Written by : Ewen McCann and Tim Edgar
Abstract – A country’s net flow of capital consists of simultaneously occurring imports and exports. Because a tax on the income from capital imports affects the quantity of capital exports and vice versa, tax policies toward inbound and outbound capital should be jointly formulated in order to avoid distortion of these bi-directional flows. For a small open economy, welfare- efficient local capital markets are shown to require, in the limited case of portfolio debt flows: (1) the taxation of income from capital imports by the importing country at the same rate as income of residents from locally invested capital; and (2) the exemption from tax in the home country of income of its residents from capital exports.
A country is either a net importer or exporter of capital, although the decomposition of the capital flows will show that some residents export their savings at the same time as others are importing capital. In short, the disaggregated capital flows of a country are bi-directional at any instant or over any defined period. This paper considers the optimal income tax regime for the capital imports and exports of a small open economy. The focus is the bi-directional flow of portfolio debt capital, by which we mean a loan contract between parties whose relationship is arm’s length in the sense that one party does not control the decisions of the other.
Simultaneous bi-directional flows of capital would occur in an open-economy setting without taxation when residents have different rates of time preference above and below the interest rate. Those residents whose rate of time preference exceeds the rate of interest would be borrowers, and those whose rate of time preference is below the rate of interest would be lenders. In an open-economy setting with competitive capital markets, a resident is just as likely to transact with a non-resident as with another resident. In adopting this competitive assumption, we abstract from the issue of the tax-policy significance of an observed home-country bias of resident portfolio investors. Bi-directional international flows of homogeneous capital are the result of the relationship between the world interest rate and disparate rates of time preference. Given this context, resident lenders and resident borrowers arbitrage between the local interest rate and the world interest rate, which are adjusted for the appropriate taxes. The actions of resident lenders and resident borrowers are thus linked by their arbitrage off private prices in the local capital market: that is, the local interest rate after taxes.
Perhaps somewhat surprisingly, the development of national policies toward the taxation of income from inbound and outbound capital flows does not reflect either the bi-directional nature of those flows or the interdependence of lenders and borrowers, both resident and non- resident, which arises from their participation in the same market. Taxes on capital imports or capital exports are usually developed and viewed as independent regimes, notwithstanding the private-price linkages and their simultaneity. This singular focus on either inbound or outbound capital flows is also reflected in the academic literature considering optimal tax policy in an open- economy setting.We attempt to illustrate the critical importance to the development of an international tax regime for a small open economy of the interdependence of resident borrowers and lenders and the simultaneity of their transactions. Policy for the taxation of capital imports should be developed with a view to policy for the taxation of capital exports and vice versa.
Of special significance in tax-policy formulation for bi-directional capital flows is the incorporation of the concepts of the social return to capital and its social cost. Consistent with standard usage, we distinguish private from social rates of return or prices. The “private price” of an item is the price, including all tax obligations, which an agent pays or receives for it. The “social price” of an item is the dollar value of all of the resources of the community that are necessary to produce the marginal unit of the item. A market will be said here to be “welfare- efficient” if the social price of an item equals the private price for every agent.
Part two of the paper begins with a brief background review of the standard policy prescriptions for international capital flows articulated in the literature. Part three notes the failure of this literature to account for simultaneous bi-directional flows of capital in the development of an international tax regime for a small open economy. Using some simple, numerical examples for illustrative purposes, we contrast our results with the standard policy prescriptions in the literature. In general, our policy prescription of an exclusively source-based regime for portfolio debt is consistent with the extreme results of Horst (1980) and the concept of capital-import neutrality, which is commonly associated with such a regime. Our policy prescription is also neutral, moreover, in the choice to export capital or invest in the local capital market. This result is perhaps more surprising, since this form of neutrality (commonly referred to as “capital-export neutrality”) is usually associated with an exclusively residence-based jurisdiction to tax. In deriving our policy prescription, we distinguish our approach from that of Horst, who does not account for bi-directional capital flows. In part three we also distinguish our results from those of Slemrod et al. (1997), who explicitly account for bi-directional capital flows but reach a much different policy prescription. Part four of the paper presents a formal derivation of our policy prescription for inbound portfolio debt flows. Part five presents a formal derivation for outbound portfolio debt flows. Part six is a brief conclusion.
2. THE STANDARD POLICY PRESCRIPTIONS ASSOCIATED WITH CAPITAL- EXPORT NEUTRALITY AND CAPITAL-IMPORT NEUTRALITY
Country practice has developed a compromise jurisdictional division of the income tax base. Very broadly, this accepted division allocates the principal jurisdictional right to tax portfolio income to the country in which an investor is resident. Countries in which the income is considered to arise are granted a limited ability to impose gross withholding taxes on the income streams, and the country of residence is required to credit such source-country taxes. This residence-based jurisdiction is conventionally supported by controlled foreign corporation (CFC) and foreign investment entity regimes that look through the separate-entity treatment of a non- resident corporation or other non-resident entity and attribute investment income of the corporation or entity currently to resident investors.
In contrast with the treatment of portfolio income, the principal right to tax income from direct investment is allocated to source countries, with the country of residence of the investor required to provide recognition of source-country taxation either by exempting the income from residence-country tax or crediting source-country tax. Even with credit countries, two common aspects of credit systems ensure that source-country tax on the income is predominant. First, foreign-source income earned through a foreign corporation is generally not taxed by a residence country until repatriation to a resident investor. Second, although the amount of the credit is limited to residence-country tax that is otherwise payable on the income, an element of averaging of high-tax and low-tax foreign-source income is permitted. Combined with deferral of residence- country tax, the ability to use excess foreign tax credits to offset any residual tax on low-taxed foreign-source income, means that the functional difference between exemption and credit countries is much less than the formal difference would suggest.
This accepted jurisdictional division of the international income tax base contrasts sharply with the standard policy prescriptions found in much of the economics literature. To some extent, the contrast can be attributed to a fundamental preoccupation in this literature with the specification of an efficient or optimal international tax regime, which tends to ignore other normative considerations, such as inter-nation and inter-personal equity (though Peggy Musgrave’s work is the exception here), as well as more mundane issues of enforcement and administration. The contrast between economic theory and country practice may also be attributed, in no small part, to the conflicting efficiency concepts of capital-export neutrality (CEN) and capital-import neutrality (CIN).
Both CEN and CIN focus on the maximization of worldwide welfare, where world income is the welfare criterion. CEN focuses on the allocation of investment across countries. As originally articulated by Musgrave (1963 and 1969), CEN is nothing more than an application of the Diamond-Mirlees (1971) production efficiency theorem to cross-border investment flows.
