Capital Income Taxation and Tax Criteria in International Capital Markets

The study analyses the capital income taxation of foreign-source income, where residence and source criteria are the two well-known tax criteria. The study presents a globally optimal tax rule which equalizes the shadow price of capital in the countries and which is assumed to be a weighted average of the return on savings and on investment, i.e. depending on the gross rate of return to the extent that capital contributes to the capital used, and on the net interest rate to the extent that capital displaces savings. Correspondingly, international taxation is a weighted average of domestic and foreign capital income tax rates. The weight depends on savings and investment behaviour, and also on the taxation of pure rents and on the income distribution effects of the tax scheme in the considered overlapping-generations model. The study also considers foreign direct investment an the investment incentives created by the 1993 Capital Income Tax Reform in Finland to foreign direct investment to Finland. Since the home countries of most foreign multinational enterprises apply the territorial principle, the lower capital income tax rate has real positive effects on new capital investment from abroad. The tax reform will have less significance for the acquisition of existing businesses in Finland.