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Internationally mobile firms and tax policy1
Journal of International Economics 45 (1998) 97–113
Internationally mobile firms and tax policy 1 P. Osmundsen*, K.P. Hagen, G. Schjelderup Norwegian School of Economics and Business Administration, Institute of Economics, Helleveien 30, N-5035 Bergen, Norway Accepted 17 March 1997
Abstract This paper analyses how the government should tax internationally mobile firms. The analysis finds that if tax authorities are unable to observe firms’ true mobility, and domestic and foreign profitability are uncorrelated, then: (1) information rents are acquired by immobile (inefficient) firms, and (2) the optimal policy will stimulate investment in the immobile sector compared to the complete information case. Another result of the paper is that the optimal allocation is implementable within the framework of a corporate income tax system, where mobile firms self-select more unfavourable capital allowances than immobile firms. 1998 Elsevier Science B.V. Keywords: Corporate taxation; International mobility; Private information JEL classification: D82; H21; L51
1. Introduction Accelerated economic integration leads to increased international mobility, rendering national fiscal systems more exposed to tax-induced market reactions, including capital movements, labour migration, and the location decisions of firms. This paper focuses on the latter. Differences in national fiscal systems may induce firms to direct their investments to low-tax countries. Such behaviour restricts national autonomy in fiscal matters, since national tax bases become international*Corresponding author. 1 We are indebted to two anonymous referees for constructive and valuable comments. 0022-1996 / 98 / $19.00 1998 Elsevier Science B.V. All rights reserved. PII S0022-1996( 97 )00028-7
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ly mobile and therefore more elastic. Thus, governments are forced to formulate their national fiscal policies in response to global economic forces. We attempt to analyze how the government should handle firms that demand preferential tax treatment on grounds of being internationally mobile. It is commonly assumed that mobility of tax bases calls for low effective tax rates in order to keep them in the country. To induce a firm to stay at home, the firm’s domestic after tax profit must equal or exceed the after tax profit that could be obtained by moving operations abroad, thus imposing a mobility constraint on corporate income taxation. The opportunity cost of locating at home is equal to the after-tax return on foreign investments less mobility costs. Highly mobile firms, i.e., firms with high profit opportunities abroad or low migration costs, may not be prepared to remain in the country unless they are offered lenient (accommodating) taxation. Hence, for highly mobile firms, the mobility constraint will bind at lower effective domestic corporate tax rates than for immobile firms. An additional problem facing the government is that firms are likely to have private information about their true mobility. As a consequence, the government is also constrained in its tax policy towards immobile firms. An immobile firm may imitate mobile firms, thereby obtaining a favourable tax treatment by an implicit threat of relocation. Our solution to the problems of tax-induced migration and private information about mobility, is to apply managed investment policies, implemented by a tax incentive mechanism that takes into account the difference in mobility among firms. In Section 2 we construct a tax model for internationally mobile firms, where the aim of the government is to find a revelation mechanism that maximises social welfare. Section 3 examines alternative implementation mechanisms with respect to taxes. Section 4 provides some extensions to the model, and Section 5 concludes the paper.
2. The model The government seeks to design a tax system for mobile firms, taking into account that the exact mobility is private information of the firms. To address this problem, we apply a generalised version of the Baron and Myerson (1982) model. Let u be a continuous parameter that belongs to the interval u [ [u, u¯ ]. We denote ] u] as the most mobile and u¯ as the most immobile firm type. There is a continuum of firms independently drawn from the same distribution F(u), satisfying the monotone inverse hazard rate; ≠[12F(u )) /f(u )] / ≠u #0. The exact mobility is known to the firm, whereas the government only knows the support and the distribution. Total domestic taxes payable by the firm are denoted R. Let N( K) be the firm’s net domestic revenue, where K is the firm’s domestically invested capital, and ≠ 2 N / ≠K 2 ,0. If the firm instead invests K units of capital abroad, it receives
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I( K)2 M(u, K), where I is the after-tax revenue from investing abroad, and M are type-dependent migration costs. The firm will invest at home if domestic investments yield at least the same net payoff as foreign investments, i.e., if N( K)2 R $ I( K)2 M(u,K). This inequality condition represents a mobility constraint on domestic corporate taxation. An equivalent formulation of the mobility constraint is a firm participation constraint, stating that firms will only invest in the home country if the domestic payoff exceeds the opportunity cost of capital (defined as payoff from investing the capital abroad, net of mobility costs), i.e., N( K)2 R 2[ I( K)2 M(u, K)]$0. We assume that the type-dependent mobility costs have the properties ≠M(u, K) ]]] . 0 ≠u
(A1)
≠M 2 (u, K) ]]] . 0 ≠u ≠K
(A2)
i.e., the low-mobility type firm have higher migration costs both on average, (Eq. (A1)), and at the margin, (Eq. (A2)).2 We focus on a domestic industry that is price taker in the global market, so there is no effect on consumer surplus generated from changes in domestic production. The net loss in welfare from a firm moving its operations abroad, therefore, is made up of loss in tax revenue and loss of producer surplus. We assume that foreign profits cannot be taxed by the home country (corporate income is taxed at source)3 , and that foreign producer surplus is not appropriated by the home country, i.e., all taxes and all of the producer surplus are lost when a firm migrates. Let hR( uˆ ), K( uˆ ), uˆ [ [u], u¯ ]j be a direct mechanism that induces truthful revelation of the firm’s mobility parameter.4 Hence, private rents for a firm of type u announcing uˆ are given by:
p ( uˆ, u ) 5 N(K( uˆ )) 2 I(K( uˆ )) 1 M(u, K( uˆ )) 2 R( uˆ )
(1)
Note that in calculating private rents we account for both production and opportunity costs. Therefore, p is the domestic private after tax return in excess of the net income foregone by not investing K abroad, i.e., country-specific profits or localisation rent. Multinational firms—seeking to maximise global profits—will 2 The type-dependent migration costs may be seen as firms differing in international orientation and competence to handle foreign direct investments, i.e., they face different training expenses and market research costs when they invest abroad. Another interpretation is that the degree of irreversibility in firms’ current domestic investment portfolios differs. 3 By making this assumption, we acknowledge that the analysis abstracts from some multinational tax issues. 4 The revelation principle states that the principal—without loss of generality—can restrict his attention to the class of mechanisms in response to which the firms report their types truthfully. For a more precise definition, see Dasgupta et al. (1979).
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choose K to maximise p, and will not invest in the home country unless p $0. The national perspective of the government means that it would like the firms to maximise the total profits accruing to domestic owners. As a consequence, the opportunity costs of locating in the home country do not (directly) represent domestic social costs. Hence, social profits (denoted P ) are defined by P;p1 ( I 2 M), i.e., domestic industrial profits.5 The objective function of the utilitarian government is assumed to be a weighted sum of tax revenue and the industry profits accruing to domestic owners, i.e., the social welfare generated by a firm of type u is given by W 5 (1 1 l)R(u ) 1 mP (u )
(2)
where (11 l) is the general equilibrium shadow cost of public funds, and m is the welfare weight attached to industry profits.6 By using Eq. (1), the social-welfare function can be restated as W 5 (1 1 l)N(K(u )) 2 (1 1 l 2 m )P (u )
(3)
The regulatory problem is to maximise social welfare u¯
Max K(u )
E h(1 1 l)N(K(u )) 2 (1 1 l 2 m)P(u )j dF(u )
(4)
u ]
subject to a set of participation and incentive constraints
p (u, u ) $ 0 , ;u
(5)
p (u, u ) $ p ( uˆ, u ) , ;uˆ, u
(6)
The second order condition for incentive compatibility implies dK / du $0 (monotonicity constraint), which is assumed to be strictly satisfied. Following conventional procedures 7 , information rents are given by u
≠M( u˜ , K( u˜ )) E H]]]] J du˜ ≠u˜
p (u ) 5
(7)
u ]
From Eq. (7) it now follows that: 5
The opportunity cost of investing in the home country drives a wedge between private and social profits from domestic investments, and by assumption the wedge is subject to private information. Thus, welfare maximisation necessitates that firms’ investment incentives are corrected both under complete and private information. 6 To finance public expenditure the government must resort to distortive taxes, yielding l.0. The cost of public funds is taken as exogenously given in this partial model. If a denotes foreign equity share in the domestic firm, it would be natural to set m512a. 7 For a technical survey of principal-agent theory, see Guesnerie and Laffont (1984).