Where investors allocate capital to maximize their income, risk-adjusted, pre-tax rates of return to investment will be equalized across countries such that no reallocation of investment can result in an increase in world income. The standard international tax policy prescription for the realization of production efficiency is an exclusively residence-based jurisdiction to tax, which is equated with CEN. This standard prescription is well known and similar in both a co-operative and a non- cooperative setting.
In the former setting, all countries co-operate and agree to tax the foreign-source income of their residents consistent with the taxation of their domestic-source income. Consistency of treatment generally means recognition of foreign-source income by residents on an accrual basis. Residents thus face the same after-tax return on investments, which should ensure that the pre-tax returns on investments in different locations are not disturbed as compared to a no-tax world. Those returns are equated, and no reallocation of the location of investment would result in an increase in world income. In effect, the decision to locate an investment is not distorted by the imposition of a residence-based tax.
In a non-cooperative setting, the same residence-based approach also arises as the standard policy prescription. In order to maximize the social return from foreign-source income, a single capital-exporting country should attempt to equate the pre-tax returns from domestic investment with the returns on foreign investment after any source-country tax. This result is realized generally by taxing the pre-tax foreign-source income of residents on an accrual basis, with a deduction from such income for any source-country taxes. This particular residence-based system is commonly associated with the concept of “national neutrality” (NN) and the work of Peggy Musgrave (1963 and 1969). Although foreign-source income is subject to a higher tax burden than domestic-source income, the social returns to foreign and domestic investments are equated. Accordingly, the tax system of the capital-exporting country is said to be neutral as between foreign and domestic investment.
For a single, capital-importing country whose economy is small and open, the standard policy prescription in a non-co-operative setting is the non-taxation of income from capital imports, except to the extent that the residence jurisdiction provides a credit for source-country taxes. In the absence of a credit, any tax on capital imports would impose a wedge between pre- and after-tax returns. Because the tax can be avoided by investing elsewhere, pre-tax returns in the capital-importing country must rise to equate after-tax returns, with the incidence of the tax ultimately falling on immobile factors, such as labour. The inequality in pre-tax returns means that capital is misallocated in the sense that a re-allocation could increase income. A direct tax on labour is thus preferable, since it would avoid the distortion of the location of investment.
In contrast with CEN, CIN focuses on the allocation of savings across countries. In other words, CIN is concerned with the maintenance of “inter-temporal exchange efficiency,” whereby the savings decision (that is, the choice between current and deferred consumption) is not distorted in a cross-border context. This decision is, in fact, distorted by the use of an exclusively residence-based system in pursuit of CEN. Although such a system ensures that the location of investment across jurisdictions is not distorted, differences in country tax rates mean that the savings decision is distorted. In a simple two-country model with the savings decision responsive to after-tax rates of return, investors resident in the country with a higher tax rate will save too little as compared to investors resident in a country with the lower tax rate.World welfare could be increased if returns from savings were transferred from residents of the low-tax country to residents of the high-tax country. The standard tax-policy prescription for the realization of inter-temporal exchange efficiency is an exclusively source-based jurisdiction to tax, which is commonly associated with CIN. Under this system, investors in a particular location are taxed at the same rate, so that after-tax returns to savings invested in that location are equated.
It is well recognized that in a world of different country tax rates applied to investment and savings, CEN and CIN cannot be realized simultaneously, unless demand for capital or the supply of capital is completely inelastic.When these extreme assumptions are relaxed, the alternatives for tax policy-makers are seen to be an international tax regime that is: (i) source- based and thereby distorts the allocation of investment across countries; or (ii) residence-based and thereby distorts the choice between current and deferred consumption and the level of worldwide savings. The decision variables in the choice between these alternatives are formally modeled by Horst (1980), who builds on the earlier work of Musgrave (1963; 1969), but defines an optimal international tax regime as one that maintains the social opportunity cost of capital rather than maximizes national income as the policy goal. He argues that such a regime should ensure the equality of the weighted average of pre-tax and after-tax returns to capital, with the weighting determined by the elasticity of the supply of capital. An exclusively residence-based system is optimal only if the demand for capital is elastic and the supply of capital is inelastic. In that case, such a system maintains equality of pre-tax returns across investments in different countries without distorting the level of worldwide savings. An exclusively source-based system is optimal if the demand for capital is inelastic and the supply of capital is elastic. In that case, such a system increases the level of worldwide savings without disturbing the location of investment.
Much of the international tax debate following the work of Musgrave and Horst has focused on CEN and CIN as guiding principles in the taxation of foreign-source income from foreign direct investment. The debate has tended to coalesce around the dictates of CEN, which are seen to require the accrual taxation of foreign-source income with credit for any source- country taxes, and the dictates of CIN, which are seen to require exemption of such income in the residence country. In the context of foreign direct investment, the compromise position appears to be the deferral of the residence jurisdiction until repatriation of foreign-source income to the residence country. Provision of deferral with credit or exemption results in a tax rate on foreign- source income that is somewhere between zero and the rate on the domestic income in the residence country. It has been suggested that this compromise rate can be justified on the basis that the optimal tax rate on foreign-source income is somewhere within this band, depending on the relative elasticities of the demand for and supply of capital.
In contrast with the heated debate over the optimal taxation of income from foreign direct investment, the treatment of income from foreign portfolio investment has received little attention. Indeed, it seems to be accepted that an exclusively-residence based system dictated by CEN is optimal. This position is even advocated by some analysts who see an exclusively source-based system as desirable for foreign direct investment, and draw on the concept of CIN as tantamount to a requirement of equality of after-tax returns to ensure the competitiveness of multinational firms headquartered across different countries. For example, Frisch (1990) and Hufbauer (1992) both argue that increased capital mobility means that portfolio investment flows determine the allocation of savings worldwide, and direct investment no longer serves this important allocative function. In effect, direct investment is no longer needed to intermediate the source and use of funds when portfolio investors resident in a particular country can invest directly, or indirectly through investment funds, in the securities of entities resident in another country. An exclusively residence-based jurisdiction to tax is advocated as the means to achieve CEN in the allocation of worldwide savings. Graetz and Grinberg (2003) even argue that a deduction for source-country taxes should be the residence-country norm for foreign-source income from portfolio investment, on the apparent basis that the residence-country tax treatment of such income does not affect the important decision as to the location of investment. Source- country withholding taxes on inbound portfolio capital are considered desirable only to the extent that they serve as a backup to the enforcement of the residence-country jurisdiction.
