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Journal of International Economics
Copyright 2006 Elsevier B.V. All rights reserved

Volume 44, Issue 1, Pages 1-180 (1 February 1998)

articles 1 - 10
1.
The overvaluation of purchasing power parity ARTICLE
Pages 1-19
Paul G. J . O'Connell
SummaryPlus | Full Text + Links | PDF (92 K)
2.
Effective protection redux ARTICLE
Pages 21-44
J ames E. Anderson
3.
A pecking order of capital inflows and international tax principles ARTICLE
Pages 45-68
Assaf Razin, Efraim Sadka and Chi-Wa Yuen
4.
Habits and durability in consumption, and the dynamics of the current account ARTICLE
Pages 69-82
Arman Mansoorian
5.
Are windfalls a curse?: A non-representative agent model of the current account ARTICLE
Pages 83-112
Aaron Tornell and Philip R. Lane
6.
Intertemporal substitution in imported durables ARTICLE
Pages 113-133
J aewoo Lee
7.
Tax competition in imperfectly competitive markets ARTICLE
Pages 135-153
Eckhard J aneba
8.
Government finance with currency substitution ARTICLE

Pages 155-172
Anne Sibert and Lihong Liu
9.
Book Review BOOK REVIEW
Pages 173-177
PDF (28 K)
10.
Book Review BOOK REVIEW
Pages 177-180
PDF (14 K)
articles 1 - 10
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Copyright 2006 Elsevier B.V. All rights reserved. ScienceDirect is a registered trademark of Elsevier B.V.
Journal of International Economics 44 (1998) 4568
A pecking order of capital inows and international tax
principles
a ,b,c a d,
*
Assaf Razin , Efraim Sadka , Chi-Wa Yuen
a
Eitan Berglas School of Economics, Tel Aviv University, Ramat Aviv, Tel Aviv 69978, Israel
b
CEPR, 2528 Old Burlington Road, London W1X 1LB, UK
c
NBER, 1050 Massachusetts Avenue, Cambridge, MA 02138, USA
d
School of Economics and Finance, University of Hong Kong, Pokfulam Road, Hong Kong
Received 30 April 1996; received in revised form 31 January 1997; accepted 5 February 1997
Abstract
Even though nancial markets today show a high degree of integration, the world capital
market is still far from the textbook story of high capital mobility. The purpose of this paper
is to highlight key sources of market failure in the context of international capital ows and
to provide guidelines for efcient tax structure in the presence of capital market
imperfections. The analysis distinguishes three types of international capital ows: foreign
portfolio debt investment, foreign portfolio equity investment and foreign direct investment.
The paper emphasizes the efciency of a non-uniform tax treatment of the various vehicles
of international capital ows. 1998 Elsevier Science B.V.
Keywords: Foreign portfolio debt investment; Foreign portfolio equity investment; Foreign
direct investment; Asymmetric information; International taxation
JEL classication: F21; F35; H25; H30
1. Introduction
Even though nancial markets today show a high degree of integration with
large amounts of capital owing across international borders to take advantage of
rates of return and risk diversication benets, the world capital market is still far
*
Corresponding author. Tel.: 1852-2859 1051; fax: 1852-2548 1152; e-mail: cwyuen@econ.hku.hk
0022-1996/ 98/ $19.00 1998 Elsevier Science B.V. All rights reserved.
PI I S0022- 1996( 97) 00009- 3
46 A. Razin et al. / Journal of International Economics 44 (1998) 4568
from the textbook story of perfect capital mobility. As an example of the limited
degree of capital mobility, Tesar and Werner (1995) nd that despite the recent
increase in US equity investment abroad (including investment in emerging stock
1
markets), the US portfolio remains strongly biased towards domestic equity.
Capital immobility has been explained not only by capital controls, but also by
the informational problems associated with international investment. Because of
adverse selection and moral hazard problems, real rates of return across countries
2
are not fully equalized. Capital market regulations and better rules of disclosure as
applied to the information about the protability of domestic rms alleviate some
of these asymmetric information problems. The stationing of managers from the
headquarters of multinational rms at their foreign direct investment establish-
ments in the destination countries is one way to monitor closely the operation of
such establishments, thus circumventing some of these informational problems.
It is well known that, in a perfectly functioning world capital market, the
efcient international tax principle is the residence principle. That is, foreign-
source and domestic-source incomes of residents are taxed at equal rates, and
3
nonresidents incomes are fully tax exempt. In a less-than-perfect world capital
market, the residence principle may no longer be efcient, however, and the
optimal tax structure may also require substantial modications. The failure to
have a tax scheme under which rates of return across countries are equated can
lead to inefcient capital ows across countries. Such investment inefciency
4
results from the interactions of imperfect market and the tax system. The purpose
of this paper is to highlight some key sources of market failure in the context of
international capital ows and to provide guidelines for efcient tax structure in
the presence of capital market imperfections.
In general, capital ows can be in the form of either direct investment or
portfolio investment. Depending on the specic types of securities involved, we
can further subdivide the latter into portfolio debt investment and portfolio equity
investment. In this paper, we attempt to provide a synthesis of these three types of
capital inows, i.e., foreign direct investment (FDI), foreign portfolio debt
investment (FPDI), and foreign portfolio equity investment (FPEI). In particular,
1
They report that equity portfolio ows to West Europe, as a fraction of the capitalized value of the US
equity markets, rose only from 0.3% in 1976 to about 2.2% in 1990. The share invested in Canada
remained fairly constant, at less than 1%.
2
See Obstfeld and Rogoff (1996) (Chapter 6) for a further discussion.
3
The residence principle means that the home country does not levy additional taxes on incomes of
nonresidents over and above what they will have to pay in their country of residence. In case the latter
country offers credits for foreign taxes (that is, for the taxes paid by these nonresidents in the home
country), then the home country will only levy a tax on nonresidents which is equal to what they will
be liable to pay (before the credit) in their country of residence. Therefore, the zero-tax reference
point for nonresidents would mean same tax as the tax levied on nonresidents in the country of
residence.
4
For an application of the interaction between taxation and ination, see Bayoumi and Gagnon (1996).
A. Razin et al. / Journal of International Economics 44 (1998) 4568 47
we would like to examine how the optimal tax treatment of the capital incomes of
both domestic and foreign residents may vary across these three forms of foreign
investment.
According to Claessens (1995), portfolio ows now account for about a third of
the net resource ows to developing countries. To get a sense of their relative
importance, we provide in Table 1 the breakdown among the various kinds of
capital ows. It shows that although equity ows to developing countries have
risen fast in recent years, they are still a much smaller fraction of the total portfolio
ows than debt instruments (such as bonds, certicates of deposits, and commer-
cial papers). There is a striking feature in this table: FDI makes up over half of
private ows, followed by debt nance, while equity ows are relatively
unimportant. Indeed, our model suggests some reasons associated with asymmetric
information as to why this pattern might occur.