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Proposition 1: Information rents are acquired by immobile firms. Reporting a high migration cost will reveal the firm as a dependable tax base, since capital is country specific (locked-in). If the government taxes such a firm heavily, it will create an incentive for an immobile firm to claim to be a mobile firm. To induce truthful reporting, the government’s policies must guarantee an immobile firm a positive rent. It now follows from Eq. (1) that net taxes are given by u
≠M( u˜ , K( u˜ )) E H]]]] J du˜ ≠u˜
R(u ) 5 N(K(u )) 2 I(K(u )) 1 M(u, K(u )) 2
(8)
u ]
Inserting for the rent expression Eq. (7) in the objective function Eq. (4) and integrating by parts, give the following expression for expected welfare u¯
E h(1 1 l)N(K(u )) 2 (1 1 l 2 m)(I(K(u ) 2 M(u, K(u ))) ≠M(u, K(u )) 1 2 F(u ) 2 (1 1 l 2 m )F]]]]G ]]]J dF(u ) . ≠u f(u )
EW 5
u ]
(9)
A characterisation of the optimal investment level is obtained by pointwise differentiation of Eq. (9) over []u, u¯ ] with respect to K(u), and equating to zero:
S
dN(K * (u )) 1 1 l 2 m dI(K * (u )) ≠M(u, K * (u )) ]]] 5 ]]] ]]] 2 ]]]] dK 11l dK ≠K
F
1 1 l 2 m ≠ 2 M(u, K * (u )) ]]] ]]]] 1 11l ≠u ≠K
GS
D
1 2 F(u ) ]]] f(u )
D
(10)
To interpret the first-order condition Eq. (10), it is useful to think of optimal corporate taxation in three different situations: (1) a closed economy, (2) an open economy with complete information about mobility, and (3) an open economy with private information about mobility. Whereas the regulatory situation under (1) is unconstrained (first best), the government faces mobility constraints under (2) (second best), and (3) imposes additional incentive constraints (third best). Moving from (1) to (3), therefore, gradually reduces the scope for taxation, and the optimal policy response is to impose increasingly larger distortions. In a closed economy with complete information, it is in the interest of the government that net domestic revenue is maximised (dN / dK50), since the government is able to capture all social rents by imposing lump sum taxes. In an open economy with complete information with respect to u, the optimal solution is obtained by setting the left-hand side of Eq. (10) equal to the first distortionary term on the right-hand side. Under complete information the government is able to
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capture all country-specific rents, i.e., p (u )50, ;u, implying that the realised after-tax profits, P(u)5 I( K(u))2 M(u,K(u)), are (by definition) positive for mobile firms. The government is unable to capture those mobility rents, due to the participation constraint.8 Assuming that the marginal opportunity costs are positive, P is increasing in the investment level. Thus, by reducing the investment level relative to the closed economy solution, the government is able to capture a larger fraction of P. Hence, the optimal policy is determined by a trade-off between the marginal social gain of enhanced rent capture, and the marginal social costs of underinvestment. Note that the investment distortion is due to the fact that the government is unable to tax foreign income. Accordingly, the distortion can be seen as the optimal response to fiscal externalities implied by the source principle of taxation. Introducing private information to the open economy framework generates the additional second term on the right-hand side of Eq. (10), which is equal to marginal information costs. The presence of private information about mobility, therefore, calls for higher tax distortions, driving more capital abroad. We may now state: Proposition 2: Private information about mobility leads to lower domestic investment levels for all types but the least mobile, and the distortion is largest for the most mobile type. The economic explanation for this distortion, is that rent extraction is enhanced since the incentives for mimicking are reduced.9 Whenever private information about mobility is present, the government’s effort in revealing true mobility and capturing rents, creates a relative advantage for low mobility firms. Thus, we have: Corollary: The optimal policy will induce the immobile sector to expand at the expense of the mobile sector as compared to the situation with complete information. The optimal regulatory outcome has a clear interpretation in terms of public economics. The problem facing the government is that those firms claiming to be highly internationally mobile—but are in fact relatively immobile—are those firms 8 Hence, the optimisation problem for the government under complete information is given by max h(11l)N( K)2(11l2m)( I 2 M)j. K9 Choosing K lower than the first best level, however, implies suboptimal investments. It is optimal to reduce investments to the point where the expected value-weighted marginal deadweight loss from these distortions equals the expected marginal reduction in the deadweight loss in other sectors of the economy, made possible by increased tax revenue from mobile firms. The result corresponds to the theory of second-best taxation; when neutral taxes are not available it is optimal to spread taxation over several sectors of the economy, to the point where the marginal deadweight losses are equalised across sectors.
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that can sustain the highest burden of taxation. Put differently, the government wants as many firms as possible to invest in immobile activities and then tax them at a higher average tax rate. This is done by implementing an optimal regulatory solution that at the margin makes it unfavourable (by distorting investment incentives) to invest in mobile industries. By doing so the government will reduce the average mobility and enhance the tax potential of the corporate tax base, at the cost of a reduction in the overall tax base due to suboptimal investments.
3. Implementation In developing the optimal contract under private information, we have used a direct revelation mechanism. The firm reports its true mobility parameter, in response to which it will be instructed to invest according to Eq. (10) and pay net taxes according to Eq. (8). Comparing this contract with present tax systems is difficult, since direct revelation mechanisms are rarely used. However, the optimal contract can be given alternative implementations that are more similar to actual tax regimes: (I) a menu of linear tax contracts generated by investment fees and lump sum taxes, where net taxes are a function of the investment level and a mobility parameter report, and (II) non-linear corporate income taxation where net taxes are only a function of the investment level. The first implementation scheme is developed by Laffont and Tirole (1986), and the latter is developed below. Both schemes imply delegation as the investment levels are left for the firms to decide. We do not observe governments offering capital-tax menus that depend on report of a cost parameter. Neither do we see corporate income tax systems consisting merely of investment fees and lump sum taxes. Our objective in this section, therefore, is to construct an implementation mechanism that reflects more accurately the type of information usually available and the type of instruments governments actually use. The self-selection mechanism developed below is general in the sense that it applies to all regulatory settings where the optimal mechanism implies information-induced distortions of investments in the corporate sector. Most countries tax firms by means of a corporate income tax system. The corporate income tax base is often a non-linear function of the firm’s investments, due to non-linear deductible capital allowances and possibly a tax-exempt income. Moreover, governments tend to offer firms a choice of different depreciation rates and tax base formulas. The optimal regulatory solution (given by Eqs. (8) and (10)) can be implemented within a corporate income tax system, by offering firms with varying degrees of capital mobility tax base adjustments in the form of a capital allowance as a function of the firm’s investment, and in addition a tax exempt income. By the monotonicity constraint the socially optimal domestic investments are an increasing function of the mobility parameter u, so that the government can derive the inverted function u (K) from the optimal regulatory
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solution. Hence, there exists a capital allowance schedule as a function of the firm’s investment that induces a firm of type u to choose a profit maximising investment level satisfying the optimality condition Eq. (10). The conditions for the optimal tax revenue given by Eq. (8) are satisfied through adjusting the tax exempt income, which through the inverse of K(u) will be a unique function of the socially optimal investment schedule too. Thus, the implementation mechanism is indirect in the sense that it is a unique function of the firm’s investment levels which the tax authorities can observe. Faced with the optimal capital allowance schedule the firms reveal their true mobility through their profit-maximising choice of domestic investments. Implementing the optimum policy through the design of the corporate income tax base requires that a distortion is built into the tax system to the effect that profit maximising firms invest according to the optimum conditions given by Eq. (10). Generally, a neutral profits tax requires that the tax base represents true economic rent. In a closed economy this in turn requires deductions in taxable income for true economic depreciation and the financial opportunity cost of the invested capital. The latter corresponds to interest on borrowing and to the returns forfeited on invested equity. Ceteris paribus, insufficient capital allowances will act as a factor tax on capital. Hence, investment fees and (inadequate) tax write offs for investments are equivalent means for controlling firms’ investment.10 In an open economy with mobile capital, neutrality also requires that the tax system does not affect the location decision with respect to investment. This can be achieved by having worldwide income taxed according to the residence principle under the national corporate income tax. In the present paper, however, we assume that corporate income is taxed at source. Hence, domestic firms may locate investments abroad in order to take advantage of more lenient taxation. Foreign investment opportunities imply that only domestic pure profits in excess of after-tax opportunity returns abroad can be captured through the domestic profits tax. As a consequence, a neutral source tax on corporate income with internationally mobile capital would require the opportunity returns abroad net of foreign taxes and migration costs to be deductible in the domestic tax base. We will show how a non-linear corporate income tax system can implement the optimal regulatory solution given by the optimal schedules for tax payments in Eq. (8) and the optimal investment decisions in Eq. (10). We assume a corporate income tax system with a flat corporate income tax rate t and a non-linear capital write off schedule B( K). Assuming equity financing, a firm’s net domestic revenue can be defined as N(K) ; F(K) 2 d K
10
For more details, see Auerbach (1983).