We believe, however, that this standard policy prescription for the taxation of portfolio income is incorrect, because of a failure in the international tax literature to account for the two- way or bi-directional flow of capital. In particular, the literature is dichotomized in a way that is similar to that of international tax regimes. A paper will usually deal either with inbound capital or with outbound capital, but not with both of them occurring simultaneously. A gap in both practice and in theory is the consequence of this characteristic. Capital-market distortions to outbound capital that are created by a tax policy towards inbound capital are camouflaged by the dichotomy. Conversely, a recommended tax policy on capital imports will miss the distortions it introduces to capital exports, if the capital flows are viewed separately. The bifurcation of theory and policy may be traceable to the early tax papers that dichotomize the problem into taxes on inbound capital and taxes on outbound capital.
We believe that the disparity and the complexity of the separated approaches to taxing capital imports and capital exports, in theory and in practice, offers the prospect that an alternative organizing principle might succeed in simplifying international tax regimes. The notions that we offer here are:
- bifurcated tax regimes for inbound and outbound capital bring about an unrecognized capital market distortion that arises because resident lenders and borrowers arbitrage off their local after-tax interest rate;
- bi-directional capital flows, and the arbitrage between them, are to be treated simultaneously in the development of international tax policy; and
- the equality of the private and social rates of return to outbound capital with the private and social rates of return to inbound capital integrates the tax treatment of capital exports and imports.
We are careful, however, to limit our approach and alternative organizing principle to portfolio debt capital, since we believe there are certain features of such capital flows that lend themselves more easily to an integrated approach. In particular, international portfolio debt markets are closely integrated, with interest expense and income subject generally to a deduction/inclusion tax treatment across countries. Moreover, the arm’s length nature of the relationship between the borrower and the lender means that non-tax factors generally constrain the ability to substitute debt and equity securities in response to differences in tax treatment in source and residence countries, with an eye to the foreign tax credit position of the lender.
3. SOURCE-BASED TAXATION OF PORTFOLIO DEBT IN THE PRESENCE OF BI- DIRECTIONAL CAPITAL FLOWS
We argue that an exclusively source-based system for the taxation of income from portfolio debt is optimal for a small country in the sense that it equalizes the inter-temporal marginal rates of substitution in production and consumption in that country. In effect, this policy prescription promotes welfare-efficient local capital markets in the sense of the equality between the private and the social rates of interest on capital. One of our fundamental points, which the literature has largely ignored, is that a tax on capital exports affects capital imports, and vice versa. The recognition of this effect indicates that tax policies towards inbound and outbound capital should be developed simultaneously. A failure to recognize this effect means that the standard international tax-policy prescriptions described in the previous part of the paper introduce a distortion to local capital markets that is overlooked.
Slemrod et al. (1997) is the only paper of which we are aware that treats inbound and outbound capital flows simultaneously. They derive a “seesaw” principle for the establishment of optimal tax rates. Under this principle, an increase in the tax rate on capital imports implies a reduction in the tax rate on capital imports and vice versa. Consistent with much of the economics literature on international taxation, Slemrod et al. maximize national income with respect to the stocks of inbound and outbound capital, holding wealth constant.
In terms of approach, Slemrod et al. solve in the standard way the first-order conditions that maximize the national income of the small country to obtain the stock levels for: (i) inbound capital; (ii) outbound capital; and (iii) domestically-located capital. Those first-order conditions are then compared with the international after-tax interest arbitrage conditions for inbound and outbound capital[.20] The two sets of conditions are seen to be inconsistent for arbitrary rates of tax on capital imports and capital exports. The tax rates on imported capital and exported capital are then changed to bring about the consistency of the two sets of conditions. The first-order conditions and the arbitrage conditions are found by this process to hold simultaneously when: (i) the capital-import tax rate is zero; and (ii) the capital-export tax rate equals the tax rate on the domestically-located capital of residents of the small country. These changes are claimed to provide the optimal relation between capital-import and capital-export tax rates.
The principal difficulty with the approach of Slemrod et al. is that it assumes that the levels of the stocks of inbound and outbound capital are independent of the key capital income tax rates. Their approach does not allow for the effects of the required adjustments to the capital import and export tax rates on the levels of inbound and outbound capital stocks or on total wealth. Correcting the rates of capital-import and capital-export taxes would result in a modification to the stocks of inbound and outbound capital from the quantities that provided the maximum value for national income. Those stocks would then no longer be at the levels determined by the first-order conditions and required to maximize national income. The rates of capital-import and capital-export taxes would thus be sub-optimal in the sense of not maximizing national income.Important points of difference between the approach of Slemrod et al. and the approach we develop in this paper are that we: (i) recognize that the levels of inbound and the outbound capital stock each depend on the specified capital import and capital export taxes; (ii) close the gap between private and social prices that is otherwise inherent in the different taxation of international capital flows; (iii) apply the results of the theory of welfare economics on the optimality of competitive markets; and (iv) treat international flows of portfolio debt only.
There is some degree of similarity between our results and those of Horst (1980). In particular, he found that a large capital importer should tax income from capital imports at the same rate as income of residents from domestically-located capital. Further, a separate, large capital-exporting country should not tax income from capital exports. These results apply for inelastic supplies of domestic capital. As well, they apply for the respective countries with uni- directional net capital flows. In contrast, our similar results on tax rates are for a small country that both imports and exports capital, and they apply regardless of the elasticities.
Before providing a formal proof for our policy prescription in the next two parts of the paper, we attempt to illustrate the intuition underlying that prescription with two numerical examples, one illustrating the sub-optimality of the standard policy prescription and the other illustrating our optimal policy prescription. Assume, for the first example, that the tax system of a small country has the following features, which conform to the standard policy prescription in the sense that the rate of tax on capital exports is somewhat higher than the rate of tax on capital imports:
- outbound tax rate, 30 per cent.
- inbound tax rate,15 per cent, and
- tax rate on the locally sourced income of residents, 30 per cent.
Capital importers may deduct interest expense at the rate of 30 per cent, and interest on loan transactions between resident borrowers and lenders are taxed and deducted, respectively at 30 per cent. For simplicity, we assume that all taxes in the rest of the world are zero. The world interest rate for the small country is 5 per cent. This example will reveal the neglected distortion induced by the standard policy prescription.
