Tax Credit Puzzle

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International Capital Tax Evasion and the Foreign Tax Credit Puzzle

Kimberley A. Scharf

The Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 34, No. 2. (May,2001), pp. 465-480.

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International capital tax evasion and the

foreign tax credit puzzle

Kimberley A. Scharf Department of Economics, University of

Wanvick

Abstract. In this paper we exa mine how the presence of international tax evasion affects thechoice of a foreign tax credit by a capital exp orting region. Since the credit raises the oppor-tunity cost of concealing foreign source incom e, it can be employed to discourage evasionactivity. International tax evasion can thus he lp to rationalize the ado ption of a tax credit inexcess of a deduction-equivalent rate. JEL Classification: H21, H26

Evasionfiscale pour le capital international et leprobl2me du crt dit d'imp dtpou r le ardeaufiscal a l'ttranger Ce memoire examine comment la presence d'evasion fiscale pour lecapital international affecte le choix du credit d'imp6t pour le fardeau fiscal a l'etranger parune region qui ex porte du capital. Puisque le credit d'impbt accroit le cofit d'opportunite ducamouflage de la source etrangkre d e revenus, c'est une technique qui peut &tre employeepour decourager 1'Cvasion fiscale. Voila qui peut expliquer qu'on adopte un credit d'impbtqui est plus genereux que ce qui constituerait la deduction dans un systkme ou le fardeaufiscal i 'etranger est simplement deduit du revenu imposable.

1. Introduction

In the literature on the international taxation of capital autho rs have been at pains to

explain why the majority of capital exporting countries are observed to choose a

foreign tax credit system over a deduction system when taxing internationally mobile

capital. Under a deduction sy stem a capital exporter taxes the wo rldwide income o f

its residents, but allows foreign taxes paid to be deducted from taxable income,

The first draft of this paper was prepared in Septemb er 1994. Financial supp ort from SSH RC isgratefully acknowledged. I would also like to thank Richard Bird, Sam Bucovetsky, MichaelKeen, Jack Mintz, John Whalley, three anonymous referees, and participants at the CEPR confer-ence on International Taxation held in Bergen, Norway, in September 1995 for valuable commentsand suggestions. Email: [email protected]

Canadian Journal of Economics / Revue can adie me d'Economique, Vol 34, No. 2

May / ma1 2001. Printed in Canada / Impnm e au Canada

0008-4085 / 01 / 465480 / 0 Canadian Economics Association



466 K.A. Scharf

while under a tax credit system the ex porter offers double-taxation relief by allow-

ing residents to credit foreign tax paym ents against do mestic tax liabilities.'

A long-established result in the literature is that a full tax c redit is superior to a

deduction on global efficiency grou nds (Ham ada 1966; Bond 1991). Recent litera-ture on tax com petition , however, has stressed the essentially non-cooperative nature

of the interaction between sovereign jurisdictions. W ith reference to the choice of a

foreign tax credit in the presence of international capital flows, Bond and Samu el-

son (1989 ) and Gordon (1991) have concluded that, since a deduction is superior to

a full tax credit from the individual point of view of a capital exporter (Mu sgrave

1969), a tax cred it system is generally not sustainable as pa rt o f a non-cooperative

outcome.* This theoretical prediction is in stark co ntrast to what we actually observe

in real-world tax systems; many countries grant double taxation relief fo r fractions

of foreign taxes in excess of the domestic tax value of a deduction, thereby adoptinga foreign tax credit policy that is closer to a full foreign tax credit system.3 The

standard tax competition framework thus appears to be ill equipped to provide a

solution to this foreign tax credit 'puzzle.'

Even if we assume that coordination between countries is possible, it may be

difficult to rationalize the choice o f a tax credit in excess of the deduction equiva-

lent credit as part of a coordinated outcom e unless side paymen ts are feasible. This

is because no mutual gains can arise from a full double-taxation treaty between a

pure capital exporter and a pure capital importer, unless the exporter can be com-

pensated directly.4 If cross-hauling in capital flows takes place betw een two coun-tries, there could be reciprocal gains that could justify a double-taxation treaty

involving the adoption of the source principle of taxation (which would require

reciprocity). But this observation still fails to explain the stylized fact that large

foreign tax credits are granted in situations where capital flows are largely

unidirectional."

