Gradualism in Tax Treaties with Irreversible Foreign Direct Investment

Bilateral tax treaties govern host country taxation for most of the world's foreign direct investment (FDI). To explain why the tax rates used under these treaties are gradually falling we consider two-way capital flows with irreversible FDI. The extent of irreversibility determines the magnitude of initial tax reductions. When Pareto-optimal taxes are not initially self-enforcing, more modest tax reductions generate an increase in irreversible bilateral FDI so that further tax reductions become self-enforcing. Depending on the extent of irreversibility and asymmetry, Pareto-optimal tax rates may be obtainable in the long run