(11)
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where F is a production function, and d is the rate of economic depreciation. The firm’s optimisation problem is given by maxhF(K) 2 d K 2 I(K) 1 M(u, K) 2 t[F(K) 2 B(K)]j
(12)
K
with the first-order condition
F
S
dF(K) 1 dI(K) ≠M(u, K) dB(K) ]] 2 d 5 ]] ]] 2 ]]] 1 t d 2 ]] dK 12t dK ≠K dK
DG
(13)
By substituting the inverse function u( K) in the first-order condition for the principal’s decision problem, Eq. (10), and inserting it into Eq. (13), we get dB(K) ]] 5 d dK 1 1] t
FS
11l2m 1 2 (1 2 t) ]]] 11l
dI(K) ≠M(u (K), K) DS]] 2 ]]]]D dK ≠K
1 1 l 2 m ≠ 2 M(u (K), K) 1 2 F(u (K)) 2 (1 2 t) ]]] ]]]] ]]]] 11l ≠u (K) ≠K f(u (K))
G
(14)
By integrating Eq. (14) and by imposing the optimal revenue condition in Eq. (8), we obtain the function for optimal capital write offs B(K) 5 d K 1 (I(K) 2 M(u (K), K))
S S
D
12t 11l2m 1 ]] 1 2 ]]] (I(K) 2 M(u (K), K)) t 11l 12t 11l2m ≠M(u (K), K) 1 2 F(u (K)) p (u (K)) 2 ]] ]]] ]]]] ]]]] 1 ]]] t 11l t ≠u (K) f(u (K))
DF
G
(15) That Eq. (15) induces optimal investment levels and optimal tax payments, is verified in Appendix A. One interpretation of this implementation mechanism— which corresponds to commonly observed corporate income tax systems—is that the government offers the mobile firms a corporate income tax base which consists of a non-linear capital allowance a( K)K (where a( K) is a non-linear tax depreciation schedule), and a tax-exempt income E( K), so that the total tax base deductions are given by B(K) 5 a(K)K 1 E(K) , where
(16)
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1 a(K) 5 d 1 ] (I(K) 2 M(u (K), K)) K 1 12t 11l2m 1 ] ]] 1 2 ]]] (I(K) 2 M(u (K), K)) K t 11l 1 12t 11l2m ≠M(u (K), K) 1 2 F(u (K)) 2 ] ]] ]]] ]]]] ]]]] K t 11l ≠u (K) f(u (K))
S S
D
DF
G
(17)
and
p (u (K) E(K) 5 ]] t
(18)
The implementation mechanism contains three tax instruments: t, a( K) and E( K). We set t arbitrarily, e.g., equal to the statutory corporate income tax rate applying to both mobile and immobile firms, and we use a( K) and E( K) as instruments for a managed investment policy for mobile firms.11 The depreciation schedule Eq. (17) induces the firms to make socially optimal investments. The tax exempt income levels Eq. (18) secure optimal tax revenues, i.e., E( K) are set so as to capture an optimal fraction of the information rent. The depreciation schedule has a clear economic interpretation. As a first reference case, a corporate income tax system that does not distort private investment decisions in a closed economy, is implemented by setting the capital allowance equal to the true economic depreciation, i.e., a( K) is set equal to the first term on the right-hand side of Eq. (17) (i.e., d ). This is the first best (closed economy, complete information) solution, where firms maximise their net domestic revenue. A further reference case relates to the open economy where nondistorted taxation induces the firms to maximise country specific profits, which is achieved by setting a( K) equal to the first two terms in Eq. (17), i.e., by letting the opportunity cost of domestic investment be tax deductible. The depreciation schedule in this case implies localisation neutrality, and represents the optimal tax policy for the case where there is complete information and the government places no weight on industry profits ( m 50). The second best (open economy, complete information) solution for the case with a positive weight on industry profits is implemented by adding the third term in Eq. (17), distorting the solution in favour of domestic investment. The last terms in the expressions for a( K) is added to implement the third best (open economy, private information) solution. In an open economy, both under complete and private information, a tax system for mobile firms needs to address the issue of imperfect rent capture. The fourth 11
The same tax schedule is optimal in the case of debt financing, since interest payments are tax exempt. Capital tax allowance schedules may seem artificial in a static model. Assuming the government is able to credibly commit to a taxation scheme for the entire investment horizon, however, the model can be extended to a multi-period context.
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term in the depreciation schedule relaxes the self-selection constraint. By imposing an investment distortion the government is able to capture a larger fraction of the information rent, i.e., the last term in the expression for a( K) is the tax depreciation equivalent of the distortion due to private information. It is obtained by dividing the marginal information costs in optimum by (12 t) /(tK). To enhance rent extraction, the corporate income tax is designed so that mobile firms self-select more unfavourable capital allowances than immobile firms. From the last term on the right-hand side of Eq. (17), we see that the tax-deductible capital allowance is reduced for all types but u¯ , and that the optimal information-induced reduction in a( K) is higher when: (a) the benefit of capturing rent is high, i.e., when l is high and m is low, (b) the marginal opportunity costs are sensitive with respect to differences in mobility (making it a good screening instrument), and (c) the fraction of firms at the particular investment level, f(u )du, is small (distortions are preferred at the parts of the distribution where the magnitudes of distortions are kept at a minimum). These results are rather contrary to common practice: internationally mobile firms are often offered generous depreciation rates in order to make it attractive for them to remain in the country. The analysis has shown, however, that as a means of enhancing the government’s bargaining position under private information about mobility, it may be optimal to let part of the most mobile capital flee the country. To summarise: Proposition 3: The optimal allocation under private information is implementable within the framework of a corporate income taxation system. Mobile firms will self-select more unfavourable capital allowances than immobile firms.
4. Extensions The results obtained in Sections 2 and 3 are based on two underlying assumptions. The first is that there is private information about a firm’s return on investments abroad, net of mobility costs, so the authorities cannot establish the level of domestic reservation profits. This presupposes that it is easier for the tax authorities to ascertain domestic profitability than net payoff on foreign investments. This is reflected in the model, where we assume complete information about domestic profitability and private information about mobility costs.12 The second assumption is that foreign and domestic profitability are uncorrelated. If we 12 An alternative formulation—that will produce the same results—is to assume private information about the payoff on foreign investments, while assuming complete information about moving costs. In this alternative model, the opportunity cost of domestic investments is given by I(u, K(u))2 M( K(u)), where mobile firms are assumed to have a higher return on foreign investments on average and at the margin, i.e., ≠I(u, K(u )) / ≠u ,0 and ≠ 2 I(u, K(u )) / ≠u ≠K ,0.
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change these underlying assumptions to the effect that there is private information about both domestic and foreign profitability, and that firms that are profitable abroad also predominantly have a high payoff on domestic investments, we may obtain results that are qualitatively different. To see how the results change given the new set of assumptions, we let the information parameter u represent productivity, with u] denoting the lowest productivity type and u¯ the highest productivity type. Since mobility is determined by the firm’s net return on foreign investments, u can still be interpreted as a mobility parameter. Let net domestic revenue be given by N(u, K(u)), where ≠N / ≠u .0 and ≠ 2 N / ≠u ≠K .0. While there is decreasing economic returns in the smaller domestic market, i.e., ≠ 2 N / ≠K 2 ,0 and ≠ 2 N / ≠u 2 ,0, the firm has constant returns on investments in the larger foreign market, given by (u 2u] )K. Location rents are now equal to
p ( uˆ, u ) 5 N(u, K( uˆ )) 2 (u 2u] )K( uˆ ) 2 R( uˆ ) .
(19)
If it is common knowledge that foreign and domestic profitability is positively correlated, we get countervailing incentives.13 On the one hand the firm would like to report a high earning potential on foreign investments (i.e., report a high u ), signalling that the firm is likely to move abroad if taxed too hard. On the other hand the firm has an incentive to report low profitability on domestic investments (i.e., report a low u ). The two incentives may be exactly offsetting at an interior value of the information parameter, denoted uˆˆ. At this point, implicitly determined by p 9( uˆˆ ) 5 0, the participation constraint will bind, and the complete information investment level is obtained. The second-order condition for incentive compatibility implies (≠ 2 N / ≠u ≠K 2 1)dK / du $ 0 or, by assuming ≠ 2 N / ≠u ≠K . 1, simply dK / du $0. In the following, the monotonicity constraint is assumed to be satisfied. Note that p 0(u )5≠ 2 N / ≠u 2 ,0, implying fully separating contracts.14 Optimal solution to the managed investment problem is now given by 15 dN(u, K * (u )) 1 1 l 2 m ]]]] 5 ]]] (u 2u ) ] dK 11l
F
GS
1 1 l 2 m ≠ 2 N(u, K * (u )) 1 ]]] ]]]] 2 1 11l ≠u ≠K
F( uˆˆ ) 2 F(u ) ]]]] f(u )
D
(20)
We see that the presence of private information makes is optimal to reduce investments for immobile types (u , uˆˆ ) and to increase investments for mobile
13
See Lewis and Sappington (1989). ´ See Maggi and Rodrıguez-Clare (1995). 15 Eq. (20) is derived by an analogous application of the solution procedure outlined in the appendix of Lewis and Sappington (1989). 14
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types (u . uˆˆ ). For type uˆˆ there is no information-induced distortions in the investment decision. The optimal solution can be implemented within the framework of a corporate income tax system, where the optimal depreciation schedule is as follows
S
D
1 12t 11l2m a(K) 5 d 1 ] 2 ]] ]]] (u 2u] ) t t 11l
S
12t 11l2m 2 ]] ]]] t 11l
≠N(u, K(u )) F( uˆ ) 2 F(u ) DFS]]]] /KD 2 1GS]]]]D ≠u f(u ) ˆ
(21) It is clear from the third term on the right-hand side of Eq. (21) that the optimal governmental response to private information about both domestic and foreign profitability, is to reduce capital allowances for immobile types and increase capital allowances for mobile types.16 This reverses the qualitative result in Section 3 on private information about foreign profitability, where mobile firms self-select more unfavourable capital allowances than immobile firms.17
5. Concluding remarks The wave of reforms of the corporate income tax that has swept the western world for the last 10–15 years has had tax neutrality and a level playing field for investments as their common objective. Equal tax treatment of capital assets was taken to be essential for profit maximising choice of investment to be compatible with maximising social surplus. Maximising after tax profits would in that case imply equalising marginal pre-tax returns across assets. Tax neutrality between industries, firms and capital assets requires capital write offs in the tax base to reflect true economic depreciation of the firm’s real assets. The conventional line of reasoning is however based on two important assumptions. First, the desirability of a neutral corporate income tax was analyzed 16
In Eq. (21) the sign of the expression in the square bracket is positive. This follows from integration of the condition ≠ 2 N / ≠u ≠K .1. 17 The assumption of constant returns on foreign investment is crucial for obtaining a fully separating contract. Under different assumptions, pooling regions may emerge. If I(u, K) denotes return on foreign investments, and p0(u)5 Nu u 2 Iu u .0, the monotonicity condition dK / du $0 is preserved under the assumption that Nu K . Iu K . The analytical framework of Lewis and Sappington (1989) is now applicable. Pooling may appear for an intermediate range of types u1 #u#u2 , whose investment levels are set equal to the complete information solution for type uˆˆ. We also get the complete information solution for the types u and u¯ . Furthermore, contrary to the fully separating solution, the optimal policy ] response to private information in this setting is to increase investments for immobile types (u , u , ] u1 ), and reduce investments for mobile types ( u¯ . u . u2 ). The latter result is also contrary to Lewis and Sappington (1989).
