Finance in Europe
International Taxation

A CEPR workshop on international taxation was held in Bergen on 8/9 September. The workshop was organized by Michael Keen (University of Essex and CEPR) and Cornelius Schilbred (Norwegian School of Economics and Business Administration). It formed part of CEPR's research programme on `Finance in Europe: Markets, Instruments and Institutions', funded by the European Commission's Human Capital and Mobility programme. Additional financial support was provided by Norsk Hydro, Statoil and the Norwegian School of Economics and Business Administration.
Alfons Weichenrieder (Universität München) presented `Transfer Pricing, Double Taxation, and the Cost of Capital', analysing the effects of double taxation when a multinational enterprise can shift profits by transfer pricing. Differences in statutory corporation taxes, custom duties and conflicts between tax codes leading to double taxation of a subsidiary's profits are all incentives for transfer pricing. The paper analyses the steady states of a dynamic model with a parent and foreign affiliate where there are restrictions on the profit share shifted. No assumptions are made about the relationship between the tax rate on retained earnings in the host country and the income tax rate of the parent; but the former rate is assumed to be less than the rate on the subsidiary's distributed profits channelled to the parent as dividends. The main result suggests that foreign subsidiaries' investment is positively related to the combined taxation of dividends. A reduction in double taxation tends to increase the cost of capital for foreign investment. This effect is most likely when the steady state growth rate of the subsidiary is low rather than high, suggesting that recent efforts to reduce double taxation of international investment may lead to a reduction in investment by existing subsidiaries. Reduced double taxation may also affect the overall number of foreign subsidiaries.
Mark Robson (Bank of England) stated that the OECD has different transfer pricing guidelines, where profits are related to specific transactions rather than controlling transfer prices by gross profit. Kim Scharf (University of Warwick) wondered what would take place in the adjustment process until a steady state is reached. Reformulations of the profit-shifting function were also addressed.
Bernd Huber (Universität München) presented `The Role of Fiscal Integration in a Monetary Union', focusing on the consequences of economic and monetary union (EMU) for fiscal policy: as currently planned, it will involve a low degree of fiscal integration. The paper analyses whether the introduction of a common currency requires coordination of fiscal policies, based on time-consistency considerations and using a stylized two-period public finance model of the EU, where all countries are identical and small relative to the rest of the world. The paper compares the outcomes in a system of national currencies and in a monetary union. In the first period, the government in each country provides a national public good financed by debt issues. In the second period, the debt is repaid with receipts from two distortionary taxes: an inflation tax and a wage tax. The time-inconsistency problem arises when tax policy is chosen in the second period. If national fiscal policies are uncoordinated, the introduction of a monetary union results in excessive inflation and government spending. As a consequence, welfare is lower relative to the outcome with national currencies, because of national government free-riding. Hence, if policies are subject to time-inconsistency problems, a need for fiscal integration arises. But if institutions can be designed where precommitment becomes possible, fiscal integration would become unnecessary.
Massimo Bordignon (Cattolica Università di Milano) reflected on the relevance of the results for EMU, suggesting that the European Central Bank may not be as accommodating as assumed. It is more likely to select a course in line with Bundesbank policy. Moreover, he questioned the assumption of identical countries. Søren Bo Nielsen (Copenhagen Business School and CEPR) was interested in the consequences of spillover effects, which arise when countries are asymmetric.
Michael Daly (OECD) presented `The Role of Capital Income Taxation in the EU: An Overview of the Main Issues', assessing the extent to which member states' existing income tax laws, and the principles underlying them, are compatible with the single market, as well as the implications of a single market for EU tax policies and tax administration. International taxation is mainly based on bilateral agreements and is not neutral within the single market. The paper argues that the reason for this treatment is that it is difficult for countries to make neutral tax agreements. Between 33–50% of merchandise trade is intra-company, and the fair division of these multinational enterprises' tax bases demands an exploration of alternative allocation methods among member states. In particular, the arm's length principle reinforces the difficulties. As for the relevance of types of corporation tax for investment decisions, the paper anticipates a great need for coordination and harmonization of such taxes. Consorted action is essential to cope with these tax policy problems, but such action is currently unlikely. Corporation taxes will not disappear since non-resident companies are profitable and, according to many politicians, should be taxed as they are using a country's infrastructure.
