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Journal of International Economics

Copyright 2006 Elsevier B.V. All rights reserved

Volume 44, Issue 1, Pages 1-180 (1 February 1998)

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1.

The overvaluation of purchasing power parity ARTICLE

Pages 1-19

Paul G. J . O'Connell

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Effective protection redux ARTICLE

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J ames E. Anderson

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A pecking order of capital inflows and international tax principles ARTICLE

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Assaf Razin, Efraim Sadka and Chi-Wa Yuen

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Habits and durability in consumption, and the dynamics of the current account ARTICLE

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Arman Mansoorian

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Intertemporal substitution in imported durables ARTICLE

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Tax competition in imperfectly competitive markets ARTICLE

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Eckhard J aneba

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Government finance with currency substitution ARTICLE

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Copyright 2006 Elsevier B.V. All rights reserved. ScienceDirect is a registered trademark of Elsevier B.V.

Journal of International Economics 44 (1998) 4568

A pecking order of capital inows and international tax

principles

a ,b,c a d,

*

Assaf Razin , Efraim Sadka , Chi-Wa Yuen

a

Eitan Berglas School of Economics, Tel Aviv University, Ramat Aviv, Tel Aviv 69978, Israel

b

CEPR, 2528 Old Burlington Road, London W1X 1LB, UK

c

NBER, 1050 Massachusetts Avenue, Cambridge, MA 02138, USA

d

School of Economics and Finance, University of Hong Kong, Pokfulam Road, Hong Kong

Received 30 April 1996; received in revised form 31 January 1997; accepted 5 February 1997

Abstract

Even though nancial markets today show a high degree of integration, the world capital

market is still far from the textbook story of high capital mobility. The purpose of this paper

is to highlight key sources of market failure in the context of international capital ows and

to provide guidelines for efcient tax structure in the presence of capital market

imperfections. The analysis distinguishes three types of international capital ows: foreign

portfolio debt investment, foreign portfolio equity investment and foreign direct investment.

The paper emphasizes the efciency of a non-uniform tax treatment of the various vehicles

of international capital ows. 1998 Elsevier Science B.V.

Keywords: Foreign portfolio debt investment; Foreign portfolio equity investment; Foreign

direct investment; Asymmetric information; International taxation

JEL classication: F21; F35; H25; H30

1. Introduction

Even though nancial markets today show a high degree of integration with

large amounts of capital owing across international borders to take advantage of

rates of return and risk diversication benets, the world capital market is still far

*

Corresponding author. Tel.: 1852-2859 1051; fax: 1852-2548 1152; e-mail: cwyuen@econ.hku.hk

0022-1996/ 98/ $19.00 1998 Elsevier Science B.V. All rights reserved.

PI I S0022- 1996( 97) 00009- 3

46 A. Razin et al. / Journal of International Economics 44 (1998) 4568

from the textbook story of perfect capital mobility. As an example of the limited

degree of capital mobility, Tesar and Werner (1995) nd that despite the recent

increase in US equity investment abroad (including investment in emerging stock

1

markets), the US portfolio remains strongly biased towards domestic equity.

Capital immobility has been explained not only by capital controls, but also by

the informational problems associated with international investment. Because of

adverse selection and moral hazard problems, real rates of return across countries

2

are not fully equalized. Capital market regulations and better rules of disclosure as

applied to the information about the protability of domestic rms alleviate some

of these asymmetric information problems. The stationing of managers from the

headquarters of multinational rms at their foreign direct investment establish-

ments in the destination countries is one way to monitor closely the operation of

such establishments, thus circumventing some of these informational problems.

It is well known that, in a perfectly functioning world capital market, the

efcient international tax principle is the residence principle. That is, foreign-

source and domestic-source incomes of residents are taxed at equal rates, and

3

nonresidents incomes are fully tax exempt. In a less-than-perfect world capital

market, the residence principle may no longer be efcient, however, and the

optimal tax structure may also require substantial modications. The failure to

have a tax scheme under which rates of return across countries are equated can

lead to inefcient capital ows across countries. Such investment inefciency

4

results from the interactions of imperfect market and the tax system. The purpose

of this paper is to highlight some key sources of market failure in the context of

international capital ows and to provide guidelines for efcient tax structure in

the presence of capital market imperfections.

In general, capital ows can be in the form of either direct investment or

portfolio investment. Depending on the specic types of securities involved, we

can further subdivide the latter into portfolio debt investment and portfolio equity

investment. In this paper, we attempt to provide a synthesis of these three types of

capital inows, i.e., foreign direct investment (FDI), foreign portfolio debt

investment (FPDI), and foreign portfolio equity investment (FPEI). In particular,

1

They report that equity portfolio ows to West Europe, as a fraction of the capitalized value of the US

equity markets, rose only from 0.3% in 1976 to about 2.2% in 1990. The share invested in Canada

remained fairly constant, at less than 1%.

2

See Obstfeld and Rogoff (1996) (Chapter 6) for a further discussion.

3

The residence principle means that the home country does not levy additional taxes on incomes of

nonresidents over and above what they will have to pay in their country of residence. In case the latter

country offers credits for foreign taxes (that is, for the taxes paid by these nonresidents in the home

country), then the home country will only levy a tax on nonresidents which is equal to what they will

be liable to pay (before the credit) in their country of residence. Therefore, the zero-tax reference

point for nonresidents would mean same tax as the tax levied on nonresidents in the country of

residence.

4

For an application of the interaction between taxation and ination, see Bayoumi and Gagnon (1996).

A. Razin et al. / Journal of International Economics 44 (1998) 4568 47

we would like to examine how the optimal tax treatment of the capital incomes of

both domestic and foreign residents may vary across these three forms of foreign

investment.

According to Claessens (1995), portfolio ows now account for about a third of

the net resource ows to developing countries. To get a sense of their relative

importance, we provide in Table 1 the breakdown among the various kinds of

capital ows. It shows that although equity ows to developing countries have

risen fast in recent years, they are still a much smaller fraction of the total portfolio

ows than debt instruments (such as bonds, certicates of deposits, and commer-

cial papers). There is a striking feature in this table: FDI makes up over half of

private ows, followed by debt nance, while equity ows are relatively

unimportant. Indeed, our model suggests some reasons associated with asymmetric

information as to why this pattern might occur.

This ranking of capital inows is somewhat similar to the pecking order of

capital structure in corporate nance. Recall that, in corporate nance, the

hypothesis maintains that rms prefer internal nance (retained earnings: the

analogue of our FDI) to external nance. If the latter is required, then rms will

issue the safest security (debt: the analogue of our FPDI), and issue new equity

5

(the analogue of our FPEI) only as a last resort. The pecking order of capital

inows can be stated in terms of the magnitudes of those ows in, say, 1995.

Table 1 shows the dominance of FDI ($86.1 billion), compared to private debt

ows ($53.5 billion) and portfolio equity ows ($22.2 billion). In terms of

percentages of total private ows, the numbers are 53.2%, 33.1%, and 13.7%,

respectively.

