Imperfect tax competition for profits, asymmetric equilibrium and beneficial tax havens

a r t i c l e i n f o We present a model of tax competition for real investment and profits and show that the presence of tax havens in some cases increases the tax revenue of countries. In the first part of the paper, we argue that tax competition for profits is likely to be imperfect in the sense that the jurisdiction with the lowest tax rate does not necessarily attract all shifted profits. Under this assumption, tax competition between a large number of identical countries may lead to either a symmetric equilibrium with no profit shifting or an asymmetric equilibrium where firms shift profits from high-tax to low-tax countries. In the second part of the paper, we introduce tax havens. Starting from a symmetric equilibrium, tax havens unambiguously reduce the tax revenue of countries due to a 'leakage effect' — tax havens attract tax base from countries — and a 'competition effect' — the optimal response to the increased tax sensitivity of tax bases involves a reduction of tax rates. Starting from an asymmetric equilibrium, however, tax havens also raise the tax revenue of countries through a 'crowding effect' — tax havens make it less attractive to compete for profits and thus induce low-tax countries to become high-tax countries. We demonstrate that the latter effect may dominate the former effects so that countries, on balance, benefit from the presence of tax havens. While most of the theoretical literature on tax competition has focused on competition for mobile real capital, there is now ample empirical evidence that multinational firms also respond to tax differences by shifting profits between jurisdictions. Bartelsman and Beetsma, (2003) and Clausing, (2003) demonstrate that multinational firms manipulate transfer prices in order to minimize global tax costs whereas Desai et al., (2004), Huizinga et al. (2008) and a number of studies reviewed by Hines (1999) report results consistent with profit shifting through finance structures. A number of recent papers have contributed to the emerging understanding that profit shifting fundamentally reshapes the incentives underlying optimal taxation of capital. Haufler and Schjelderup (2000) find that profit shifting introduces an incentive to reduce tax rates and broaden tax bases. 1 Mintz and Smart (2004) show that profit shifting lowers the tax sensitivity of real investment, which suggests that profit shifting softens tax competition for real investment. Hong and Smart (2010) demonstrate that high-tax countries may benefit from …