Source-based Tax Research Articles

Tax competition with two tax instruments — and tax base erosion

We consider a world in which countries apply optimal taxes on mobile capital and savings (like in Bucovetsky and Wilson, 1991). Firms and savers may underreport income to avoid or evade taxation. We show that, even in the presence of underreporting, the equilibrium under tax competition may still be constrained-efficient (in the sense that there is no scope for welfare-enhancing tax coordination). This is the case if the marginal social costs of underreporting savings and investment income are equal. The model demonstrates that, if source-based taxes on capital are inefficiently low, as is often assumed, taxes on savings must be inefficiently high. Constrained-efficient tax policy minimizes the social cost of underreporting. The results are robust to introducing taxes on profit or labor income, if these types of income can be underreported as well. We conclude that commonly held assumptions on the need for coordination under tax competition need to be revised or qualified.

U.S. Income Taxation of Cross-Border Pensions

This article will explore the U.S. income tax rules applied to deferred compensation transactions that cross national borders; it will consider whether the rules that the U.S. has developed, as a source country and as a residence country, constitute both a coherent and administrable approach and one that meshes harmoniously with the laws of other countries. One objective in this context is to avoid erecting barriers to the free movement of employees across borders. Others are to avoid creating unwarranted loopholes for employees and to insure that the U.S. obtains its rightful share of tax revenues. This topic is of increasing significance because of the growth in cross-border movements of employees in recent years.There are a number of troubling features of the U.S. rules for taxing cross-border deferred compensation that suggest the need for this exploration. The rules for U.S. source-based taxation are often complex and difficult to administer. In stark contrast to its stringent source-based taxation under the Code, the U.S. in its treaties completely surrenders source-based jurisdiction over "pensions." However, no such treaty relief is provided for other forms of deferred compensation; yet the term "pension" has not been defined by the IRS in an authoritative form, and the rationale for the special treatment of "pensions" remains unclear.It seems doubtful that U.S. residence-based jurisdiction over "pensions" is exercised effectively, at least when the employer is not affiliated with a U.S. multinational. U.S. tax concepts employed in a domestic context are employed to characterize foreign retirement schemes even though the effects of such characterizations probably were not foreseen when the concepts were developed. The U.S. residence-based rules, even as supplemented by treaty, fail to take into account the manner of taxation by the source-country so as to guard against double taxation or inadvertent tax exemption.

Is the Nation of Immigrants Punishing Its Emigrants: A Critical Review of the Expatriation Rules Revised by the American Jobs Creation Act of 2004

The thesis of this article is that the revised U.S. tax expatriation provisions fail to correct the most important defects of the prior U.S. tax expatriation regimes. Under the new rules, expatriating U.S. citizens and resident aliens subject to the U.S. tax expatriation rules can still avoid U.S. tax on items properly taxable by the U.S. On the other hand, they remain subject to U.S. tax on income that should fall outside of U.S. tax jurisdiction.During the last forty years, the U.S. has undertaken several attempts to capture what it sees as its rightful share of the income and gain of tax-motivated expatriates. In carrying out this policy, Congress developed a set of alternative U.S. tax rules applicable only to tax-motivated expatriates, subjecting them to an alternative method of U.S. taxation. From the perspective of the U.S., the necessity for an alternative method of taxation arises because of the bifurcated structure of the U.S. tax system, applying one set of rules to U.S. persons and another, generally more favorable set of rules to nonresident aliens. The U.S. imposes residence-based taxation on U.S. persons, subjecting them to U.S. income tax on their worldwide income, to U.S. estate tax on their worldwide estates, and to U.S. gift tax on their worldwide gifts. On the other hand, the U.S. imposes source-based and business-based taxation on nonresident aliens, subjecting them to U.S. income tax on U.S.-source passive and business income, and to U.S. estate and gift tax on U.S. situs property. In both situations, income is subject to U.S. tax only upon the occurrence of a recognition event. The divergence in the scope of the two tax regimes creates a situation in which the U.S. tax liability of an individual calculated under one tax regime could be markedly different from the individual's U.S. tax liability determined under the other tax regime, with nonresident alien status generally rendering the less "taxing" result. The financial benefits of nonresident alien tax status may encourage wealthy U.S. persons to expatriate and be taxed by the U.S. as nonresident aliens. The challenge posed by expatriation is especially acute because it involves moving from residence-based taxation to source- based taxation, potentially causing some unrealized gain to escape U.S. tax as certain gains are not subject to U.S. tax under source-based taxation.