This ranking of capital inows is somewhat similar to the pecking order of
capital structure in corporate nance. Recall that, in corporate nance, the
hypothesis maintains that rms prefer internal nance (retained earnings: the
analogue of our FDI) to external nance. If the latter is required, then rms will
issue the safest security (debt: the analogue of our FPDI), and issue new equity
5
(the analogue of our FPEI) only as a last resort. The pecking order of capital
inows can be stated in terms of the magnitudes of those ows in, say, 1995.
Table 1 shows the dominance of FDI ($86.1 billion), compared to private debt
ows ($53.5 billion) and portfolio equity ows ($22.2 billion). In terms of
percentages of total private ows, the numbers are 53.2%, 33.1%, and 13.7%,
respectively.
Table 1
Aggregate net long-term resource ows to developing countries, 19901995 (In billions of US dollars)
1990 1991 1992 1993 1994 1995
Aggregate net resource ows 103.5 129.2 159.7 212.8 212.9 233.3
Ofcial development nance 57.2 64.4 55.3 52.5 44.9 71.5
Ofcial grants 28.8 36.9 31.6 28.5 27.6 27.0
Ofcial loans 28.4 27.5 23.7 24.0 17.3 44.5
Bilateral 13.2 12.6 10.9 9.4 7.1 32.6
Multilateral 15.2 15.0 12.8 14.6 10.2 11.9
Total private ows 46.3 64.8 104.4 160.3 168.0 161.8
Private debt ows 16.2 20.5 42.4 45.8 56.1 53.5
Commercial banks 1.1 3.9 14.3 22.6 15.1 17.0
Bonds 3.1 12.4 12.9 39.9 38.0 33.0
Others 12.0 4.2 15.2 8.5 3.0 3.5
Foreign direct investment 26.3 36.7 47.8 67.6 77.3 86.1
Portfolio equity ows 3.8 7.6 14.2 46.9 34.6 22.2
Source: World Bank, Debtor Reporting System.
5
See Myers (1984) for an explanation based on asymmetric information.
Contrary to the efciency implications of the residence principle in international
taxation emphasized by the literature (e.g., Frenkel et al., 1991; Gordon and
Varian, 1989), our main conclusion is that it is generally efcient to have different
tax treatments for these three types of international capital ows. First, we show
that, for both FPDI and FPEI, deviations from residence-based taxation may be
called for on efciency grounds, while efcient taxation of FDI is compatible with
the residence principle. Second, while it is efcient to subsidize nonresidents on
their investment and to tax domestic corporate income in the case of FPEI (as
shown by Gordon and Bovenberg, 1996), it is still efcient to grant nonresidents a
favorable tax treatment over residents (but not necessarily to actually subsidize
foreign investment) in the case of FPDI. In the latter case, it remains efcient to
tax domestic corporate income and interest income of residents.
The organization of the paper is as follows. Section 2 develops the analytical
methodology employed in this paper. The framework is rst applied to FPDI. The
other kind of portfolio ow, FPEI, analyzed by Gordon and Bovenberg (1996), is
recast in our framework in Section 3. In Section 4, we look at FDI. In Section 5,
we address the issue of pecking order in capital inows using simulation methods.
Conclusions and possible extensions are provided in Section 6.
2. Foreign portfolio debt investment (FPDI)
Throughout this paper, we assume a small, capital-importing country, referred to
as the home country. In this section, it is assumed that capital imports are
channelled solely through borrowing by domestic rms from foreign banks and
other lenders. The economy is small enough that, in the absence of any
government intervention, it faces a perfectly elastic supply of external funds at a
* given risk-free world rate of interest, r . However, as in Stiglitz and Weiss (1981),
a rm may choose to default on its debt if its future cash ow falls short of its
accumulated debt. Therefore, foreign lenders may charge ex ante a higher rate of
interest for domestic borrowers than for foreign borrowers.
In the planning stage of the rst period, the rms commit their investment; but
the actual investment and its funding are delayed to the implementation stage in
6
the rst period. We follow Gordon and Bovenberg (1996) in modelling the risk in
this economy and the asymmetry in information between foreign investors and
domestic investors. Consider a two-period model with a very large number (N) of
ex ante identical domestic rms. Each rm employs capital input (K) in the rst
period in order to produce a single composite good in the second period. For the
sake of simplicity, we assume that capital depreciates fully at the end of the
production process in the second period. Gross output in the second period is equal
to F(K)(1 1e), where F is a production function exhibiting diminishing marginal
6
This is a simple way to represent asymmetric information for lenders in a general equilibrium model.
productivity of capital and e is a random productivity factor. The latter has zero
mean and is independent across all rms. (e is bounded from below by 21, so
that output is always nonnegative.) Given the very large size of N and the
independence of e across rms (which allow for complete diversication of such
idiosyncratic risks through risk pooling), we assume that consumers-investors
behave in a risk-neutral way.
Following Gordon and Bovenberg (1996), we assume that rms make their
investment decisions before the state of the world (i.e., e) is known. Since all rms
face the same probability distribution of e, they all choose the same level of
investment (K). They then issue debt, either at home or abroad, to nance the
investment. At this stage, domestic lenders are better informed than foreign
lenders. There are many ways to specify the degree of this asymmetry in
information. In order to facilitate the analysis, however, we simply assume that
domestic lending institutions, being close to the action, observe e before they
make their loan decisions; but foreign lending institutions, being far away from
the action, do not.
Throughout this paper, we consider three tax instruments: a tax on capital
* income of nonresidents (at the rate t ), a tax on capital income of residents (at the
rate t), and a corporate income tax (at the rate u ). However, with debt nancing, a
corporate tax is essentially a tax on pure prots (rents), and therefore does not
affect corporate behavior (see Appendix A, Section A.1). For notational simplicity,
therefore, we set u equal to zero in this section. In practice, the neutrality of this
tax in the presence of debt nance makes it efcient to set it at a high rate.
Competition among the borrowing rms and among the lending institutions,
both domestic and foreign, ensures that there will be a unique interest rate charged
to all the domestic borrowing rms. Denote this domestic interest rate by r. Given
its investment decision (K), a rm will default on its debt if the realization of its
random productivity factor is low so that its output F(K)(1 1e) is smaller than its
accumulated debt K(1 1r). Thus, there is a cut-off value, e , such that all rms
o
which realize a value of e below e default and all other rms (i.e., rms with
o
e .e ) fully repay their debts. This cut-off level of e is dened by
o
F(K)(1 1e ) 5(1 1r)K (1)
o
Denote the cumulative probability distribution of e by F(.). Then, NF(e ) rms
o
default on their debt while the other N[12F(e )] rms remain solvent.
o
Recall that domestic lenders observe the value of e before making their loan
decisions. Therefore, they will not lend money to a rm that realized a value of e
lower than e . But foreign lenders do not observe e, so that they will advance loans
o
to all rms, since they all look identical to them. Thus, foreign lenders will give
loans to all the NF(e ) would-be bankrupt rms and to some fraction (say, b) of
o
the N[12F(e )] would-be solvent rms. (The other fraction, 12b, of the
o
would-be solvent rms is nanced by domestic lenders). Foreign lenders therefore
receive a total of bN[12F(e )]K(11r) from the solvent rms. Each bankrupt rm
o
can pay back only its gross output, i.e., F(K)(11e). Thus, foreign lenders receive
2 2
a total of NF(e )F(K)(11e ) from the bankrupt rms, where e is the mean value
o
of e realized by the bankrupt rms:
2
e ;E(e/e #e ) (2)
o
2
i.e., e is the conditional expectation of e, given that e #e . For later use, we also
o
1
dene by e the conditional expectation of e, given that e $e :
o
1
e ;E(e/e $e ) (3)
o
2 1
Note that the weighted average of e and e must yield the average value of e that
is:
2 1
F(e )e 1[1 2F(e )]e 5E(e) 50 (4)
o o
2 1
The latter equation also implies that e ,0 while e .0, i.e., the expected value of
e for the bad (good) rm is negative (positive).
