ELSEVIER

Journal of Public Economics 63 (1997) 301-309

Strategic taxation of the multinational enterprise: A new argument for double taxation
Denise Eby Konan
Department of" Economics, University of Hawaii at Manoa, Honolulu, HI 96822, USA Received September 1994; final version received October 1995

Abstract This paper analyzes the social welfare effects of multinational enterprise taxation by home and host governments. In a general equilibrium model, direct foreign investment arises to employ a firm-specific asset abroad. Either a tax credit or deduction for foreign taxes paid results in the host fully taxing locally earned economic profits. Welfare, endogenous market structure, and profit results are identical in tax credit and deduction regimes. Because it lowers host government taxation in the subgame-perfect equilibrium, double taxation of foreign-earned profits emerges as a weakly dominant strategy for the source government. Keywords: Direct foreign investment; Double taxation JEL classification: F2; H2; H3; LI

1. Introduction
Should governments unilaterally relieve the b u r d e n of double taxation

faced by multinational enterprises (MNEs)? Alworth (1988) finds that

double taxation relief is frequently the subject of international tax treaty negotiations, with tax credits or, to a lesser extent, exemptions, the most common outcome. However, optimal-tax theorists (Bond and SamueL~on, 1989; Frenkel et al., 1991; Feldstein and Hartman, 1979; Slemrod, 1988; and Horst, 1980), suggest that governments should deduct, rather than credit, taxes paid abroad from domestic taxable profits and apply the same tax rates
0047-2727/97/$17.00 ~) 1997 Else,tier Science S.A. All rights reserved Pll S0047-2727(96)01592-7

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to resident profits from any source.~ In contrast, this paper proposes a model in wtfich double taxation may be a superior unilateral policy for the source country, while tax credits and deductions produce equivalent outcomes. Previous tax models treat foreign investment as physical capital exports to the region offering the highest average return in competitive markets. Yet various studies (Markusen, 1984; Helpman, 1984; and Horstmann and Markusen, 1992) have shown that MNEs arise because they possess firmspecific asset~ that are intangible and difficult to trade at arm's length.~ This paper attempts to integrate the main elements of these models into the direct foreign investment (r.Fl) tax literature.3 Several models of DFI have examined tax competition between governments (Levinsohn and Slemrod, 1993). Janeba's (1995) model implies a non-cooperative tax competition equilibrium in which tax credits and deductions are equivalent when governments cannot discriminate between capital located domestically and exported capital. Hamada (1966) found that both capital-importing and capital-exporting countries prefer a cooperative equilibrium under a tax credit system to a non-cooperative Nash equilibrium under a tax deduction system. In Bond and Samuelson's (1989) model, each country prefers tax deductions to credits because Nash equilibrium tax rates under the tax credit system eliminate trade in capital. However, in each of these models DFI is a movement of capital and the market structure decision is exogenous. Using a technology-based theory of the MNE, this paper considers welfare under non-cooperative taxation policies of home (source of DFI) and foreign (host for DFI) governments. While foreign production possibilities expand under MNE production owing to scale economies, the MNE's ability to repatriate profit: results in a decline in the foreign country's social welfare below that available under domestic monopoly production. Governments exhibit strategic behavior as they compete for tax revenues and profits of subsidiary operations. Relief from double taxation by either a credit or deduction gives the host country the first crack at taxing profits, implying a dominant host strategy of full taxation. No double taxation relief is thus a weakly dominant source country strategy because the home government eliminates the host's first-mover advantage. The paper is organized as follows. In Section 2 we model the nature of the game in a general-equilibrium, open-economy framework. Firm responses
1 An exception, Janeba (1995), finds that tax credits and deductions give the same national income. See Markusen (1995) for a summary. 3 One exception is the model by Huizinga (1991) in which DFI allows the firm to expand investment in new product varieties. A Home tax credit towards income taxes paid abroad emerges as the equilibrium tax policy because it encourages the optimal amount of product innovation.

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to global tax policies are considered in Section 3. Section 4 provides a social welfare analysis for each country inclusive of tan policy and resulting firm behavior. Finally, Section 5 summarize~ and provides concluding observations.

