International tax neutrality: reconsiderations.

(35) In Figure 1 the capital stock in equilibrium in both countries is K, but that is not necessarily the case. If the elasticities of the demand for capital (the slope of the demand curve) are different in the two countries, equilibrium on [r.sub.F] may be reached with different capital stocks ([K.sub.e] and [K.sub.i], while [K.sub.e] [not equal to] [K.sub.i]).

(36) For analysis showing how large economies affect the world rate of return, see Slemrod, supra note 33, at 133-35.

(37) Unless indicated otherwise, reference to source-based taxation assumes, for purposes of the theoretical analysis, that no other taxation is imposed.

(38) See Slemrod, supra note 33, at 120 fig.2.

(39) It is also plausible to think about the occurrences as follows. In a non-tax world, capital inflows into a capital importing country continue until the rate of return on capital invested therein drops down to [r.sub.F]. When source-based taxation (t) is imposed by the capital-importing country, capital starts flowing back out until the rate of return has risen from [r.sub.F] up to [r.sub.F]/(1-t).

(40) Note that in fact the demand for capital curve is not parallel to the after-tax marginal product of capital curve. For convenience, it is common to use parallel curves when the implications are not significant. For purposes of tax neutrality analysis it makes no significant difference to use parallel curves.

(41) See Slemrod, supra note 33, at 120.

(42) Unless otherwise indicated, for purposes of the following theoretical analysis, reference to residence-based taxation assumes such an ideal imposition thereof.

(43) Because CEN is concerned with capital-export the focus here is mainly on capital-exporting, rather than capital-importing, countries. However, similar analysis may apply for capital-importing countries.

(44) See supra notes 6-10 and accompanying text.

(45) See Slemrod, supra note 33, at 122.

(46) See id. at 121.

(47) Clearly, an unlimited FTC system would have the effect of a residence-based taxation only with respect to the residents of the country adopting such a system, but not to the country itself (the tax revenue of which will be equal to the revenue that would have been collected under pure residence-based taxation reduced by the FTCs and increased by the source-based taxation on inbound foreign investments), nor to foreign investors from countries employing different systems (who will not be, fully or at all, credited by their home country for foreign taxes paid to foreign countries, even if such foreign countries exercise unlimited FTC systems). These distributive effects are immaterial for CEN analysis.

(48) See, e.g., Corporate Tax Policy, supra note 29.

(49) See supra note 29 and accompanying text.

(50) See discussion supra Part III.B.

(51) This is true as to domestically owned capital as well as to foreign capital owned by residents of countries that do not impose residence-based taxation. Residents of a residence-based (full FTC) taxing country are indifferent as to the taxing method of the country of source.

(52) See discussion supra Part III.C.2.

(53) See discussion supra Part III.B.

(54) Investors from Country A investing in Country B will be subject to 40% source-based taxation by Country B and to 10% residual taxation by Country A (50% tentative tax rate minus 40% FTC).

(55) It is noteworthy that this analysis shows that it is not an absolute truth that pre-tax rates of return are tax neutral. Pre-tax rates of return in a source-based taxing country are not tax neutral but tax distorted. Such distortion affects the international allocation of capital and full FTC systems of other countries may not cure this distortion, not even with respect to their own domestically owned capital. This analysis casts doubt on the common belief that CEN is achieved when capital is allocated to its highest pre-tax rate of return location.

(56) See infra notes 69 and 67.

(57) Referring to Figure 1, a reduction in saving stock is reflected in a leftward movement off K, which is associated with an upward movement off [r.sub.F]. See supra Part III.A.

(58) It could be argued, however, that sovereign countries desiring to apply classic CEN policy would simply assume, as a policy matter, the tax obligations of others.

(59) See supra Part III.B; see also discussion infra Part IV.A.2.

(60) See discussion infra Part IV.A.2.

(61) Id.