Altogether, foreign lenders receive the following sum before domestic taxes are
levied on their total loans (FPDI) made to the domestic rms:
2
A;bN[1 2F(e )]K(1 1r) 1NF(e )F(K)(1 1e ) (5)
o o
where the amount of loans is given by
FPDI 5bN[1 2F(e )]K 1NF(e )K (6)
o o
They thus accumulate a capital income of A2FPDI, which is subject to domestic
* * taxation at the rate t . Net of tax, their FPDI yields A2t (A2FPDI). This
* * amount must be equal to FPDI(11r ), as foreign lenders can earn a return of r
in their own countries. Consequently,
* * FPDI[1 1r /(1 2t )] 5A (7)
The rationale for the above equality is straightforward: foreign lenders must earn a
* * before-tax rate of return of r /(12t ) on their FPDI so that their after-tax rate of
* return remains r , the rate of return they can earn in their own countries. As a
result, the tax that our small economy imposes on their capital income is fully
shifted to the domestic borrowers. Substituting for the values of A and FPDI from
Eqs. (5) and (6), Eq. (7) becomes:
* * hbN[1 2F(e )]K 1NF(e )Kj[1 1r /(1 2t )]
o o
(8) 2
5bN[1 2F(e )]K(1 1r) 1NF(e )F(K)(1 1e )
o o
Let us now examine the debt-nanced investment decision of a representative
rm. This rm invests K in the rst period and expects to receive a gross output of
E[F(K)(11e)]5F(K) in the second period. It also knows that if e turns out to be
smaller than e , it will default on its debt. This rm expects then to pay back its
o
accumulated debt, i.e., K(11r), with probability 12F(e ). It expects to default,
o
2
paying only F(K)(11e ), with probability F(e ). Thus, the expected value of its
o
cash receipts in the second period are
2
F(K) 2[1 2F(e )]K(1 1r) 2F(e )F(K)(1 1e ) (9a)
o o
Maximizing the latter expression with respect to K yields the following rst-order
condition:
[1 2F(e )](1 1r)
o
]]]]] F9(K) 5 (9) 2
1 2F(e )(1 1e )
o
2
Since 11e ,1, it follows that
F9(K) ,1 1r (10)
Knowing that in bad realizations of e (when e #e ) it will not fully repay its
o
loan, the rm invests beyond the level where the unconditionally expected net
marginal productivity of capital (viz., F9(K)21) is just equal to the interest rate
7
(viz., r). Note that, unlike the case of FPEI discussed in Section 3, we cannot
* * assert here that F9.11r /(12t ). However, as expected, because of the default
possibility, foreign lenders charge an ex ante interest rate (r) which is higher than
* * what they will be satised with [r /(12t )], given that the alternative return at
8
* home is r . This difference is a reection of the risk premium.
We abstract from income-distributional equity considerations, implicitly assum-
ing that the government can optimally redistribute income via lump-sum transfers
` a la Samuelson (1956). This means that, with no loss of generality, we may
assume that there is one representative individual-consumer in the economy. She
has an initial endowment of I in the rst period and I in the second period. She
1 2
consumes c in the rst period and c in the second period. Her saving earns an
1 2
9
after-tax rate of return of (12t)r, so that her net discount factor is equal to
21
q ;[1 1(1 2t)r] or t ;(rq 21 1q) /rq (11)
We denote her net wealth (i.e., the present value of her after-tax lifetime income)
by W. As we assume that the government can levy lump-sum taxes, it essentially
7
Eaton and Gersovitz (1989) consider related interactions in the context of foreign investment with
sovereign debt.
8
* * More specically, one can show (by substituting Eq. (1) into Eq. (8)) that [11r /(12t )] /(11r)5
2
* a1(12a)(11e ) /(11e ), where a5b[12F(e )] / hF(e )1b[12F(e )]j. Thus, [11r /(12
o o o o
2 2
* t )](11r) is a weighted average of 1 and (11e ) /(11e ). Since (11e ) /(11e ),1, it follows that
o o
* * * * 11r /(12t ),11r. This implies that r /(12t ),r.
9
Her saving is either deposited with domestic intermediaries (banks, etc.) that channel it to the rms or
in government bonds that also yield before-tax rate of return of r. Assuming, as we are, that the
government can levy lump-sum taxes in each period to balance its budget makes these bonds
superuous.
controls W. The consumer budget constraint is given by c 1qc 5W. The
1 2
maximization of her utility subject to this constraint gives rise to an indirect utility
function, v(W,q), and consumption demand functions, c (W,q) and c (W,q), in the
1 2
rst and second periods, respectively.
In the rst period, the economy faces a resource constraint, stating that FPDI
must sufce to cover the difference between domestic investment (viz., NK) and
national savings (viz., I 2c (W,q)2G , where G is public consumption nanced
1 1 1 1
through lump-sum taxes):
FPDI 5NK 2[I 2c (W,q) 2G ] (12)
1 1 1
No matter what taxes are levied by the home country on FPDI, foreigners will be
* able to extract from the home country an amount of 11r units of output in the
second period for each unit that they invest in the rst period. Therefore, the home
10
country faces the following second-period budget constraint:
* NF(K) 2(1 1r )FPDI 1I 5c (W,q) 1G (13a)
2 2 2
* That is, gross national output [NF(K)2(11r )FPDI] and the initial endowment
(I ) must sufce to support private consumption (c ) and public consumption (G ).
2 2 2
Employing Eq. (12), one can rewrite Eq. (13a) in present value terms as
* * * I 1I /(1 1r ) 1NF(K) /(1 1r ) 5c (W,q) 1c (W,q) /(1 1r ) 1G
1 2 1 2 1
* 1G /(1 1r ) 1NK (13)
2
We are now in a position to formulate an optimal tax policy for the government.
Since we concentrate on tax policy, we may consider the public expenditure
variables (namely, G and G ) as exogenous, with no loss of generality. (This
1 2
means that our results are valid whether or not the government expenditure policy
is optimal.) The aim of our benevolent government is to maximize the utility,
v(W,q), of the representative individual. There are nine endogenous variables: K, r,
* e , b, t , t, q, W and FPDI. There are also seven constraints that combine real
o
resource constraints (namely, Eqs. (12) and (13)), market equilibrium constraints
(namely, Eqs. (1), (6), (8)), an optimizing-agent behavioral constraint (namely, Eq.
(9)), and a denition of the consumers discount factor (namely, Eq. (11)).