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within a closed economy setting.18 In an open economy context, tax neutrality would have to mean that the taxation of investment returns does not distort the location of mobile capital. Second, the tax authorities were taken to have complete information about the private and social profitability of firms’ investment. As pointed out by among others Boadway and Bruce (1992), in an open economy the corporate income tax will in practice come close to a source tax on investment returns. With returns on mobile investments taxed at source the national government can tax away only domestic investment returns in excess of opportunity returns abroad net of mobility costs. In that case tax neutrality with respect to location of investments is achieved by allowing tax base deductions in the domestic tax on corporate profits to include true economic depreciation and net opportunity returns from investing abroad, implying a capital-dependent tax base equal to the location rent on domestic investment.19 If only profits on domestic investments accrue to the domestic country the domestic government would like the firm to maximise domestic pre-tax profits whereas the globally mobile firm is maximising after-tax domestic profits in excess of opportunity profits abroad, creating a wedge between government and firm objectives. Yet, if the sole government objective is to maximise tax revenue from the industry, the optimal tax base would be given by the location rent implying deductibility for both true depreciation and opportunity returns abroad. That would imply more generous deductions for firms with more profitable opportunities abroad. If the government also attaches a positive welfare weight to domestic industry profits, that would increase the optimum tax base deduction for domestic investments in the domestic profits tax even further as there would now be a trade off between tax revenue and after-tax industry profits. That means that the government would be willing to sacrifice some tax revenue in order to distort the location of mobile investment in favour of locating in the domestic country. Generous tax treatment of mobile capital in order to stimulate domestic investments is in line with conventional thinking about tax policy and capital mobility in many countries, and with taxation at source and complete information about returns home and abroad this does also have some theoretical support from an efficiency point of view. The present analysis shows, however, that with private information about the profitability of foreign options this structure of the optimal tax treatment of mobile capital may be reversed. In this case there will be a trade-off between keeping mobile capital in the country and improving the tax potential from immobile firms. Hence, the optimal tax policy response to private information about the net foreign returns is to face firms with tax schemes that stimulate investment in immobile firms as compared to the case with complete information. It may therefore be optimal to let part of the most mobile capital migrate in order to extract more revenue from the immobile sector. It should, 18 19
See for instance the influential study by King and Fullerton (1984). In addition one needs a lump sum component ensuring that all the location rent is taxed away.
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however, be pointed out that the analysis ignores possible positive welfare effects from capital that has left the country. This is a strong assumption as most systems for taxing foreign investments are a hybrid of source and residence taxation; moreover, some foreign profits will normally also be repatriated. Usually, information revealing mechanisms are direct in the sense that they require the agent to identify her type through an explicit cost report. In the present analysis the implementation is indirect as the firm reveals its true mobility through its choice of domestic investment level. The discussion is however partial in the sense that it does not consider inter-jurisdictional tax competition; neither does it consider the effects that changes in the national tax policy have on the investment of firms in other countries. The lack of inter-jurisdictional competition can be justified by a small country assumption. In general, however, the non-linear tax schedule that we obtain in a partial equilibrium, may induce tax competition in a multi-principal setting.20 The results of our static model carry over to a dynamic setting if the government can commit to a tax menu for the entire horizon of the investments. If commitment is not credible, e.g., because the present government cannot bind the tax policy of future governments, the optimal static solution (under complete as well as private information) cannot be implemented. The existence of mobility costs render investments to some extent irreversible. Under complete information, therefore, the firms may expect taxes to rise once the investments are sunk (locked-in), resulting in under-investment. Also, under the reasonable assumption that the mobility parameter is correlated over time, it will be harder to obtain revelation. The reason is that by revealing its true type in period one, the firm is not likely to reap any information rents in later periods, since the government is unable to commit not to exploit the information obtained (the ratchet effect).21 An important policy implication of the present paper is that private information as to opportunity returns abroad for domestic investments calls for domestic tax incentives that discriminate against the most mobile investments. It should be noted, though, that this result depends on the information structure as to investment returns as well as the taxation principle underlying the national taxation of mobile capital. First, if there is private information about both domestic and foreign profitability of investments (countervailing incentives), the direction of the optimal distortion may change: in the case of decreasing returns in the home market and constant returns abroad, the optimal tax mechanism implies that the mobile firms self-select the most favourable capital allowances. Second, if returns on foreign investments are taxed according to the residence principle, then it is optimal for mobile firms to underreport the foreign opportunity returns, which is achieved by increasing domestic investments beyond the level of maximising 20
See Biglaiser and Mezzetti (1993). The incentive constraints may now bind in both directions, causing the nature of equilibria to be extremely complex, see Laffont and Tirole (1988). 21
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global returns. The optimal policy response to this would be to implement tax incentives making it less profitable at the margin to invest at home.
Appendix A We will verify that the corporate income tax implementation mechanism induces the optimal investment level given by Eq. (10), and the optimal tax payments given by Eq. (8).Inserting for the optimal tax base adjustment B( K) (Eq. (15)), in the first-order condition for the optimisation program for a firm of type u (Eq. (13)), it is clear that the firm invests according to the social optimum:
S
dF(K) 1 1 l 2 m dI(K) ≠M(u, K) ]] 2 d 5 ]]] ]] 2 ]]] dK 11l dK ≠K)
F
1 1 l 2 m ≠ 2 M(u, K) 1 ]]] ]]] 11l ≠u ≠K
D
GS
1 2 F(u ) ]]] f(u )
D
(A.1)
We proceed by verifying that the firm pays the optimal amount of taxes. By integrating Eq. (A.1), we get 11l2m F(K) 2 d K 5 ]]] (I(K) 2 M(u, K)) 11l 1 1 l 2 m ≠M(u, K) 1 2 F(u ) 1 ]]] ]]] ]]] 11l ≠u f(u )
F
GS
D
(A.2)
The tax payments are given by T(K) 5 t[F(K) 2 B(K)] or T(K) 5 t(F(K) 2 d K)
F
11l2m ≠M(u, K) 1 2 F(u ) 1 (1 2 t) ]]] (I(K) 2 M(u, K)) 5 ]]] ]]] 11l ≠u f(u ) 2 (I(K) 2 M(u, K)) 2 p (u )
G (A.3)
after inserting for B( K) and rearranging. Finally, inserting Eq. (A.2) in Eq. (A.3) yields the optimal tax payments T(K) 5 F(K) 2 d K 2 I(K) 1 M(u, K) 2 p (u ) .
References Auerbach, A.J., 1983. Taxation, corporate financial policy and the cost of capital. Journal of Economic Literature, 905–940.
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Baron, D.P., Myerson, R.B., 1982. Regulating a monopolist with unknown costs. Econometrica 50, 911–930. Biglaiser, G., Mezzetti, C., 1993. Principals competing for an agent in the presence of adverse selection and moral hazard. Journal of Economic Theory 61, 302–330. Boadway, R., Bruce, N., 1992. Problems with integrating corporate and personal income taxes in an open economy. Journal of Public Economics 48, 39–66. Dasgupta, P., Hammond, P., Maskin, E., 1979. The implementation of social choice rules. Review of Economic Studies 46, 185–216. Guesnerie, R., Laffont, J.J., 1984. A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm. Journal of Public Economics 25, 329–369. King, M.A., Fullerton, D. (Eds.), 1984, The Taxation of Income from Capital: A Comparative study of the United States, the United Kingdom, Sweden and West Germany, University of Chicago Press, Chicago. Laffont, J.J., Tirole, J., 1988. The dynamics of incentive contracts. Econometrica 56, 1153–1175. Laffont, J.J., Tirole, J., 1986. Using cost observation to regulate firms. Journal of Political Economy 94, 614–641. Lewis, T., Sappington, D., 1989. Countervailing incentives in agency problems. Journal of Economic Theory 49 (2), 294–313. ´ Maggi, G., Rodrıguez-Clare, A., 1995. On countervailing incentives. Journal of Economic Theory 66, 238–263.
