Abstract
This paper analyzes the effects of switching from a corporate tax system based on separate accounting (SA) towards a system in which two countries form a formula apportionment (FA) union while a third country sticks to SA (water's edge). Our analysis draws a positive picture on the water's edge regulation. In the short-run, for given tax rates, the transition from SA to FA is likely to reduce profit shifting from the FA union to non-FA tax havens. In a long-run tax competition analysis, we find a negative water's edge externality under FA that tends to be less detrimental than the profit shifting externality under SA and may offset other externalities under FA.
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