Taxing the Financially Integrated Multinational Firm

This paper develops a theoretical model of corporate taxation in the presence of financially integrated multinational firms. Under the assumption that multinational firms use some measure of internal loans to finance foreign investment, we find that the optimal corporate tax rate is positive from the perspective of a small, open economy. This finding contrasts the standard result that the optimal-source-based capital tax is zero. Intuitively, when multinational firms finance investment in one country with loans from affiliates in another country, the burden of the corporate taxes levied in the latter country partly falls on investment and thus workers in the former country. This tax exporting mechanism introduces a scope for corporate taxes, which is not present in standard models of international taxation. Accounting for the internal capital markets of multinational firms thus helps resolve the tension between standard theory predicting zero capital taxes and the casual observation that countries tend to employ corporate taxes at fairly high rates.