1 Mintz and Tulkens (1993) show that a mix of residence-based and source-based taxes is equivalent

to a foreign tax credit in com binatio n with a residence-based tax . Also, note that one method o fimplementing a deduction system is to employ a partial foreign tax credit, where only a fraction

of foreign taxes can be claimed, this fraction being equal to the foreign taxes paid times the

dom estic rate of residence taxation (i.e. , equal to the dome stic tax savings associa ted wlth a

deduction).2 See Janeba (1995) for an analysis of non-cooperative outcome s in corporate income tax rules in

the presence of international capital mobility.

3 Some countries offer double-taxation relief by glving limited foreign tax credits, where the credit

cannot exceed domestic tax liabilities. Countries that have adopted this measure include the

United States, Japan, the United Kingd om, De nmark , Portugal, and S pain. Italy offers a refund on

excess credits, which constitutes a full foreign tax credit, while other countries such as Germany

and Ireland offer a choice between using a deduction or a limited credit (Frenkel, Razin, and

Sadka 1991).4 A combination of a foreign tax and a domestic foreign tax credit that exactly offset each othergen erates no distortions in international factor flows and therefore am oun ts to a transfer from theexporter to the importer: but a transfer in the opposite direction would require the use of explicit

side payments.5 Japa n, for examp le, recently allowed unilateral foreign tax cred its to be claimed by second-tier

subsidiaries of Japanese parent com panies, which may also claim limited foreign tax credits (with

a three-year ca rry forward of excess credits: see Ma gnin and Rautalahti 1993: Anderson 1991 1 .



International capital tax evasion 467

In this paper we exp lore the idea that a foreign tax credit might be employed by

a capital exporter as a means to discourage international tax evasion. The basic

intuition behind this con jecture is as follows. A foreign tax credit reduces the effec-

tive tax rate o n exported capital; at the sam e time, it represents a private cost for theexporter of capital who chooses to evade, since, by concealing foreign source income,

an expo rter must forgo the associated tax credit. Hence, by raising the opportun ity

cost of concealm ent, a foreign tax cred it can dampen internationa l tax evasion, thus

lowering the social cost a ssociated with evasion activities. This notion is novel in

the tax competition literature to date6 and could help to explain why so many

countries unilaterally choose tax credit rates in excess of the domestic rate of

residence-based taxation.'

We examine this conjecture by first focusing on the optimal crediting choice fo r

a small capital exporter, and we derive conditions under which the presence ofinternational tax evasion results in an op timal foreign tax credit rate in excess o f the

domestic rate of residence-based taxation. We then discuss implications for the

optimal choice of residence-based taxation as well as source-based taxation for a

capital importer. Our analysis suggests that a high credit rate is more likely to be

observed the broader is the tax base on which residence-based taxes are levied and

the larger is the number of countries competing in the world capital market.

2. International tax evasion and foreign tax crediting

The basic structure of our mod el is an adaptation of the Ricardo-Viner international

trade model, where imm obile factors of production are com bined with mobile fac-

tors to produce internationally traded goods. In this we will embed tax evasion

choices by investors and tax choices by government. We shall begin by laying down

the structure o f the tax design problem for a small capital exporter in the absence of

tax evasion , formalizing the standard resu lts of the literature on the optimal design

of a foreign tax credit. We will then introduce international tax evasion in the model

and conclude by discussing implications for international tax competition.

6 In the legal literature, Bracewell-Milnes (1980) made passing reference to the potential use of aforeign tax credit a s a fiscal instrum ent that could be employed to coun ter international tax eva-

sion, but he provided no intuition as to why this might be the case. There has been som e research

on the im plications of international tax evasion in the tax com petition literature. G ordon (1991)

incorporated evasion in his analysis and add ressed the issue of whether o r not capital incometaxes can survive in an open economy by examining the choice between a full credit (limited to

dom estic tax liabilities) and a deduction. He showed that a credit system is generally not sustain-

able, but he did not examine the op timal choice of a foreign tax credit. Bruce (1992) examine dthe foreign tax credit puzzle in a tax comp etition mod el with discrete costless evasion choices.His analysis, however, does not examine the implications of trade-offs in evasion costs for the

optimal cho ice of foreign tax credit, but focu ses instead on the strategic implications of a taxcredit in a sequential tax competition game. Fan and Wilson (1997) explore a related issue,namely, whether, in the presen ce o f tax evasion o n cap ital income from all sources, foreign-sourceincome should be taxed more or less heavily than domestic-source income, but they do not exam-ine the question addressed here.