2. Model and nature of the game

A general equilibrium mode1 is developed with two countries, Home and Foreign. The full-employment labor endowment (L) and technology are identical in the Home and Foreign countries, as are co~isumer preferences, which are characterized by a homothetic utility function. Each country produces two goods, X and Y. Good Y is produced competitively with constant returns to scale technology. X is not exported owing to high transportation costs but is produced with increasing returns to scale.4 The X market is sufficiently small that two X firms in one country incur negative profits in the post-entry Cournot-Nash equilibrium. Thus X is produced either by an MNE with a production plant in each country or by a national enterprise (NE). We assume further that innovation originates at home. The two governments compete by strategically setting tax rates. Revenues are redistributed, lump sum, to domestic citizens. Home taxes MNE profits on a residency basis with relief from double taxation, tax credits or deductions, granted at Home's discretion. Foreign also taxes MNE sub~idiary profits on a territorial principle. To avoid the issue of deferrals, MNE profits earned abroad are immediately repatriated to the home country. Likewise, transfer pricing is not considered.5 In a game played by X-firms and governments, all players possess common knowledge. In the initial stage, Home selects among three taxation rules for the treatment ot foreign-earned profits: F~--Home credits foreign taxes paid against the MNE's tax bill; Fd--Home deducts foreign taxes paid from the MNE's tax base; and F , , - - n o relief from double taxation. After the tax rule is announced, Home and Foreign move simultaneously to set profit tax rates of t h and t~, respectively. Next, the Home firm decides whether to produce X in both the Home and Foreign markets, thus becoming an MNE, or whether to produce only at Home as a NE. Finally, the Foreign firm decides whether to enter the Foreign X market as a NE. The game is unravelled by backwards induction and the solution characterized by a subgame-peffect Nash equilibrium in pure strategies. ~This correspondswith cases one and three in Horstmann and Markusen (1992). 5In a transfer pricing model with an exogenousMNE market structure, Konan (1995) finds that the source country will set a higher tax on foreign repatriated profits than on domestic profits.

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3. Decisions of firms in resporl:t= to tax policy We follow the general equilibrium approach of Markusen (1984) to describe the global nature of production with imperfect competition in the X sector. The X industry is relatively small so that wages are exogenous, as determined in the Y sector, which employs only labor (L) under constant ~eturns to scale. We define one unit of labor as the quantity required to produce one unit of Y (Y = L). The real wage is the value of the marginal product of labor in Y. Let the wage or price of Y be the numeraire. Good X is the output of two activities: a corporate administrative activity and a manufacturing activity. Manufacturing requires that inputs of labor, Lm, be employed with constant returns to scale. Manufacturing is not geographically constrained so that factories within a firm may exist in multiple locations, each at varying distances from the administrative activity. The administration activity, A(L,), centralizes the fixed quantity of labor it employs (-La) in one location. In a multi-plant firm, this activity has a 'public goods' aspect that is firm-specific in nature. Multiple manufacturing activities are serviced by a common administration without reducing the marginal product of labor employed in A in any plant:

X=A(-L~)[2LJm],
L i d

i,j=h,f.

(1)

The NE moves last after observing the global tax policy and the MNE's response. We assume two X producers in a country incur negative profits in the post-entry Cournot-Nash equilibrium. If the MNE invests abroad, the NE's strategy to enter is strictly dominated by no entry which has zero payoff. If an MNE is not present, both Home and Foreign NEs are domestic monopolists. We first consider the decision of a NE in either country. Domestic profits are taxed at a rate t i and p(X) is the inverse demand function of X. Thus NE profit is given by

H i" "~ = (1 - ti)[p(X)A(-Li,)Lim - L ~ - L i ] ,

i = h, f.

(2)

The first-order condition for profit maximization is p 1=A(-ia) - t , where e ~ -

Op X "

(3)

The price of X in terms of Y is a markup over marginal cost. Labor employed in A is fixed and manufacturing activity exhibits constant returns to scale. Thus, marginal cost is constant. Home-earned MNE profits (lr), i.e. Home revenues less Home accrued costs, are taxed at the rate t h. Foreign profits, a , are taxed at the rates t b

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and t f under one of three H o m e tax regimes (F~, i = c, d, o) with an effe,ctive foreign tax rate (t*). The M N E maximizes net global profits, F '**, given by 6 H ""~ = (1 -- l")'n" + (1 -- t*)fr* = (1 - t ) [ p ( X ) A ( - L a ) L m - L ~ h h h --h

Lm]
h

+ (1 - t * ) [ p ( X ) A ( - L ~ ) L ~ - L ~ ] .