Table 1

Aggregate net long-term resource ows to developing countries, 19901995 (In billions of US dollars)

1990 1991 1992 1993 1994 1995

Aggregate net resource ows 103.5 129.2 159.7 212.8 212.9 233.3

Ofcial development nance 57.2 64.4 55.3 52.5 44.9 71.5

Ofcial grants 28.8 36.9 31.6 28.5 27.6 27.0

Ofcial loans 28.4 27.5 23.7 24.0 17.3 44.5

Bilateral 13.2 12.6 10.9 9.4 7.1 32.6

Multilateral 15.2 15.0 12.8 14.6 10.2 11.9

Total private ows 46.3 64.8 104.4 160.3 168.0 161.8

Private debt ows 16.2 20.5 42.4 45.8 56.1 53.5

Commercial banks 1.1 3.9 14.3 22.6 15.1 17.0

Bonds 3.1 12.4 12.9 39.9 38.0 33.0

Others 12.0 4.2 15.2 8.5 3.0 3.5

Foreign direct investment 26.3 36.7 47.8 67.6 77.3 86.1

Portfolio equity ows 3.8 7.6 14.2 46.9 34.6 22.2

Source: World Bank, Debtor Reporting System.

5

See Myers (1984) for an explanation based on asymmetric information.

48 A. Razin et al. / Journal of International Economics 44 (1998) 4568

Contrary to the efciency implications of the residence principle in international

taxation emphasized by the literature (e.g., Frenkel et al., 1991; Gordon and

Varian, 1989), our main conclusion is that it is generally efcient to have different

tax treatments for these three types of international capital ows. First, we show

that, for both FPDI and FPEI, deviations from residence-based taxation may be

called for on efciency grounds, while efcient taxation of FDI is compatible with

the residence principle. Second, while it is efcient to subsidize nonresidents on

their investment and to tax domestic corporate income in the case of FPEI (as

shown by Gordon and Bovenberg, 1996), it is still efcient to grant nonresidents a

favorable tax treatment over residents (but not necessarily to actually subsidize

foreign investment) in the case of FPDI. In the latter case, it remains efcient to

tax domestic corporate income and interest income of residents.

The organization of the paper is as follows. Section 2 develops the analytical

methodology employed in this paper. The framework is rst applied to FPDI. The

other kind of portfolio ow, FPEI, analyzed by Gordon and Bovenberg (1996), is

recast in our framework in Section 3. In Section 4, we look at FDI. In Section 5,

we address the issue of pecking order in capital inows using simulation methods.

Conclusions and possible extensions are provided in Section 6.

2. Foreign portfolio debt investment (FPDI)

Throughout this paper, we assume a small, capital-importing country, referred to

as the home country. In this section, it is assumed that capital imports are

channelled solely through borrowing by domestic rms from foreign banks and

other lenders. The economy is small enough that, in the absence of any

government intervention, it faces a perfectly elastic supply of external funds at a

* given risk-free world rate of interest, r . However, as in Stiglitz and Weiss (1981),

a rm may choose to default on its debt if its future cash ow falls short of its

accumulated debt. Therefore, foreign lenders may charge ex ante a higher rate of

interest for domestic borrowers than for foreign borrowers.

In the planning stage of the rst period, the rms commit their investment; but

the actual investment and its funding are delayed to the implementation stage in

6

the rst period. We follow Gordon and Bovenberg (1996) in modelling the risk in

this economy and the asymmetry in information between foreign investors and

domestic investors. Consider a two-period model with a very large number (N) of

ex ante identical domestic rms. Each rm employs capital input (K) in the rst

period in order to produce a single composite good in the second period. For the

sake of simplicity, we assume that capital depreciates fully at the end of the

production process in the second period. Gross output in the second period is equal

to F(K)(1 1e), where F is a production function exhibiting diminishing marginal

6

This is a simple way to represent asymmetric information for lenders in a general equilibrium model.

A. Razin et al. / Journal of International Economics 44 (1998) 4568 49

productivity of capital and e is a random productivity factor. The latter has zero

mean and is independent across all rms. (e is bounded from below by 21, so

that output is always nonnegative.) Given the very large size of N and the

independence of e across rms (which allow for complete diversication of such

idiosyncratic risks through risk pooling), we assume that consumers-investors

behave in a risk-neutral way.

Following Gordon and Bovenberg (1996), we assume that rms make their

investment decisions before the state of the world (i.e., e) is known. Since all rms

face the same probability distribution of e, they all choose the same level of

investment (K). They then issue debt, either at home or abroad, to nance the

investment. At this stage, domestic lenders are better informed than foreign

lenders. There are many ways to specify the degree of this asymmetry in

information. In order to facilitate the analysis, however, we simply assume that

domestic lending institutions, being close to the action, observe e before they

make their loan decisions; but foreign lending institutions, being far away from

the action, do not.

Throughout this paper, we consider three tax instruments: a tax on capital

* income of nonresidents (at the rate t ), a tax on capital income of residents (at the

rate t), and a corporate income tax (at the rate u ). However, with debt nancing, a

corporate tax is essentially a tax on pure prots (rents), and therefore does not

affect corporate behavior (see Appendix A, Section A.1). For notational simplicity,

therefore, we set u equal to zero in this section. In practice, the neutrality of this

tax in the presence of debt nance makes it efcient to set it at a high rate.

Competition among the borrowing rms and among the lending institutions,

both domestic and foreign, ensures that there will be a unique interest rate charged

to all the domestic borrowing rms. Denote this domestic interest rate by r. Given

its investment decision (K), a rm will default on its debt if the realization of its

random productivity factor is low so that its output F(K)(1 1e) is smaller than its

accumulated debt K(1 1r). Thus, there is a cut-off value, e , such that all rms

o

which realize a value of e below e default and all other rms (i.e., rms with

o

e .e ) fully repay their debts. This cut-off level of e is dened by

o

F(K)(1 1e ) 5(1 1r)K (1)

o

Denote the cumulative probability distribution of e by F(.). Then, NF(e ) rms

o

default on their debt while the other N[12F(e )] rms remain solvent.

o

Recall that domestic lenders observe the value of e before making their loan

decisions. Therefore, they will not lend money to a rm that realized a value of e

lower than e . But foreign lenders do not observe e, so that they will advance loans

o

to all rms, since they all look identical to them. Thus, foreign lenders will give

loans to all the NF(e ) would-be bankrupt rms and to some fraction (say, b) of

o

the N[12F(e )] would-be solvent rms. (The other fraction, 12b, of the

o

would-be solvent rms is nanced by domestic lenders). Foreign lenders therefore

50 A. Razin et al. / Journal of International Economics 44 (1998) 4568

receive a total of bN[12F(e )]K(11r) from the solvent rms. Each bankrupt rm

o

can pay back only its gross output, i.e., F(K)(11e). Thus, foreign lenders receive

2 2

a total of NF(e )F(K)(11e ) from the bankrupt rms, where e is the mean value

o

of e realized by the bankrupt rms:

2

e ;E(e/e #e ) (2)

o

2

i.e., e is the conditional expectation of e, given that e #e . For later use, we also

o

1

dene by e the conditional expectation of e, given that e $e :

o

1

e ;E(e/e $e ) (3)

o

2 1

Note that the weighted average of e and e must yield the average value of e that

is:

2 1

F(e )e 1[1 2F(e )]e 5E(e) 50 (4)

o o

2 1

The latter equation also implies that e ,0 while e .0, i.e., the expected value of

e for the bad (good) rm is negative (positive).