7 On direct investment, evasion takes the form of transfer pricing, while on portfolio investment(which may include corporate activity) evasion takes the form of misdeclaring foreign sourceincome. Both o f these activities reduce the effective tax rate that the ex porter of capital faces.



468 K.A. Scharf

2. I . The no-evasion case

Cons ider a small capital-exp orting region, endowed with two factors of production:

capital, which is perfectly mobile internationally and available in quantity K,, and

an internationally immobile factor (e.g., labour), which is available in fixed quan-tity. A single comm odity is produced in quantity Q Dusing the mobile factor through

a production technology that exhibits decreasing returns to scale (reflecting the

presence of the im mo bile factor). This is represented as

where X is capital expo rts. Th e functionf is assume d to be increasing and concave;

in order to ensure that output is positive, we also assum e that the Inada conditions

( f (0) = w andf ' ( w ) 5 0) are satisfied. Producers in the exp orting region dem and

capital up to the point where the marginal revenue product of capital is equal to r,,

the marginal gro ss-of-tax return to capital in the exporting region. Normalizing the

price of output to be unity, we have

, f r ( K D - X ) = r,. ( 2 )

Th e capital-expo rting country levies a residence-based income tax that does not

discriminate between the domestic and foreign source income earned by residents.

Th e ad valorem rate of residence-based taxa tion is t,. Capital exports earn a gros s-

of-tax return equal to 7,; if the foreign sou rce tax rate is t,, then the net-of-taxreturn to capital exports is (1- t , - tF)rF.' Th e capital-exporting country may also

choose to grant a foreign tax credit for a fraction a (0 5 a 5 1) of foreign tax

payments. We can then define

as the statutory rate of tax payable on the income earned by exported capital. The

statutory rate of tax on the domestic income earned by domestic capital is simply

t,. Then a rbitraging in investment op portunities requires eq ualization between the

marginal net-of-tax return to exports and to the marginal net-of-tax return to employ-ing capital at home, that is,9

Notice that, when t, > 0 and a < 1, we m ust have rF > r, for an interior solution in

3., must be sufficient to more than com pensate expo rts for the double taxation that

capital exports are sub ject to in the presen ce of an y positive foreign source tax rate.

8 This specification is equivalent to one where there are no credits, but the exporting region is ableto levy both residence-based taxes and source-based taxes, thus discriminating between capital leftat home a nd capital employed abroad. Se e Mintz and Tulkens (1993) for more on this issue ofmultiplicity of instruments and equivalence between a mix of residence-based and source-basedtaxes with a foreign tax credit in combination with a residence-based tax.

9 Formally, condition (4) is a necessary condition for the maxim ization of disposable income V +

(1 - t ,)r ,(K, - X ) + (1 - t,)r,X, where V represents rents, by a representative investor, withboth terms V and r , taken as given.



Internationa l ca pita l tax evasion 469

The efficient choice of a -th e one that max imizes global income - is clearly a = 1,

whereby double taxation is fully eliminated, and capital location decisions are un-

distorted. This, however, is not the optim al cho ice from the point o f view of the ex-

porting country. No te that the relative social return of foreign investment versusdom estic investment from the point o f view o f the exporting country is (1 - tF)rF/

r,, while in the absence of a foreign tax credit, the relative private return o f foreign

investment versus dom estic investment is (1- t, - tF)rF/[(l - tD)rD]< (1 - tF)rF/

r,; thus, residence -based taxation drives a wedge between private and social returns.

This 'compounding ' effect of residence-based taxation can be reduced by a tax credit

and, with a = t,, fully eliminated . Thus, a small capita l-exporting region, taking rF

and tF as given, would maximize nationa l income YD =f (KD-X ) + (1 - tF) rFX(th e

sum ofp rivate domestic income and tax revenues) by choosing a *= t,, tha t is, a credit

rate exactly equal to the rate of the dom estic residence-based tax, which in turn amounts

to choosing a ded uction system.