Internationally mobile firms and tax policy 1 P. Osmundsen*, K.P. Hagen, G. Schjelderup Norwegian School of Economics and Business Administration, Institute of Economics, Helleveien 30, N-5035 Bergen, Norway Accepted 17 March 1997
Abstract This paper analyses how the government should tax internationally mobile firms. The analysis finds that if tax authorities are unable to observe firms’ true mobility, and domestic and foreign profitability are uncorrelated, then: (1) information rents are acquired by immobile (inefficient) firms, and (2) the optimal policy will stimulate investment in the immobile sector compared to the complete information case. Another result of the paper is that the optimal allocation is implementable within the framework of a corporate income tax system, where mobile firms self-select more unfavourable capital allowances than immobile firms. 1998 Elsevier Science B.V. Keywords: Corporate taxation; International mobility; Private information JEL classification: D82; H21; L51
1. Introduction Accelerated economic integration leads to increased international mobility, rendering national fiscal systems more exposed to tax-induced market reactions, including capital movements, labour migration, and the location decisions of firms. This paper focuses on the latter. Differences in national fiscal systems may induce firms to direct their investments to low-tax countries. Such behaviour restricts national autonomy in fiscal matters, since national tax bases become international*Corresponding author. 1 We are indebted to two anonymous referees for constructive and valuable comments. 0022-1996 / 98 / $19.00 1998 Elsevier Science B.V. All rights reserved. PII S0022-1996( 97 )00028-7
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ly mobile and therefore more elastic. Thus, governments are forced to formulate their national fiscal policies in response to global economic forces. We attempt to analyze how the government should handle firms that demand preferential tax treatment on grounds of being internationally mobile. It is commonly assumed that mobility of tax bases calls for low effective tax rates in order to keep them in the country. To induce a firm to stay at home, the firm’s domestic after tax profit must equal or exceed the after tax profit that could be obtained by moving operations abroad, thus imposing a mobility constraint on corporate income taxation. The opportunity cost of locating at home is equal to the after-tax return on foreign investments less mobility costs. Highly mobile firms, i.e., firms with high profit opportunities abroad or low migration costs, may not be prepared to remain in the country unless they are offered lenient (accommodating) taxation. Hence, for highly mobile firms, the mobility constraint will bind at lower effective domestic corporate tax rates than for immobile firms. An additional problem facing the government is that firms are likely to have private information about their true mobility. As a consequence, the government is also constrained in its tax policy towards immobile firms. An immobile firm may imitate mobile firms, thereby obtaining a favourable tax treatment by an implicit threat of relocation. Our solution to the problems of tax-induced migration and private information about mobility, is to apply managed investment policies, implemented by a tax incentive mechanism that takes into account the difference in mobility among firms. In Section 2 we construct a tax model for internationally mobile firms, where the aim of the government is to find a revelation mechanism that maximises social welfare. Section 3 examines alternative implementation mechanisms with respect to taxes. Section 4 provides some extensions to the model, and Section 5 concludes the paper.
2. The model The government seeks to design a tax system for mobile firms, taking into account that the exact mobility is private information of the firms. To address this problem, we apply a generalised version of the Baron and Myerson (1982) model. Let u be a continuous parameter that belongs to the interval u [ [u, u¯ ]. We denote ] u] as the most mobile and u¯ as the most immobile firm type. There is a continuum of firms independently drawn from the same distribution F(u), satisfying the monotone inverse hazard rate; ≠[12F(u )) /f(u )] / ≠u #0. The exact mobility is known to the firm, whereas the government only knows the support and the distribution. Total domestic taxes payable by the firm are denoted R. Let N( K) be the firm’s net domestic revenue, where K is the firm’s domestically invested capital, and ≠ 2 N / ≠K 2 ,0. If the firm instead invests K units of capital abroad, it receives
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I( K)2 M(u, K), where I is the after-tax revenue from investing abroad, and M are type-dependent migration costs. The firm will invest at home if domestic investments yield at least the same net payoff as foreign investments, i.e., if N( K)2 R $ I( K)2 M(u,K). This inequality condition represents a mobility constraint on domestic corporate taxation. An equivalent formulation of the mobility constraint is a firm participation constraint, stating that firms will only invest in the home country if the domestic payoff exceeds the opportunity cost of capital (defined as payoff from investing the capital abroad, net of mobility costs), i.e., N( K)2 R 2[ I( K)2 M(u, K)]$0. We assume that the type-dependent mobility costs have the properties ≠M(u, K) ]]] . 0 ≠u
(A1)
≠M 2 (u, K) ]]] . 0 ≠u ≠K
(A2)
i.e., the low-mobility type firm have higher migration costs both on average, (Eq. (A1)), and at the margin, (Eq. (A2)).2 We focus on a domestic industry that is price taker in the global market, so there is no effect on consumer surplus generated from changes in domestic production. The net loss in welfare from a firm moving its operations abroad, therefore, is made up of loss in tax revenue and loss of producer surplus. We assume that foreign profits cannot be taxed by the home country (corporate income is taxed at source)3 , and that foreign producer surplus is not appropriated by the home country, i.e., all taxes and all of the producer surplus are lost when a firm migrates. Let hR( uˆ ), K( uˆ ), uˆ [ [u], u¯ ]j be a direct mechanism that induces truthful revelation of the firm’s mobility parameter.4 Hence, private rents for a firm of type u announcing uˆ are given by:
p ( uˆ, u ) 5 N(K( uˆ )) 2 I(K( uˆ )) 1 M(u, K( uˆ )) 2 R( uˆ )
(1)
Note that in calculating private rents we account for both production and opportunity costs. Therefore, p is the domestic private after tax return in excess of the net income foregone by not investing K abroad, i.e., country-specific profits or localisation rent. Multinational firms—seeking to maximise global profits—will 2 The type-dependent migration costs may be seen as firms differing in international orientation and competence to handle foreign direct investments, i.e., they face different training expenses and market research costs when they invest abroad. Another interpretation is that the degree of irreversibility in firms’ current domestic investment portfolios differs. 3 By making this assumption, we acknowledge that the analysis abstracts from some multinational tax issues. 4 The revelation principle states that the principal—without loss of generality—can restrict his attention to the class of mechanisms in response to which the firms report their types truthfully. For a more precise definition, see Dasgupta et al. (1979).
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choose K to maximise p, and will not invest in the home country unless p $0. The national perspective of the government means that it would like the firms to maximise the total profits accruing to domestic owners. As a consequence, the opportunity costs of locating in the home country do not (directly) represent domestic social costs. Hence, social profits (denoted P ) are defined by P;p1 ( I 2 M), i.e., domestic industrial profits.5 The objective function of the utilitarian government is assumed to be a weighted sum of tax revenue and the industry profits accruing to domestic owners, i.e., the social welfare generated by a firm of type u is given by W 5 (1 1 l)R(u ) 1 mP (u )
(2)
where (11 l) is the general equilibrium shadow cost of public funds, and m is the welfare weight attached to industry profits.6 By using Eq. (1), the social-welfare function can be restated as W 5 (1 1 l)N(K(u )) 2 (1 1 l 2 m )P (u )
(3)
The regulatory problem is to maximise social welfare u¯
Max K(u )
E h(1 1 l)N(K(u )) 2 (1 1 l 2 m)P(u )j dF(u )
(4)
u ]
subject to a set of participation and incentive constraints
p (u, u ) $ 0 , ;u
(5)
p (u, u ) $ p ( uˆ, u ) , ;uˆ, u
(6)
The second order condition for incentive compatibility implies dK / du $0 (monotonicity constraint), which is assumed to be strictly satisfied. Following conventional procedures 7 , information rents are given by u
≠M( u˜ , K( u˜ )) E H]]]] J du˜ ≠u˜
p (u ) 5
(7)
u ]
From Eq. (7) it now follows that: 5
The opportunity cost of investing in the home country drives a wedge between private and social profits from domestic investments, and by assumption the wedge is subject to private information. Thus, welfare maximisation necessitates that firms’ investment incentives are corrected both under complete and private information. 6 To finance public expenditure the government must resort to distortive taxes, yielding l.0. The cost of public funds is taken as exogenously given in this partial model. If a denotes foreign equity share in the domestic firm, it would be natural to set m512a. 7 For a technical survey of principal-agent theory, see Guesnerie and Laffont (1984).