Stanley Surrey, the 1981 US Model, and the Single Tax Principle

2021 marks the fortieth anniversary of the 1981 US Model Tax Treaty as well as the fifth anniversary of the 2016 US Model Tax Treaty. The first author has repeatedly argued that the 1981 Model gave life to the single tax principle (‘STP’). The 2016 Model updates effectively implemented the principle that cross-border income should be taxed once – that is not more and but also not less than once. For example, the 2016 Model does not reduce withholding taxes on payments of highly mobile income that are made to related persons that enjoy low or no taxation with respect to that income under a preferential tax regime. The aim of this article is to identify with relative certainty the origins of the STP. The purpose is to give a systematic and historical interpretation of the STP by looking at the context during which it was purportedly founded. This article draws extensively on published and unpublished writings of the main architect of US international tax rules, Stanley Surrey, and is the result of archival research conducted at the Historical & Special Collections of Harvard Law School Library. The aim of this article is to show that the origins of the STP, from the perspective of the United States as a source country, can be traced to the eight-year period from 1961 to 1969 when Surrey, a Harvard law professor (1950-1984) became the first US Assistant Secretary of the Treasury for Tax Policy. As far as tax treaties are concerned, Surrey made two major contributions to applying the STP in practice. First, the tax treaties negotiated by Surrey: (1) the Luxembourg-United States Income and Capital Tax Treaty (1962), (2) the 1963 protocol to the treaty with the Netherlands applicable to the Netherlands Antilles, and (3) the Canada-United States Income Tax Treaty (1966) took pains to enforce source-based taxation in cases where there was no residence-based taxation of passive income. Second, it was during Surrey’s time at the US Treasury Department that the US delegation wrote two notes to the OECD Fiscal Committee recommending the establishment of a new Working Group which would address the problem of Tax Avoidance through the Improper Use or Abuse of Tax Conventions. This article discusses Surrey’s contributions to the practical implementation of the STP. Tax system, tax reform, Czechoslovakia, Czech Republic, Velvet Revolution, nullum tributum sine lege, income tax, property tax, VAT.

Profit Shifting and Equilibrium Principles of International Taxation

We study the choice between source-based and destination-based corporate taxes in a two-country model, allowing multinational firms to use transfer pricing to allocate profits across tax jurisdictions. We show that source-based taxation is a Nash equilibrium for tax revenue maximizing jurisdictions if domestic and foreign firms generate large revenues. We also show that destination-based taxes are a Nash equilibrium when firms generate low revenues, which implies the presence of multiple equilibria. Both the source and the destination principle coexist in equilibrium when domestic and foreign corporate revenues are intermediate. However, the source principle always tax-dominates the destination principle.

Tax Competition with Two Tax Instruments - and Tax Evasion

We consider a world in which countries apply optimal taxes on mobile capital and savings (like in Bucovetsky and Wilson, 1991). Firms and savers may underreport income in order to avoid or evade taxation. We show that, even in the presence of underreporting, the equilibrium under tax competition may still be constrained-efficient (in the sense that there is no scope for welfare enhancing tax coordination). This is the case if the marginal social costs of underreporting savings and investment income are equal. The model demonstrates that, if source-based taxes on capital are inefficiently low, as is often assumed, taxes on savings must be inefficiently high. Constrained-efficient tax policy minimizes the social cost of underreporting. The results are robust to introducing taxes on profit or on labor income, if these types of income can be underreported as well. We conclude that commonly held assumptions on the need for coordination under tax competition need to be revised or qualified.