2.2. Internationa l tax evasion an d cap ital exports

Suppose that there exist differential evasion possibilities for taxes payable on cap-

ital income from domestic and foreign investments. The idea is that evasion for

domestic source capital income is relatively more difficult to perpetrate than eva-

sion of residence-based taxes on foreign source income, owing to the imperfect

sharing of information between the tax authorities of the importing and exportingregions. Available evidence seems to suggest that this is, in fact, the case.'' For the

purpose of our analysis, we shall focus on the limit case where evasion takes place

only with respect to residence-based taxes on foreign source income and is fully

infeasible with respect to dom estic income." Evasion is mod elled as a costly pro-

portional abatement, E (0 5 E 5 1) of the tax base X- which reduces the effective

base to (1 - E ) X - and evasion costs per unit of exports are represented by a convex

function c, increasing in E and independent of X. If we then denote by c ( E ) evasion

costs per unit of exports, then total evasion costs are c (E )X , that is, linear in X.12

10 Even when countries enter into bilateral information sharing agreemen ts vis a vis reciprocal

double-taxation agreeme nts, the effectiveness o f the agreemen t is typically hamp ered by lack ofcooperation between the co untries involved (Bey er 1993).

11 Allowing for costly evasion of taxes at source does not change the insights obtained in this frame-

work, as long as evasion costs are not 'shared' across different form s of evasion.12 Thi s specification reflects the idea that there are decreasing returns to efforts directed at gene rat-

ing higher levels of evasion, but that a given evasion 'method' can be replicated at will. Alterna-tively, total evasion costs can be generally tho ught o f as depend ing jointly on X and E, butassuming a cost structure consistent with this would not qualitatively cha nge our results. Ulti-mately, of course, the characteristics of evasion costs a re an em pirical matter on which little evi-

dence is available. The convex cost hypothesis is viewed as being the m ost plausible by somewriters (e.g., Kaplow 1990; Usher 1986), while non-convex cost structures have been adopted by

others. With fixed evasion co sts, individual eva sion choices would b e discontinuou s: individualswould ch oose either to evade all taxes or not to evade at all. Nevertheless, if such fixed costs wereheterogeneo us across individuals, aggrega te evasion choices would still exhibit characteristicssimilar to those that would b e obse rved if individuals faced a com mon convex evasion cost sched-ule. For a discussion of the imp lications of non-convex avoidance cost s in a cross-border shopp ingcontext, see Scharf (1999).



470 K.A. Scharf

We assume that the function c satisfies the following p roperties: cl(0)= 0, c(0)= 0,

c(1) = co.

Th e presence of international tax evasion possibilities causes the effectiverate of

tax on exp orted capital to differ from the statutory rate of tax on exported cap ital asdefined above. In the a bsence o f a foreign ta x credit, this effective rate would be

If we assume that the foreign tax rate is known to the capital-expo rting region, then,

when foreign source income is concealed from the tax authority, the exporter of

capital also forgoes the applicable foreign tax credit. In this situation the effective

tax rate on capital that is exported may be defined as

Since no evasion takes place on domestic income that is earned by domestically

owned capital, the applicable effective tax rate still will be tD .

Maximization, by choice of X and E, of disp osable income for a representative

c o n ~ u m e r ' ~ields

where cl (E) is the marginal cost of evasion per unit of x.'~he first co ndition is

analogous to the one obtained when there is no evasion, that is, the gross-of-tax

return to investing abroad, net of evasion, must be larger than the gross-of-tax

return to investing at home in order to compensate an investor for the double tax-

ation of capital and evasion costs. The second condition simply says that at the

optim um the ex porter of capital will choose not to evade at all when the value of tax

credits that he must give up is larger than his tax savings from evading, a situation

that will occur under full credits when the domestic residence-based tax rate issmaller than the foreign sou rce tax rate and under partial credits w hen the savings

from evasion in terms of domestic residence-based taxes are less than the cost of

forgone tax c redits that are ind uced by evasion activity. A necessary condition for

an interior solution in E is tD> at,. This restricts the credit to be 'limited,' that is,

not to exceed dom estic taxes payable, which is consistent with tax practice.

13 Disposable income is V + (1 - tD) rD(KD- X ) + (1 - t , ) r ,X - c( E) X , with Vrepresentingrents. Evasion costs are treated as non-deductible here, although in reality some portion of actualcosts (e.g., legal fees) is likely to be deductible from taxable income. Allowing for this possibility

would slightly comp licate the an alysis without affecting the substance of our results.14 When capital flows are not real but financial flows, this specification of evasion could generatearbitraging possibilities through cross-hauling of financial capital across regions if both regionslevled residence-based taxes. It should be noted, how ever, that if the rates of source andresidence-based taxes were chosen endogenously by both regions, then the region that is a netimporter o f capital would find it optimal to move from a residence-based tax system to a puresource-based tax. Such arbitraging possibilities would thus be elim inated in a tax com petitionequilibrium.