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Proposition 1: Information rents are acquired by immobile firms. Reporting a high migration cost will reveal the firm as a dependable tax base, since capital is country specific (locked-in). If the government taxes such a firm heavily, it will create an incentive for an immobile firm to claim to be a mobile firm. To induce truthful reporting, the government’s policies must guarantee an immobile firm a positive rent. It now follows from Eq. (1) that net taxes are given by u
≠M( u˜ , K( u˜ )) E H]]]] J du˜ ≠u˜
R(u ) 5 N(K(u )) 2 I(K(u )) 1 M(u, K(u )) 2
(8)
u ]
Inserting for the rent expression Eq. (7) in the objective function Eq. (4) and integrating by parts, give the following expression for expected welfare u¯
E h(1 1 l)N(K(u )) 2 (1 1 l 2 m)(I(K(u ) 2 M(u, K(u ))) ≠M(u, K(u )) 1 2 F(u ) 2 (1 1 l 2 m )F]]]]G ]]]J dF(u ) . ≠u f(u )
EW 5
u ]
(9)
A characterisation of the optimal investment level is obtained by pointwise differentiation of Eq. (9) over []u, u¯ ] with respect to K(u), and equating to zero:
S
dN(K * (u )) 1 1 l 2 m dI(K * (u )) ≠M(u, K * (u )) ]]] 5 ]]] ]]] 2 ]]]] dK 11l dK ≠K
F
1 1 l 2 m ≠ 2 M(u, K * (u )) ]]] ]]]] 1 11l ≠u ≠K
GS
D
1 2 F(u ) ]]] f(u )
D
(10)
To interpret the first-order condition Eq. (10), it is useful to think of optimal corporate taxation in three different situations: (1) a closed economy, (2) an open economy with complete information about mobility, and (3) an open economy with private information about mobility. Whereas the regulatory situation under (1) is unconstrained (first best), the government faces mobility constraints under (2) (second best), and (3) imposes additional incentive constraints (third best). Moving from (1) to (3), therefore, gradually reduces the scope for taxation, and the optimal policy response is to impose increasingly larger distortions. In a closed economy with complete information, it is in the interest of the government that net domestic revenue is maximised (dN / dK50), since the government is able to capture all social rents by imposing lump sum taxes. In an open economy with complete information with respect to u, the optimal solution is obtained by setting the left-hand side of Eq. (10) equal to the first distortionary term on the right-hand side. Under complete information the government is able to
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capture all country-specific rents, i.e., p (u )50, ;u, implying that the realised after-tax profits, P(u)5 I( K(u))2 M(u,K(u)), are (by definition) positive for mobile firms. The government is unable to capture those mobility rents, due to the participation constraint.8 Assuming that the marginal opportunity costs are positive, P is increasing in the investment level. Thus, by reducing the investment level relative to the closed economy solution, the government is able to capture a larger fraction of P. Hence, the optimal policy is determined by a trade-off between the marginal social gain of enhanced rent capture, and the marginal social costs of underinvestment. Note that the investment distortion is due to the fact that the government is unable to tax foreign income. Accordingly, the distortion can be seen as the optimal response to fiscal externalities implied by the source principle of taxation. Introducing private information to the open economy framework generates the additional second term on the right-hand side of Eq. (10), which is equal to marginal information costs. The presence of private information about mobility, therefore, calls for higher tax distortions, driving more capital abroad. We may now state: Proposition 2: Private information about mobility leads to lower domestic investment levels for all types but the least mobile, and the distortion is largest for the most mobile type. The economic explanation for this distortion, is that rent extraction is enhanced since the incentives for mimicking are reduced.9 Whenever private information about mobility is present, the government’s effort in revealing true mobility and capturing rents, creates a relative advantage for low mobility firms. Thus, we have: Corollary: The optimal policy will induce the immobile sector to expand at the expense of the mobile sector as compared to the situation with complete information. The optimal regulatory outcome has a clear interpretation in terms of public economics. The problem facing the government is that those firms claiming to be highly internationally mobile—but are in fact relatively immobile—are those firms 8 Hence, the optimisation problem for the government under complete information is given by max h(11l)N( K)2(11l2m)( I 2 M)j. K9 Choosing K lower than the first best level, however, implies suboptimal investments. It is optimal to reduce investments to the point where the expected value-weighted marginal deadweight loss from these distortions equals the expected marginal reduction in the deadweight loss in other sectors of the economy, made possible by increased tax revenue from mobile firms. The result corresponds to the theory of second-best taxation; when neutral taxes are not available it is optimal to spread taxation over several sectors of the economy, to the point where the marginal deadweight losses are equalised across sectors.
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that can sustain the highest burden of taxation. Put differently, the government wants as many firms as possible to invest in immobile activities and then tax them at a higher average tax rate. This is done by implementing an optimal regulatory solution that at the margin makes it unfavourable (by distorting investment incentives) to invest in mobile industries. By doing so the government will reduce the average mobility and enhance the tax potential of the corporate tax base, at the cost of a reduction in the overall tax base due to suboptimal investments.
3. Implementation In developing the optimal contract under private information, we have used a direct revelation mechanism. The firm reports its true mobility parameter, in response to which it will be instructed to invest according to Eq. (10) and pay net taxes according to Eq. (8). Comparing this contract with present tax systems is difficult, since direct revelation mechanisms are rarely used. However, the optimal contract can be given alternative implementations that are more similar to actual tax regimes: (I) a menu of linear tax contracts generated by investment fees and lump sum taxes, where net taxes are a function of the investment level and a mobility parameter report, and (II) non-linear corporate income taxation where net taxes are only a function of the investment level. The first implementation scheme is developed by Laffont and Tirole (1986), and the latter is developed below. Both schemes imply delegation as the investment levels are left for the firms to decide. We do not observe governments offering capital-tax menus that depend on report of a cost parameter. Neither do we see corporate income tax systems consisting merely of investment fees and lump sum taxes. Our objective in this section, therefore, is to construct an implementation mechanism that reflects more accurately the type of information usually available and the type of instruments governments actually use. The self-selection mechanism developed below is general in the sense that it applies to all regulatory settings where the optimal mechanism implies information-induced distortions of investments in the corporate sector. Most countries tax firms by means of a corporate income tax system. The corporate income tax base is often a non-linear function of the firm’s investments, due to non-linear deductible capital allowances and possibly a tax-exempt income. Moreover, governments tend to offer firms a choice of different depreciation rates and tax base formulas. The optimal regulatory solution (given by Eqs. (8) and (10)) can be implemented within a corporate income tax system, by offering firms with varying degrees of capital mobility tax base adjustments in the form of a capital allowance as a function of the firm’s investment, and in addition a tax exempt income. By the monotonicity constraint the socially optimal domestic investments are an increasing function of the mobility parameter u, so that the government can derive the inverted function u (K) from the optimal regulatory
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solution. Hence, there exists a capital allowance schedule as a function of the firm’s investment that induces a firm of type u to choose a profit maximising investment level satisfying the optimality condition Eq. (10). The conditions for the optimal tax revenue given by Eq. (8) are satisfied through adjusting the tax exempt income, which through the inverse of K(u) will be a unique function of the socially optimal investment schedule too. Thus, the implementation mechanism is indirect in the sense that it is a unique function of the firm’s investment levels which the tax authorities can observe. Faced with the optimal capital allowance schedule the firms reveal their true mobility through their profit-maximising choice of domestic investments. Implementing the optimum policy through the design of the corporate income tax base requires that a distortion is built into the tax system to the effect that profit maximising firms invest according to the optimum conditions given by Eq. (10). Generally, a neutral profits tax requires that the tax base represents true economic rent. In a closed economy this in turn requires deductions in taxable income for true economic depreciation and the financial opportunity cost of the invested capital. The latter corresponds to interest on borrowing and to the returns forfeited on invested equity. Ceteris paribus, insufficient capital allowances will act as a factor tax on capital. Hence, investment fees and (inadequate) tax write offs for investments are equivalent means for controlling firms’ investment.10 In an open economy with mobile capital, neutrality also requires that the tax system does not affect the location decision with respect to investment. This can be achieved by having worldwide income taxed according to the residence principle under the national corporate income tax. In the present paper, however, we assume that corporate income is taxed at source. Hence, domestic firms may locate investments abroad in order to take advantage of more lenient taxation. Foreign investment opportunities imply that only domestic pure profits in excess of after-tax opportunity returns abroad can be captured through the domestic profits tax. As a consequence, a neutral source tax on corporate income with internationally mobile capital would require the opportunity returns abroad net of foreign taxes and migration costs to be deductible in the domestic tax base. We will show how a non-linear corporate income tax system can implement the optimal regulatory solution given by the optimal schedules for tax payments in Eq. (8) and the optimal investment decisions in Eq. (10). We assume a corporate income tax system with a flat corporate income tax rate t and a non-linear capital write off schedule B( K). Assuming equity financing, a firm’s net domestic revenue can be defined as N(K) ; F(K) 2 d K
10
For more details, see Auerbach (1983).
