Second-Best Source-Based Taxation of Multinational Firms

Abstract

I consider a continuum of multinational enterprises (MNEs), which differ in profitability. MNEs employ capital, shift profit to tax havens and may relocate their production facilities to other countries. Source countries provide public inputs and levy taxes. I derive optimal policy choices for different government objectives (to maximize tax revenue, national income or the representative household’s utility) allowing for an unrestricted set of tax policy instruments — in contrast to most existing work on corporate taxation. With observable productivity types, source governments set type-dependent lump-sum taxes and attain the first-best allocation. With unobservable productivity types, the optimum source-based tax system consists of a small lump-sum tax (driving low-profit types out of the market) and positive marginal taxes on reported profit. Optimal marginal tax rates on capital inputs are positive if more profitable firms employ more capital. Optimal public inputs are lower than in the first best if they are of higher value to more profitable firm types. I use a sufficient statistics approach (following Saez 2001) to express optimal tax and input choices as functions of elasticities of observable choice variables. Finally, I use the model to evaluate tax policy measures, e.g. the introduction of an effective minimum tax on profits in tax havens, and to derive the welfare properties of tax competition with an unrestricted set of tax instruments.