Second-Best Source-Based Taxation of Multinational Firms

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.

Tax's Digital Labor Dilemma

Digitalization has reshaped the relationship between companies and their customers and users. Customers and users increasingly serve a dual role. They are not only consumers but also producers, creating content and data. They are a value-creating workforce, functioning as “digital laborers.” Under the current U.S. international tax system, the presence of digital laborers in a country does not grant that country taxing rights over income stemming directly from those digital laborers’ content and data creation. As a result, what are essentially the same business activities—workforces creating products and performing services for a company—are taxed differently when they are performed by digital laborers rather than a traditional workforce. This inconsistency and the accompanying outcome that countries cannot tax corporate income arising from extensive business activities within their borders has led to cries that the current system is unfair. Recent reforms addressing this outcome, including digital services taxes and proposals granting taxing authority over residual profits to market jurisdictions, most notably the OECD Pillar One Blueprint, share a common weakness. They do not recognize the function of digital laborers as producers in the modern economy. As a result, they overturn the theory of source-based taxation as a taxing right granted to the country of production, not the country of consumption, as well as introduce major structural changes to the international tax system—all to correct an unfairness that can be remedied under the system’s current theoretical framework and structure. This Article rejects the notion that these major theoretical and structural changes are necessary or even an appropriate method to allow digital laborers’ home countries to tax income directly related to their work. Instead, the international tax system should recognize digital laborers’ role as a new type of workforce for companies and, accordingly, allow their home countries to tax income related to their work under the existing application of the source principle and with more incremental structural reforms. In addition to minimizing disruption in international tax law, this approach brings a return of coherence and a sense of fairness by taxing equivalent economic activities equivalently.

Taxes and Custom: Tax Treaties as Evidence for Customary International Law

ABSTRACT Scholars of public international law have not paid attention to international tax law in the past. This article seeks to fill this vacuum and to foster cross-field research by studying customary international law in international tax law. It assesses the value of international tax law’s most prominent feature for the identification of custom: the dense network of almost identical, bilateral double tax treaties. The primacy of source-based taxation for business profits serves as a test case for this purpose. The International Law Commission’s conclusions on the identification of customary international law constitute the theoretical reference point that informs the empirical analysis. Thus, this article simultaneously serves as a treadmill test to appraise whether the International Law Commission’s conclusions actually offer practical guidance. The analysis culminates in the conclusion that tax treaties have only little value for the identification of customary international law. First, tax treaties alone do not entail representative state practice. Second, tax treaties give rise to the pitfalls of the Baxter paradox. Third, the tax treaty network yields no evidence that any state practice originates from opinio juris. Judging by the evidence brought into play so far, states likely display uniform treaty practice in international taxation because they believe it is in their best interest, not due to any legal conviction.

Residence- and source-based capital taxation in open economies with infinitely-lived consumers

In this paper we investigate tax competition in a neoclassical growth model where each country may use both residence- and source-based capital taxes. We show that both types of capital taxes are zero at any interior steady state, just as in a closed economy. For symmetric countries, and even for countries that differ only with respect to size and productivity, we prove analytically and verify numerically that the open-economy policies coincide exactly with the closed-economy policies in all time periods. For countries that are asymmetric in other dimensions, we find that source-based taxes are used to manipulate the intertemporal terms of trade in the short run. Either way, the fiscal externalities of source-based taxes vanish once residence-based taxes are allowed.

Unilateral tax reform: Border adjusted taxes, cash flow taxes, and transfer pricing

We study the economic effects of unilateral adoption of corporate tax policies that include the choice between destination-based and source-based taxation and between cash flow and income taxes. We utilize a heterogeneous firm model in which monopolistically competitive North firms choose whether to outsource an intermediate good to an unrelated South firm or to produce in a subsidiary in the South. Standard pass through arguments no longer apply because of the income shifting behavior of multinationals and endogenous choice of organizational form. The high tax North country will prefer a destination-based tax over a source-based tax if it adopts a cash flow tax, but whether the cash flow tax is preferred to an income tax will depend on the volume of trade in the differentiated products sector. If the high tax country adopts a destination-based cash flow tax, the low tax country will prefer a destination-based income tax to capture rents from the foreign subsidiaries.

