Source versus residence: A comparison from a new economic geography perspective

A standard result on international capital income taxation is that applying the residence principle does not affect industrial location and is therefore more efficient than applying the source principle. However, many countries do in fact apply the source principle. We argue that in a new economic geography framework the standard result needs to be qualified: the size of the market is crucial for industry location and it is changed by taxation and by public expenditures; we show that – for the high tax region – this effect dampens capital losses under the source principle and causes them under the residence principle. The sharp difference between the two taxation principles blurs and, unsurprisingly, both principles are found in taxation laws.