A non-resident investing in the small country would receive 5 per cent by investing elsewhere, since there are no taxes in the rest of the world. In a world of mobile capital, arbitrage opportunities dictate that a non-resident investor receive 5 per cent after any tax in the small country. That is, the non-resident requires a pre-tax interest rate that leaves 5 per cent after the small-country tax. The pre-tax interest rate in the small country must rise therefore by the amount of tax that the inbound investor is required to pay.After payment of tax to the small country on the higher interest rate, the inbound investor would be left with 5 per cent, which is the opportunity cost of capital. If r is the higher interest rate in the small country,
After this tax gross up, the after-tax interest rate for a capital importer resident in the small country (that is, the private rate of interest) is,
At the income tax rate for resident capital exporters, their after-tax or private rate of return in the small country, which is based on the world interest rate, is,
The private rate of interest is higher for resident capital importers than it is for resident capital exporters. This difference shows that there is room for a strike price in the range 3.5 per cent to 4.1177 per cent (the range of private prices after tax in the small country at 30 per cent). This range of private prices, by definition being after tax in the small country, has a pre-tax counterpart,
0.035/(1-0.3) to 0.041177/(1-0.3)
0.05 to 0.058824
Suppose that the pre-tax strike price is 5.3 per cent. A resident lender and a resident borrower then face an after-tax or private interest rate of,
This rate compares with the private price of 4.117 per cent paid by resident capital importers, and a private price of 3.5 per cent received by capital exporters, so both are better off with the strike price. Accordingly, at a strike price of 5.3 per cent before tax, a potential resident capital exporter finds it more profitable to lend to a resident than to lend abroad. The resident borrower, in turn, finds this source of capital less costly than borrowing abroad. Potential capital exports are diverted to the local market and capital imports shrink. Notice, especially, this interaction between capital exports and imports that is a feature of our approach. The value of the marginal product of capital for capital importers and capital exporters changes to their after-tax private prices of 3.71 per cent for each, which distorts the local capital market. The example shows how the standard policy prescription distorts the capital market in the small country. The distortion arises because the interaction between inbound and outbound capital is neglected.
More particularly, the social cost of imported capital is the grossed up domestic interest rate less the 15 per cent tax that a non-resident lender pays to the government of the small country, that is,
This rate is the same as capital exporters receive before they pay their small-country tax. The social return to capital exports is therefore 5 per cent. The social return to capital (imported and exported) equals its social cost: that is, both equal 5 per cent. This equality is the result of zero taxes in the rest of the world. The difference, disregarding sign, between the social rate of return to capital, 5 per cent, and the value of the marginal product of capital, 3.71 per cent, is the social loss at the margin (in the example |0.0371-0.05|= 0.0129).
Let us now increase the tax rate on inbound capital in the small country so it equals the
30 per cent rate applied to the locally-sourced income of residents. We will also reduce the tax rate on the income from capital exports of residents to zero. Explicitly, the tax system reverses the relation between capital import and export taxes dictated by the standard policy prescription and is,
- outbound tax rate, zero
- inbound tax rate, 30 per cent, and
- tax rate on locally sourced income of residents, 30 per cent.
For simplicity, we continue to assume that taxes in the rest of the world are zero, and the world interest rate for the small country is 5 per cent. We also continue to assume that borrowers resident in the small country deduct interest expense at the 30 per cent rate.
In the presence of the 30 per cent tax rate, non-resident investors would gross up local interest rates to,
A resident capital importer would therefore face an after tax, or private, rate of interest of
The private rate of interest for resident capital importers therefore equals the social cost of inbound capital. Capital transactions between residents would also take place at the pre-tax rate of interest of 7.1429 per cent, which converts to a private rate of interest of 5 per cent after tax. Removal of the tax on capital exports also means that resident capital exporters receive 5 per cent: that is, the full world rate of interest, which is the social rate of return to capital. Resident capital importers and resident capital exporters now have the same private price of capital of 5 per cent, and the possibility of further profitable trades between them is eliminated.
The upshot is that the private rate of return to capital, or private cost of capital, is 5 per cent for all residents. The social rate of return or the social cost of capital is also 5 per cent. Private and social costs are equal in every direction, and the local capital market is welfare- efficient under this tax regime. That is to say, the policy of not taxing the income of resident capital exporters and taxing capital imports at the same rate as the locally sourced income of residents, results in welfare-efficient local capital markets. The amount of capital remaining in the small country, the amount of capital imported into the country, and the amount of capital exported by residents, all settle at their welfare-efficient no-tax levels.
To reiterate, our proposed policy for a small country is exemption of income from portfolio debt capital exports and taxation of portfolio debt capital imports at the same rate as the taxation of the locally-sourced income of residents. The argument that our prescribed tax policy results in local capital markets that are welfare-efficient can be set out in terms of the following components:
- Inbound non-resident investors gross up the tax rate on the local income of residents into the interest rate in the local capital markets of a small country;
- The gross up ensures that inbound non-resident investors are paid the world rate of interest by a small country;
- The world rate of interest is the social cost of capital to a small country;
- Residents transacting with each other in the local capital market do so at the interest rate that is grossed up by their own tax rate, and this interest is either taxable or tax deductible so that loan transactions between residents result in an after-tax interest rate that is equal to the world rate of interest;
- Exporters of capital resident in the small country are not taxed by it, so they too receive the world rate of interest; and
- Every resident of the small country – capital exporters, capital importers and residents transacting with each other – have the same private price of capital: that is, the world rate of interest, which is the social price of capital.
We recognize that adoption of our policy prescription presents some significant implementation issues. In particular, the existing international tax compromise has embedded within in it certain procedural aspects that are intended to protect the status quo. Perhaps most importantly, effective enforcement of an exclusively source-based jurisdiction to tax portfolio debt requires the use of interest withholding taxes for capital imports. Consistency of treatment with resident lenders requires the extension of these withholding taxes to local capital markets, including otherwise tax-exempt investors, such as pension funds.The required use of a uniform withholding tax applicable to capital imports and domestically-located portfolio debt would also necessitate the renegotiation of bilateral tax treaties to establish such a tax in excess of currently permissible amounts on portfolio interest. The alternative to renegotiation is the use of tax-treaty overrides in domestic legislation implementing a uniform withholding tax. However, this alternative is contentious and arguably constrained, particularly in certain countries that have incorporated a “monist” doctrine, whereby international law is considered superior to domestic law and cannot be overridden.
An exclusively source-based jurisdiction to tax also places pressure on the rules in a small country that determine the source of interest income. In general, there is a high element of arbitrariness in sourcing rules for income and expense. Sourcing of interest income is not all that different in this respect, with the residence of a borrower conventionally taken as the reference point for the sourcing of interest income. The integrity of this rule would need to be protected from tax-avoidance arrangements that attempt to exploit residence rules for corporations, trusts and partnerships as both lenders and borrowers.
A related problem is the need to source interest expense, where such expense is to be accounted for in measuring interest income subject to tax. In fact, “net” reporting of interest income is enforceable and thereby feasible for residents of the small country and non-residents, such as international banks, with a business presence in the country. Interest expense sourcing rules become necessary for these lenders as a function of a decision to extend net reporting as an option to a gross interest withholding tax. For non-residents, a gross withholding tax may be maintained as a proxy for net reporting, with the country of residence providing interest expense allocation rules for net reporting purposes, including the foreign tax credit mechanism.