International cap ital tax evasion 471

P RO P O SIT IO N 1 . An increase in a unambiguously discourages evasion and encour-

ages exports.

Proof: Invoking the Im plicit Function Theorem an d applying Cramer's Rule to ( 7 )an d (8), we obtain

and

These results are as expected: an increase in a results in a higher opportunity

cost of evasion, which discourages evasion activity; and reduces the effective for-

eign tax rate, which encourages exports.

2. 3. The optimal foreign tax credit

Ou r preceding discussion has hinted at the potential trade-offs involved in choosing

the correct combination of fiscal instruments for the exporting region, suggesting

that the exporting region m ay be able to employ a foreign tax credit as a means of

containing the resource w aste associated with international tax evasion.15To exam-

ine this conjecture formally, consider the optimal crediting problem facing the export-

ing region in the presence of evasion, for a rate of residence-based taxation t, .

Maximization, by choice of a, of national income minus evasion costs, Y =

f ( K D - X ) + ( 1 - t F ) r F X - c ( E ) X ,gives the first-order condition

where

The expression S measures the change in income resulting from a change in X and

consists of two terms: the term rF - r , represents the wedge between the gross-of-

tax returns to investing at home and abroad; the term - t F r F is the direct loss in

15 Since evasion costs are borne by residents, they will be ac counted for in formulating optima ldom estic policies on welfare-maximization, non-paternalistic grounds (i.e.. disregarding the'demerit' nature of evasion activities).



472 K.A . Scharf

income resulting from allowing a higher tax credit (commonly thought of as a

transfer to the foreign treasury). Thus , 6aXlaa meas ures the marginal social benefit

of reducing the co mp oundin g effect of residence-based taxes, net of the marginal

social cost of transferring surplus to the capital-importing region, while y is themarginal social cost (or benefit) associated with the increase (or reduction) in the

total cost of evasion that results from an increase in a .

To gain som e intuition about the implications of (1 1), suppos e, first, that evasion

costs were excluded from the maximand. Then, the term y would drop from (1 1)

and the first-order condition for an optim um would require 6 = 0. The correspond-

ing optimal a , which we can denote as 6, can be show n to be less than t,." Th us , if

the exporting region fails to take evasion cos ts into account, the presence of inter-

national tax evasion causes its optimal tax credit rate to be less than the deduction-

equivalent rate. The reason for this result is that evasion reduces the c om pound ingeffect of residence-based taxation, thereby serving the same role as a foreign tax

credit. In other words, the evasion-related wedge amplifies the capital flight effect

of a given foreign tax credit, which, when evasion costs are ignored, results in a

lower optimal foreign tax credit rate fo r a capital-expo rting country.

If, however, the costs of evasion are taken into accoun t by the tax a uthorities, a

choice of a = cl does not cause the left-hand side of (1 1) to vanish. Wh en a = d,we

have 6 = 0, and the sig n of the left-han d side of (1 1) becom es opp osite to the sign

of y . If y < 0, then it will be necessary for 6 to d ecrease from zero for (1 1) to be

satisfied. Since a6lda < 0, we can con clude that, in this case, a* > d , unambigu-ously; and if y is large enough in absolute value, a* could be larger than t,." On

the other hand, if y is positive, we m ust co nclude that a* < d.Thus, a* can exceed

t, on ly if y < 0, that is, if an increase in the credit results in reduced evasion

costs.1X

Although a higher credit rate lowers the evasion abatem ent E, its effect on eva-

sion costs also dep ends on how the volume of capital exports is affected. Formally,

y includes two terms: a negative term , which reflects the decrease in evasion activ-

ity per unit of exports associated with an increase in a ; and a positive term , which

reflects an increase in capital exports. An increase in a above t , will be effective atcontaining evasion costs only if the first effect dominates the s econd. But a negative

y is not enough to justify a choice of a* > t,. The margina l reduction in evas ion

16 When y = 0 the optimal choice of foreign tax credit for the exporter is given by (1 - t,)r, -r, = 0. Solving expression (8) for r, and substituting into (32) then yields (t, - ci)t,rF =

[c ' (E) - c(E) /E ]E . This implies t, 3 ri if and only if c' (E) > c(E)/E, which is satisfied by

convexity of c.17 The credit rate that does not distort exports from a global point of view is the one for which

r, = r, - c( E) , hat is, a = [t, - Et, + t,c(E)/r,]/t,(l - E) , which is also generallydifferent from a = 1 (the corresponding value for the no-evasion case).

