Niels Johannesen, University of Copenhagen: "Optimal fiscal barriers to international economic integration in the presence of tax havens".
We analyze taxation of cross-border interest payments from the perspective of a group of countries and show that the optimal tax system has two important features: Firstly, the tax rate on interest payments to other countries (i.e. the 'internal fiscal barrier') is zero since an internal barrier would imply a disproportionately high tax burden on multinational firms causing economic integration to be suboptimal. Secondly, the tax rate on interest payments to tax havens (i.e. the 'external fiscal barrier') is high enough to deter firms from using intra-group loans to shift profits to tax havens. In practice, however, international cooperation has been limited to reduction of internal barriers. We show that when a group of countries simply eliminate internal barriers, a tax competition dynamics drives external barriers down to zero leaving countries very exposed to profit shifting. The key to this result is that firms circumvent high external barriers by means of conduite loans introducing an incentive for countries to undercut the external barriers of other countries. Finally, we show that when cooperation is imperfect, the optimal internal barrier is positive. Raising the internal barrier above zero introduces a tax cost of conduit loans, which allows countries to maintain a positive external barrier. The efficiency cost of a raising the internal barrier marginally above zero is second-order and thus strictly dominated by the first-order gains of improved protection against profit shifting.”