Gradualism In Tax Treaties With Irreversible Foreign Direct Investment*

Abstract

Bilateral international tax treaties govern the host country taxation for the vast majority of the world's foreign direct investment (FDI). Of particular interest is the fact that the tax rates used under these treaties are gradually falling although the treaties themselves do not specify any such reductions. Since there is no outside governing agency to redress treaty violations, such reductions must be both mutually beneficial and self-enforcing. Furthermore, the optimal tax rates must be less than those initially set, otherwise no reductions would be necessary. To explain such behavior, we model a two-country setting with two-way capital flows. In particular, only part of FDI is immediately reversible. As the extent of irreversibility increases, the likelihood of Pareto optimal tax rates obtaining as a self-enforcing outcome in the initial period is reduced. More modest tax reductions, from the non-treaty levels, are still possible. These limited tax reductions generate an increase in bilateral FDI. As countries increase the stock of capital in one another, further reductions in taxes become self-enforcing. Depending on the extent of irreversibility and asymmetry, Pareto optimal tax rates may be obtainable in the long run. Thus, the amount of inbound investment a country can attract may be related to the commitment to which its outbound investment binds it. This final insight provides an additional rationale for the observed pattern of capital flows in which those countries with the greatest outbound capital flows are also those with the highest inbound flows.JEL Classification: F21, F23, F13, C73.

It’s All in the Timing: Assessing the Impact of Bilateral Tax Treaties on U.S. FDI Activity

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Bilateral Tax Competition and Regional Spillovers in Tax Treaty Formation

“…Third, we add to the theoretical work of Chisik and Davies (2004b) and the broad literature on the political economy of international institutions. Chisik and Davies (2004b) argue that the magnitude of the initial tax reductions under a tax treaty -as compared to the non-treaty case -depends on the extent of irreversibility of FDI. When the initial set of treaty rates is not self-enforcing, more modest tax reductions generate an increase in irreversible bilateral FDI so that further tax reductions become self-enforcing.…”