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Publisher : Elsevier - Science Direct (الزویر - ساینس دایرکت)
Journal : Regional Science and Urban Economics, Available online 20 March 2013
This paper investigates tax competition under uncertainty, when local governments levy a linear source-based tax on corporate income. As the corporate tax transfers part of the risk of investment from firms to the government (risk sharing), two differences to the previous literature arise. First, the capital mobility externality may be positive or negative, depending on how strong the risk sharing effect of taxation is. Second, the sign of the tax exporting externality is also indeterminate. Each government not only exports the burden of taxation, but also bears risk which would have been borne by foreigners instead. Thus, while the socially optimal tax rate equates the risk exposure of the private and the public sectors, the equilibrium decentralized tax may be inefficiently high or low.
Losses are treated in a different way from profits by tax authorities. If a firm experiences a loss, it usually receives a loss carryforward, which allows it to offset future profits and reduce tax payments. Alternatively, some countries also grant loss carrybacks, which take the form of an immediate tax refund against profits in the past. Thus, loss offset provisions facilitate investment of those firms, which operate in highly volatile industries and expect losses in the future (or already have loss carryforwards from the past). It has long been known that a full loss-offset corporate tax reduces the risk premium charged on investment by lowering the volatility of after-tax income (Gordon, 1985). As a result, it may leave investment incentives unaffected. Nevertheless, much of the tax competition literature neglects uncertainty and the tax treatment of losses, mainly because of the tradition to model the corporate tax as being levied on the stock of capital rather than on profits.1 This paper departs from the literature by investigating the consequences of full loss-offset ad-valorem corporate taxation in a model of tax competition. A CAPM framework is considered, in which investors from n identical regions of a federation make optimal portfolio decisions. Each local government chooses a lump sum and a corporate income tax in order to maximize the utility of its representative household. Even in the presence of nondistortionary taxation, a positive corporate tax is levied in equilibrium, because of its risk sharing characteristic. In contrast to previous studies on tax competition, we show that the sign of the capital mobility externality is indeterminate. The reason is that a higher tax rate reduces both expected return and risk of investment. The relative magnitude of each effect determines whether capital flows in or out of a region after a tax rate hike. Capital may move toward the jurisdiction which sets a higher tax rate if the economic environment is highly uncertain and investors are sufficiently risk averse. Moreover, since investors make an optimal portfolio choice, they invest part of their wealth in each region. This leads to exporting of taxation to foreigners. In the classical tax competition model, governments export part of the burden of taxes (see Huizinga and Nielsen, 1997 and Lee, 1997). In addition to this negative externality, with full loss-offset provisions the risk borne by foreign investors is also reduced by home taxation. Thus, the sign of the tax exporting externality is ambiguous and it may turn out that it reduces equilibrium tax rates, while the capital mobility externality corrects them in upward direction. Altogether, it is unclear whether public goods are over- or underprovided in a tax competition game. Uncertainty affects in different ways the two externalities which arise in the model. On one hand, when volatility is higher each government can set the corporate tax rate at a higher level, because the tax sensitivity of physical capital is reduced. On the other hand, some of the risk sharing is lost due to tax exporting. This effect reduces the optimal tax rate. It cannot be proved in general which of the two effects dominates. Therefore, uncertainty may affect both positively and negatively equilibrium decentralized taxes. As a result, this article is related to two strands of literature. The first deals with loss offset provisions and their impact on firms' investment decisions. The second focuses on tax competition under uncertainty and the efficiency of public good provision. The role of the corporate tax rate as a risk sharing device in the presence of full loss-offset has long been understood. Early contributions to the literature include Domar and Musgrave (1944) and Mossin (1968) who show that a corporate income tax with full loss-offset provisions reduces the private risk borne by investors and increases their risk taking. On the other hand, Stiglitz (1969) and Mintz (1981) prove that private risk taking increases only if certain limitations on the utility function of investors are fulfilled. Moreover, Gordon (1985) shows that such a tax on corporate income may leave investment decisions unaffected, because it reduces both the expected return on investment and the uncertainty associated with it and these effects could be offsetting. More recently, Dreßler and Overesch (forthcoming) find empirical evidence that the tax rate sensitivity of investment is largely reduced for firms which have existing loss carryforwards. Additionally, this article is related to the literature on tax competition under uncertainty. Chung and Wilson (1997) show that if a government is less risk-averse than private investors, it will levy a positive corporate tax and absorb some part of private risk. Their analysis focuses on finding a rationale for the use of source-based capital taxes in a tax competition setting. However, it neglects tax exporting and the implications of risk sharing for the sensitivity of investment to tax rate changes. Wildasin and Wilson (1998) consider tax exporting in a framework with uncertain capital, labor and land income. Investors trade ownership shares and find it optimal to own only foreign land, because home land income is positively correlated with labor income. Thus, each government sets the tax on land income at 100% and expropriates foreign-owned land. Therefore, Wildasin and Wilson find that tax exporting is intensified in an uncertain environment, while the current article has an opposite result. The difference between this article and Wildasin and Wilson (1998) is later discussed in further detail. Lee (2004) also investigates tax competition in a risky environment and shows that a corporate tax levied on the stock of capital can serve as insurance against uncertain wage income. An increase in the corporate tax rate drives capital out of a region, which reduces both the expected wage and uncertainty associated with wage income. There are two differences between the current article and Lee (2004). First, we consider how an ad valorem tax can be used to reduce the volatility of capital income. Second, this paper assumes that investors cannot fully diversify away capital income risk, which leads to implications of risk transfer for the signs of the externalities in the model. Panteghini and Schjelderup (2006) and Panteghini (2009) analyze the relationship between corporate taxation and uncertainty in a tax competition setting. Panteghini and Schjelderup (2006) consider a model in which investors choose the optimal time of investment and find a negative relationship between volatility and the optimal tax rate. The intuition is that an increase in uncertainty reduces the overall level of FDI and by lowering the tax rate, the government can alleviate this effect. On the other hand, Panteghini (2009) finds a positive impact of volatility on corporate taxation, because it reduces the optimal level of profit shifting of multinationals though internal debt. This article contributes to the literature by analyzing further implications of uncertainty for decentralized tax rates. The rest of the paper is organized as follows. Section 2 describes the model and determines the optimal household and firm behavior. 3 and 4 solve for the optimal policies followed by a social planner and by decentralized governments, respectively. Section 5 concludes and provides policy implications and directions for future research.