18 The technology that would lead to y < 0 is one for which the elasticity of evasion costs withrespect to changes in E (the product of the elasticity of marginal evasion costs with respect to Eand of the elasticity of evasion with respect to a ) is large in absolute value in comparison withthe inverse elasticity of the domestic gross return to capital with respect to changes in domesticinvestment.




costs must be large enough to compensate for the direct capital flight effect asso-

ciated with the evasion wedge:19

PROPOSITION 2 . A necess aly condition for the domestic welfare-maximizing oreign

tax credit rate to exceed the rate of residence based taxation is that, at a* ,

In turn, this requires that the marginal ef ec t o f the credit on the domestic tax base

be positive.

Proof Condition (1 1) can be written as

Notice tha t the left-hand side of (15) is negative if and only if a > tD .This implies

that a > tD if and only if the right-hand side of (15) is negative. The latter condition

can be rewritten as (14). If we then combine (13) and (14), we obtain

The ex pression on the left-hand side of the above is simply the marginal effect of a

on the domestic tax base K D - X + (1 - E)X. QED

The above result does support the idea that international tax evasion can cause

the optimal tax credit to exceed the deduction-equivalent rate for a capital ex-porter. The condition for this to occur is simply that the credit must raise the

domestic tax base at the margin. A higher credit rate lowers E and thus yields a

higher tax base for a given level of capital exports; but it also raises exports,

which, for a given evasion rate E, yields a lower tax base; what is required is that

the first effect dom inate the second . Clearly, since E = 0 fo r at, r D , it can never

be optimal for an exporter to select a credit rate in excess of the maxim um 'lim-

ited' credit rate t D / t F .

19 The intuition for this ambiguity is also evidenced by the observation that, in the presence of eva-sion and no tax credit, the relative social return of foreign investment versus dom estic investment,[(I - tF)rF - c(E)]/rD, can be greater or less than the corresponding relative private return,{[I - tD( l - E ) - t,]r, - c(E)}/[(l - tD)rD] .A tax credit unambiguously raises the relativeprivate return of foreign investment vis a vis its social return; thus, in attempting to decrease thesize of this w edge, the dom estic government w ill choose a foreign tax credit rate that lies belowor above the deduction-eq uivalent rate, depending on whether the wedge is positive or negative.



474 K.A. Scharf

FIGURE 1 Optim um credit ra te w ith t , = 0.2

The results of the preced ing analysis are best illustrated by means of a numericalexam ple. Suppos e that the production function takes the form

which satisfies the conditions f '( 0 ) = so and f '(co)= 0. For the evasion cost func -

tion, we specify the form

which satisfies the conditions cl (0 ) = 0, c(0 ) = 0, c(1) = so. Parameter values are

specified as follows: cu = 0.1, ,8 = 0.33, t/ ~ = 0.2.

Figure 1 shows the level of a * for different values oft,. For low levels of foreign

taxation, a full crediting system is adopted ( a * = 1). An increase in tF genera tes two

main first-order effects: it raises the negative impact of a on the compou ndin g effect

of residence-based taxes (since @/at, < 0) and lowers its negative impa ct on eva-

sion costs (the first-order effects on E and X i n y are given, respectively, by aE/dt, =

a rFX/ c l ' (E ) > 0 and dX/atF = [ l - (1 - E)a]t,/[(l - t,) f "(KD -X )] < 0). Bothfirst-order effects work to make a * smaller through (1 I), although the presence of

second -order effects (which involve third derivatives) make da*/dtF impossible to

sign without further restrictions. In the example shown, however, first-order effects

dominate, and higher rates of foreign tax result in lower credit rates.




