Multinational Taxation under Pressure: The Role of Tax Deductibility

To address international profit shifting by multinational enterprises, a number of countries are broadening their tax bases and using turnover tax to secure corporate tax revenues. This paper investigates the impact of tax deductibility on multinationals’ behavior and corporate taxes by considering a model of corporate tax competition with two countries and a tax haven. A pure profit tax (with either separate accounting or formula apportionment) giving deductions for all costs can preserve production efficiency at the expense of tax base erosion. In contrast, a turnover tax with no deductibility of costs can eliminate profit shifting incentives at the expense of production distortion. We show that profit tax with formula apportionment dominates the other two tax regimes when the output elasticity is high and tax capacity is intermediate. In other cases, turnover tax (profit tax with separate accounting) can dominate under low (high) tax capacity. We then analyze the general case to allow for partial tax deductibility and revisit the Diamond-Mirrlees production efficiency theorem in the profit shifting context. We show that less deductibility can yield more revenue when tax capacity is low, but that revenue increases with deductibility when tax capacity is sufficiently high. Simulations further suggest that the optimal deductibility rate increases with the tax capacity and the output elasticity.