Introduction

Many countries tax corporate income heavily despite the incentives that they face to reduce tax rates in order to attract greater investment, particularly investment from foreign sources. The volume of world foreign direct investment (FDI) has grown enormously since 1980, thereby increasing a country's ability to attract significant levels of new investment by reducing corporate taxation. The evidence indicates, however, that corporate tax collections are remarkably persistent relative to gross domestic product (GDP), government revenues, or other indicators of underlying economic activity or government need. If this were not true – if corporate income taxation were rapidly disappearing around the world – then such a development might be easily explained by pointing to competitive pressures to attract foreign investment and retain domestic investment. Hence, the question remains why growing international capital mobility has not significantly reduced reliance on corporate income taxation.

There are at least three possible resolutions of this puzzle, of which the simplest is that the continued taxation of corporate income at high rates reflects the politics of tax policy formation. Corporate taxation may be popular because its incidence is so uncertain, leading large numbers of voters and various interest groups to conclude that others, and not they, bear the burden of this tax. If this political phenomenon is important, then it would explain why greater international capital mobility might not be accompanied by sharp tax reductions around the world.

Introduction

The history of European capital taxation is one of 12 disparate systems, competing for revenue not only with each other but also – and sometimes dramatically – with their own taxpayers. With the imminent arrival of 1992 the fiscal landscape will change significantly: if current capital tax systems are left untouched, European governments are likely to find it very hard to collect revenue from internationally mobile capital. Indeed, Europe may transform itself into a single (large) tax haven.

In this paper we perform an exercise in applied positive economics: we design a model of residence-based corporate taxation that, while preserving national tax sovereignties, minimizes the distortions arising from international capital mobility. This type of exercise is in our view especially useful because in the current debates over tax reform in Europe there is much confusion between administrative problems and political constraints. Analysis of models of taxation like ours can help clarify where administrative issues end and political issues begin.

To motivate our study, we begin in section 2 with a look at the data on revenue from capital income taxes and a brief discussion of the role of the history of capital taxation in shaping the fiscal institutions and private practices that are visible today. After listing in section 3 the (often unintended) distortionary incentives embodied in current tax treatments of international income, we analyse in section 4.1 a plan for a system of corporate income taxation that is consistent with the goal of minimizing the distortions arising from the international mobility of capital. The plan is inspired by the full application of the residence principle of taxation of international capital income.