2.4. The optimal residence-based tax

In the absence of evasion, and if the expo rting country places no premium on tax

revenues, any choice of tD will be consistent with national welfare maximization

as long as it is matched by a : setting a = tD in the expression for YD makes itindependent of tD . On the other hand, in the presence of evasion and absent a

premium on tax revenues, it would always be optimal for the capital-exporter to

se t a = tD = 0; this eliminates evasion and ensures equality between the domestic

social return to investing at home and that of investing abroad. Thus, when eva-

sion is possible, a positive rate of domestic residence-based taxation would be

adopted by the exporting country only if public funds carry a positive premium.

But then o ne would conjecture that a premium on public funds should make it less

attractive for the exporting country to forgo tax revenues, which, other things be-

ing equal, could result in the choice of a lower credit rate.

The ex istence of a premium on public funds can be cap tured, in its simplest form,

by taking the objective of the tax autho rity to be ID + ( 1 + p D ) G D ,where ID is dis-

posable private incom e ( I D= V+ ( 1 - t D ) r D ( K D- X ) + (1 - t,)r,X - c ( E ) X ,with

Vrepresenting rents), GDis domestic tax revenues, and p D is a constant premium. Note

that this objective can be rewritten as YD+ p D G D .The im plicit premium that ratio-

nalizes the cho ice of a given rate tD can then be expressed as

which is positive as long as aGD/atD> o.~'

It can be shown that a positive premium p D > 0 will indeed result in the choice

of a lower credit rate:

P R OP OSITION3 . For a given rate of residence-based taxation , the effect of an increase

in the revenue premium on the dom estic welfa re-ma ximizing credit rate is negative.

Proof: Differentiating ID + ( 1 + p D ) G Dwith respect to a yields

ax ~ G D6 - - y + p ~ - - - 0 .

da da

Totally differentiating ( 2 0 )with respect to a and p D , we obtain

20 Here as in other models of international taxation, the possibility of a negative revenue effect can-not be excluded under general conditions. The effect of t , on national income is

where dE/dt , = r , / c U ( E ) an d a x / & , = - [ r , - (1 - E ) r , ] / [ ( l - t,) f " ( K , - X ) ] .



476 K.A. Scharf

FIGURE 2 Optim um comprehensive residence-b ased income tax rate and credit rate with F, = 0.01

If a is optimal for the government for a given t, and p,, then dI,/da and dG,/damust be opposite in sign. Furthermore, since both X and E have been chosen by

investors to max imize I,, by the E nvelope Theorem only the direct effects of a on

I , must be considered. These are given by (1 - E ) r F t FX 3 0. It follows that

dG,/da < 0, SO,by (21), aa*lapD< 0. QED

Thus, when we consider the endo genou s choice of domestic tax rate by a capital

exporter alongside the choice of a credit rate, we must conclude that, other things

being equal, a credit rate in excess of tD is less likely to be adopted. It should be

noted, however, that even a small premium on public funds can justify the use of

residence-based taxes if the tax base is broader than capital income alone. For

exam ple, if dom estic taxes are levied on all income o f residents at a single rate, we

have

Since the tax base includes rents, dG,/dt, is larger than it would be with a more

restricted base. The implicit premium defined by ( 1 9 )would therefore be smaller

and the co rresponding credit rate larger.The possibility of a*> tiwhen the choice of t, is endog enous can be illustrated

again by an example where all functional forms and parameters are as before and

pD = 0.01 . The optimal tax and credit rates for the expo rter, for varying levels of

t,, are shown in figure 2.



Interna tional cap ital tax evasion 477

2.5. Interna tional tax competition

The presence of a tax credit has the effect of lowering the elasticity of capital

imports with respect to changes in source tax rates in the capital-impo rting country,

thus enhancing the importing country's ability to capture foreign surplus throughtaxation, notwithstanding its size.

To see this, consider, first, a scenario with a single small capital-imp orting co un-

try that takes the exporting country's gro ss rate of return to capital, r,, as given and

is endowed with an am ount KF of capital. The capital market arbitraging condition

and the equilibrium evasion condition are as before, but with r, constant and

Private disposable income and tax revenues for the capital importer under a co m-

prehensive income tax are

GF = tFf(KF +X ) . (25)

Maximization, by choice oft,, of IF + (1 + p F ) G F -where p, denotes a premium

on public funds - for a given combination t, and a , gives

The sign of at;/aa is the same as the sign of aR,/aa. If we neglect second-orde r

effec ts (those invo lving third derivatives), all the first-order effects involved in aR,/aa

are positive.2' So the expec ted response to an increase in the foreign tax credit

granted by a capital importer is to raise its source-based taxes.