It turns out, however, that the optimal policy problem can be simplied a great
deal. To accomplish this, notice that the objective function [v(W,q)] and the
present-value resource constraint Eq. (13) contain only three endogenous (control)
variablesW, q and K. Thus, we can rst choose these three variables so as to
maximize the individual utility function, subject to the present-value resource
constraint Eq. (13). The Lagrangean expression for this optimization problem is
10
Note that the expected value of output is E[NF(K)(11e)]5NF(K), since E(e)50.
L 5v(W,q)
* * * 1l[I 1I /(1 1r ) 1NF(K) /(1 1r ) 2c (W,q) 2c (W,q) /(1 1r )
1 2 1 2
* 2G 2G /(1 1r ) 2NK] (14)
1 2
where l$0 is a Lagrange multiplier. Having solved for the optimal values of W, q,
and K, we can then employ the remaining six constraints Eqs. (1), (6), (8), (9),
(11), and (12) to solve for the optimal values of the remaining six control
* variables (i.e., r, e , b, t , t, and FPDI).
o
There are three main policy conclusions that we wish to emphasize here. First,
the optimal level of investment is such that the expected net marginal product of
* capital (that is, F9(K)21) is equal to the world rate of interest (that is, r ):
* F9(K) 51 1r (15)
* (Note that it then follows from Eq. (10) that r.r , i.e., the domestic rate of
interest stays above the world rate of interest.) Eq. (15) is essentially a corollary of
the familiar aggregate production efciency theorem of welfare economics: A
small open economy should equate all of its marginal rates of transformation to the
corresponding world prices. In our case, there is only one marginal rate of
transformation [the intertemporal rate F9(K)] and the corresponding world price is
* 11r . The proof of Eq. (15) follows immediately upon differentiating L in Eq.
(14) with respect to K and setting the derivative equal to zero.
Second, the optimal policy calls for a tax on capital income of residents, i.e.,
t .0. To prove this, observe that with the availability of lump-sum, nondistortion-
ary taxes, it is optimal to follow the Pareto-efciency rule of equating the marginal
21
rate of substitution between present and future consumption (q ) to the gross
* marginal product of capital (F9(K)511r ):
21
* q 51 1r (16)
(See also Appendix A, Section A.2 for a formal proof.) Substituting Eq. (16) into
Eq. (11) yields
* 1 1(1 2t)r 51 1r
* Given r ,r, this implies that:
* t 51 2r /r .0 (17)
* Third, the rate of tax on capital income of nonresidents (t ) must be lower than
the rate of tax on residents capital income (t). To prove this, substitute Eq. (1)
into Eq. (8) to get:
* * hbN[1 2F(e )]K 1NF(e )Kj[1 1r /(1 2t )]
o o
2 21
5bN[1 2F(e )]K(1 1r) 1NF(e )K(1 1r)(1 1e )(1 1e )
o o o
Rearranging terms yields
2
b[1 2F(e )] 1F(e )(1 1e ) /(1 1e ) * * 1 1r /(1 2t )
o o o
]]]]] ]]]]]]]]]]] 5 ,1
1 1r b[1 2F(e )] 1F(e )
o o
2
The inequality follows from e ,e . By Eq. (17), this implies that
o
* * t ,1 2r /r 5t (18)
* In fact, t may even be negative. It is worth emphasizing that the two tax
* instruments (t and t ) support a rst-best allocation.
* The rationale behind the optimal tax policy (namely, t .0, and t ,t) is quite
straightforward. First, given the possibility of default, in which case rms do not
fully repay their loans, they tend to overinvest relative to the domestic interest rate
that they face: the expected net marginal product of capital (F9(K)21) is driven
below the domestic rate of interest (r). (See Eq. (10).) In order to ensure that rms
do not drive their expected net marginal product of capital below the world rate of
* interest (r ), the government must positively tax domestic interest so as to
maintain the domestic rate of interest above the world rate of interest. Second, by
the small country assumption, any tax levied on foreign lenders must be shifted
fully to domestic borrowers. Therefore, foreign lenders must earn an expected
* * return of r /(12t ) on their loans. Since the interest cannot be fully recouped in
the case of default, they must initially charge domestic borrowers a higher rate of
* * interest than r /(12t ). As a result, the domestic rate of interest (r) which is
* charged by all lenders, both foreign and domestic, must be higher than r /(12
* * * * * t ). In other words, r.r /(12t ), or r(12t ).r . This means that if the
* nonresident tax rate (t ) were to be applied to residents, their net of tax interest
* * rate [(12t )r] would have been higher than the world rate of interest (r ). But
Pareto-efciency requires that the net of tax domestic interest rate [(12t)r] be
equal to the world rate of interest. Therefore, residents must be levied a higher tax
rate on their capital income than nonresidents.
3. Foreign portfolio equity investment (FPEI)
In this section, we assume that capital ows are channelled solely through
portfolio equity investment, FPEI. Ofcially, foreign portfolio equity investment is
dened as buying less than a certain small fraction (say, 1020%) of shares of a
rm. However, from an economic point of view, the critical feature of FPEI is the
lack of control of the foreign investor over the management of the domestic rm,
because of the absence of foreign managerial inputs. For our purposes, we shall
simply assume that foreign investors buy shares in existing rms without
exercising any form of control or applying its own managerial inputs.
This is also why we assume, in complete analogy to the information asymmetry
assumed in the model of FPDI, that foreign investors do not observe the actual
value of e when they purchase shares in existing rms. Domestic investors, on the
other hand, do observe the value of e at that stage. As before, we continue to
assume that e is not known to the rm or to anyone else when capital investment
is made.
This is precisely the model which was developed by Gordon and Bovenberg
(1996). For the sake of completeness, we employ the analytical apparatus that we
developed in Section 2 in order to derive optimal policy prescriptions in this case.
These policy prescriptions are different than those obtained in the Section 2, in the
case of FPDI.
As before, all rms choose the same level of K in the rst period, since e is
unknown to them at this stage. All rms are originally owned by domestic
investors who equity-nance their capital investment K. After this capital
investment is made, the value of e is revealed to domestic investors, but not to
foreign investors. The latter buy shares in the existing rms at a total amount of
FPEI. They expect their investment to appreciate in the second period to an
* * * amount of FPEI[11r /(12t )], as the capital gains are taxed at the rate t and
* foreign investors must earn a net-of-tax rate of return of r , which is the
alternative rate of return they can earn when they invest in their home countries.
Being unable to observe e, foreign investors will offer the same price for all
rms reecting the average productivity for the group of low productivity rms
they purchase. On the other hand, domestic investors who do observe e will not be
willing to sell at this price the rms which experienced high values of e.