نتیجه گیری انگلیسی
This paper has shown that introducing uncertainty to the standard tax competition model can have many implications. First, due to the transfer of risk through loss-offset provisions, real investment may be attracted to a jurisdiction with higher corporate taxation. This means that the capital mobility externality may be negative. Second, because of the stochastic shocks, investors diversify their portfolios. This leads to joint ownership of firms and exporting of the tax burden. This paper contributes to the tax exporting literature by showing that the government reduces the uncertainty of capital income, which accrues to foreigners. Thus, the tax exporting externality is also with an ambiguous sign. As a result, it is undetermined whether tax competition leads to a “race-to-the-bottom” under uncertainty. The above ambiguity vanishes when the number of regions is large. In this case investors are able to fully diversify their portfolios and the externalities have their expected signs. Even though the large n case may be more realistic, full diversification is not observed in practice. Pischke (1995) estimates idiosyncratic shocks to be about 6.5 times more volatile than aggregate volatility. As a result, nondiversifiable risk can push the price of risk significantly above zero even when there are many regions. This case may arise for small firms, which are usually owned by undiversified entrepreneurs. It may also apply for countries with less developed capital markets. Furthermore, the small n case may be empirically relevant for subnational regions, which operate under an economic regime of strict national-level capital controls.17 Thus, the sensitivity of the results to the number of regions may provide predictions about tax competition before and after capital-market liberalization. Therefore, the results of the paper cannot be interpreted as showing that the basic tax competition predictions break down in the presence of uncertainty. Nevertheless, they indicate that the usual assumptions of perfect capital markets and no uncertainty may overestimate the arising externalities. Moreover, changes in the degree of nondiversifiable risk or the perception of risk by capital markets affect both the socially optimal and the decentralized corporate tax rates. Future research may explicitly consider nondiversifiable risk, e.g. by including nontradable equity, in a tax competition framework. The risk sharing role for corporate taxation should depend positively on the proportion of nontradable equity held by the resident of each region. The results of this article rely also upon the assumption of full loss-offset provisions. Even though the existing rules constrain the use of carrybacks and carryforwards, there is recent empirical evidence that the responsiveness of investment to corporate taxation can be significantly reduced by existing carryforwards (Dreßler and Overesch, forthcoming). An interesting issue is whether it is beneficial for governments to react to tax competition by reducing the statutory tax rate or by relaxing loss-offset provisions. Both of these measures may reduce tax revenues of the government. The advantage of a lower tax rate is that it discourages profit shifting by multinational enterprises. On the other side, it reduces the transfer of risk. Alternatively, a relaxation of loss-offset rules increases the transfer of risk, but some of it will accrue to foreign owners of domestic capital through tax exporting. Additionally, it may enable the government to charge a higher tax rate. Furthermore, transferring risk from the private to the public sector may not be desired by governments, if they do not want to increase the variability of tax revenues. Even though governments are usually not credit constrained and are able to smooth their expenditures over time, tax codes of most countries try to avoid the possibility of large negative shocks to revenues. Additional research is required to determine how governments deal with the issues which arise from the risk transfer. An extension of the model to incorporate international profit shifting by multinational firms is desirable. Hong and Smart (2010) show that international tax planning activities reduce the tax rate sensitivity of investment and this effect may dominate the tax erosion effect. As a result, profit shifting may lead to higher tax rates. Future research may investigate whether this result holds under uncertainty when the tax sensitivity of capital is already reduced by loss-offset provisions. Moreover, relaxing loss-offset rules may be used as a tax competition instrument to attract mobile profits, since a firm needs to report profits in order to use its loss carryforwards. Additionally, the paper cannot determine an unambiguous relationship between uncertainty and the corporate tax rate. The reason is that volatility affects in opposite ways the externalities, which arise in the model. However, it complements the previous results of Panteghini and Schjelderup (2006), Panteghini (2009) and Köthenbürger and Lockwood (2010). Thus, while there are many different links between volatility and corporate taxation in a tax competition setting, furth