Note that if a = 1 and there is no evasion, t, cancels from t, and therefore has

no effect on the capital location decision (i.e., ax/&, = 0); then we have R, > 0

for any t,, an d the optima l cho ice of t, for a cap ital-im portin g cou ntry

becomes unbounded - or, with a limited credit system, coincides with the upper

bound t, = t,/a. With international tax evasion, however, the effective tax credited

is only (1 - Elat,, which makes the foreign tax t, non-neutral with respect to

capital location even when a = 1. It is then possible for the above problem to adm it

an in terior solutio n with t; < t, for a = 1. This is more likely to occur the m ore

responsive are capital exports to changes in the effective net-of-tax rate of return

(the larger is dX/dtF in absolute value).

If we next consider a general-equilibrium tax com petition model, two additional

effects will be present: the capital-expo rting country will no longer take r, as given,

and the importing country will no longer take r, as given. As we have shown, an

2 1 Note that, even if we consider the limit of this expression for t , approaching zero, we are still left

with an ambiguous second-order effect that involves the third derivative c U ' ( E ) .



478 K.A. Scharf

increase in a stimulates exports. Thus, other things being equal, the first effect

would induce a large capital exporter to lower a in order to raise the price of its

exports. A large capital importer, on the other hand, will levy taxes on capital

impo rts at a higher rate than it would if it took the world capital price as given. Theincentives associated with general equilibrium effects, however, will be small if a

large number of countries is involved, For example, in a scenario with a single

capital-exporting country facing a large number n of cap ital-importing countries,

the expo rting country will have limited market power. Th e importin g countries will

be competing with each other for capital imports, which will make their capital

imports more elastic to chang es in their own source-based tax and induce them to

adopt a low source-based tax rate, which in turn can make a high credit rate more

attractive to the cap ital exporter. This is the type of scena rio where a high credit rate

would be more likely to be observed.This possibility can be illustrated by mean s of a param eterized numerical exam -

ple. Using a subscript i to identify variables referring to country i = I , . . ,n and

assum ing identical prod uction technologies for all countries, we can write

where

The capital market equilibrium conditions are

where

Also, suppose that evasion is not country specific, and a single aba teme nt choice Eapplies to all countries to which capital is exported; then the necessary condition

for an interior choice of E becomes

The above conditions define an international capital market equilibrium for given

tax parameters. A non-cooperative tax competition equilibrium is then defined by

the above conditions and the first-order conditions for maximization of, respec-

tively, welfare in the capital-e xportin g coun try by cho ice of t, and a, and welfare in

the capital-im porting countries by choice of t i , i = 1 , . . . ,n . Spec ifying all functional

forms a s in our previous examples, and assuming KF = 113,n = 1000 and p, = p, =

0.01, we find a non-cooperative equilibrium with t; = 0.18, a* = 0.66 and t; =

0.017. If p, is lowered to 0.001 , we obtain t i = 0.175, a* = 1 and t; = 0.008.




3. Summary and conclusion

In this paper we have exam ined the role o f international tax evasion for the choice

of an optimal foreign tax credit by a capital-exporting country. In the presence ofinternational tax evasion, a foreign tax credit can affect the private op portu nity cost

of evasion for a capital exporter and can thus be used by an exporting country to

discourage evasion activities. Our results show that, under certain conditions, the

presence of international tax evasion can indeed result in a higher optimal foreign

tax cre dit. Ou r analysis also suggests that full crediting is more likely to be observed

the broader is the tax base o n which residence-based taxes are levied and the larger

is the number of countries competing in the world capital market, a scenario not

unlike that which faces the capital-exporting countries that have adopted a full

crediting regime.Further research should also examine the role of mo nitoring choices in this frame-

work. Monitoring activity by a capital-importing region has the potential to alter the

cost of evasion that foreign firms operating in its jurisdiction face. A capital importer

may thus have an incentive to undertak e globally suboptimal levels of monitoring in

order to create ev asion possibilities and thus capture evasion rents. This incentive

may persist even when undermon itoring affects evasion decisions by the importing

country's residents. This line of investigation raises the broader question of the

structural conditions under which, in a tax competition game, a capital-importing

country will behave as a tax haven, relying on international tax evasion to encour-age capital inflows.

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