(Equivalently, domestic investors will outbid foreign investors for these rms.) As
before, there will be a cutoff level of e, say e (possibly different than the one
o
under FPDI), such that all rms which experience a lower value of e than the
cutoff level will be purchased by foreigners. All other rms will be retained by
domestic investors. The cutoff level of e is then dened by
2
* * [(1 2u )F(K)(1 1e )] / [1 1r /(1 2t )]
(19)
5[(1 2u )F(K)(1 1e )] / [1 1(1 2t)r]
o
The value of a typical domestic rm in the second period is equal to its gross
11
output minus corporate prot taxes, i.e., (12u )F(K)(11e). Because foreign
equity investors will buy only those rms with e #e , the expected second-period
o
2
value of a rm they buy is (12u )F(K)(11e ), which they then discount by the
* * factor 11r /(12t ) to determine the price they are willing to pay in the rst
period. At equilibrium, this price is equal to the price that a domestic investor is
willing to pay for the rm which experiences a productivity value of e . The cutoff
o
11
Strictly speaking, the corporate tax rate (u ) applies to prots, F(K)2K, i.e., output minus
depreciation, and not to output, F(K). However, there is a one-to-one relation between the tax base
F(K)2K and the tax base F(K). We therefore follow Gordon and Bovenberg (1996) in levying a tax at
a rate u on output, F(K), which simplies the notation a great deal.
price is equal to the output of the rm, minus corporate prot taxes, discounted at
the rate domestic investors can earn on bonds issued by their own government, i.e.,
12
(12t)r. This explains the equilibrium condition Eq. (19). Rearranging terms, Eq.
(19) reduces to:
2
* * (1 1e ) / [1 1r /(1 2t )] 5(1 1e ) / [1 1(1 2t)r] (19)
o
2
As e ,e , an equilibrium with both foreigners and residents having nonzero
o
holdings in domestic rms requires that the foreigners net-of-tax rate of return
* * [r /(12t )] be lower than the residents net-of-tax rate of return [(12t)r]. In
some sense, this means that foreign investors are overcharged for their purchases
of domestic rms. They outbid domestic investors that are willing to pay on
2
average only a price of (12u )F(K)(11e ) / [11(12t)r] for the low productivity
rms. Since there are F(e )N rms purchased by foreign investors, the amount of
o
FPEI is given by
2
* * FPEI 5[F(e )N(1 2u )F(K)(1 1e )] / [1 1r /(1 2t )] (69)
o
Consider now the capital investment decision of the rm that is made before e
becomes known. The rm seeks to maximize its market value, net of the original
investment (K). With a probability F(e ), it will be sold to foreign investors, who
o
2
* * pay (12u )F(K)(11e ) / [11r /(12t )]. With a probability [12F(e )], it will
o
1
be sold to domestic investors, who pay on average (12u )F(K)(11e ) / [11(12
t)r]. Hence, the rms expected market value, net of the original capital
investment, is
2
* * 2K 1F(e )(1 2u )F(K)(1 1e ) / [1 1r /(1 2t )]
o
1
1[1 2F(e )](1 2u )F(K)(1 1e ) / [1 1(1 2t)r] (9a9)
o
Maximizing this expression with respect to K yields the following necessary and
sufcient rst-order condition:
2
* * F(e )(1 2u )F9(K)(1 1e ) / [1 1r /(1 2t )]
o
1
1[1 2F(e )](1 2u )F9(K)(1 1e ) / [1 1(1 2t)r] 51 (99)
o
Unlike the debt-nance case of Section 2, the corporate tax in this equity-nance
case does affect the rms behavior, as expected and as can be seen immediately
from Eq. (99). Since the rm knows, when making its capital investment decision,
that it will be sold to foreign investors at a premium under low-productivity
events, it tends to overinvest relative to the net-of-tax rate of return to domestic
12
Here again, government bonds are superuous, but we maintain them in order to establish a
possibility for the consumer to lend money and assign some meaningful value to a net-of-tax domestic
interest rate, namely (12t)r.
investors and underinvest relative to the net-of-tax rate of return to foreign
investors:
* * 1 1r /(1 2t ) ,(1 2u )F9(K) ,1 1(1 2t)r (109)
(A formal proof of these inequalities is provided in Appendix A, Section A.3.)
The remaining equations of the FPEI model are essentially similar to those of
the FPDI model in Section 2. Eq. (11), which denes the consumers discount
factor, stays intact. In Eq. (12), we have to replace FPDI by FPEI. Accordingly,
FPEI 5NK2[I 2c (W,q) 2G ] (129)
1 1 1
Eq. (13), the present-value resource constraint, remains unchanged.
The public nance objective is again to maximize v(W,q), subject to six
constraints: Eqs. (19), (69), (99), (11), (129), (13). There are nine control
* (endogenous) variables: K, r, e , t , t, u, q, W and FPEI. Note that we have the
o
same number of variables as before, but one fewer constraint. This is not
surprising because t and r cannot be uniquely determined. Since the only
lending/ borrowing activity here is carried out between the government and the
(homogeneous) household sector, what matters is the net-of-tax rate of interest,
i.e., (12t)r, and not t and r separately. An analytical procedure similar to that in
Section 2 is also applied here.
13
The optimal policy prescriptions are as follows:
(1) As in the FPDI case, the expected net (of depreciation) marginal product of
* capital (F9(K)21) must be equated to the world rate of interest (r ) so that
* F9(K) 51 1r (159)
This means that capital investment per rm is identical in the two cases (FPDI and
FPEI).
(2) The optimal policy calls for a subsidy to foreign investment, i.e.,
* t ,0 (189)
To get this, observe rst that, as in Section 2, one can show that 11(12t)r511
* * * r (Eq. (16)). Substituting this equality into Eq. (109) yields 11r /(12t ),11
* r , which implies Eq. (189).
(3) It is optimal to levy a positive tax on corporate income, i.e.,
u .0 (20)
* To see this, substitute Eqs. (15) and (16) into Eq. (109) to get (12u )(11r ),11
* r , which implies that u .0.
Indeed, by using the optimal tax instruments, we obtain again the rst-best
13
These are precisely the policy prescriptions derived by Gordon and Bovenberg (1996).
allocation, as in Section 2. Thus, the volume of optimal foreign investment is
identical in both cases: FPDI5FPEI. The difference lies in the mix of policy tools:
(a) In the debt-ow case, the corporate income tax (u ) is a neutral tax that could
be set at any (arbitrarily high) level. In the equity-ow case, we nd a well-dened
tax u .0.
(b) In the debt-ow case, the capital income of residents should be positively
taxed (i.e., t .0). In the equity-ow case, t is irrelevant.
* (c) In the debt-ow case, the tax on capital income of nonresidents (t ) should
* be lower than the corresponding tax on residents (t), i.e., t ,t. In the equity-ow
* case, foreign investment should actually be subsidized, i.e., t ,0, while t is
irrelevant.
In concluding the discussion of the two indirect ows of capital, let us
emphasize that the real system with xed corporate, domestic and foreign
investment tax rates ts closely the rst-best equilibrium that is achieved in the
full information setup.
4. Foreign direct investment (FDI)
In this section, we consider international capital ows in the form of foreign
direct investment (FDI). In a formal sense, a foreign acquisition of shares in
domestic rms is classied as a foreign direct investment when the shares acquired
exceed a certain fraction of ownership (say, 1020%). From an economic point of
view, we look at FDI not just as a purchase of a sizable share in a company but,
more importantly, as an actual exercise of control and management. We thus view
FDI as a tie-in activity, involving an inow of both capital and managerial inputs.