Under an exclusively source-based jurisdiction to tax portfolio debt with a net reporting element, residents of a small country would have an incentive to source interest expense in the small country, since such expense would be recognized in applying tax to interest income from domestically-located capital.Moreover, non-residents could face the same sourcing incentives depending on the tax rates in their residence countries. Formulary allocation approaches can be justified, not on the basis that they realize some correct allocation in any normative sense, but rather as an allocation methodology that most effectively constrains tax-driven allocations of interest expense. That said, proposals for the formulary allocation of expenses have proven particularly contentious in many countries.
We abstract from the constraints of these kinds of implementation issues. What follows in the next two parts of the paper is an algebraic treatment or formal proof of our argument and tax- policy prescription for a small country in the presence of bi-directional flows of portfolio debt capital. We first treat inbound capital, and then integrate the taxation of capital imports with the taxation of capital exports. Foreign tax credits will be allowed in the small country and in the rest of the world, where there will be taxes on all income sourced there and abroad.
4. WELFARE-EFFICIENT TAX ON INBOUND CAPITAL
This part of the paper exploits the idea that welfare-efficiency requires the equality of the private and social prices faced by residents of a small country. Private prices in our case are the after-tax interest rates for resident lenders and resident borrowers. We must work out the social price of loan capital.
Private and social interest rates for the small country can be expressed in terms of world interest rates or local interest rates without affecting tax-policy outcomes. This is because those interest rates are a constant multiple of one another where the constant depends on certain tax rates and on the operation of foreign tax credit systems. The relationship between the interest rates in the small country and in the rest of the world is developed in section 4.1. Section 4.2 works out the social cost of a dollar of inbound capital, given the constant relationship found in section 4.1. That social cost of capital is equated to the private cost of (and return to) loan capital of residents, and the equality will provide the welfare-efficient rate of tax on inbound investment in section 4.2. Section 4.3 provides the interpretation of the welfare-efficient tax rate for inbound investment.
4.1 The Gross-Up Principle
As already noted, it is well known that arbitrage opportunities in a world of mobile capital dictate that non-residents investing in a small country receive an after-tax return equal to the after-tax return on their capital in the rest of the world. We first see how the tax in a small country on capital imports affects its interest rates through the operation of this arbitrage.
However, the after-tax return of a non-resident from investing in a small country includes the effects of any foreign tax credits available in the country of residence for tax payable to the small country. In terms of broad design features, the foreign tax credit systems of all countries limit, in some way, the amount of any credit to the amount of residence-country tax otherwise payable on
specified foreign-source income. Residents earning such income may thus be in one of two credit positions, depending on whether the tax rate on inbound capital in the small country exceeds (“excess credit”) or is less than (“excess limitation”) the tax rate in the country of residence (the rest of the world).
We model below the foreign tax credit system that is to apply in all countries. This model is a reasonable representation of the broad design features of foreign tax credit systems applicable to income from foreign portfolio debt investment. Our approach is broadly consistent with that of Huizinga (1996), who models the relationship between the gross-up principle and the foreign tax credit mechanism. He suggests that the extent of the gross up depends on the availability of offsetting foreign tax credits for lenders, although he finds that foreign tax credits are largely unexploited by the borrowing countries in his data set, which may be attributable to a fear of retaliation and to differences in tax bases in the borrowing and lending countries that push lenders into an excess credit position. Our approach differs, nonetheless, from that of Huizinga in that we deal with bi-directional capital flows. Also we also treat a certain world and model the foreign tax credit mechanism explicitly.
Let r and rw, respectively, be the pre-tax rates of interest in the small country and in the rest of the world. Let τI and τw be the tax rate on inbound capital in the small country and the tax rate in the rest of the world, respectively. Suppose that τwcis the rate of foreign tax credit that the foreign government allows its resident capital exporters. We suppose throughout that τI>0.
For residents of the large country, an excess limitation position arises when the relation between the tax rates in the two countries is,
This situation generates total tax in the two jurisdictions per unit of small-country capital imports of,
Under condition (1) (excess limitation position), expression (2) says that the small country imposes a tax on its inbound foreign investors of, τIr. Then, the foreign country taxes its capital exporters at the rate τw as modified in the square brackets. The square brackets give the
amount of tax raised by the foreign government under its foreign tax credit system. Initially, the foreign government taxes, at rate τw, the full amount of interest earned in the small country, r. As the foreign government recognizes the source-country tax of the small country, there is a deduction of that tax, of τIr, in the round brackets. Continuing, the foreign tax credit, τwcr, is incorporated, first, as a part of the taxable income in the round brackets and, second, as a deduction in the last term in the square brackets from the amount of tax otherwise raised by the foreign country.
in which case the foreign country does not extract more tax from its resident capital exporters over and above what they pay to the small country. The tax rules of the foreign country are then, first,
so that the total tax liability in the two jurisdictions is,
which follows from equation (4).
We now develop the effects that an excess limitation position in the large country has on the interest rate in the small country. The pre-tax interest rate in the small country is r, and equation (2) gives the total of the tax payable in the two jurisdictions. After all taxes the inbound non-resident investor receives, as a result of investing in the small country, the amount r less the taxes in (2) that is,
Solving for r gives the effect of all taxes and foreign tax credits on the interest rate in the small country where non-resident investors are in an excess limitation position in their country of residence,
tax in the small country into the interest rate after allowing for the foreign tax credits granted by their country of residence when they are in an excess limitation position.
When non-resident investors are in an excess credit position, the tax liability in the two jurisdictions together is given by equation (5). The after-tax return to non-residents on inbound investment in the small country is therefore,
so that the gross-up expression for a non-resident investor in an excess credit position is,
4.2 Private and Social Costs of Inbound Capital
Welfare-efficiency requires that the private cost of capital equals the social cost of capital for the small country as a whole. That is to say, the socially efficient use of capital requires that the private interest rate is equal to the social cost of capital. Taxes, at other than the efficient rates, break the equality. We must therefore work out the cost of inbound capital for the country as a whole when there are taxes, which is the social cost of capital.
The small country levies an amount of tax, τIr, per unit of capital imports, where from equation (8), r is the grossed up interest rate in the small country in the case of a non-resident investor in an excess limitation position. The amount remitted to the non-resident investor from thesmallcountryasawholeisthus,
The non-resident in an excess limitation position pays further residence-country taxes out of this amount. Since it is the amount that the small country as a whole sends abroad per dollar of inbound investment,equation (12) is the cost of a unit of foreign capital for the small country in terms of the interest rate in that country. Using equation (8) in equation (12), this may be convertedintothesocialcostofcapitalinthesmall countryintermsoftheworldinterestrate,
Equation (13) is the expression for the social cost of imported capital in terms of either interest rate.