Altogether, foreign lenders receive the following sum before domestic taxes are

levied on their total loans (FPDI) made to the domestic rms:

2

A;bN[1 2F(e )]K(1 1r) 1NF(e )F(K)(1 1e ) (5)

o o

where the amount of loans is given by

FPDI 5bN[1 2F(e )]K 1NF(e )K (6)

o o

They thus accumulate a capital income of A2FPDI, which is subject to domestic

* * taxation at the rate t . Net of tax, their FPDI yields A2t (A2FPDI). This

* * amount must be equal to FPDI(11r ), as foreign lenders can earn a return of r

in their own countries. Consequently,

* * FPDI[1 1r /(1 2t )] 5A (7)

The rationale for the above equality is straightforward: foreign lenders must earn a

* * before-tax rate of return of r /(12t ) on their FPDI so that their after-tax rate of

* return remains r , the rate of return they can earn in their own countries. As a

result, the tax that our small economy imposes on their capital income is fully

shifted to the domestic borrowers. Substituting for the values of A and FPDI from

Eqs. (5) and (6), Eq. (7) becomes:

* * hbN[1 2F(e )]K 1NF(e )Kj[1 1r /(1 2t )]

o o

(8) 2

5bN[1 2F(e )]K(1 1r) 1NF(e )F(K)(1 1e )

o o

Let us now examine the debt-nanced investment decision of a representative

rm. This rm invests K in the rst period and expects to receive a gross output of

E[F(K)(11e)]5F(K) in the second period. It also knows that if e turns out to be

smaller than e , it will default on its debt. This rm expects then to pay back its

o

A. Razin et al. / Journal of International Economics 44 (1998) 4568 51

accumulated debt, i.e., K(11r), with probability 12F(e ). It expects to default,

o

2

paying only F(K)(11e ), with probability F(e ). Thus, the expected value of its

o

cash receipts in the second period are

2

F(K) 2[1 2F(e )]K(1 1r) 2F(e )F(K)(1 1e ) (9a)

o o

Maximizing the latter expression with respect to K yields the following rst-order

condition:

[1 2F(e )](1 1r)

o

]]]]] F9(K) 5 (9) 2

1 2F(e )(1 1e )

o

2

Since 11e ,1, it follows that

F9(K) ,1 1r (10)

Knowing that in bad realizations of e (when e #e ) it will not fully repay its

o

loan, the rm invests beyond the level where the unconditionally expected net

marginal productivity of capital (viz., F9(K)21) is just equal to the interest rate

7

(viz., r). Note that, unlike the case of FPEI discussed in Section 3, we cannot

* * assert here that F9.11r /(12t ). However, as expected, because of the default

possibility, foreign lenders charge an ex ante interest rate (r) which is higher than

* * what they will be satised with [r /(12t )], given that the alternative return at

8

* home is r . This difference is a reection of the risk premium.

We abstract from income-distributional equity considerations, implicitly assum-

ing that the government can optimally redistribute income via lump-sum transfers

` a la Samuelson (1956). This means that, with no loss of generality, we may

assume that there is one representative individual-consumer in the economy. She

has an initial endowment of I in the rst period and I in the second period. She

1 2

consumes c in the rst period and c in the second period. Her saving earns an

1 2

9

after-tax rate of return of (12t)r, so that her net discount factor is equal to

21

q ;[1 1(1 2t)r] or t ;(rq 21 1q) /rq (11)

We denote her net wealth (i.e., the present value of her after-tax lifetime income)

by W. As we assume that the government can levy lump-sum taxes, it essentially

7

Eaton and Gersovitz (1989) consider related interactions in the context of foreign investment with

sovereign debt.

8

* * More specically, one can show (by substituting Eq. (1) into Eq. (8)) that [11r /(12t )] /(11r)5

2

* a1(12a)(11e ) /(11e ), where a5b[12F(e )] / hF(e )1b[12F(e )]j. Thus, [11r /(12

o o o o

2 2

* t )](11r) is a weighted average of 1 and (11e ) /(11e ). Since (11e ) /(11e ),1, it follows that

o o

* * * * 11r /(12t ),11r. This implies that r /(12t ),r.

9

Her saving is either deposited with domestic intermediaries (banks, etc.) that channel it to the rms or

in government bonds that also yield before-tax rate of return of r. Assuming, as we are, that the

government can levy lump-sum taxes in each period to balance its budget makes these bonds

superuous.

52 A. Razin et al. / Journal of International Economics 44 (1998) 4568

controls W. The consumer budget constraint is given by c 1qc 5W. The

1 2

maximization of her utility subject to this constraint gives rise to an indirect utility

function, v(W,q), and consumption demand functions, c (W,q) and c (W,q), in the

1 2

rst and second periods, respectively.

In the rst period, the economy faces a resource constraint, stating that FPDI

must sufce to cover the difference between domestic investment (viz., NK) and

national savings (viz., I 2c (W,q)2G , where G is public consumption nanced

1 1 1 1

through lump-sum taxes):

FPDI 5NK 2[I 2c (W,q) 2G ] (12)

1 1 1

No matter what taxes are levied by the home country on FPDI, foreigners will be

* able to extract from the home country an amount of 11r units of output in the

second period for each unit that they invest in the rst period. Therefore, the home

10

country faces the following second-period budget constraint:

* NF(K) 2(1 1r )FPDI 1I 5c (W,q) 1G (13a)

2 2 2

* That is, gross national output [NF(K)2(11r )FPDI] and the initial endowment

(I ) must sufce to support private consumption (c ) and public consumption (G ).

2 2 2

Employing Eq. (12), one can rewrite Eq. (13a) in present value terms as

* * * I 1I /(1 1r ) 1NF(K) /(1 1r ) 5c (W,q) 1c (W,q) /(1 1r ) 1G

1 2 1 2 1

* 1G /(1 1r ) 1NK (13)

2

We are now in a position to formulate an optimal tax policy for the government.

Since we concentrate on tax policy, we may consider the public expenditure

variables (namely, G and G ) as exogenous, with no loss of generality. (This

1 2

means that our results are valid whether or not the government expenditure policy

is optimal.) The aim of our benevolent government is to maximize the utility,

v(W,q), of the representative individual. There are nine endogenous variables: K, r,

* e , b, t , t, q, W and FPDI. There are also seven constraints that combine real

o

resource constraints (namely, Eqs. (12) and (13)), market equilibrium constraints

(namely, Eqs. (1), (6), (8)), an optimizing-agent behavioral constraint (namely, Eq.

(9)), and a denition of the consumers discount factor (namely, Eq. (11)).

It turns out, however, that the optimal policy problem can be simplied a great

deal. To accomplish this, notice that the objective function [v(W,q)] and the

present-value resource constraint Eq. (13) contain only three endogenous (control)

variablesW, q and K. Thus, we can rst choose these three variables so as to

maximize the individual utility function, subject to the present-value resource

constraint Eq. (13). The Lagrangean expression for this optimization problem is

10

Note that the expected value of output is E[NF(K)(11e)]5NF(K), since E(e)50.