Unilateral introduction of destination-based cash-flow taxation

We analyze the unilateral introduction of a destination-based corporate cash-flow tax system (DBT), as proposed by Auerbach and Devereux (AEJ Policy 2018). We show that, first, the DBT rate is decision-neutral only if the source tax country makes the DBT payments deductible from its tax base. Second, a unilateral DBT introduction is, in many aspects, equivalent to completely abolishing the corporate tax and, instead, taxing domestic investors based upon their worldwide profit income, net of foreign taxes and on accrual. In this sense, the DBT is actually a pure residence-based tax. This implies that, from a foreign investor’s perspective, the DBT country is like a zero-rate tax haven and has the same gravitational power on taxable profits and economic activity. Third, the location of profit and activity within its borders is, however, without any fiscal value for the DBT country. Fourth, the introduction of a DBT system reduces national income. Fifth, the DBT country can only individually benefit from its new tax system if public goods provision is substantially increased. Finally, it is optimal to complement a unilateral DBT system with a source-based tax.

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Tax competition and the efficiency of “benefit-related” business taxes

We construct a tax competition model in which local governments finance business public services with either a source-based tax on mobile capital, such as a property tax, or a tax on production, such as an origin-based value-added tax, and then assess which of the two tax instruments is more efficient. Many taxes on business apply to mobile inputs or outputs, such as property taxes, retail sales taxes, and destination-based VATs, and their inefficiency has been examined in the literature; however, proposals from several prominent tax experts to utilize a local origin-based VAT have not been analyzed theoretically. Our primary finding is that the production tax is less inefficient than the capital tax under many—but not all—conditions. The intuition underlying this result is that the efficiency of a user fee on the public business input is roughly approximated by a production tax, which applies to both the public input and immobile labor (in addition to mobile capital). In marked contrast, the capital tax applies only to mobile capital and is thus likely to be relatively inefficient.

Has the Permanent Establishment Rule Outlived Its Utility in a Digitalized World?

This article is written at a critical time when countries across the world are meaning to design effective ways to tackle the international tax challenges posed by digital economy. Although the Organisation for Economic Co-operation and Development’s final report on base erosion and profit shifting Action 1 discusses some of the key challenges, it does not provide concrete solutions or recommendations for world governments to act upon. We note that the traditional international tax rules governing source-based taxation of business profits of foreign enterprises need to be reconceptualised in view of the recent advancements in information and communication technology. This could be done by supplementing the current “physical nexus” rule stipulated in the permanent establishment article of tax treaties with a new nexus to tax based on “significant economic presence”. We recommend two Options that countries can consider while drawing this new nexus.

Optimal Fiscal Equalisation and Its Application to Australia: Updated

The first part of this paper develops a theoretical model of fiscal equalisation to derive an optimal equalisation formula that has general applicability for federations. If vertical equity is achieved by the central government and horizontal equity by interstate migration, the welfare-maximising role of fiscal equalisation is to support an efficient distribution of different labour types across states. The theoretical model further develops work by Boadway and Flatters and by Albouy with some Australian-oriented extensions. Under optimal equalisation, full equalisation is applied when a state government achieves a fiscal advantage by using source-based taxes to raise revenue from non-residents (e.g. mining royalties) or from spreading its fixed costs over a large population. However, efficiency also dictates that equalisation is limited to fiscal advantages arising from differences in state population composition when applied to revenue raised from residents (e.g. via labour or consumption taxes) or to the variable costs of government. Simplifying assumptions are discussed. The second part of this paper applies the optimal equalisation approach to Australia using, as a base, the Commonwealth Grants Commission (CGC) assessments for 2017/18 and 2018/19. 2016 Census data is used to measure the impact of each state’s population composition on its ability to raise revenue from residence-based taxes for use in applying limited equalisation. The gain in consumer welfare of moving from the current Australian full equalisation system to optimal equalisation is estimated. Policy alternatives that are found to be inferior to the current full equalisation system include no equalisation, half-equalisation and the donor relief equalisation schemes recently recommended by the Australian Productivity Commission.