A capital importer resident in the small country can deduct the interest expense at the small country’s tax rate τ, so the after-tax cost of the grossed up interest from equation (8) is,
Expression (14) is the private cost of capital in the small country expressed in terms of each interest rate. The socially efficient use of capital requires that the private cost of capital, expression (14), should equal its social cost, expression (13). Equating the two,
Expression (15) equates the private and social costs of imported capital, which is a necessary condition for the efficient use of it. So solving (15) for τI=τI* provides the efficient rate of tax on inbound foreign investment, that is
where a non-resident investor is in an excess limitation position. This result is discussed below in section 4.3.
Where a non-resident investor is in an excess credit position, the residence country does not impose tax on its capital exports. The tax revenue received by the small country is given by
equation (5) as τIr. The amount remitted abroad from the small country to the non-resident
investor, who pays no further tax, is (1-τI)r. This amount is the social cost of inbound capital for the small country, because it is the per unit amount it pays overseas. We express this social cost, (1-τI)r, in terms of world interest rates by substituting equation (11) into (1-τI)r for non-residents in an excess credit position,
Expression (17) gives the social cost of imported capital in terms of either interest rate, for the excess credit case.
The private cost of inbound capital is (1-τ)r. Substituting (11) into this private cost of inbound capital and equating the result with the social cost of capital given by (17), we obtain
Expression (18) equates the private cost of capital and its social cost, which is a necessary condition for welfare-efficiency in capital markets, where a non-resident investor is in an excess
credit position. Solving for τI will therefore provide the efficient rate of tax on inbound
The welfare-efficient rate of tax on inbound investment is thus τI*=τ for non-resident investors in both foreign tax credit positions. This result is now discussed.
4.3 Interpretation of Welfare-Efficient Tax on Inbound Capital
As a formal matter we have seen how the efficient rate of tax in a small country on inbound investment is the tax rate otherwise applicable to lenders and borrowers resident in the
smallcountry onincomefromdomestically-located capital. Thatis,τ*I=τ,irrespective ofthe
foreign tax credit position of a non-resident investor. We can unify the discussion of this common result by recognizing that the residence country collects positive tax on investments in the small country where its resident investors are in an excess limitation position and zero tax where those same investors are in an excess credit position. We may examine the amount of tax raised by the residence country on its investments in the small country on this understanding. Simply, we speak of the amount tax raised on capital exports by the country of residence, whether it is positive or zero. This will allow us to discuss the two foreign tax credit positions together.
The organizing principle for the discussion of the result, that inbound investment should be taxed at the same rate as the local investment of residents, is that the private cost of capital should equal its social cost. The social cost of capital is the amount per unit of inbound capital that the small country as a whole sends abroad. This cost of capital consists of two components for the small country: (i) the after world tax world rate of interest that a large country investor must receive from every investment; and (ii) any tax that the large country levies on its outbound investment, after accounting for foreign tax credits. Such tax is a necessary supplement to the first component of the social cost of capital for a small country, otherwise the non-resident investors would not receive the after world tax world rate of interest from the small country. The sum of the two components is the amount that the small country remits overseas and is the social cost of inbound capital. Interest rates must alter sufficiently in the small country to at least meet the sum of components (i)and (ii) of the social cost of capital, although there is another effect on the interest rate in a small country.
An additional component in the interest rate in a small country is the gross up of the rate to account for the tax that the small country imposes on capital imports. The gross up is not, however, a part of the social cost of capital, because it is not remitted overseas. The interest rate in the small country is thus the sum of three components, but only the first two described above constitute the social cost of capital. Provided that the tax rate on inbound capital is set to equal the tax rate on the local capital of residents, the interest rate in the small country should exceed the social cost of inbound capital by the rate of tax on local capital of residents. Deduction of interest at this rate of tax brings the private interest rate of residents into equality with the social rate of interest, being the sum of the first two components described above. Thus the efficient rate of inbound tax is equal to the rate of tax on residents.
5. WELFARE-EFFICIENT TAX ON OUTBOUND CAPITAL
The formal derivation of the welfare-efficient rate of foreign tax credit for capital exporters resident in a small country follows a pattern similar to the derivation of the efficient rate of tax on inbound capital in such a country. In particular, succinct derivations of the efficient rate of foreign tax credit for capital exporters is possible now that the background to the approach has been developed for inbound capital.
On the capital-export side, we shall use the welfare-efficiency condition that corresponds to the one for capital-import efficiency: that is, for outbound capital, the social rate of return should equal its private rate of return. The principal difference in the development of welfare- efficient capital-import and capital-export taxation is the fact that, by the definition of a small country, capital exporters resident in the country cannot gross up their foreign taxes into the world interest rate; yet, non-resident investors can influence the interest rate in the small country through a gross up for taxes imposed by the country on capital imports. We choose to look for the welfare-efficient rate of foreign tax credits for capital exporters resident in the small country rather than the efficient rate of tax on capital exports, in order to preserve the existing separation of those two features of the international tax system.
Section 5.1 begins this part of the paper by developing the private rates of return to capital exports of residents of the small country in either an excess limitation or an excess credit position for foreign tax credit purposes. The social rate of return to outbound capital is found in section 5.2, and is equated there to the private rate of return to provide the efficient rate of foreign tax credits for capital exporters. Section 5.3 treats the problem of international tax inconsistency and the consequent arbitrage condition for capital exporters. Section 5.4 interprets the efficient rate of tax on capital exports.
5.1 Private Rate of Return on Outbound Capital
Capital exports from residents of a small country provide a private rate of return that depends on: (i) tax paid to the foreign jurisdiction on those exports; (ii) the tax rate in the small country on income of its residents;and (iii) the foreign tax credit position of its residents. A
where τc is the rate of foreign tax credit that the small country allows its capital exporters, τwI is the rate of tax that the foreign jurisdiction imposes on capital exports from the small country, and τwis the rate of tax that residents of the foreign jurisdiction pay.
Capital exporters resident in the small country face an after tax, or private rate of return
and our search for the efficient rate of foreign tax credit terminates. In effect, the rate given by equation (24) would not be efficient, because the private rate of return to capital exports that it provides would not be equated with the social rate of return to capital. We accept that this inefficiency is a feature of the FTC system and without condoning it we examine just the excess limitation case.
5.2 Social Rate of Return on Outbound Capital
where we can be concerned only with a resident of the small country in an excess limitation position.
Condition (26) is a capital market efficiency condition so we may solve it for τc=τc*, the efficient rate of foreign tax credit where a resident is in an excess limitation position. Thus, from
is the efficient rate of foreign tax credit in the small country for a resident in an excess credit position. Notice from equation (27) that,
which is not unlikely.