A. Razin et al. / Journal of International Economics 44 (1998) 4568 53

L 5v(W,q)

* * * 1l[I 1I /(1 1r ) 1NF(K) /(1 1r ) 2c (W,q) 2c (W,q) /(1 1r )

1 2 1 2

* 2G 2G /(1 1r ) 2NK] (14)

1 2

where l$0 is a Lagrange multiplier. Having solved for the optimal values of W, q,

and K, we can then employ the remaining six constraints Eqs. (1), (6), (8), (9),

(11), and (12) to solve for the optimal values of the remaining six control

* variables (i.e., r, e , b, t , t, and FPDI).

o

There are three main policy conclusions that we wish to emphasize here. First,

the optimal level of investment is such that the expected net marginal product of

* capital (that is, F9(K)21) is equal to the world rate of interest (that is, r ):

* F9(K) 51 1r (15)

* (Note that it then follows from Eq. (10) that r.r , i.e., the domestic rate of

interest stays above the world rate of interest.) Eq. (15) is essentially a corollary of

the familiar aggregate production efciency theorem of welfare economics: A

small open economy should equate all of its marginal rates of transformation to the

corresponding world prices. In our case, there is only one marginal rate of

transformation [the intertemporal rate F9(K)] and the corresponding world price is

* 11r . The proof of Eq. (15) follows immediately upon differentiating L in Eq.

(14) with respect to K and setting the derivative equal to zero.

Second, the optimal policy calls for a tax on capital income of residents, i.e.,

t .0. To prove this, observe that with the availability of lump-sum, nondistortion-

ary taxes, it is optimal to follow the Pareto-efciency rule of equating the marginal

21

rate of substitution between present and future consumption (q ) to the gross

* marginal product of capital (F9(K)511r ):

21

* q 51 1r (16)

(See also Appendix A, Section A.2 for a formal proof.) Substituting Eq. (16) into

Eq. (11) yields

* 1 1(1 2t)r 51 1r

* Given r ,r, this implies that:

* t 51 2r /r .0 (17)

* Third, the rate of tax on capital income of nonresidents (t ) must be lower than

the rate of tax on residents capital income (t). To prove this, substitute Eq. (1)

into Eq. (8) to get:

* * hbN[1 2F(e )]K 1NF(e )Kj[1 1r /(1 2t )]

o o

2 21

5bN[1 2F(e )]K(1 1r) 1NF(e )K(1 1r)(1 1e )(1 1e )

o o o

54 A. Razin et al. / Journal of International Economics 44 (1998) 4568

Rearranging terms yields

2

b[1 2F(e )] 1F(e )(1 1e ) /(1 1e ) * * 1 1r /(1 2t )

o o o

]]]]] ]]]]]]]]]]] 5 ,1

1 1r b[1 2F(e )] 1F(e )

o o

2

The inequality follows from e ,e . By Eq. (17), this implies that

o

* * t ,1 2r /r 5t (18)

* In fact, t may even be negative. It is worth emphasizing that the two tax

* instruments (t and t ) support a rst-best allocation.

* The rationale behind the optimal tax policy (namely, t .0, and t ,t) is quite

straightforward. First, given the possibility of default, in which case rms do not

fully repay their loans, they tend to overinvest relative to the domestic interest rate

that they face: the expected net marginal product of capital (F9(K)21) is driven

below the domestic rate of interest (r). (See Eq. (10).) In order to ensure that rms

do not drive their expected net marginal product of capital below the world rate of

* interest (r ), the government must positively tax domestic interest so as to

maintain the domestic rate of interest above the world rate of interest. Second, by

the small country assumption, any tax levied on foreign lenders must be shifted

fully to domestic borrowers. Therefore, foreign lenders must earn an expected

* * return of r /(12t ) on their loans. Since the interest cannot be fully recouped in

the case of default, they must initially charge domestic borrowers a higher rate of

* * interest than r /(12t ). As a result, the domestic rate of interest (r) which is

* charged by all lenders, both foreign and domestic, must be higher than r /(12

* * * * * t ). In other words, r.r /(12t ), or r(12t ).r . This means that if the

* nonresident tax rate (t ) were to be applied to residents, their net of tax interest

* * rate [(12t )r] would have been higher than the world rate of interest (r ). But

Pareto-efciency requires that the net of tax domestic interest rate [(12t)r] be

equal to the world rate of interest. Therefore, residents must be levied a higher tax

rate on their capital income than nonresidents.

3. Foreign portfolio equity investment (FPEI)

In this section, we assume that capital ows are channelled solely through

portfolio equity investment, FPEI. Ofcially, foreign portfolio equity investment is

dened as buying less than a certain small fraction (say, 1020%) of shares of a

rm. However, from an economic point of view, the critical feature of FPEI is the

lack of control of the foreign investor over the management of the domestic rm,

because of the absence of foreign managerial inputs. For our purposes, we shall

simply assume that foreign investors buy shares in existing rms without

exercising any form of control or applying its own managerial inputs.

This is also why we assume, in complete analogy to the information asymmetry

A. Razin et al. / Journal of International Economics 44 (1998) 4568 55

assumed in the model of FPDI, that foreign investors do not observe the actual

value of e when they purchase shares in existing rms. Domestic investors, on the

other hand, do observe the value of e at that stage. As before, we continue to

assume that e is not known to the rm or to anyone else when capital investment

is made.

This is precisely the model which was developed by Gordon and Bovenberg

(1996). For the sake of completeness, we employ the analytical apparatus that we

developed in Section 2 in order to derive optimal policy prescriptions in this case.

These policy prescriptions are different than those obtained in the Section 2, in the

case of FPDI.

As before, all rms choose the same level of K in the rst period, since e is

unknown to them at this stage. All rms are originally owned by domestic

investors who equity-nance their capital investment K. After this capital

investment is made, the value of e is revealed to domestic investors, but not to

foreign investors. The latter buy shares in the existing rms at a total amount of

FPEI. They expect their investment to appreciate in the second period to an

* * * amount of FPEI[11r /(12t )], as the capital gains are taxed at the rate t and

* foreign investors must earn a net-of-tax rate of return of r , which is the

alternative rate of return they can earn when they invest in their home countries.

Being unable to observe e, foreign investors will offer the same price for all

rms reecting the average productivity for the group of low productivity rms

they purchase. On the other hand, domestic investors who do observe e will not be

willing to sell at this price the rms which experienced high values of e.

(Equivalently, domestic investors will outbid foreign investors for these rms.) As

before, there will be a cutoff level of e, say e (possibly different than the one

o

under FPDI), such that all rms which experience a lower value of e than the

cutoff level will be purchased by foreigners. All other rms will be retained by

domestic investors. The cutoff level of e is then dened by

2

* * [(1 2u )F(K)(1 1e )] / [1 1r /(1 2t )]

(19)

5[(1 2u )F(K)(1 1e )] / [1 1(1 2t)r]

o

The value of a typical domestic rm in the second period is equal to its gross

11

output minus corporate prot taxes, i.e., (12u )F(K)(11e). Because foreign

equity investors will buy only those rms with e #e , the expected second-period

o

2

value of a rm they buy is (12u )F(K)(11e ), which they then discount by the

* * factor 11r /(12t ) to determine the price they are willing to pay in the rst

period. At equilibrium, this price is equal to the price that a domestic investor is

willing to pay for the rm which experiences a productivity value of e . The cutoff

o

11

Strictly speaking, the corporate tax rate (u ) applies to prots, F(K)2K, i.e., output minus

depreciation, and not to output, F(K). However, there is a one-to-one relation between the tax base

F(K)2K and the tax base F(K). We therefore follow Gordon and Bovenberg (1996) in levying a tax at

a rate u on output, F(K), which simplies the notation a great deal.

