Reforming Capital Income Taxation

Horst Siebert

• Publisher: Routledge
• Year: 2019
• eBook ISBN: 9781000309362
• Edition: 1
• Topic: Politique et relations internationales
• Subtopic: Politique

This book surveys the theoretical issues that characterize the problem of reforming capital income taxes in an open economy. It explores the tax incentives and disincentives to investment in an open economy framework allowing cross-border portfolio and direct investment.

III
The Harmonization Issue

Capital Market Integration: Issues of International Taxation

Assaf Razin Efraim Sadka

1. Introduction

International capital market integration has become the subject of major theoretical and practical interest in recent times. Policymakers are becoming more and more aware of the potential benefit accruing from such integration, which allows more efficient allocation of investment and savings between the domestic and the foreign market. In particular, with the prospective comprehensive integration of capital markets in Europe in 1992, some key policy issues arise.¹ The implications of capital market integration for financial, monetary and exchange rate management policy have been widely discussed in the context of the European Monetary System (EMS); see, for instance, the survey by Micossi [1988]. However, capital market integration also has profound effects on the fiscal branch of each country separately and on the scope of tax coordination among them. These issues have not been dealt with extensively so far.²

One issue is the tax-induced distortions in the allocation of world savings and investment. In a world with international capital mobility, the equality between savings and investment need not hold for each country separately, but rather for world aggregate savings and investment. This separation brings out new issues in the theory and practice of taxation. In a closed economy, a tax on capital income drives just one wedge between the consumer/saver marginal intertemporal rate of substitution and the producer/investor marginal productivity of capital. In a world of open economies, there are two more types of distortions which can be caused by capital income taxation: (1) international differences in intertemporal marginal rates of substitution, implying an inefficient allocation of world savings across countries; (2) international differences in the marginal productivity of capital, implying that world investment is not efficiently allocated across countries.

The fundamental result of the theory of second best suggests that adding distortions to already existing ones may very well enhance efficiency and welfare. To put it differently, reducing the number of distortions in the economy may well lower well-being. Thus, even though there are gains to be derived in general from international trade, some restrictions on free trade may be called for in a distortion-ridden economy.

The opening up of an economy to international capital movements affects the size and structure of the fiscal branch of its government. Capital flows influence both the optimal structure of taxes (on domestic as well as foreign-source income) and the welfare cost of taxation. As a result, the optimal size of government (the optimal provision of public goods) and the magnitude of its redistribution (transfer) policies are affected as well.

Another issue is capital flight. There is now substantial evidence that governments encounter severe enforcement difficulties in attempting to tax foreign-source income. Dooley [1987] estimates that in the 1980-82 time period as much as $250 bill, invested by US residents may have been involved in capital flight. Tanzi [1987] reports that tax experts were concerned that lowering the US individual and corporate tax rates in the US Tax Reform Act of 1986 would induce capital drain from other countries by providing a tax advantage to investments in the US. The concerns are based on an implicit assumption that the governments of these countries cannot effectively tax their residents on their US income so as to wipe out the US tax advantage. The issue of capital flight is even more relevant for developing countries. Cumby and Levich [1987] estimate that a significant portion of the external debt in developing countries is channeled into investments abroad through overinvoicing of imports and underinvoicing of exports. Dooley [1988] estimates that capital flight from a large number of developing countries amounted to about one-third of their external debt in the time period 1977-84.

Finally, integration of capital markets brings up the issues of international tax coordination, harmonization and competition. There are two polar principles of international taxation: the residence (of the taxpayer) and the source (of income) principles. According to the first principle, residents are taxed on their world-wide income equally, regardless of whether the source of income is domestic or foreign.³ A resident in any country must earn the same net return on his/her savings, no matter to which country he/she chooses to channel his/her savings (the rate-of-return arbitrage). If a country adopts the residence principle, taxing capital income from all sources at the same rate, then the gross return accruing to an individual in that country must be the same, regardless of which country is the source of that return. Thus, fee marginal product of capital in that country will be equal to the world return to capital. If all countries adopt the residence principle, the capital income taxation does not disturb the equality of the marginal product of capital across countries which is generated by a free movement of capital. However, if the rax rate is not the same in all countries, then the net returns accruing to savers in different countries vary and the international allocation of world savings is distorted.

According to the second principle, residents of a country are not taxed on their income from foreign sources and foreigners are taxed equally as residents on income from domestic sources. Now, suppose that all countries adopt this principle. Then a resident of country H will earn the same net return in country F as the resident of country F earns in country F. Since a resident in country H must earn the same net return whether he/she channeled his/her savings to country H or to country F, it follows that residents of all countries will earn the same net return. Thus, intertemporal marginal rates of substitution will be equated across countries, implying that the international allocation of world savings is efficient. However, if the tax rate is not the same in all countries, then the marginal product of capital will also not be the same in all countries. In this case the international allocation of the world stock of capital will not be efficient.

Although there are these two extreme principles of international taxation, in reality, countries adopt a mixture of the two polar principles. Accordingly, in practice, countries partially tax foreign-source income of residents and domesticsource income of nonresidents, in which case both the international allocations of world savings and of world investments are distorted.

These issues are of particular relevance for Europe 1992. In the absence of a full-fledged harmonization of the income tax systems, the creation of a single capital market in the European Community will raise the possibility of tax competition among the member countries. Also, the possibility of capital flight from the EC to low-tax countries elsewhere has strong implications for the national tax structures in the EC. These developments have renewed the interest among public finance and international finance economists in the issues of tax harmonization and coordination, tax competition, the international structure of taxation, etc.⁴

2. Restrictions on Capital Mobility

Since there are distortionary taxes as part of real world fiscal programs, obviously the resource allocation is not Pareto-efficient: the intertemporal allocation of consumption, the leisure-consumption choice and the private/public consumption trade-offs are all distorted. Nevertheless, when the government can tax its residents on their foreign-source capital income, it should allow capital to move freely in or out of the country. That is, optimal policy [see Razin, Sadka, 1989b; 1990] requires an efficient allocation of capital between investment at home and abroad, so that the marginal product of domestic capital must be equated to the world rate of interest (net of foreign taxes). Evidently, this is an open economy variant of the aggregate efficiency theorem in optimal tax theory [see Diamond, Mirrlees, 1971; Sadka, 1977; Dixit, 1985].

Notice also that this production-efficiency result also implies that there should be no differential tax treatment of foreign and domestic sources of income. One might argue that the investment efficiency result (i.e., equating the return on capital at home to the return on capital abroad via free international capital flows) is not valid when the government is concerned about financing its debt, for opening an economy to international capital flows will raise the domestic interest rate to the world rate. In such a case, a government that is burdened by an ongoing deficit incurs a higher interest cost in financing this deficit. In fact, it loses some of its monopsony power in the domestic capital market. It can then be argued in this case that the government may not wish to allow residents to invest abroad. However, in this case it can be shown that the investment efficiency result is still valid nevertheless [see Razin, Sadka, 1989b]. This is because the government can offset the cost of losing its monopsony power by pursuing an appropriate tax policy.

Suppose now that the government cannot effectively tax income from investment abroad. In this case, if the government allows unlimited exports of capital, then capital will flow out of the country up to the point where the net return on domestic investment equals the net return on investment abroad. This means that the marginal productivity of domestic capital will exceed the world rate of interest, so that the domestic stock of capital will be too small. The mirror image of such an underinvestment in capital at home is an overinvestment in capital ab...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Preface
• I. Allocation and Taxation
• II. Taxation and Capital Flows
• III. The Harmonization Issue
• IV. Restructuring Capital Income Taxation
• List of Contributors