(62) If immobile factors bear the burden of source-based taxation in order to prevent capital outflow, should a similar process not have occurred in the non-tax world at the transformation from a closed economy to an open one in order to prevent capital outflow from a capital-exporting country? As discussed in Part III.A, the rate of return that would have prevailed in a closed economy (or if capital were immobile) is [r.sub.0] provided that the wealth of the country is W. Once the economy is opened, capital will flow out of a capital-exporting country and into a capital-importing country until the rate of return in each country has reached the world rate of return ([r.sub.F]) and capital invested in each country has been set on K (Figure 1). This is the most efficient allocation of capital. A capital-exporting country is a country with over-supply of national capital and a capital-importing country is a country with under-supply of national capital. That is, a capital-exporting country is a country with more national capital than needed and a capital-importing country is a country with less national capital than needed. Therefore, it is unlikely that immobile factors will bear the economic burden of preventing the outflow of capital in excess supply.

(63) In her 1969 work, Musgrave interestingly pointed out that her conclusions might be altered and that source-based taxation might be called for on international tax neutrality grounds "depending on the degree of tax shifting, in the short-run sense of administered price adjustments." MUSGRAVE, supra note 2, at 111-15. She summarizes this point as follows:

Although the empirical evidence available at present is not sufficient

to permit firm conclusions to be drawn, some economists argue that a

large degree of domestic shifting of the U.S. tax takes place. Others

have concluded that this is not the case. If general shifting of the

corporate income tax to the extent of the tax rate imposed by each

country of source of income were a firmly established fact of life,

taxation only by the country of source would be justified on

neutrality grounds. The crediting of foreign withholding taxes against

the individual income tax would be called for on the assumption that

they would not be shifted.

More evidence is needed on the degree of tax shifting with respect to

both domestic and foreign investments before tax policy can be

adjusted along the lines suggested in the four cases above [no

shifting, foreign and U.S. taxes shifted, foreign tax shifted and U.S.

tax not shifted, and foreign tax not shifted and U.S. tax shifted]. At

present, the econometrics is inconclusive and likely to remain so for

many years. In the meantime, most economists feel that tax policy

should be based on the no-shifting assumption, and that taxation on

the residence principle with a full foreign tax credit is thus the

appropriate policy to pursue for reasons of tax neutrality.

Id. at 115. Musgrave addresses this issue again when she discusses CIN:

Businessmen frequently maintain that neutrality should apply between

U.S. foreign investors and their competitors abroad. This view of

neutrality, which may be termed 'capital-import neutrality,' suggests

taxation by source or exemption of foreign investment income by the

United States. Several assumptions may, explicitly or implicitly,

underlie this argument.

1. Profit taxes are universally shifted in the short run to the extent

of the tax rate imposed in each country of source of income and are

reflected in higher product prices....

Under the assumption of universal forward shifting, taxes on profits

are reflected in commodity prices. Tax neutrality in these

circumstances ... requires that profits from all sales in a particular

market be taxed at the same rate, with export rebates and compensating

import duties placed on traded goods to match the tax on profit

margins. Thus neutrality would call for taxation at the business

argument for exempting foreign source income from the U.S. corporation

income may be justified on neutrality grounds if the shifting

assumption is valid. Yet, without more conclusive evidence, it is

preferable to make the traditional no-shifting assumption.

Id. at 119. Musgrave refers here to tax shifting in the narrower context of "short-run sense of administered price adjustments" and not in the context of immobile business factors. Even if her no-shifting assumption with respect to price adjustments is correct (a question beyond the scope of this work), it is irrelevant to the analysis presented above regarding shifting the economic burden of source-based taxation on investment capital to immobile factors.

(64) HAL R. VARIAN, MICROECONOMIC ANALYSIS 4-5 (3rd ed. 1992).

(65) Peter A. Diamond & James A. Mirrlees, Optimal Taxation and Public Production (pts. 1 & 2), 61 AM. ECON. REV. 8 (1971), 61 AM. ECON. REV. 261 (1971).

(66) Cf. International Taxation, supra note 13, at 496-97.