56 A. Razin et al. / Journal of International Economics 44 (1998) 4568

price is equal to the output of the rm, minus corporate prot taxes, discounted at

the rate domestic investors can earn on bonds issued by their own government, i.e.,

12

(12t)r. This explains the equilibrium condition Eq. (19). Rearranging terms, Eq.

(19) reduces to:

2

* * (1 1e ) / [1 1r /(1 2t )] 5(1 1e ) / [1 1(1 2t)r] (19)

o

2

As e ,e , an equilibrium with both foreigners and residents having nonzero

o

holdings in domestic rms requires that the foreigners net-of-tax rate of return

* * [r /(12t )] be lower than the residents net-of-tax rate of return [(12t)r]. In

some sense, this means that foreign investors are overcharged for their purchases

of domestic rms. They outbid domestic investors that are willing to pay on

2

average only a price of (12u )F(K)(11e ) / [11(12t)r] for the low productivity

rms. Since there are F(e )N rms purchased by foreign investors, the amount of

o

FPEI is given by

2

* * FPEI 5[F(e )N(1 2u )F(K)(1 1e )] / [1 1r /(1 2t )] (69)

o

Consider now the capital investment decision of the rm that is made before e

becomes known. The rm seeks to maximize its market value, net of the original

investment (K). With a probability F(e ), it will be sold to foreign investors, who

o

2

* * pay (12u )F(K)(11e ) / [11r /(12t )]. With a probability [12F(e )], it will

o

1

be sold to domestic investors, who pay on average (12u )F(K)(11e ) / [11(12

t)r]. Hence, the rms expected market value, net of the original capital

investment, is

2

* * 2K 1F(e )(1 2u )F(K)(1 1e ) / [1 1r /(1 2t )]

o

1

1[1 2F(e )](1 2u )F(K)(1 1e ) / [1 1(1 2t)r] (9a9)

o

Maximizing this expression with respect to K yields the following necessary and

sufcient rst-order condition:

2

* * F(e )(1 2u )F9(K)(1 1e ) / [1 1r /(1 2t )]

o

1

1[1 2F(e )](1 2u )F9(K)(1 1e ) / [1 1(1 2t)r] 51 (99)

o

Unlike the debt-nance case of Section 2, the corporate tax in this equity-nance

case does affect the rms behavior, as expected and as can be seen immediately

from Eq. (99). Since the rm knows, when making its capital investment decision,

that it will be sold to foreign investors at a premium under low-productivity

events, it tends to overinvest relative to the net-of-tax rate of return to domestic

12

Here again, government bonds are superuous, but we maintain them in order to establish a

possibility for the consumer to lend money and assign some meaningful value to a net-of-tax domestic

interest rate, namely (12t)r.

A. Razin et al. / Journal of International Economics 44 (1998) 4568 57

investors and underinvest relative to the net-of-tax rate of return to foreign

investors:

* * 1 1r /(1 2t ) ,(1 2u )F9(K) ,1 1(1 2t)r (109)

(A formal proof of these inequalities is provided in Appendix A, Section A.3.)

The remaining equations of the FPEI model are essentially similar to those of

the FPDI model in Section 2. Eq. (11), which denes the consumers discount

factor, stays intact. In Eq. (12), we have to replace FPDI by FPEI. Accordingly,

FPEI 5NK2[I 2c (W,q) 2G ] (129)

1 1 1

Eq. (13), the present-value resource constraint, remains unchanged.

The public nance objective is again to maximize v(W,q), subject to six

constraints: Eqs. (19), (69), (99), (11), (129), (13). There are nine control

* (endogenous) variables: K, r, e , t , t, u, q, W and FPEI. Note that we have the

o

same number of variables as before, but one fewer constraint. This is not

surprising because t and r cannot be uniquely determined. Since the only

lending/ borrowing activity here is carried out between the government and the

(homogeneous) household sector, what matters is the net-of-tax rate of interest,

i.e., (12t)r, and not t and r separately. An analytical procedure similar to that in

Section 2 is also applied here.

13

The optimal policy prescriptions are as follows:

(1) As in the FPDI case, the expected net (of depreciation) marginal product of

* capital (F9(K)21) must be equated to the world rate of interest (r ) so that

* F9(K) 51 1r (159)

This means that capital investment per rm is identical in the two cases (FPDI and

FPEI).

(2) The optimal policy calls for a subsidy to foreign investment, i.e.,

* t ,0 (189)

To get this, observe rst that, as in Section 2, one can show that 11(12t)r511

* * * r (Eq. (16)). Substituting this equality into Eq. (109) yields 11r /(12t ),11

* r , which implies Eq. (189).

(3) It is optimal to levy a positive tax on corporate income, i.e.,

u .0 (20)

* To see this, substitute Eqs. (15) and (16) into Eq. (109) to get (12u )(11r ),11

* r , which implies that u .0.

Indeed, by using the optimal tax instruments, we obtain again the rst-best

13

These are precisely the policy prescriptions derived by Gordon and Bovenberg (1996).

58 A. Razin et al. / Journal of International Economics 44 (1998) 4568

allocation, as in Section 2. Thus, the volume of optimal foreign investment is

identical in both cases: FPDI5FPEI. The difference lies in the mix of policy tools:

(a) In the debt-ow case, the corporate income tax (u ) is a neutral tax that could

be set at any (arbitrarily high) level. In the equity-ow case, we nd a well-dened

tax u .0.

(b) In the debt-ow case, the capital income of residents should be positively

taxed (i.e., t .0). In the equity-ow case, t is irrelevant.

* (c) In the debt-ow case, the tax on capital income of nonresidents (t ) should

* be lower than the corresponding tax on residents (t), i.e., t ,t. In the equity-ow

* case, foreign investment should actually be subsidized, i.e., t ,0, while t is

irrelevant.

In concluding the discussion of the two indirect ows of capital, let us

emphasize that the real system with xed corporate, domestic and foreign

investment tax rates ts closely the rst-best equilibrium that is achieved in the

full information setup.

4. Foreign direct investment (FDI)

In this section, we consider international capital ows in the form of foreign

direct investment (FDI). In a formal sense, a foreign acquisition of shares in

domestic rms is classied as a foreign direct investment when the shares acquired

exceed a certain fraction of ownership (say, 1020%). From an economic point of

view, we look at FDI not just as a purchase of a sizable share in a company but,

more importantly, as an actual exercise of control and management. We thus view

FDI as a tie-in activity, involving an inow of both capital and managerial inputs.

This combination of inputs accords foreign investors with the same kind of

home-court advantage (with respect to, say, business information) that domestic

investors have, but foreign portfolio (debt and equity) investors lack. Specically,

foreign direct investors can learn about the state of the world (i.e., the realization

of the productivity factor e) at the same time as domestic investors. The

asymmetric information feature of the two preceding sections is thus circumvented

14

by FDI.