Tax revenue of the small country from taxation of the income from outbound capital at rate τ with foreign tax credit at rate τc, is given by the terms contained in the square brackets in equation (21). Using the efficient rate of foreign tax credit, τc* from (27), in those square brackets
provides tax revenue per dollar of capital exports of
That is, the efficient rate of foreign tax credit on capital exporters is such as to offset the tax that they would otherwise pay as residents of the small country. The efficient net tax that resident capital exporters pay to the government of the small country is zero.
5.3 International Tax Inconsistency and Investment Costs
Substantial disequilibrium in the current account of the balance of payments could arise from inconsistent country tax rates and tax bases.Such a disequilibrium would be driven by indefinitely large flows of capital. International tax inconsistency is a possibility for any international tax regime and is discussed thoroughly, for example, in Frenkel et al (1991, 26). This section of the paper circumvents this type of disequilbrium in the current account by introducing an increasing marginal foreign investment cost mechanism. Our purpose here is to cope with a possible structural inconsistency in country tax rates and to see the effects of the corrective mechanism on the policy recommendations that we make.
We are aware that some countries in Latin America in the 1980s used source-based tax systems along the lines that we recommend here, and that these systems are seen, in part at least, as inducing capital flight.Virtually any international tax change will cause both temporary and permanent alterations in capital flows, however. The Latin American experience would have been at least partly due to these adjustments. The capital flight, which has been attributed in part to source-based taxation, is possibly an effect of internationally inconsistent tax rates. Nevertheless, international tax inconsistency and stock/flow adjustments are not unique to source-based taxation. Since we show the existing residence-based policy prescription for portfolio debt capital to be sub-optimal, retaining that prescription for fear of changed capital flows is also sub-optimal in the long run. Temporary capital surges would be a part of the costs of adjustment to the optimal policy that we have found.
The effect of the increasing marginal costs of outbound investment is that they reduce the overall return to a foreign interest rate. As the outbound capital flow increases, the profitability associated with tax arbitrage reduces. Further increases in outbound investment per unit of time eventually become unprofitable so that the amount of such investment is finite and asset prices can equilibrate.
We assume that a tax deduction is not provided for the investment costs. Since the costs are not tax-deductible, the private return to inbound investment in the small country, equation (6), becomes,
The first term in this equation is the earlier private rate of return from equation (6) without investment costs. It is after tax in the small and large countries countries, including the foreign tax credit granted by the large country. The whole of the marginal foreign investment cost is subtracted from it, because investment costs are not tax deductible, giving equation (6’),which is the private rate of return to inbound investment in the small country. The no profit from further
The marginal investment costs of inbound investment thereby increase the interest rate, r, in the small country. Because the small country taxes the income from inbound investment given by equation (8’), the country now remits abroad the after-tax amount (1-τI)r, where r now reflects the marginal investment costs of the inbound investment. Using equation (8’), this social cost of inboundcapitalbecomes,
which is also increased by the marginal cost incurred by non-resident investors.
The private cost of capital in the small country is the local rate of interest after tax for residents, which is,
where again we have used equation (8’). Inbound investors incur their investment costs in the rest of the world, and the small country pays those investors for these costs as set out in equation (13’).
Welfare-efficiency requires equality of the social and private costs of capital given by the two previous equations, that is,
Solving equation (15’) for the optimal rate of capital-import tax with investment costs for inbound investment, we obtain,
which was the result obtained at equation (16). Accordingly, when non-resident investors incur investment costs, welfare efficient capital markets require that inbound capital be taxed at the same rate as residents are taxed on their domestically located capital.
The corresponding procedure for capital exports with marginal foreign investment costs provides the earlier result (27) for the optimal rate of foreign tax credit for the small country. The analysis starts with an adjustment to the private rate of return to capital exports, equation (22), to reflect the marginal foreign investment costs incurred by residents of the small country, that is,
On the assumption that outbound investors resident in the small country incur their investment costs in that country, the social rate of return to capital exports is,
and the analysis proceeds as in section 4.2 to provide the same optimal rate of foreign tax credit as in equation (27).
The introduction of increasing marginal investment costs of outbound investment in the large and small countries thus resolves the possible international tax inconsistency difficulty without altering our policy prescription.
5.4 Interpretation of Welfare-Efficient Tax on Outbound Capital
We have shown at equation (29) that the efficient rate of foreign tax credit on capital exports from a small country should be such that the net tax paid to the small country by its residents on income from such exports is zero. “Net tax” here means the tax liability after the application of the foreign tax credit system in the small country. This result may be surprising, although the reason for it is clear, once we consider the meaning of the social rate of return to outbound capital. That return is the world interest rate less any tax paid to the foreign government.
If the private rate of return to outbound investment differed from the social rate of return to it, there would be capital market inefficiency. Thus, if in addition to foreign tax paid, the small country levied tax on outbound capital, the private rate of return would be driven below the social rate of return to it, and this would introduce a capital market inefficiency. In the presence of a foreign tax credit system, the income tax due to the small country is offset by the efficient rate of foreign tax credit. The design technicalities of the foreign tax credit system for capital exports given in equation (21) means, however, that the efficient rate of foreign tax credit does not equal the residents’ tax rate. Equation (27) furnishes the efficient rate of foreign tax credit that results from that design.
The paper has developed a regime for a small country for the taxation of income from portfolio debt in the presence of bi-directional capital flows. Our fundamental point, which has largely been neglected in the literature, is that tax policy for non-resident lenders into the small country and tax policy for resident lenders out of the country should be formulated together in order to ensure that policy in one area does not introduce distortions for the other. In other words, portfolio debt imports and exports should not have unrelated international tax regimes. Our reason for this position is that resident lenders and borrowers arbitrage off the same after-tax local interest rate, whether or not they transact with non-residents. The local capital market will be welfare efficient when this private price equals the social cost and return to international capital.
We have attempted to link the tax regimes of a small country on capital imports and exports in our search for the efficient rate of tax on inbound investment, as well as the efficient rate of foreign tax credit. The general methodology involved the following four steps:
- find the social rate of interest and return to capital imports and capital exports;
- find the private rate of interest and return to capital imports and capital exports;
- allow for the gross up into interest rates of local taxes on capital imports into the small country;
- apply arbitrage conditions between lending and borrowing locally or abroad, and
- equate the private and social costs of and returns to capital under this arbitrage and gross up.
In order to maintain equality of the social and private rate of return, we have argued that a small country should adopt an exclusively source-based regime in which: (i) capital imports are taxed at the same rate as the domestically-located capital of residents; and (ii) capital exports are exempted from taxation.
