Strategic Taxation of the Multinational Enterprise: When Tax Credits and Deductions are Equivalent

This paper analyzes the national social welfare effects of taxation on direct foreign investment (DFI) income from the operations of a multinational enterprise (MNE). This paper is unique as it both treats DFI as endogenous to tax policy and considers rival governments strategic behavior in the establishment of international tax policy. A general-equilibrium model sets forth the simple case of two countries which are identical in tastes, fixed factor endowments, and technology. MNE investment abroad is the application of corporate activities, such as research and development, across borders. It is argued that home and host countries will tax strategically so that the combined burden of their taxes is not prohibitive of DFI. If the home country offers no double taxation relief infinite sets of equilibria taxes exist. Under home taxation regimes which provide alleviation of double taxation, such as credit or deduction for foreign taxes paid, the host will fully tax locally-earned economic profits. Moreover, welfare, market structure, and profit results are identifcal in tax credit and deduction regimes when competition between governments is assumed.