A foreign direct investor purchases a domestic company from scratch, at the

greeneld stage, i.e., before any capital investment has been made. In fact, the

14

Caballero and Hammour (1996) identify a potentially important cost associated with foreign direct

investment. They view FDI as a specic relation between domestic and foreign inputs which, to the

extent that FDI is irreversible, creates specic quasi-rent that may not be divided ex post according to

the parties ex ante terms of trade. The ex post bilateral monopoly, known in the literature as the

hold-up problem, requires prior protection through comprehensive and enforceable long-term

contracts. The problem is that such contracts are not easily implementable in actual practice. The

consequent under-supply of FDI may warrant favorable tax treatment by the host country. Furthermore,

the shortage of FDI is exacerbated by the existence of technological spillovers.

A. Razin et al. / Journal of International Economics 44 (1998) 4568 59

foreign direct investor makes the capital investment decision herself and imports a

* * * * bundle of inputs, K and M , where K is capital input and M is a managerial

g

* * input. Gross output in the second period is (11M ) F(K )(11e), where 0,g ,

* 1. If J rms are purchased by the foreign direct investors, for a price of V per

rm, then the total volume of FDI is given by

* * FDI 5J(K 1V ) (21)

(Recall that foreign direct investors bring to the rm which they purchase their

* own capital input K .)

Gross output of a domestically owned rm, which invests a capital input of K,

continues to be F(K)(11e). As foreign investors and domestic investors are

equally informed, the expected value of e is equal for both investors, i.e., zero.

If a rm is sold to foreign direct investors, its expected second-period cash

15

receipts, net of corporate taxes, will be

g

* * * * * (1 2u )[(1 1M ) F(K ) 2w M /(1 2t )]

M M

which, in the rst period, is worth to the foreign investors

g

* * * * * * (1 2u )[(1 1M ) F(K ) 2w M /(1 2t )] / [1 1r /(1 2t )]

M M

* * where w is the world wage of managerial inputs and t is the tax rate levied by

M M

* the home country on nonresident managers. (Notice that the tax t levied by the

M

small home country on nonresident managers is again shifted fully back to itself.)

Subtracting from the last expression, the original capital investment yields the

following as the market value of a rm purchased by foreign direct investors:

* * V 5 2K

g

* * * * * * * 1(1 2u )[(1 1M ) F(K ) 2W M /(1 2t )] / [1 1r /(1 2t )]

M M

(22)

Similarly, the market value of a domestically owned rm is given by

V5 2K 1(1 2u )F(K) / [1 1(1 2t)r] (23)

Thus, a rm is sold to foreign direct investors if Eq. (22) exceeds Eq. (23) (when

* * K , M and K are optimally chosen). At an equilibrium with a positive number of

rms owned by both types of investors, we must therefore have equality between

Eqs. (22) and (23), i.e.,

* * V 5 2K

g

* * * * * * * 1(1 2u )[(1 1M ) F(K ) 2w M /(1 2t )] / [1 1r /(1 2t )]

M M

5 2K 1(1 2u )F(K) / [1 1(1 2t)r] 5V (10)

15

We continue to ignore depreciation in calculating the corporate tax base with no loss of generality.

60 A. Razin et al. / Journal of International Economics 44 (1998) 4568

Optimizing behavior on the part of all rms (i.e., maximization of Eq. (22) with

* * respect to K and M and maximization of Eq. (23) with respect to K) yields

g

* * * * (1 1M ) F9(K ) 51 1r /(1 2t ) (9a0)

g21

* * * * g(1 1M ) F(K ) 5w /(1 2t ) (9b0)

M M

and

(1 2u )F9(K) 51 1(1 2t)r (9c0)

The total effective tax rate levied by the home country on capital income of

* nonresidents at both the corporate and individual levels, denoted by t , is dened

implicitly by:

* * * * 1 1r /(1 2t ) ;[1 1r /(1 2t )] /(1 2u )

In this case of fully symmetric information, the optimal scal policy conclusions

are quite straightforward (formal proofs are relegated to Appendix A, Section

A.4).

First, it will still be optimal to follow the aggregate production efciency rule,

which requires that

g

* * * (1 1M ) F9(K ) 51 1r (15a0)

and

g21

* * * g(1 1M ) F(K ) 5w (15b0)

M

Comparing Eq. (15a0) to Eq. (9a0) and Eq. (15b0) to Eq. (9b0) implies that

nonresidents incomes should not be taxed, i.e.,

* * t 5t 50 (24)

M

Thus, the residence principle of international taxation should be followed in this

case. Foreign direct investment, which circumvents the asymmetric information

distortion, restores the efciency of the residence-based taxation on international

16

ows of factors of production. (See Frenkel et al., 1991.)

Note also that aggregate production efciency requires that the net of deprecia-

tion marginal product of capital of the non-FDI domestic rm (F9(K)21) should

* be equal to the world rate of interest (r ), i.e.,

* F9(K) 51 1r (15c0)

16

It is worth emphasizing that this strong result of no taxation of nonresidents income holds whether

or not the government can levy lump-sum taxes or transfers, i.e., whether or not a rst-best allocation is

attained. Thus, even when the government must resort to distortionary taxation on residents incomes

(namely, t .0) in order to meet its revenue needs, it will still be efcient to exempt nonresidents.

A. Razin et al. / Journal of International Economics 44 (1998) 4568 61

Comparing Eq. (15a0) to Eq. (15c0) implies that due to the advantage afforded by

foreign managerial inputs, the rm owned by the foreign direct investor nds it

protable to carry larger capital investment than the domestically owned rm, i.e.,

* K .K. Also, comparing Eq. (15c0) to Eq. (9c0) implies that domestic tax rates

must be set in such a way so as to satisfy:

* 1 1(1 2t)r 5(1 1r )(1 2u ) (25)

That is, there should be no tax distortions on corporate prots of non-FDI rms.

(Recall from Eq. (9c0) that the term on the left-hand side of Eq. (25) is the

corporate return factor, net of all taxes, both at the individual level and the

corporate level.)

In addition, aggregate production efciency requires that the number of rms

sold to foreign direct investors is such that the net economic value of a rm at the

hands of foreign direct investors must be equal to the net economic value of a rm

remaining under domestic control and management, that is:

g

* * * * (1 1M ) F(K ) 2w M F(K)

M

]]]]]]]] ]] * 2K 5 2K (26)

* * 1 1r 1 1r

Indeed, when the residence principle of international taxation is fullled and the

domestic tax rates are set as in Eq. (25), then Eq. (26) must also be satised. This

can be seen by substituting the optimal tax rules Eqs. (24) and (25) into Eq. (10)

* * and comparing the outcome to Eq. (26). (Recall also that 11r /(12t );

* * [11r /(12t )] /(12u ).)

* To avoid distortions on the consumption side (i.e., to achieve MRS511r ), we

17

* * must have 11(12t)r511r . Hence, (12t)r5r . Then, Eq. (25) implies that

u50.

5. A pecking order?

The main policy conclusions for the three forms of capital inows are

summarized in Table 2. The table emphasizes the efciency of a non-uniform

treatment of the various vehicles of international capital ows. In order for the

three kinds of capital inows to efciently co-exist, their tax treatment cannot be

identical. For sure, the co-existence of the three regimes is only a by-product of

optimal tax policies, which are governed by the objective of national welfare

maximization.

