Template-Type: ReDIF-Paper 1.0
Author-Name: Richard Chisik
Author-X-Name-First: Richard
Author-X-Name-Last: Chisik
Author-Email: rchisik@economics.ryerson.ca 
Author-Workplace-Name: Department of Economics, Ryerson University, Toronto, Canada
Author-Name: Ronald B. Davies
Author-X-Name-First: Ronald  
Author-X-Name-Last: Davies
Author-Email: rdavies@oregon.uoregon.edu
Author-Workplace-Name:  Department of Economics, University of Oregon, Eugene, Oregon
Title: Gradualism in Tax Treaties with Irreversible Foreign Direct Investment
Abstract: Bilateral international tax treaties govern the host country taxation for the vast majority
of the world’s foreign direct investment (FDI). Of particular interest is the fact that the tax rates
used under these treaties are gradually falling although the treaties themselves do not specify any
such reductions. Since there is no outside governing agency to redress treaty violations, such
reductions must be both mutually beneficial and self-enforcing. Furthermore, the optimal tax
rates must be less than those initially set, otherwise no reductions would be necessary. To explain
such behavior, we model a two-country setting with two-way capital flows. In particular, only
part of FDI is immediately reversible. As the extent of irreversibility increases, the likelihood of
Pareto optimal tax rates obtaining as a self-enforcing outcome in the initial period is reduced.
More modest tax reductions, from the non-treaty levels, are still possible. These limited tax
reductions generate an increase in bilateral FDI. As countries increase the stock of capital in one
another, further reductions in taxes become self-enforcing. Depending on the extent of
irreversibility and asymmetry, Pareto optimal tax rates may be obtainable in the long run. Thus,
the amount of inbound investment a country can attract may be related to the commitment to
which its outbound investment binds it. This final insight provides an additional rationale for the
observed pattern of capital flows in which those countries with the greatest outbound capital
flows are also those with the highest inbound flows.
Classification-JEL: F21, F23, F13, C73.
Keywords: Foreign Direct Investment, Tax Treaties, Multinational Enterprise, Gradualism,
Irreversibilities, Dynamic Games.
Length: 39 pages
Creation-Date: 2010-08
Number: 019
File-URL: http://economics.ryerson.ca/workingpapers/wp019.pdf
File-Format: Application/pdf
Handle: RePEc:rye:wpaper:wp019