 4, at 271; International Tax Reform, supra note 13, at 493.

(26) Id.

(27) See infra note 69; see also infra note 67.

(28) In other words, for CON to be satisfied, the identity of the investor should not be distorted by the imposition of the tax. However, capital import neutrality (CIN) may be satisfied even if the identity of the investor is distorted, as long as the "old" and "new" investors are from the same location.

(29) Mihir A. Desai & James R. Hines Jr., Old Rules and New Realities: Corporate Tax Policy in a Global Setting, 57 NAT'L TAX J. 937, 955 (2004) [hereinafter Corporate Tax Policy].

(30) Id.

(31) Graetz, supra note 4, at 272 n.36; see also Michael J. Graetz & Alvin C. Warren Jr., Income Tax Discrimination and the Political and Economic Integration of Europe, 115 YALE L.J. 1186, 1216-17 (2006).

(32) It is noteworthy, though, that the equality terminology used by Graetz in stating Principles 1 and 2 is not meant to indicate equality, equity, or fairness values. Graetz, supra note 4, at 272 n.36. In the context of neutrality equality terminology is meant to simply indicate practical similarity. Otherwise, arguing that "[p]rinciple 1 states a requirement of capital export neutrality" and that "principle 2 states a version of capital import neutrality" would be problematic. Id. Neutrality theories are efficiency driven, and as such have nothing to do with equity, equality, or fairness values. Neutrality theories seek tax neutrality not tax equality. By achieving neutrality, types of equality may be achieved as well, but only as a side effect. Equity, fairness, and equality are not factors at all for achieving tax neutrality.

(33) The following descriptive analysis of the non-tax world is largely drawn, with changes, from Joel Slemrod, Effect of Taxation with International Capital Mobility, in UNEASY COMPROMISE: PROBLEMS OF A HYBRID INCOME CONSUMPTION TAX 115, 118-19 (Henry J. Aaron, Harvey Galper & Joseph A. Pechman eds., 1988) (referring to the analysis of G.D.A. MacDougall, The Benefits and Costs of Private Investment from Abroad: A Theoretical Approach, 36 ECON. RECORD 13 (1960)).

(34) The height of the demand curve is equal to the net marginal product of capital. Obviously, the demand curve illustrates that the demand for capital decreases when rates of return on such capital increase and vice versa. This statement might seem counter-intuitive, but this is not the case. Rates of return on capital may be viewed as the cost of capital (e.g., for borrowers). The increase (decrease) in rates of return thus means an increase (decrease) in the cost of capital. Therefore, when rates of return (costs) increase (decrease), the demand for capital (e.g., borrowing) decreases (increases).