In the previous sections, we analyze separately each nancing vehicle to

determine the set of taxes that will be selected by the host government in order to

maximize its national welfare. Analytical solutions of the intensity of capital

17

Since there is no borrowing/ lending except from/ to the government, t and r are not relevant

* separately. All it matters is that (12t)r5r , as in the FPEI case.

62 A. Razin et al. / Journal of International Economics 44 (1998) 4568

Table 2

Tax treatment of foreign investment

Type of tax Type of foreign investment

Foreign portfolio Foreign portfolio Foreign direct

debt investment equity investment investment

Corporate tax (u ) High Positive Zero

Tax on capital income Positive Irrelevant Irrelevant

of residents (t)

Tax on capital income Lower than on residents Negative Zero

* * of nonresidents (t or t )

inows and the levels of welfare are not easy to obtain. We therefore resort to

numerical simulations to evaluate their magnitudes.

We have shown before that once the optimal tax system is implemented, the

FPDI and FPEI solutions will be identical in equilibrium. Furthermore, in the

* limiting case of FDI with g50 (so that M 50)the case with identical

technology as in the FPDI and FPEI regimes and without informational asymmetry

problems, the optimal tax system will yield the same allocations as in the other

two cases as well. As a result, the amounts of capital inows and the levels of

welfare will be the same across all three regimes, and the pecking order is

18

destroyed. However, an indirect indication of the pecking order is reected by

the ranking of the optimal tax rates on the capital income of non-residents reported

at the bottom of Table 2. That is, the tax rates are zero in the case of FDI, lower

than on residents in the case of FPDI, and strictly negative in the case of FPEI.

To get some insight about a more direct pecking order in the absence of

national-welfare-maximizing taxes, we now assume away the government (spend-

ing and taxes). In Table 3, we describe the results from simulations which compare

the three regimes that are assumed to be different only along the asymmetric

information dimension (and not the technology dimension). In other words, we use

the same set of fundamental preference, technology, and endowment parameter

values in all the scenarios. The utility function is isoelastic, the production

function is Cobb-Douglas, and the probability distribution of the productivity

parameter (e) is uniform. Details about the choice of parameter values are

described in Appendix B.

18

Our notion of pecking order is somewhat different from the classic notion of pecking order in

corporate nance. The classic notion considers a single investment. Information asymmetry exists since

the manager is better informed than new entrants. As a result, the manager prefers to rely on retained

earnings. If these funds are insufcient, debt is preferred to equity nance since the latter is more

expensive: the choice of equity nance sends the potential signal that the manager thinks the rms

shares are overvalued. (See Myers, 1984.) In contrast, our setup assumes away informational

asymmetry between the manager and the domestic investors. It does, however, assume an informational

asymmetry between domestic and foreign investors. In the case of FDI, where the information

problems are circumvented through direct monitoring by foreign managers, this asymmetry vanishes.

A. Razin et al. / Journal of International Economics 44 (1998) 4568 63

Table 3

Ranking of FDI, FPDI and FPEI

Capital flows Saving Capital

]]] ]] ]] Welfare

output output output

a

FDI 0.171 20.106 1 0.064

FPDI 0.027 0.034 0.9984 0.061

FPEI 0 0.051 0.9979 0.051

a

* With g5M 50.

We rig the parameters in such a way as to provide a sharp contrast among the

three kinds of capital inows. In the case of FDI, all the investment and production

activities in the domestic economy are carried out by foreign rms; whereas, in the

case of FPEI, we have another extreme corner solution where there is no foreign

involvement in investment activities at home (i.e. autarky). The FPDI represents

an intermediate case where a portion of investment is nanced by foreign debt and

the rest by domestic savings. The pecking order for capital ows as a proportion of

GDP is: 17.1% for FDI, 2.7% for FPDI, and 0% for FPEI. As expected,

FDIwhich circumvents the informational problemsyields the highest level of

welfare (normalized to unity), the other two vehicles of nancingwhich suffer

from the informational problemsare welfare-inferior to FDI: FPDI (0.9984) and

FPEI (0.9979). Thus, the pecking order in terms of welfare ranking is also

preserved.

6. Conclusion

This paper considers optimal tax design by a small host country which is

characterized by asymmetric information problems: domestic investors are better

or earlier informed about the protability of investment projects than are

prospective foreign investors. We sequentially analyze debt, equity, and direct

investment nance. For each nancing vehicle, we determine the set of taxes that

will be selected by the host government in order to maximize welfare in the host

country. The main nding is that the conguration of optimal taxes differs

markedly across these forms of nance.

Among other conclusions of our paper, the reader may query whether subsidies

should be provided to the ignorant. The foreign investors in our treatment have no

incentive to invest in information gathering since they receive a rate of return on

their investment which is the same as the rate of return they obtain elsewhere. In

the political correctness terminology, they are not informationally challenged,

especially because there is a cost of acquiring information in reality.

On political economy grounds, one may also object to our conclusion of

providing subsidies to the foreign investors. Although the political economy

equilibrium is likely to be dominated by domestic pressure groups, it must

64 A. Razin et al. / Journal of International Economics 44 (1998) 4568

incorporate the efciency costs associated with the asymmetric information

problems that we highlight in this paper. This problem is reected in the

under-supply of foreign capital, which the subsidies help to alleviate.

If we take it for granted that foreign capital should be subsidized, do we actually

observe subsidization of capital inows in the real world? There is some evidence

that regional governments and states compete for foreign capital through subsidies.

But whether or not capital inows effectively receive favorable tax treatment in

the real world should, in our view, be a subject for future inquiries.

The afore-mentioned issues aside, our analysis in this paper is by no means

complete. It provides some guidelines for optimal international tax principles

without fully characterizing the optimal tax rates and allocations. It will be

illuminating to compute the latter through simulations.

Since our analysis is conned to a small open economy, one may wonder

whether the results in this paper will carry over straightforwardly to large open

economies? In the large economies case, will international policy coordination

necessarily welfare-dominate policy competition? Will there be situations under

which policy cooperation among benevolent governments may be undesirable as

in Kehoe (1989)? Will the conclusions depend on the timing convention of the tax

policies: in particular, whether taxes are set before or after investment decisions

are made by the domestic and/ or foreign investors?

Obviously, our paper abstracts from discussing many related issues in the

taxation of foreign investment. One such issue is the existence of insured domestic

nancial intermediaries, as in the case of the central bank (or the government)

bailing out troubled commercial banks and savings and loans institutions. If these

intermediaries are not excluded from international transactions, the essentially

domestic moral hazard problem may also plague international capital inows. This

problem, however, calls for applying different policy instruments than the ones

analyzed in this paper.

In addition to informational asymmetry, there are other differences between

foreign portfolio investment (FPI) and foreign direct investment (FDI). One

noticeable difference lies in the degree of reversibility of these investment

decisions: while FDI is almost irreversible, FPI is not. How would this difference

in lock-in effects affect the time consistency of the Ramsey-efcient tax policies

and international tax principles?