This combination of inputs accords foreign investors with the same kind of
home-court advantage (with respect to, say, business information) that domestic
investors have, but foreign portfolio (debt and equity) investors lack. Specically,
foreign direct investors can learn about the state of the world (i.e., the realization
of the productivity factor e) at the same time as domestic investors. The
asymmetric information feature of the two preceding sections is thus circumvented
14
by FDI.
A foreign direct investor purchases a domestic company from scratch, at the
greeneld stage, i.e., before any capital investment has been made. In fact, the
14
Caballero and Hammour (1996) identify a potentially important cost associated with foreign direct
investment. They view FDI as a specic relation between domestic and foreign inputs which, to the
extent that FDI is irreversible, creates specic quasi-rent that may not be divided ex post according to
the parties ex ante terms of trade. The ex post bilateral monopoly, known in the literature as the
hold-up problem, requires prior protection through comprehensive and enforceable long-term
contracts. The problem is that such contracts are not easily implementable in actual practice. The
consequent under-supply of FDI may warrant favorable tax treatment by the host country. Furthermore,
the shortage of FDI is exacerbated by the existence of technological spillovers.
foreign direct investor makes the capital investment decision herself and imports a
* * * * bundle of inputs, K and M , where K is capital input and M is a managerial
g
* * input. Gross output in the second period is (11M ) F(K )(11e), where 0,g ,
* 1. If J rms are purchased by the foreign direct investors, for a price of V per
rm, then the total volume of FDI is given by
* * FDI 5J(K 1V ) (21)
(Recall that foreign direct investors bring to the rm which they purchase their
* own capital input K .)
Gross output of a domestically owned rm, which invests a capital input of K,
continues to be F(K)(11e). As foreign investors and domestic investors are
equally informed, the expected value of e is equal for both investors, i.e., zero.
If a rm is sold to foreign direct investors, its expected second-period cash
15
receipts, net of corporate taxes, will be
g
* * * * * (1 2u )[(1 1M ) F(K ) 2w M /(1 2t )]
M M
which, in the rst period, is worth to the foreign investors
g
* * * * * * (1 2u )[(1 1M ) F(K ) 2w M /(1 2t )] / [1 1r /(1 2t )]
M M
* * where w is the world wage of managerial inputs and t is the tax rate levied by
M M
* the home country on nonresident managers. (Notice that the tax t levied by the
M
small home country on nonresident managers is again shifted fully back to itself.)
Subtracting from the last expression, the original capital investment yields the
following as the market value of a rm purchased by foreign direct investors:
* * V 5 2K
g
* * * * * * * 1(1 2u )[(1 1M ) F(K ) 2W M /(1 2t )] / [1 1r /(1 2t )]
M M
(22)
Similarly, the market value of a domestically owned rm is given by
V5 2K 1(1 2u )F(K) / [1 1(1 2t)r] (23)
Thus, a rm is sold to foreign direct investors if Eq. (22) exceeds Eq. (23) (when
* * K , M and K are optimally chosen). At an equilibrium with a positive number of
rms owned by both types of investors, we must therefore have equality between
Eqs. (22) and (23), i.e.,
* * V 5 2K
g
* * * * * * * 1(1 2u )[(1 1M ) F(K ) 2w M /(1 2t )] / [1 1r /(1 2t )]
M M
5 2K 1(1 2u )F(K) / [1 1(1 2t)r] 5V (10)
15
We continue to ignore depreciation in calculating the corporate tax base with no loss of generality.
Optimizing behavior on the part of all rms (i.e., maximization of Eq. (22) with
* * respect to K and M and maximization of Eq. (23) with respect to K) yields
g
* * * * (1 1M ) F9(K ) 51 1r /(1 2t ) (9a0)
g21
* * * * g(1 1M ) F(K ) 5w /(1 2t ) (9b0)
M M
and
(1 2u )F9(K) 51 1(1 2t)r (9c0)
The total effective tax rate levied by the home country on capital income of
* nonresidents at both the corporate and individual levels, denoted by t , is dened
implicitly by:
* * * * 1 1r /(1 2t ) ;[1 1r /(1 2t )] /(1 2u )
In this case of fully symmetric information, the optimal scal policy conclusions
are quite straightforward (formal proofs are relegated to Appendix A, Section
A.4).
First, it will still be optimal to follow the aggregate production efciency rule,
which requires that
g
* * * (1 1M ) F9(K ) 51 1r (15a0)
and
g21
* * * g(1 1M ) F(K ) 5w (15b0)
M
Comparing Eq. (15a0) to Eq. (9a0) and Eq. (15b0) to Eq. (9b0) implies that
nonresidents incomes should not be taxed, i.e.,
* * t 5t 50 (24)
M
Thus, the residence principle of international taxation should be followed in this
case. Foreign direct investment, which circumvents the asymmetric information
distortion, restores the efciency of the residence-based taxation on international
16
ows of factors of production. (See Frenkel et al., 1991.)
Note also that aggregate production efciency requires that the net of deprecia-
tion marginal product of capital of the non-FDI domestic rm (F9(K)21) should
* be equal to the world rate of interest (r ), i.e.,
* F9(K) 51 1r (15c0)
16
It is worth emphasizing that this strong result of no taxation of nonresidents income holds whether
or not the government can levy lump-sum taxes or transfers, i.e., whether or not a rst-best allocation is
attained. Thus, even when the government must resort to distortionary taxation on residents incomes
(namely, t .0) in order to meet its revenue needs, it will still be efcient to exempt nonresidents.
Comparing Eq. (15a0) to Eq. (15c0) implies that due to the advantage afforded by
foreign managerial inputs, the rm owned by the foreign direct investor nds it
protable to carry larger capital investment than the domestically owned rm, i.e.,
* K .K. Also, comparing Eq. (15c0) to Eq. (9c0) implies that domestic tax rates
must be set in such a way so as to satisfy:
* 1 1(1 2t)r 5(1 1r )(1 2u ) (25)
That is, there should be no tax distortions on corporate prots of non-FDI rms.
(Recall from Eq. (9c0) that the term on the left-hand side of Eq. (25) is the
corporate return factor, net of all taxes, both at the individual level and the
corporate level.)
In addition, aggregate production efciency requires that the number of rms
sold to foreign direct investors is such that the net economic value of a rm at the
hands of foreign direct investors must be equal to the net economic value of a rm
remaining under domestic control and management, that is:
g
* * * * (1 1M ) F(K ) 2w M F(K)
M
]]]]]]]] ]] * 2K 5 2K (26)
* * 1 1r 1 1r
Indeed, when the residence principle of international taxation is fullled and the
domestic tax rates are set as in Eq. (25), then Eq. (26) must also be satised. This
can be seen by substituting the optimal tax rules Eqs. (24) and (25) into Eq. (10)
* * and comparing the outcome to Eq. (26). (Recall also that 11r /(12t );
* * [11r /(12t )] /(12u ).)
* To avoid distortions on the consumption side (i.e., to achieve MRS511r ), we
17
* * must have 11(12t)r511r . Hence, (12t)r5r . Then, Eq. (25) implies that
u50.