Corporation taxes in the European Union: Slowly moving toward comprehensive business income taxation?

This paper surveys and evaluates the corporation tax systems of the Member States of the European Union on the basis of a comprehensive taxonomy of actual and potential regimes, which have as their base either profits; profits, interest and royalties; or economic rents. The current regimes give rise to various instate and interstate spillovers, which violate the basic tenets—neutrality and subsidiarity—of the single market. The trade-offs between the implications of these tenets—harmonization and diversity, respectively—can be reconciled by a bottom-up strategy of strengthening source-based taxation and narrowing differences in tax rates. The strategy starts with dual income taxation, proceeds with final source withholding taxes and rate coordination, and is made complete by comprehensive business income taxation. Common base and cash flow taxation are not favored.

A Global Treaty Override? The New OECD Multilateral Tax Instrument and Its Limits

The new OECD Multilateral Instrument to amend tax treaties (MLI) is an important innovation in international law. Hitherto, international economic law was built primarily on bilateral treaties (e.g., tax treaties and BITs) or multilateral treaties (the WTO agreements). The problem is that in some areas, like tax and investment, multilateral treaties proved hard to negotiate, but only a multilateral treaty can be amended simultaneously by all its signatories. The MLI provides an ingenious solution: A multilateral instrument that automatically amends all the bilateral treaties of its signatories. If the MLI succeeds, it can be a useful model in other areas, such as investment, where a multilateral agreement was not successful, but there is a growing consensus about the need to adjust the terms of BITs to address investor responsibilities and the definition of investment comprehensively. Whether the MLI will succeed remains to be seen. A recent estimate has suggested that the US will not agree to anything except the arbitration provision, and other OECD members may agree to only a limited set of provisions. On the other hand, the MLI may prove more appealing to developing countries because it enhances source-based taxation and limits treaty shopping. Even a limited MLI would be a step forward. The current tax reform proposals in the US pose a significant threat to the international tax regime Countries that wish to limit the damage would be wise to accede to the MLI this year and prevent a massive race to the bottom that could ensue if the US becomes (from the perspective of the rest of the world) a giant tax haven.

Die radikalen Steuerpläne der US-Republikaner und die Folgen für die EU

The Republican majority in the US House of Representatives is considering the introduction of a destination-based cash flow tax (DBCFT). While its global implementation has the potential to substantially increase welfare, a unilateral introduction of such a tax system raises a range of questions due to the existence of source-based taxation systems abroad. We consider the US tax plans from an EU perspective. We show that European exporters may suffer, but European firms with affiliation in the US may benefit from a switch to the DBCFT. American firms will be the likely losers of this policy. Finally, we discuss potential policy reactions by the EU and its member countries as well as legal and economic implications of possible adjustments in EU tax systems.

Learning to Tax - Interjurisdictional Tax Competition Under Incomplete Information

We present a multi-period model in which countries set source-based taxes without having precise information how their and their neighbours' tax rates affect the tax base. Countries can learn from past experience and from observing their neighbours' outcomes and/or tax policy choices. We consider the sequence of Markov perfect equilibria and show that the beliefs become more precise over time and, eventually, correct. The precision of beliefs in a given period increases in the number of observed countries. In equilibrium, tax rates are inefficiently low if the value of learning is positive and the pace of learning increases in the level of tax rates (because higher tax rates trigger larger tax base effects which helps learning); in the presence of fiscal externalities, tax rates are too homogeneous (because variance in tax policies enhances learning). If, due to fiscal externalities, the value of learning is negative, the opposite may be true. From the viewpoint of empirical measurement, the model generates time patterns that look as if countries react to each other even if there are no fiscal externalities. We conclude that the existing evidence may therefore be inconclusive with regard to the existence of tax competition.