TAX Havens final presentation

1. TAX Havensfinal presentation Group 12: RalucaStanescu Tiara Utomo Tina Thomas YuxianLun

2. Main issue • What is the impact of tax havens on non-haven countries in terms of foreign investment? • Predicted result: • Economic activity in non-havens is diverted.

3. Variables • = Tax rate on the firm’s foreign investment outside of tax havens • = Tax rate on the profit if the firm also has a tax haven operation • = Level of capital investment in non-haven • = Level of capital investment in haven • Q(,) = Production function of firm’s output in countries outside of havens • ()= Return to the tax haven earned in the tax haven itself • = Cost per unit of capital investment in foreign countries outside tax havens • = Cost per unit capital invested in the tax haven • = Profit- maximising level of foreign investment • = Shadow cost • = Fixed amount of capital given in non haven • = Fixed amount of capital given in tax haven

4. Assumptions = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven • •To the extent that the firm is able to use tax haven investments to reduce effective foreign tax rates on income earned outside of havens, it follows that • Firms are assumed to invest equity capital for which there is a shadow cost.

5. Equations in the model = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven • If the firm elects not to invest in the tax haven, its after-tax returns are given by: • .(1) in which = the profit-maximizing level of foreign investment, characterized by the first-order condition:

6. = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven Equations in the model • If the firm instead chooses to invest in the tax haven, its returns are given by: • (3) in which satisfies:

7. Equations in the model = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven • The first-order Conditions (2) and (4) together imply that and satisfy: (5)

8. Two cases • We now consider two cases to demonstrate that the relationship between and is theoretically ambiguous: • Case 1: firm can use tax havens to reduce foreign tax rates on income earned outside of havens (). • Case 2: tax havens do not reduce foreign tax rates ( ).

9. = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven 1st case • Assumption: • Because • => (6)

10. 1st case = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven The marginal product of capital investment is subject to diminishing returns => concavity. Product of capital Investment (6) So => tax havens do not divert investment in non - havens Capital investment

11. 2nd case = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven 1st Assumption: Tax havens do not appreciably reduce effective foreign tax rates • We have • (5)So • If • Then = • = > 0 (7)

12. 2nd case = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven 2nd Assumption: If the marginal product of capital in non-havens falls as more capital is invested in havens ( specifically, if < 0 (8) ) • = > 0 (7) • < 0 (8) • From 1st and 2nd assumption: • > (9)

13. 2nd case = Tax rate on the firm’s foreign investment outside of tax havens = Tax rate on the profit if the firm also has a tax haven operation = Level of capital investment in non-haven = Level of capital investment in haven Q(,) = Production function of firm’s output in countries outside of havens ()= Return to the tax haven earned in the tax haven itself = Cost per unit of capital investment in foreign countries outside tax havens = Cost per unit capital invested in the tax haven = Profit- maximising level of foreign investment = Shadow cost = Fixed amount of capital given in non haven = Fixed amount of capital given in tax haven • = (7) • > (9) Product of capital Investment Then > So.. => tax havens do divert investment in non-havens Capital investment

14. result • 1st CASE: => tax havens do not divert investment in non - havens • 2nd CASE: => tax havens do divert investment in non-havens • We get two different results. • Conclusion? The result is theoretically ambiguous.

15. result • So, the tax havens do not necessarily harm the economic activity in non-havens. • In the end – it depends on tax rates, amount of capital invested, shadow costs etc.

16. References • Desai, Mihir A. and Foley, C. Fritz and Hines Jr., James R., Do Tax Havens Divert Economic Activity? (April 2005). Ross School of Business Paper No. 1024.