A first draft of the paper was prepared for the New Zealand “Tax Review 2001” (New Zealand Treasury), where member Srikanta Chatterjee’s engagement with the ideas was appreciated. Andrea Black, Geoff Cuthell,Robin Oliver and the participants in the workshops of the New Zealand Inland Revenue Department, Policy Advice Division provided useful discussion. Andrea Black and Paul Cooper raised the need for a coherentinternational tax model of bi-directional capital flows.
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 The distinction between direct and portfolio investment is commonly defined in terms of the ownership of the voting securities of an entity. The bright-line conventionally used in the literature and by tax policy-makers as a proxy for control is a 10 percent or more ownership stake.
 Gordon and Hines (2002) survey briefly some of the literature documenting an apparent home- country bias of portfolio investors and the possible causes of this bias. Razin et al (1999) argue that optimal tax policy for portfolio debt in the presence of a home-country bias requires that a capital-importing country subsidize capital imports. The subsidy is intended to correct market failure and restore the cost of capital for resident borrowers of a small country to the world rate. See also Gordon and Bovenberg (1996) for a similar argument in the context of portfolio equity.
 The one exception in the literature, of which we are aware, is Slemrod et al. (1997). See part three infra.
 We adopt, for the purpose of the paper, the standard concept of a “small open economy” as one in which the interest rate is determined exogenously in the international market.
 This division of the jurisdiction to tax international income has been referred to as the “international tax compromise.” The early development of this compromise is described in Graetz and O’Hear (1997).
 Hufbauer (1975) is another important early work developing the equivalence of CEN and the maximization of world income.
 Slemrod (1995) draws on the production efficiency theorem as the basis for the development of an international tax regime that implements CEN as the income-tax equivalent of a free-trade tax regime.
 Razin and Sadka (1990).
Feldstein and Hartman (1979) have an early paper expressing this result.
 These results are obtained in Gersovitz (1987); Gordon (1986); and Gordon (1992).
 Altshuler (2000, at 1581).
 Id, at 1580-81.
 See, for example, Graetz (2001, at 272).
 United States (2000, at 23-42) surveys much of this literature in the context of foreign direct investment.
 Altshuler (2000, at 1582).
 Brean, Bird and Krauss (1991) provide a detailed development of this position in the context of an international tax regime that permits a limited source-based jurisdiction to tax portfolio income and requires the provision of a foreign tax credit mechanism by the residence jurisdiction.
 Zee (1998). See also Gordon (1992) and Slemrod (1988). This role is reflected, in part, in the initiative of the European Union (EU) to adopt a minimum interest withholding tax. See Huizinga and Nielsen (2000); and Huizinga (1994).
 See Slemrod et al. (1997) equations (5a), (5b) and the earlier unnumbered definition of Ks.
 Id., equations (5a)-(6b).
 Id., discussions following equations (5a)-(6b). The result cited is the principal one from among several results in a taxonomy of tax situations in the paper involving a succession of constant tax rates and is the reverse of the policy prescription developed in our paper.
 None of the inbound, outbound or total capital stocks of either country in any equation in Slemrod et al. (1997) is written as a function of any tax rate or of any interest rate.
 The standard approach to constrained optimization is to set up a Lagrange multiplier expression and to optimize it with respect to the choice variables, in this case the inbound and outbound tax rates. This procedure, not followed in the seesaw model, yields complex partial derivatives with respect to inbound and outbound tax rates of the domestic and foreign located capital stocks. These effects are important and are omitted from the seesaw approach; it therefore fails to optimize with respect to the policy variables. Applying the Lagrangian technique to the seesaw model provides several complicated equations that are devoid of policy conclusions.
 We refer to this increase in the pre-tax interest rate as “the gross-up principle.” See section 4.1, infra.
[25 ] An important second-order design issue is a legislative definition of “interest” subject to withholding tax. In general, the definition needs to extend to both original issue and secondary market discounts, as well as interest surrogates generally. Such definitions are part of much of the legislative regimes governing the income tax treatment of interest income in many countries. See generally, Edgar (2000).
To the extent symmetrical rates are adopted for resident borrowers and lenders (both resident and non-resident), accrual recognition of interest income and expense is not required to constrain tax- avoidance opportunities based on asymmetrical rates. See Bradford (1995). Cash-basis recognition for interest withholding purposes could be used for deduction purposes.
 This incentive is muted if capital-exporting residents of the small country can report interest income on a net basis for source-country purposes, and the source-country tax rate exceeds that of the small country on domestically-located capital.
[28 ] Huizinga (1996) provides some empirical evidence of the gross-up of source-country withholding taxes into pre-tax interest rates. His data set, taken from the World Bank’s Debtor Reporting System, consists of 510 individual loans made by international banks to borrowers resident in developing countries from 1971-1981.
 The limitation commonly takes the form of residence-country tax payable on specified income earned in a source country (a per-country limitation) or such tax payable on specified foreign- source income (a basket limitation).
 Symbols will be defined where they are introduced though they are gathered here as well, for convenience: A star on a symbol indicates its optimum value. τ is the rate of tax imposed by the small country on the lending or borrowing transactions of its residents in the local segment of the world capital market; τcis the rate of foreign tax credit that the small country allows its resident capital exporters; τI is the tax rate imposed by the small country on the income from inbound investment of non-residents; τxis the tax rate imposed by the small country on the income from the capital exports of its residents; r is the market rate of interest in the small country; rwis the rate of interest in the rest of the world; τw is a tax rate imposed in the rest of the world on the domesticallysourcedincomeofitsresidents;τw is the rate of foreign tax credit that the rest of theworldgrantsitsresidentcapitalexporters;andτw isthetaxratethattherestoftheworldimposeson income from its capital imports.
 The small country as a whole must pay at least this amount to non-resident investors.
 An important difference in the tax base rules that can result in inconsistent tax rates is different rules for the allocation of interest expense, where interest income is accounted for in one or both of a residence and a source country on a net basis. See part 3, supra. Another important source of potential difference is the accounting of foreign exchange gains and losses. These amounts are inconsistently accounted for as ordinary income versus capital amounts. As well, expected foreign exchange gains and losses may be accounted for differently from unexpected gains and losses in some countries. See Edgar (2000).
 See Williamson and Lessard (1987) for a comprehensive analysis of the magnitude of the problem, its consequences for Latin American economies, and the possible causes. Source-based taxation regimes are examined as one of the possible causes (at 40-43).
 This is for a non-resident in an excess limitation position. A similar analysis applies when the non- resident is in an excess credit position.
 Slemrod et al. (1997, 168) use transactions costs for the same reason as we use investment costs. They impose a definite sign for the net flow of foreign capital. We do not need any restriction.