(4)

NINE production is a global welfare i,vprovemcnt over duopoly N E production because the A activity is concentrated at Home. Relative to N E production, the H o m e firm moves down its average cost curve. T h e M N E ' s profit-maximizing decision reduces to Eq. (4) 7 With a pure profit tax, optimal marginal decisions are not affected. Prior to the foreign firm's entry decision, the H o m e firm decides whether or not to invest abroad. Knowing that the Foreign firm will not jointly enter and receive a negative payoff, the duopoly outcome (with a negative Home-firm payoff) is off the path of play. Thus the H o m e firm invests abroad only if net subsidiary profits are positive or, equivalently, t* <~ 1.

4. Problem of governmeats: A social welfare analysis O n e implication of MNE production is that Foreign-earned profits (or'! otherwise earned by the Foreign N E are repatriated, thus redistributing ~to H o m e M N E shareholders. A n incentive arises for H o m e and Foreign to use tax policy to compete for ~r . The balance of payments constraint requires that the value of national consumption be equal to national income. Prices are identical in each market structure. Thus welfare is maximized when national income is maximized,s If t * > 1, then NINE production is not profitable and equilibrium production is comprised of two NEs. X revenues include N E profits (H he) and payments to labor. Zero profits in Y imply revenues equal factor payments. National income for H o m e or Foreign is given by
N I = Y"~ + p X ~e =-L + 1 1 u,

if t * > l .

(5)

The H o m e firm becomes an M N E if t* ~< 1. With an MNE, administration

6To avoid the issue of transfer pricing, we assume that the MNE cannot charge the subsidiary for use of the firm-specificasset. 7 Symmet~ and the assumptionof identical and homothetie preferences implies that p is the same for both market structures. ~There is no aggregation problem under the assumption of identical and homothetic preferences.

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activity is concentrated at H o m e . Foreign benefits as labor resources, otherwise devoted to administration, are freed for other uses, but this is offset by profit repatriation. Foreign national income is given by
Nlf=yt .... +pX f. . . .

_(l_tf)Tr,=~+tfTr,,

if t * ~ < l .

(6)

H o m e income includes factor payments, H o m e profits, and net repatriated profits:

N I h = yh . . . . + p X h. . . . + (1 - tf)lr * = L + / / " ~ + (1 - tf)~"*

if t* ~< 1.

(7)

E a c h H o m e tax regime (F~, Fd, or Fo) is associated with a subgame-perfect equilibrium t* which is a function of b o t h H o m e and Foreign tax rates. Let us consider the g o v e r n m e n t ' s response to taxation regime Fo, i.e. n o double taxation relief, where t* = t h + t f. H o m e is indifferent between income in the f o r m of M N E repatriated profits and tax revenues because both are redistributed to citizens lump-sum. We assume H o m e will not intentionally set a tax that will rule out M N E p r o d u c t i o n ? Given the conjectured Foreign tax rate (tt), the set of optimal H o m e tax rates is t h ~ [0, 1 - tf). T h e r e exists a critical tax rate (trc) where Foreign is indifferent b e t w e e n M N E and domestic N E production. We c o m p u t e tf~ by comparing national i n c o m e s that are attainable under alternative market structures, i.e. Eqs. (5) and (6). Note that or* = H n~ +La- The critical tax rate is thus a function of the ratio of foreign administration costs (avoided under M N E production) to gross M N E profits, given by

t'~ = l - ~ / ~ - * .

(8)

T h e Foreign country will plohibit D F I (t f > 1 - t h) unless it can feasibly tax at or above the critical rate (t~c). Regime Fo does not yield a unique o u t c o m e b u t rather a set of Nash equilibria tax rates given by t ~= (1 - t ) if 0 ~ t h < 1 - tf~ and t r > (1 - t h) otherwise. 1 U n d e r F~, the M N E credits foreign income taxes paid at rate t f, not exceeding t h. T h e effective tax rate on ~r" is t * = t h - m i n ( t , t f) + t f or, equivalently, t* = max(t h, tf). Given a conjectured t ~, the Nash equilibrium t h is an element of the closed set [0,1]. Realizing the M N E will avoid double taxation t h r o u g h H o m e ' s tax credit policy, F0reign's dominant strategy is to

This assumption is innocuous because NE production will never result in Home welfare that iS higher than MNE production, even if no MNE profits are repatriated. However, this assumption implicitly rules out an infinite number of Nash equilibria in which each country sets its tax rate for the affiliate's profit greater than one, thus eliminating DFI altogether. tThis result is similar to that obtained by Feldstein and Hartman (1979) under a tax deduction.