Chris Higson (London Business School) found the paper very general. He argued that large differences in tax rates do not necessarily imply inefficiencies since the diversity of tax rates can generate investment and tax niches. In his opinion, lawyers rather than economists are in control on tax issues. Jack Mintz (University of Toronto) claimed that the lack of global neutrality will not impose serious problems if source-based tax systems are used. He emphasized a number of reasons why equilibrium capital taxes may be too high rather than too low.
Garry Young (National Institute of Economic and Social Research) presented `The Influence of International Taxation on Domestic Fixed Investments: A Cross-country Study', noting that foreign factor prices affect the decisions of multinational enterprises. How profits are taxed as they accrue and are distributed in different countries are also important in the location of production. Changes in relative costs alter the competitiveness of firms in the domestic economy. Increased competitiveness allows these firms to increase their share of world demand, thus increasing their demand for factors of production. Furthermore, changes in relative costs affect the attractions of different locations for production. Increased cost competitiveness also raises the world demand supplied from a particular country. The paper concludes that while the level of UK costs relative to costs in other countries has had a strong effect on investment demand, there has not been a significant domestic factor substitution effect. This suggests that the main channel through which factor price movements influence factor demand in the UK is through their effect on international competitiveness.
Julian Alworth (Università Bocconi, Milano) commented that the tax base, financial policy and the exchange rate could have been considered explicitly in the model. Moreover, he questioned the use of effective tax rates. Rachel Griffith (Institute of Fiscal Studies) suggested an extension of the model to two locations. She also commented on the use of aggregated data: for example, microeconomic data in the consumption literature typically shows high variance, while macro- economic data are smooth.
Julian Alworth presented `The Determinants of Cross-border Non-bank Deposits and the Competitiveness of Financial Market Centres', written with Svein Andresen. Using a unique and confidential data set compiled by the Bank of International Settlements, this paper examines the factors making a site attractive as a deposit location, such as tax regulations, creditworthiness and banking secrecy. The decision to place deposits in a particular location is strongly influenced by the economic interlinkages between the country of the depositor and the financial centre. Bilateral trade, the number of banks from the depositor's home country, and the withholding taxes agreed in double taxation treaties are the most important factors, simultaneously determining the outward deposits decision and the location of the funds. Following the lowering of reserve requirements in the mid-1980s, the lifting of withholding taxes in virtually all major countries and the increasing similarity of corporation tax rates, many differences between centres have been reduced. Apart from the macro- economic determinants of deposits, the extent of banking secrecy appears to be the major feature differentiating financial centres in the 1990s.
Mintz pointed out the lack of a model or consideration of borrowers' tax incentives. He conjectured that there should be some relationship between deposits and taxes, especially value added taxes. Young added some criticism on depositors' motivation.
Petter Osmundsen (Norwegian School of Economics and Business Administration) presented `Dynamic Taxation of Non-renewable Natural Resources: Asymmetric Information about Reserves'. Extraction companies obtain private information about the size of reserves through their operating activities. Such asymmetric information with respect to the government may lead them to act strategically in reporting costs. The paper presents a dynamic adverse selection model for a non-renewable natural resource, such as petroleum, examining how the real economic intertemporal dependence in extraction costs interacts with the informational dynamics. With symmetric information, the theory prescribes neutral taxation; but asymmetric information creates a second-best situation, demanding a non-neutral tax system. Optimal contracts will differ between periods, distorting both the extent and pace of depletion. The paper shows how the optimal allocation can be implemented by a menu of tangent planes, generated by license fees and royalties.
Kai Konrad (Freie Universität Berlin and CEPR) suggested a solution method based on yardstick competition and assuming no collusion would take place. Hannu Piekkola (University of Helsinki) suggested some extensions to the model, in particular dynamic price uncertainty: when there is price uncertainty, commitment is difficult.
Kim Scharf presented `International Capital Tax Evasion and the Foreign Tax Credit Puzzle'. The literature on the international taxation of capital has difficulty explaining why the majority of capital exporting regions choose a foreign tax credit system over a deduction system when taxing internationally-mobile capital. The paper examines the role of international tax evasion for the choice of an optimal foreign tax credit by a capital exporting region. It finds that: first, although an increase in the foreign tax credit reduces evasion activity per unit of exported capital, it also encourages exports, and may thus result in higher total evasion costs; second, the presence of evasion reduces the `compounding' effect of double taxation of foreign source income, reducing the need for a foreign tax credit; and third, by making residence-based taxes distortionary, evasion raises the marginal cost of public funds obtained through domestic taxes, hence raising the social cost of a foreign tax credit.
