Abstract
Multinational firms use internal debt financing to shift profits from high-tax to low-tax countries. Therefore, governments restrict the deductibility of interest expenses by applying thin-capitalization rules (TCRs). TCRs fall into two main categories: safe haven rules (SHR) and earnings stripping rules (ESR). We analyze the optimal TCR choice in a two-country tax competition model. We show that unilateral replacement of SHR by ESR imposes a negative profit shifting externality on the other country. This effect can explain the recently observed switch from SHR to ESR in many countries. However, ESR may be a dominant strategy even when SHR is socially optimal, i.e., the observed policies of ESR implementation may indicate a prisoner’s dilemma.
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