(11)
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105
where F is a production function, and d is the rate of economic depreciation. The firm’s optimisation problem is given by maxhF(K) 2 d K 2 I(K) 1 M(u, K) 2 t[F(K) 2 B(K)]j
(12)
K
with the first-order condition
F
S
dF(K) 1 dI(K) ≠M(u, K) dB(K) ]] 2 d 5 ]] ]] 2 ]]] 1 t d 2 ]] dK 12t dK ≠K dK
DG
(13)
By substituting the inverse function u( K) in the first-order condition for the principal’s decision problem, Eq. (10), and inserting it into Eq. (13), we get dB(K) ]] 5 d dK 1 1] t
FS
11l2m 1 2 (1 2 t) ]]] 11l
dI(K) ≠M(u (K), K) DS]] 2 ]]]]D dK ≠K
1 1 l 2 m ≠ 2 M(u (K), K) 1 2 F(u (K)) 2 (1 2 t) ]]] ]]]] ]]]] 11l ≠u (K) ≠K f(u (K))
G
(14)
By integrating Eq. (14) and by imposing the optimal revenue condition in Eq. (8), we obtain the function for optimal capital write offs B(K) 5 d K 1 (I(K) 2 M(u (K), K))
S S
D
12t 11l2m 1 ]] 1 2 ]]] (I(K) 2 M(u (K), K)) t 11l 12t 11l2m ≠M(u (K), K) 1 2 F(u (K)) p (u (K)) 2 ]] ]]] ]]]] ]]]] 1 ]]] t 11l t ≠u (K) f(u (K))
DF
G
(15) That Eq. (15) induces optimal investment levels and optimal tax payments, is verified in Appendix A. One interpretation of this implementation mechanism— which corresponds to commonly observed corporate income tax systems—is that the government offers the mobile firms a corporate income tax base which consists of a non-linear capital allowance a( K)K (where a( K) is a non-linear tax depreciation schedule), and a tax-exempt income E( K), so that the total tax base deductions are given by B(K) 5 a(K)K 1 E(K) , where
(16)
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1 a(K) 5 d 1 ] (I(K) 2 M(u (K), K)) K 1 12t 11l2m 1 ] ]] 1 2 ]]] (I(K) 2 M(u (K), K)) K t 11l 1 12t 11l2m ≠M(u (K), K) 1 2 F(u (K)) 2 ] ]] ]]] ]]]] ]]]] K t 11l ≠u (K) f(u (K))
S S
D
DF
G
(17)
and
p (u (K) E(K) 5 ]] t
(18)
The implementation mechanism contains three tax instruments: t, a( K) and E( K). We set t arbitrarily, e.g., equal to the statutory corporate income tax rate applying to both mobile and immobile firms, and we use a( K) and E( K) as instruments for a managed investment policy for mobile firms.11 The depreciation schedule Eq. (17) induces the firms to make socially optimal investments. The tax exempt income levels Eq. (18) secure optimal tax revenues, i.e., E( K) are set so as to capture an optimal fraction of the information rent. The depreciation schedule has a clear economic interpretation. As a first reference case, a corporate income tax system that does not distort private investment decisions in a closed economy, is implemented by setting the capital allowance equal to the true economic depreciation, i.e., a( K) is set equal to the first term on the right-hand side of Eq. (17) (i.e., d ). This is the first best (closed economy, complete information) solution, where firms maximise their net domestic revenue. A further reference case relates to the open economy where nondistorted taxation induces the firms to maximise country specific profits, which is achieved by setting a( K) equal to the first two terms in Eq. (17), i.e., by letting the opportunity cost of domestic investment be tax deductible. The depreciation schedule in this case implies localisation neutrality, and represents the optimal tax policy for the case where there is complete information and the government places no weight on industry profits ( m 50). The second best (open economy, complete information) solution for the case with a positive weight on industry profits is implemented by adding the third term in Eq. (17), distorting the solution in favour of domestic investment. The last terms in the expressions for a( K) is added to implement the third best (open economy, private information) solution. In an open economy, both under complete and private information, a tax system for mobile firms needs to address the issue of imperfect rent capture. The fourth 11
The same tax schedule is optimal in the case of debt financing, since interest payments are tax exempt. Capital tax allowance schedules may seem artificial in a static model. Assuming the government is able to credibly commit to a taxation scheme for the entire investment horizon, however, the model can be extended to a multi-period context.
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term in the depreciation schedule relaxes the self-selection constraint. By imposing an investment distortion the government is able to capture a larger fraction of the information rent, i.e., the last term in the expression for a( K) is the tax depreciation equivalent of the distortion due to private information. It is obtained by dividing the marginal information costs in optimum by (12 t) /(tK). To enhance rent extraction, the corporate income tax is designed so that mobile firms self-select more unfavourable capital allowances than immobile firms. From the last term on the right-hand side of Eq. (17), we see that the tax-deductible capital allowance is reduced for all types but u¯ , and that the optimal information-induced reduction in a( K) is higher when: (a) the benefit of capturing rent is high, i.e., when l is high and m is low, (b) the marginal opportunity costs are sensitive with respect to differences in mobility (making it a good screening instrument), and (c) the fraction of firms at the particular investment level, f(u )du, is small (distortions are preferred at the parts of the distribution where the magnitudes of distortions are kept at a minimum). These results are rather contrary to common practice: internationally mobile firms are often offered generous depreciation rates in order to make it attractive for them to remain in the country. The analysis has shown, however, that as a means of enhancing the government’s bargaining position under private information about mobility, it may be optimal to let part of the most mobile capital flee the country. To summarise: Proposition 3: The optimal allocation under private information is implementable within the framework of a corporate income taxation system. Mobile firms will self-select more unfavourable capital allowances than immobile firms.
4. Extensions The results obtained in Sections 2 and 3 are based on two underlying assumptions. The first is that there is private information about a firm’s return on investments abroad, net of mobility costs, so the authorities cannot establish the level of domestic reservation profits. This presupposes that it is easier for the tax authorities to ascertain domestic profitability than net payoff on foreign investments. This is reflected in the model, where we assume complete information about domestic profitability and private information about mobility costs.12 The second assumption is that foreign and domestic profitability are uncorrelated. If we 12 An alternative formulation—that will produce the same results—is to assume private information about the payoff on foreign investments, while assuming complete information about moving costs. In this alternative model, the opportunity cost of domestic investments is given by I(u, K(u))2 M( K(u)), where mobile firms are assumed to have a higher return on foreign investments on average and at the margin, i.e., ≠I(u, K(u )) / ≠u ,0 and ≠ 2 I(u, K(u )) / ≠u ≠K ,0.
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change these underlying assumptions to the effect that there is private information about both domestic and foreign profitability, and that firms that are profitable abroad also predominantly have a high payoff on domestic investments, we may obtain results that are qualitatively different. To see how the results change given the new set of assumptions, we let the information parameter u represent productivity, with u] denoting the lowest productivity type and u¯ the highest productivity type. Since mobility is determined by the firm’s net return on foreign investments, u can still be interpreted as a mobility parameter. Let net domestic revenue be given by N(u, K(u)), where ≠N / ≠u .0 and ≠ 2 N / ≠u ≠K .0. While there is decreasing economic returns in the smaller domestic market, i.e., ≠ 2 N / ≠K 2 ,0 and ≠ 2 N / ≠u 2 ,0, the firm has constant returns on investments in the larger foreign market, given by (u 2u] )K. Location rents are now equal to
p ( uˆ, u ) 5 N(u, K( uˆ )) 2 (u 2u] )K( uˆ ) 2 R( uˆ ) .
(19)
If it is common knowledge that foreign and domestic profitability is positively correlated, we get countervailing incentives.13 On the one hand the firm would like to report a high earning potential on foreign investments (i.e., report a high u ), signalling that the firm is likely to move abroad if taxed too hard. On the other hand the firm has an incentive to report low profitability on domestic investments (i.e., report a low u ). The two incentives may be exactly offsetting at an interior value of the information parameter, denoted uˆˆ. At this point, implicitly determined by p 9( uˆˆ ) 5 0, the participation constraint will bind, and the complete information investment level is obtained. The second-order condition for incentive compatibility implies (≠ 2 N / ≠u ≠K 2 1)dK / du $ 0 or, by assuming ≠ 2 N / ≠u ≠K . 1, simply dK / du $0. In the following, the monotonicity constraint is assumed to be satisfied. Note that p 0(u )5≠ 2 N / ≠u 2 ,0, implying fully separating contracts.14 Optimal solution to the managed investment problem is now given by 15 dN(u, K * (u )) 1 1 l 2 m ]]]] 5 ]]] (u 2u ) ] dK 11l
F
GS
1 1 l 2 m ≠ 2 N(u, K * (u )) 1 ]]] ]]]] 2 1 11l ≠u ≠K
F( uˆˆ ) 2 F(u ) ]]]] f(u )
D
(20)
We see that the presence of private information makes is optimal to reduce investments for immobile types (u , uˆˆ ) and to increase investments for mobile
13
See Lewis and Sappington (1989). ´ See Maggi and Rodrıguez-Clare (1995). 15 Eq. (20) is derived by an analogous application of the solution procedure outlined in the appendix of Lewis and Sappington (1989). 14
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types (u . uˆˆ ). For type uˆˆ there is no information-induced distortions in the investment decision. The optimal solution can be implemented within the framework of a corporate income tax system, where the optimal depreciation schedule is as follows
S
D
1 12t 11l2m a(K) 5 d 1 ] 2 ]] ]]] (u 2u] ) t t 11l
S
12t 11l2m 2 ]] ]]] t 11l
≠N(u, K(u )) F( uˆ ) 2 F(u ) DFS]]]] /KD 2 1GS]]]]D ≠u f(u ) ˆ
(21) It is clear from the third term on the right-hand side of Eq. (21) that the optimal governmental response to private information about both domestic and foreign profitability, is to reduce capital allowances for immobile types and increase capital allowances for mobile types.16 This reverses the qualitative result in Section 3 on private information about foreign profitability, where mobile firms self-select more unfavourable capital allowances than immobile firms.17
5. Concluding remarks The wave of reforms of the corporate income tax that has swept the western world for the last 10–15 years has had tax neutrality and a level playing field for investments as their common objective. Equal tax treatment of capital assets was taken to be essential for profit maximising choice of investment to be compatible with maximising social surplus. Maximising after tax profits would in that case imply equalising marginal pre-tax returns across assets. Tax neutrality between industries, firms and capital assets requires capital write offs in the tax base to reflect true economic depreciation of the firm’s real assets. The conventional line of reasoning is however based on two important assumptions. First, the desirability of a neutral corporate income tax was analyzed 16
In Eq. (21) the sign of the expression in the square bracket is positive. This follows from integration of the condition ≠ 2 N / ≠u ≠K .1. 17 The assumption of constant returns on foreign investment is crucial for obtaining a fully separating contract. Under different assumptions, pooling regions may emerge. If I(u, K) denotes return on foreign investments, and p0(u)5 Nu u 2 Iu u .0, the monotonicity condition dK / du $0 is preserved under the assumption that Nu K . Iu K . The analytical framework of Lewis and Sappington (1989) is now applicable. Pooling may appear for an intermediate range of types u1 #u#u2 , whose investment levels are set equal to the complete information solution for type uˆˆ. We also get the complete information solution for the types u and u¯ . Furthermore, contrary to the fully separating solution, the optimal policy ] response to private information in this setting is to increase investments for immobile types (u , u , ] u1 ), and reduce investments for mobile types ( u¯ . u . u2 ). The latter result is also contrary to Lewis and Sappington (1989).