5. A pecking order?
The main policy conclusions for the three forms of capital inows are
summarized in Table 2. The table emphasizes the efciency of a non-uniform
treatment of the various vehicles of international capital ows. In order for the
three kinds of capital inows to efciently co-exist, their tax treatment cannot be
identical. For sure, the co-existence of the three regimes is only a by-product of
optimal tax policies, which are governed by the objective of national welfare
maximization.
In the previous sections, we analyze separately each nancing vehicle to
determine the set of taxes that will be selected by the host government in order to
maximize its national welfare. Analytical solutions of the intensity of capital
17
Since there is no borrowing/ lending except from/ to the government, t and r are not relevant
* separately. All it matters is that (12t)r5r , as in the FPEI case.
Table 2
Tax treatment of foreign investment
Type of tax Type of foreign investment
Foreign portfolio Foreign portfolio Foreign direct
debt investment equity investment investment
Corporate tax (u ) High Positive Zero
Tax on capital income Positive Irrelevant Irrelevant
of residents (t)
Tax on capital income Lower than on residents Negative Zero
* * of nonresidents (t or t )
inows and the levels of welfare are not easy to obtain. We therefore resort to
numerical simulations to evaluate their magnitudes.
We have shown before that once the optimal tax system is implemented, the
FPDI and FPEI solutions will be identical in equilibrium. Furthermore, in the
* limiting case of FDI with g50 (so that M 50)the case with identical
technology as in the FPDI and FPEI regimes and without informational asymmetry
problems, the optimal tax system will yield the same allocations as in the other
two cases as well. As a result, the amounts of capital inows and the levels of
welfare will be the same across all three regimes, and the pecking order is
18
destroyed. However, an indirect indication of the pecking order is reected by
the ranking of the optimal tax rates on the capital income of non-residents reported
at the bottom of Table 2. That is, the tax rates are zero in the case of FDI, lower
than on residents in the case of FPDI, and strictly negative in the case of FPEI.
To get some insight about a more direct pecking order in the absence of
national-welfare-maximizing taxes, we now assume away the government (spend-
ing and taxes). In Table 3, we describe the results from simulations which compare
the three regimes that are assumed to be different only along the asymmetric
information dimension (and not the technology dimension). In other words, we use
the same set of fundamental preference, technology, and endowment parameter
values in all the scenarios. The utility function is isoelastic, the production
function is Cobb-Douglas, and the probability distribution of the productivity
parameter (e) is uniform. Details about the choice of parameter values are
described in Appendix B.
18
Our notion of pecking order is somewhat different from the classic notion of pecking order in
corporate nance. The classic notion considers a single investment. Information asymmetry exists since
the manager is better informed than new entrants. As a result, the manager prefers to rely on retained
earnings. If these funds are insufcient, debt is preferred to equity nance since the latter is more
expensive: the choice of equity nance sends the potential signal that the manager thinks the rms
shares are overvalued. (See Myers, 1984.) In contrast, our setup assumes away informational
asymmetry between the manager and the domestic investors. It does, however, assume an informational
asymmetry between domestic and foreign investors. In the case of FDI, where the information
problems are circumvented through direct monitoring by foreign managers, this asymmetry vanishes.
Table 3
Ranking of FDI, FPDI and FPEI
Capital flows Saving Capital
]]] ]] ]] Welfare
output output output
a
FDI 0.171 20.106 1 0.064
FPDI 0.027 0.034 0.9984 0.061
FPEI 0 0.051 0.9979 0.051
a
* With g5M 50.
We rig the parameters in such a way as to provide a sharp contrast among the
three kinds of capital inows. In the case of FDI, all the investment and production
activities in the domestic economy are carried out by foreign rms; whereas, in the
case of FPEI, we have another extreme corner solution where there is no foreign
involvement in investment activities at home (i.e. autarky). The FPDI represents
an intermediate case where a portion of investment is nanced by foreign debt and
the rest by domestic savings. The pecking order for capital ows as a proportion of
GDP is: 17.1% for FDI, 2.7% for FPDI, and 0% for FPEI. As expected,
FDIwhich circumvents the informational problemsyields the highest level of
welfare (normalized to unity), the other two vehicles of nancingwhich suffer
from the informational problemsare welfare-inferior to FDI: FPDI (0.9984) and
FPEI (0.9979). Thus, the pecking order in terms of welfare ranking is also
preserved.
6. Conclusion
This paper considers optimal tax design by a small host country which is
characterized by asymmetric information problems: domestic investors are better
or earlier informed about the protability of investment projects than are
prospective foreign investors. We sequentially analyze debt, equity, and direct
investment nance. For each nancing vehicle, we determine the set of taxes that
will be selected by the host government in order to maximize welfare in the host
country. The main nding is that the conguration of optimal taxes differs
markedly across these forms of nance.
Among other conclusions of our paper, the reader may query whether subsidies
should be provided to the ignorant. The foreign investors in our treatment have no
incentive to invest in information gathering since they receive a rate of return on
their investment which is the same as the rate of return they obtain elsewhere. In
the political correctness terminology, they are not informationally challenged,
especially because there is a cost of acquiring information in reality.
On political economy grounds, one may also object to our conclusion of
providing subsidies to the foreign investors. Although the political economy
equilibrium is likely to be dominated by domestic pressure groups, it must
incorporate the efciency costs associated with the asymmetric information
problems that we highlight in this paper. This problem is reected in the
under-supply of foreign capital, which the subsidies help to alleviate.
If we take it for granted that foreign capital should be subsidized, do we actually
observe subsidization of capital inows in the real world? There is some evidence
that regional governments and states compete for foreign capital through subsidies.
But whether or not capital inows effectively receive favorable tax treatment in
the real world should, in our view, be a subject for future inquiries.
The afore-mentioned issues aside, our analysis in this paper is by no means
complete. It provides some guidelines for optimal international tax principles
without fully characterizing the optimal tax rates and allocations. It will be
illuminating to compute the latter through simulations.
Since our analysis is conned to a small open economy, one may wonder
whether the results in this paper will carry over straightforwardly to large open
economies? In the large economies case, will international policy coordination
necessarily welfare-dominate policy competition? Will there be situations under
which policy cooperation among benevolent governments may be undesirable as
in Kehoe (1989)? Will the conclusions depend on the timing convention of the tax
policies: in particular, whether taxes are set before or after investment decisions
are made by the domestic and/ or foreign investors?
Obviously, our paper abstracts from discussing many related issues in the
taxation of foreign investment. One such issue is the existence of insured domestic
nancial intermediaries, as in the case of the central bank (or the government)
bailing out troubled commercial banks and savings and loans institutions. If these
intermediaries are not excluded from international transactions, the essentially
domestic moral hazard problem may also plague international capital inows. This
problem, however, calls for applying different policy instruments than the ones
analyzed in this paper.
In addition to informational asymmetry, there are other differences between
foreign portfolio investment (FPI) and foreign direct investment (FDI). One
noticeable difference lies in the degree of reversibility of these investment
decisions: while FDI is almost irreversible, FPI is not. How would this difference
in lock-in effects affect the time consistency of the Ramsey-efcient tax policies
and international tax principles?
