International capital mobility: Love of variety, tax systems and international tax competition

This thesis examines the issue of tax reform in the context of internationally mobile portfolio capital. More specifically, we examine the welfare effects of a change in the tax system from a tax credit to a tax deduction for the capital exporting country. Such a change has been proposed in the United States, which is a major source of foreign investment, both direct and portfolio. This policy issue we analyze within the context of a long run two country, two sector, two factor love of variety model that incorporates intra- and inter-industry international trade. Capital, we assume, is mobile between countries. One sector produces differentiated goods with an increasing returns to scale technology which are sold in a monopolistically competitive market. The other sector produces homogeneous goods using a constant returns to scale technology which are sold in a competitive market. The model is consistent with empirical norms and highlights new welfare effects that have been absent from previous discussions on tax reform. Generally, we find that neither the tax credit nor the tax deduction systems are likely to be optimal, from a welfare maximizing point of view, for the capital exporting country (the home economy) in a love of variety model. However, if variety is valued highly and the home economy is specialized in the production of the differentiated goods then the tax credit system may still not be liberal enough. On the other hand, if it is diversified then the tax deduction system may not be restrictive enough either. These results contradicts Hartman (1984), (1985), (1985a), Hines (1988), Frisch and Hartman (1983), Boskin and Gale (1986), Hufbauer (1992) who have made arguments that changing the tax system to a tax deduction or one that is more restrictive than a tax credit would be welfare improving for the capital exporting country.;Additionally, this thesis empirically tests for the presence of international corporate tax competition between Canada and the United States both of whom operate a tax credit system. The general aim of tax competition between countries is the attraction and maintenance of internationally mobile capital or "footloose" capital which usually conveys economic benefits on the economy that receives the capital. Using marginal effective tax rates, tax competition is proven with the U.S. being a leader in the game and Canada a very quick follower.