Cross-border loss offset can fuel tax competition

Following recent court rulings, cross-border loss compensation for multinational firms has become a major policy issue in Europe. This paper analyzes the effects of introducing a coordinated cross-border tax relief in a setting where multinational firms choose the size of a risky investment and host countries non-cooperatively choose tax rates. We show that coordinated cross-border loss compensation may intensify tax competition when, following current international practice, the parent firm's home country bases the tax rebate for a loss-making subsidiary on its own tax rate. In equilibrium, tax revenue losses may thus be even higher than is implied by the direct effect of the reform. In contrast, tax competition is mitigated when the home country bases its loss relief on the tax rate in the subsidiary's host country.