The Sovereign Bond Issuance and Tax Competition for Portfolio Investment: A Political Economy Approach

This study investigates interjurisdictional tax competition aimed at attracting foreign creditors' portfolio investments in sovereign bonds and corporate loans. In each of two jurisdictions with lower and higher capital, governments seek to maximize workers' expected utility by determining the volume of sovereign bond issuance to fund public inputs, the tax rate on creditors' interest income, and the extent of compliance with bilateral treaty provisions concerning the exchange of information on creditors' income. Under a bilateral treaty mandating only information exchange, the jurisdiction with initially lower capital tends to set a lower tax rate and exhibits less compliance effort, effectively functioning as a tax haven. Conversely, the jurisdiction with higher capital imposes a higher tax rate and demonstrates greater compliance, benefiting from the residence principle due to its substantial global interest income. Alternatively, under a bilateral treaty that includes provisions of both information exchange and withholding tax at the source for foreign creditors, the jurisdiction with lower capital sets a higher tax rate on domestic creditors and allocates more resources to public inputs than its wealthier counterpart, even at the risk of increasing sovereign default potential. These findings suggest that the specific design of international tax cooperation agreements significantly influences jurisdictions' fiscal behaviors, leading to divergent outcomes despite a shared objective of implementing residence-based taxation.