The taxation of foreign profits (CEN, CON and all that)

This paper attempts to reconcile in a unified framework different approaches to the question of the optimal taxation of foreign source income. The main finding of the analysis is that the key variables are (i) whether there is full or limited de-ductibility of capital expenses, and (ii) how foreign investment impacts on domestic economic activity. With full deductibility (a cash flow tax) and with a tradeoff between foreign investment and domestic economic activity, the "standard" results regarding the optimal taxation of foreign income hold: national optimality requries full taxation after deduction of foreign taxes and the global optimality requires a full credit system. In the reverse case, i.e. with limited deductibility and no tradeoff, exemption is optimal. Finally, with limited deductibility and a tradeo¤, there is no first-best rule for taxing foreign source income. These results do not depend on whether the foreign investment takes the form of greenfield investment or acquisition.