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within a closed economy setting.18 In an open economy context, tax neutrality would have to mean that the taxation of investment returns does not distort the location of mobile capital. Second, the tax authorities were taken to have complete information about the private and social profitability of firms’ investment. As pointed out by among others Boadway and Bruce (1992), in an open economy the corporate income tax will in practice come close to a source tax on investment returns. With returns on mobile investments taxed at source the national government can tax away only domestic investment returns in excess of opportunity returns abroad net of mobility costs. In that case tax neutrality with respect to location of investments is achieved by allowing tax base deductions in the domestic tax on corporate profits to include true economic depreciation and net opportunity returns from investing abroad, implying a capital-dependent tax base equal to the location rent on domestic investment.19 If only profits on domestic investments accrue to the domestic country the domestic government would like the firm to maximise domestic pre-tax profits whereas the globally mobile firm is maximising after-tax domestic profits in excess of opportunity profits abroad, creating a wedge between government and firm objectives. Yet, if the sole government objective is to maximise tax revenue from the industry, the optimal tax base would be given by the location rent implying deductibility for both true depreciation and opportunity returns abroad. That would imply more generous deductions for firms with more profitable opportunities abroad. If the government also attaches a positive welfare weight to domestic industry profits, that would increase the optimum tax base deduction for domestic investments in the domestic profits tax even further as there would now be a trade off between tax revenue and after-tax industry profits. That means that the government would be willing to sacrifice some tax revenue in order to distort the location of mobile investment in favour of locating in the domestic country. Generous tax treatment of mobile capital in order to stimulate domestic investments is in line with conventional thinking about tax policy and capital mobility in many countries, and with taxation at source and complete information about returns home and abroad this does also have some theoretical support from an efficiency point of view. The present analysis shows, however, that with private information about the profitability of foreign options this structure of the optimal tax treatment of mobile capital may be reversed. In this case there will be a trade-off between keeping mobile capital in the country and improving the tax potential from immobile firms. Hence, the optimal tax policy response to private information about the net foreign returns is to face firms with tax schemes that stimulate investment in immobile firms as compared to the case with complete information. It may therefore be optimal to let part of the most mobile capital migrate in order to extract more revenue from the immobile sector. It should, 18 19
See for instance the influential study by King and Fullerton (1984). In addition one needs a lump sum component ensuring that all the location rent is taxed away.
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however, be pointed out that the analysis ignores possible positive welfare effects from capital that has left the country. This is a strong assumption as most systems for taxing foreign investments are a hybrid of source and residence taxation; moreover, some foreign profits will normally also be repatriated. Usually, information revealing mechanisms are direct in the sense that they require the agent to identify her type through an explicit cost report. In the present analysis the implementation is indirect as the firm reveals its true mobility through its choice of domestic investment level. The discussion is however partial in the sense that it does not consider inter-jurisdictional tax competition; neither does it consider the effects that changes in the national tax policy have on the investment of firms in other countries. The lack of inter-jurisdictional competition can be justified by a small country assumption. In general, however, the non-linear tax schedule that we obtain in a partial equilibrium, may induce tax competition in a multi-principal setting.20 The results of our static model carry over to a dynamic setting if the government can commit to a tax menu for the entire horizon of the investments. If commitment is not credible, e.g., because the present government cannot bind the tax policy of future governments, the optimal static solution (under complete as well as private information) cannot be implemented. The existence of mobility costs render investments to some extent irreversible. Under complete information, therefore, the firms may expect taxes to rise once the investments are sunk (locked-in), resulting in under-investment. Also, under the reasonable assumption that the mobility parameter is correlated over time, it will be harder to obtain revelation. The reason is that by revealing its true type in period one, the firm is not likely to reap any information rents in later periods, since the government is unable to commit not to exploit the information obtained (the ratchet effect).21 An important policy implication of the present paper is that private information as to opportunity returns abroad for domestic investments calls for domestic tax incentives that discriminate against the most mobile investments. It should be noted, though, that this result depends on the information structure as to investment returns as well as the taxation principle underlying the national taxation of mobile capital. First, if there is private information about both domestic and foreign profitability of investments (countervailing incentives), the direction of the optimal distortion may change: in the case of decreasing returns in the home market and constant returns abroad, the optimal tax mechanism implies that the mobile firms self-select the most favourable capital allowances. Second, if returns on foreign investments are taxed according to the residence principle, then it is optimal for mobile firms to underreport the foreign opportunity returns, which is achieved by increasing domestic investments beyond the level of maximising 20
See Biglaiser and Mezzetti (1993). The incentive constraints may now bind in both directions, causing the nature of equilibria to be extremely complex, see Laffont and Tirole (1988). 21
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global returns. The optimal policy response to this would be to implement tax incentives making it less profitable at the margin to invest at home.
Appendix A We will verify that the corporate income tax implementation mechanism induces the optimal investment level given by Eq. (10), and the optimal tax payments given by Eq. (8).Inserting for the optimal tax base adjustment B( K) (Eq. (15)), in the first-order condition for the optimisation program for a firm of type u (Eq. (13)), it is clear that the firm invests according to the social optimum:
S
dF(K) 1 1 l 2 m dI(K) ≠M(u, K) ]] 2 d 5 ]]] ]] 2 ]]] dK 11l dK ≠K)
F
1 1 l 2 m ≠ 2 M(u, K) 1 ]]] ]]] 11l ≠u ≠K
D
GS
1 2 F(u ) ]]] f(u )
D
(A.1)
We proceed by verifying that the firm pays the optimal amount of taxes. By integrating Eq. (A.1), we get 11l2m F(K) 2 d K 5 ]]] (I(K) 2 M(u, K)) 11l 1 1 l 2 m ≠M(u, K) 1 2 F(u ) 1 ]]] ]]] ]]] 11l ≠u f(u )
F
GS
D
(A.2)
The tax payments are given by T(K) 5 t[F(K) 2 B(K)] or T(K) 5 t(F(K) 2 d K)
F
11l2m ≠M(u, K) 1 2 F(u ) 1 (1 2 t) ]]] (I(K) 2 M(u, K)) 5 ]]] ]]] 11l ≠u f(u ) 2 (I(K) 2 M(u, K)) 2 p (u )
G (A.3)
after inserting for B( K) and rearranging. Finally, inserting Eq. (A.2) in Eq. (A.3) yields the optimal tax payments T(K) 5 F(K) 2 d K 2 I(K) 1 M(u, K) 2 p (u ) .
References Auerbach, A.J., 1983. Taxation, corporate financial policy and the cost of capital. Journal of Economic Literature, 905–940.
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Baron, D.P., Myerson, R.B., 1982. Regulating a monopolist with unknown costs. Econometrica 50, 911–930. Biglaiser, G., Mezzetti, C., 1993. Principals competing for an agent in the presence of adverse selection and moral hazard. Journal of Economic Theory 61, 302–330. Boadway, R., Bruce, N., 1992. Problems with integrating corporate and personal income taxes in an open economy. Journal of Public Economics 48, 39–66. Dasgupta, P., Hammond, P., Maskin, E., 1979. The implementation of social choice rules. Review of Economic Studies 46, 185–216. Guesnerie, R., Laffont, J.J., 1984. A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm. Journal of Public Economics 25, 329–369. King, M.A., Fullerton, D. (Eds.), 1984, The Taxation of Income from Capital: A Comparative study of the United States, the United Kingdom, Sweden and West Germany, University of Chicago Press, Chicago. Laffont, J.J., Tirole, J., 1988. The dynamics of incentive contracts. Econometrica 56, 1153–1175. Laffont, J.J., Tirole, J., 1986. Using cost observation to regulate firms. Journal of Political Economy 94, 614–641. Lewis, T., Sappington, D., 1989. Countervailing incentives in agency problems. Journal of Economic Theory 49 (2), 294–313. ´ Maggi, G., Rodrıguez-Clare, A., 1995. On countervailing incentives. Journal of Economic Theory 66, 238–263.