If we broaden the denition of investment to include human capital, then the
issues of whether to subsidize foreign students and to tax more heavily foreign
labor become relevant. Will the optimal tax implications depend on whether
19
knowledge spillovers are generated by the inow (or outow) of workers. These
important issues and the ones mentioned in the paragraphs above are left for future
research.
19
Some of these issues are dealt with in Razin and Yuen (1996).
Acknowledgements
The paper was written while the authors were visiting the International
Monetary Fund: Razin and Yuen at the Research Department and Sadka at the
Fiscal Affairs Department. We thank Tamim Bayoumi, Jon Eaton, Liam Ebrill,
Robert Feenstra (Ed.), Se-jik Kim, John Montgomery, Vito Tanzi, Kei-Mu Yi,
participants in the 1996 NBER Summer Institute at Cambridge and the 1996
Congress of the International Institute of Public Finance at Tel Aviv, and an
anonymous referee for useful comments.
Appendix A
Proof that the corporate income tax is non-distortionary in the case of FPDI
Eq. (9a) describes the expected (second-period) cash receipts of the rm before
any corporate taxes. If a corporate tax u is levied on the rm, and assuming full
loss offset, the expected tax liability will be:
2
uhF(K) 2K 2[1 2F(e )]Kr 2F(e )[F(K)(1 1e ) 2K]j (A1)
o o
The tax is levied on net output (i.e., F(K)2K, allowing for depreciation), minus
interest expenses which are either Kr with probability [12F(e )] in the no-default
o
2
case or F(K)(11e )2K with probability F(e ) in the default case. Subtracting
o
Eq. (A1) from Eq. (9a) yields the net-of-tax expected cash receipts of the rms:
2
(1 2u )hF(K) 2[1 2F(e )]K(1 1r) 2F(e )F(K)(1 1e )j (A2)
o o
Since the after-tax objective function of the rm (namely, Eq. (A2)) differs from
its pre-tax objective function (namely, Eq. (9a)) only by a multiplicative factor
(namely, 12u ), it follows that, with a full loss offset, the tax has no effect on the
rms behavior.
Proof of Eq. (16)
Differentiate L (Eq. (14)) with respect to W and q, to get:
* v 2lc 2lc /(1 1r ) 50 (A3)
1 11 21
and
* v 2lc 2lc /(1 1r ) 50 (A4)
2 12 22
where v 5v/ W, v 5v/ q, c 5c / W, c 5c / q, c 5c / W and c 5
1 2 11 1 12 1 21 2 22
c / q. Substituting Roys identity
2
v 5 2c v (A5)
2 2 1
and the Hicks-Slutsky equations
c 5c 2c c i 51, 2 (A6)
i 2 i 2 2 i 1
where c is the Hicks-compensated derivative of c with respect to q, into Eq.
i 2 i
(A4), yields
* * 2c [v 2lc 2lc /(1 1r ) 2lc 2lc /(1 1r ) 50 (A7)
2 1 11 21 12 22
Substitute Eq. (A3) into Eq. (A7) to get
* c 1c /(1 1r ) 50 (A8)
21 22
where use is made of the symmetry of the Hicks-substitution effects: c 5c .
12 21
Substituting the Eulers equation,
c 1qc 50 (A9)
21 22
21
* into Eq. (A8) implies q 511r .
Proof of Eq. (109)
2
* * Substitute for (11e )[11r /(12t )] from Eq. (19) into Eq. (99) and rearrange
terms to get:
1
F(e )(1 2u )F9(K)(1 1e ) 1[1 2F(e )](1 2u )F9(K)(1 1e )
o o o
(A10)
51 1(1 2t)r
2
Since 11e .11e , it follows from Eq. (A10) that
o
2 1
1 1(1 2t)r .(1 2u )F9(K)hF(e )(1 1e ) 1[1 2F(e )](1 1e )j
o o
5(1 2u )F9(K)
because the term in the curly brackets is equal to 1 (see Eq. (4)). This proves the
inequality in the right end of Eq. (109). Substitute for 11(12t)r from Eq. (19)
into Eq. (99) and rearrange terms to get:
2 1
F(e )(1 2u )F9(K)(1 1e ) 1[1 2F(e )](1 2u )F9(K)(1 1e )
o o
2 21
* * 3(1 1e )(1 1e ) 51 1r /(1 2t ) (A11)
o
2 21
Since (11e )(11e ) ,1, it follows from Eq. (A11) that
o
2 1
* * 1 1r /(1 2t ) ,(1 2u )F9(K)hF(e )(1 1e ) 1[1 2F(e )](1 1e )j
o o
5(1 2u )F9(K)
which completes the proof of Eq. (109).
Proof of Eq. (26)
* * The objective of the government is to choose K, K , M , q, W and J so as to
maximize v(W,q), subject to the present-value resource constraint:
g
* * * * * I 1I /(1 1r ) 1(N 2J)F(K) /(1 1r ) 1J(1 1M ) F(K ) /(1 1r )
1 2
* * * * * 2Jw M /(1 1r ) 5c (W,q) 1c (W,q) /(1 1r ) 1G 1G /(1 1r )
M 1 2 1 2
* 1(N 2J)K 1JK (130)
* * Then, the other seven control variablesFDI, V, t, r, t , t , uare determined
M
by the following constraints: Eqs. (21), (10), (90), (9b0), (9c0), (11) and the
rst-period resource constraint:
* FDI 5JK 1(N 2J)K 2[I 2c (W,q) 2G ] (120)
1 1 1
The Langragean expression is
L 5v(W,q)
g
* * * * 1l[I 1I /(1 1r ) 1(N 2J)F(K) /(1 1r ) 1J(1 1M ) F(K ) /
1 2
* * * * * (1 1r ) 2Jw M /(1 1r ) 2c (W,q) 2G 2c (W,q) /(1 1r )
M 1 1 2
* * 2G /(1 1r ) 2(N 2J)K 2JK ] (140)
2
The rst-order conditions establish the familiar aggregate production efciency
results:
g
* * * (1 1M ) F9(K ) 51 1r (15a0)
g21
* * * g(1 1M ) F(K ) 5w (15b0)
M
* F9(K) 51 1r (15c0)
In addition, differentiating L with respect to J and setting the derivative equal to
zero yields
g
* * * * * * * (1 1M ) F(K ) 2w M 2(1 1r )K 5F(K) 2(1 1r )K
M
This proves Eq. (26).
Appendix B
In this appendix, we describe the model parameters used for the simulation
exercise in Section 5. The utility function is assumed to take the isoelastic form:
12s 12s
U(c ,c )5(c 1dc ) /(12s). The production function is Cobb-Douglas:
1 2 1 2
a a
* * F(K)5BK and F(K )5BK . The probability distribution function of e is
uniform: f(e)51/ 2a for 2a#e #a and 0 otherwise. The table below summarizes
our choice of parameter values.
Preference Technology Endowment
parameters parameters parameters
s51 B55 I 510
1
30
d5(0.95) a50.3 I 59.7
2
* g50 r 51/d21
a51
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