Taxation of Foreign Firms: Discriminative and Allocative Effects

Abstract

This paper examines the effects of various systems of taxing foreign firms on the international movement of direct investment The notions of tax equity and the neutrality of taxes on the location of investment are examined. It is shown that a tax system may be equitable in that (1) effective tax rates are equal in all countries and (2) only one country levies the tax, and yet such an equitable tax system may have nonneutral effects on the location of foreign investment as a result of different marginal efficiencies of investment. In short, tax equity does not guarantee tax neutrality. The criterion for tax neutrality is defined in detail in the text. Basically, it involves the percentage responsiveness of foreign investment to percentage changes in tax bases. The model, while applied to the specific question of tax equity and tax neutrality, can serve as a useful, general framework for analyzing the impact of taxes on the level of foreign investment.