If we broaden the denition of investment to include human capital, then the

issues of whether to subsidize foreign students and to tax more heavily foreign

labor become relevant. Will the optimal tax implications depend on whether

19

knowledge spillovers are generated by the inow (or outow) of workers. These

important issues and the ones mentioned in the paragraphs above are left for future

research.

19

Some of these issues are dealt with in Razin and Yuen (1996).

A. Razin et al. / Journal of International Economics 44 (1998) 4568 65

Acknowledgements

The paper was written while the authors were visiting the International

Monetary Fund: Razin and Yuen at the Research Department and Sadka at the

Fiscal Affairs Department. We thank Tamim Bayoumi, Jon Eaton, Liam Ebrill,

Robert Feenstra (Ed.), Se-jik Kim, John Montgomery, Vito Tanzi, Kei-Mu Yi,

participants in the 1996 NBER Summer Institute at Cambridge and the 1996

Congress of the International Institute of Public Finance at Tel Aviv, and an

anonymous referee for useful comments.

Appendix A

Proof that the corporate income tax is non-distortionary in the case of FPDI

Eq. (9a) describes the expected (second-period) cash receipts of the rm before

any corporate taxes. If a corporate tax u is levied on the rm, and assuming full

loss offset, the expected tax liability will be:

2

uhF(K) 2K 2[1 2F(e )]Kr 2F(e )[F(K)(1 1e ) 2K]j (A1)

o o

The tax is levied on net output (i.e., F(K)2K, allowing for depreciation), minus

interest expenses which are either Kr with probability [12F(e )] in the no-default

o

2

case or F(K)(11e )2K with probability F(e ) in the default case. Subtracting

o

Eq. (A1) from Eq. (9a) yields the net-of-tax expected cash receipts of the rms:

2

(1 2u )hF(K) 2[1 2F(e )]K(1 1r) 2F(e )F(K)(1 1e )j (A2)

o o

Since the after-tax objective function of the rm (namely, Eq. (A2)) differs from

its pre-tax objective function (namely, Eq. (9a)) only by a multiplicative factor

(namely, 12u ), it follows that, with a full loss offset, the tax has no effect on the

rms behavior.

Proof of Eq. (16)

Differentiate L (Eq. (14)) with respect to W and q, to get:

* v 2lc 2lc /(1 1r ) 50 (A3)

1 11 21

and

* v 2lc 2lc /(1 1r ) 50 (A4)

2 12 22

where v 5v/ W, v 5v/ q, c 5c / W, c 5c / q, c 5c / W and c 5

1 2 11 1 12 1 21 2 22

c / q. Substituting Roys identity

2

v 5 2c v (A5)

2 2 1

66 A. Razin et al. / Journal of International Economics 44 (1998) 4568

and the Hicks-Slutsky equations

c 5c 2c c i 51, 2 (A6)

i 2 i 2 2 i 1

where c is the Hicks-compensated derivative of c with respect to q, into Eq.

i 2 i

(A4), yields

* * 2c [v 2lc 2lc /(1 1r ) 2lc 2lc /(1 1r ) 50 (A7)

2 1 11 21 12 22

Substitute Eq. (A3) into Eq. (A7) to get

* c 1c /(1 1r ) 50 (A8)

21 22

where use is made of the symmetry of the Hicks-substitution effects: c 5c .

12 21

Substituting the Eulers equation,

c 1qc 50 (A9)

21 22

21

* into Eq. (A8) implies q 511r .

Proof of Eq. (109)

2

* * Substitute for (11e )[11r /(12t )] from Eq. (19) into Eq. (99) and rearrange

terms to get:

1

F(e )(1 2u )F9(K)(1 1e ) 1[1 2F(e )](1 2u )F9(K)(1 1e )

o o o

(A10)

51 1(1 2t)r

2

Since 11e .11e , it follows from Eq. (A10) that

o

2 1

1 1(1 2t)r .(1 2u )F9(K)hF(e )(1 1e ) 1[1 2F(e )](1 1e )j

o o

5(1 2u )F9(K)

because the term in the curly brackets is equal to 1 (see Eq. (4)). This proves the

inequality in the right end of Eq. (109). Substitute for 11(12t)r from Eq. (19)

into Eq. (99) and rearrange terms to get:

2 1

F(e )(1 2u )F9(K)(1 1e ) 1[1 2F(e )](1 2u )F9(K)(1 1e )

o o

2 21

* * 3(1 1e )(1 1e ) 51 1r /(1 2t ) (A11)

o

2 21

Since (11e )(11e ) ,1, it follows from Eq. (A11) that

o

2 1

* * 1 1r /(1 2t ) ,(1 2u )F9(K)hF(e )(1 1e ) 1[1 2F(e )](1 1e )j

o o

5(1 2u )F9(K)

which completes the proof of Eq. (109).

A. Razin et al. / Journal of International Economics 44 (1998) 4568 67

Proof of Eq. (26)

* * The objective of the government is to choose K, K , M , q, W and J so as to

maximize v(W,q), subject to the present-value resource constraint:

g

* * * * * I 1I /(1 1r ) 1(N 2J)F(K) /(1 1r ) 1J(1 1M ) F(K ) /(1 1r )

1 2

* * * * * 2Jw M /(1 1r ) 5c (W,q) 1c (W,q) /(1 1r ) 1G 1G /(1 1r )

M 1 2 1 2

* 1(N 2J)K 1JK (130)

* * Then, the other seven control variablesFDI, V, t, r, t , t , uare determined

M

by the following constraints: Eqs. (21), (10), (90), (9b0), (9c0), (11) and the

rst-period resource constraint:

* FDI 5JK 1(N 2J)K 2[I 2c (W,q) 2G ] (120)

1 1 1

The Langragean expression is

L 5v(W,q)

g

* * * * 1l[I 1I /(1 1r ) 1(N 2J)F(K) /(1 1r ) 1J(1 1M ) F(K ) /

1 2

* * * * * (1 1r ) 2Jw M /(1 1r ) 2c (W,q) 2G 2c (W,q) /(1 1r )

M 1 1 2

* * 2G /(1 1r ) 2(N 2J)K 2JK ] (140)

2

The rst-order conditions establish the familiar aggregate production efciency

results:

g

* * * (1 1M ) F9(K ) 51 1r (15a0)

g21

* * * g(1 1M ) F(K ) 5w (15b0)

M

* F9(K) 51 1r (15c0)

In addition, differentiating L with respect to J and setting the derivative equal to

zero yields

g

* * * * * * * (1 1M ) F(K ) 2w M 2(1 1r )K 5F(K) 2(1 1r )K

M

This proves Eq. (26).

Appendix B

In this appendix, we describe the model parameters used for the simulation

exercise in Section 5. The utility function is assumed to take the isoelastic form:

12s 12s

U(c ,c )5(c 1dc ) /(12s). The production function is Cobb-Douglas:

1 2 1 2

a a

* * F(K)5BK and F(K )5BK . The probability distribution function of e is

68 A. Razin et al. / Journal of International Economics 44 (1998) 4568

uniform: f(e)51/ 2a for 2a#e #a and 0 otherwise. The table below summarizes

our choice of parameter values.

Preference Technology Endowment

parameters parameters parameters

s51 B55 I 510

1

30

d5(0.95) a50.3 I 59.7

2

* g50 r 51/d21

a51

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