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set t f = 1, and retain w* in the form of tax revenues. Foreign's equilibrium national income under F~ is L + ~ * . H o m e receives L + H"*, a national income level that is achievable with a national enterprise equilibrium, Alternatively, H o m e may allow a deduction of taxes paid abroad under F~. The effective tax rate on Foreign-earned profits is t * = t " ( l - t f) + t f. Again H o m e sets t h in the closed set [0,1] and Foreign's dominant strategy, is to s e t t f = 1 so that t* = 1. Thus, the tax deduction and credit are equivalent. In either case the Home country is allowing the host country to ltave the first crack at taxing profits. In response, the Foreign host's dominant strategy is a 100% tax. A subgame-perfect solution to the game is derived by considering H o m e ' s choice of taxation regime in the first stage of the game. Knowing Foreign will set t f = 1, H o m e is indifferent between a tax credit or deduction as the foreign authorities fully tax subsidiary profits in either case. The commonly held belief that H o m e should prefer a tax deduction over a tax credit does not hold when Foreign responds strategically. Double taxation is a weakly dominant strategy for the H o m e government as the threshold Foreign tax rate at which the M N E refuses entry is lower. H By moving first and committing to double taxation, H o m e makes the host government less aggressive in its taxation policies, t2 O n e limitation of the analysis is worthy of attention. In this model the M N E invests abroad to employ an intar.gible firm-specific asset with public goods characteristics. This allows us to focus on the implications of globallyjoint inputs in DFl taxation. Yet the results are likely to be sensitive to this public good assumption. A more general model would consider both public and private elements of intra-firm MNE transactions and the marginal impact on the global allocation of tangible capital.

5. Concluding remarks
The point of this paper has been to study strategic taxation when the M N E s employ a firm-specific asset abroad with increasing returns to ,scale. Two key results emerge. First, to the extent that the taxation of DFl fails on profits, tax credit and deduction regimes result in identical effects on production as well as on the international distribution of profits and tax revenues. The foreign government will respond to either form 0[ double taxation relief by fully taxing DFI. Secondly, the source country's double tt The author thanks an anonymous referee for making this point. t" Although the optimal solution to this problem is indeterminate, the worst Home can do i~ either to tax at a rate above 1 - tfcso that Foreign blocks MNE entry, or not tax at all, with no net profit repatriation.

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D.E. Konan I Journal o f Public Economics 63 (1997) 301-309

t a x a t i o n s t r a t e g y w e a k l y d o m i n a t e s b o t h tax c r e d i t a n d tax d e d u c t i o n r e g i m e s b e c a u s e t h e ability to c r e d i b l y t a x M N E profits limits t h e h o s t c o u n t r y ' s t a x i n g ability. T h e c o n v e n t i o n a l result, t h a t a d e d u c t i o n o f f o r e i g n t a x e s p a i d o n D F I e m e r g e s as a t h e o p t i m a l s c h e m e , d o e s n o t h o l d w h e n g o v e r n m e n t s a c t s t r a t e g i c a l l y in t h e p r e s e n c e o f a n i m p e r f e c t l y c o m p e t i t i v e M N E . T h i s is o b t a i n e d b y r e l a x i n g t h e s t a n d a r d a s s u m p t i o n s t h a t f o r e i g n t a x r a t e s a r e i n v a r i a n t t o t h e c h o i c e o f t a x a t i o n policy a n d t h a t D F I is e q u i v a l e n t t o c a p i t a l flows.

Acknowledgements I a m g r a t e f u l t o K e i t h E. M a s k u s , J a m e s R . M a r k u s e n , M a r k B. C r o n s h a w , S u m n e r J. L a C r o i x , Nell B r u c e , J a m e s A i m , T h o m a s G r e s i k , a n d t w o a n o n y m o u s r e f e r e e s f o r insightful c o m m e n t s o n a n e a r l i e r d r a f t . Much of this paper was completed while I was at the East-West Center, and I thank them for providing a wonderful research environment.

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