Pascalis Raimondos (Copenhagen Business School) welcomed the new modelling of tax evasion costs, previously modelled as fixed costs. Wolfgang Peters (Universität Bonn) raised some points about the practical relevance of the model, questioning the assumption of n identical firms.
Søren Bo Nielsen presented `Capital Income and Profits Taxation with Foreign Ownership of Firms', written with Harry Huizinga. This paper investigates how the optimal mix of residence and source level capital income taxes in a small open economy depends on the feasibility of profits taxation and on the foreign ownership of domestic firms. The framework is a two-period consumption and saving model with an exogenous interest rate. It shows that if there are constraints on the feasibility of profits taxation, both saving and investment taxes generally form part of the optimal tax package. But if profits can be fully taxed, then source-based investment taxes vanish. If domestic firms are partly under foreign ownership, then source-based investment taxes can be used to shift income away from foreigners to domestic citizens. They may even be used to finance lump sum transfers to domestic residents.
Osmundsen recommended that a motivation for the profit tax rate not equalling 100% should be included, since the most interesting result assumes this. Weichenrieder commented on implementation issues, the fact that direct investments are often takeovers of existing firms, and the need for revelation mechanisms.
Empirical Macroeconomics
Methods and Problems
A joint CEPR workshop at ECARE, Université Libre de Bruxelles on `Empirical Macroeconomics: What Methods for What Problems?' was held on 2/3 June. The workshop was organized by Lucrezia Reichlin (ECARE and CEPR), and formed part of CEPR's research programme on `Macroeconomics, Politics and Growth in Europe', funded by the European Commission's Human Capital and Mobility programme. The workshop focused on new methods for the empirical modelling of business cycles and growth.
One main theme was how to extract information on the dynamic behaviour of cross-sections of countries, regions and sectors. Major questions were how to test empirically for convergence of income per capita across countries without losing information of possibly heterogeneous behaviour by arbitrarily averaging across countries and time. Alain Desdoigts (Paris Dauphine) in `Changes in the World Income Distribution: A Non-parametric Approach to Challenge the Neoclassical Convergence Argument', and Danny Quah (LSE and CEPR) in `Dynamic Patterns of Growth and Convergence', described econometric methods for studying the dynamics of cross-sectional distributions. In `The Poor Stay Poor: Non-convergence Across Countries and Regions', Fabio Canova and Albert Marcet (Universitat Pompeu Fabra, Barcelona, and CEPR) analysed convergence rates of income per capita for different European regions and proposed a method whereby different convergence rates to different steady states for each cross-sectional unit are possible. When this diversity is allowed, convergence of each unit to its own steady state income level is much faster than previously estimated (greater than 2% per annum), but cross-sectional differences remain. In `Time-series Estimation of Convergence Rates', Ron Miller (Columbia University) also showed that by imposing the restriction that countries' output per capita converge to the same steady state, cross-sectional regressions mismeasure convergence rates. But in `Let's Get Real: A Dynamic Factor Analytical Approach to Disaggregated Business Cycle', Mario Forni (Università di Modena) and Lucrezia Reichlin proposed a framework to estimate the dynamics of large cross-sections and to identify the common dynamic component of output and productivity in manufacturing due to technological innovations.
A second theme of the workshop was validation of business cycle models. In `Dynamic Equilibrium Economies: A Framework for Comparing Models and Data', Francis Diebold, Lee Ohanian and Jeremy Berkovitz (University of Pennsylvania) proposed a framework for assessing agreement between (generally misspecified) dynamic equilibrium models and data. In `Money, Prices, Interest Rates, and the Business Cycle', Robert King (University of Virginia) and Mark Watson (Northwestern University) investigated the relationship of money, prices and interest rates to business cycles, and matched key empirical facts with a real business cycle model, a sticky price model and a liquidity effect model. They concluded that while the models have diverse successes and failures, none can account for the fact that real nominal interest rates are `inverted leading indicators' of real economic activity.
Other themes of the workshop included the analysis of aggregate behavioural outcomes when individuals are allowed to interact: William Brock and Steven Durlauf (University of Wisconsin) presented `Discrete Choice with Social Interactions'; identification in cointegrated systems: Hashem Pesaran and Yongcheol Shin (University of Cambridge) presented `Long-run Structural Modelling'; and <M>purchase behaviour of automobiles in a large microeconomic data set: Orazio Attanasio (University College London and CEPR) presented `Consumer Durables and Inertial Behaviour'.