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1 * Associate Professor of Law, University of Virginia School of Law. 1 See, e.g., Evsey D. Domar & Richard A. Musgrave, Proportional Income Taxation and Risk-Taking, 58 Q.J.Econ. 388 (1944); James Tobin, Liquidity Preference as Behavior Toward Risk, 25 Rev. Econ. Stud. 65; Jan Mossin, Taxation and Risk-Taking: An Expected Utility Approach, 35 Economica 74 (1968); Joseph E. Stiglitz, The Effects of Income, Wealth, and Capital Gains Taxation on Risk-Taking, 83 Michigan Tax Policy Workshop – April 6, 2005 [This is a preliminary draft. Please do not cite or distribute without the author’s permission.] Risk and Redistribution in Closed and Open Economies Mitchell A. Kane * An economy in which the owners of physical and human capital undertake some amount of financial risk is surely preferable to one in which they undertake none. But what is the optimal amount of risktaking? Whatever answer we give to that question, law will necessarily play a leading role in the story. The reason is that it is impossible to divorce preferences regarding risktaking from some background legal regime. Most obviously that will be the case with respect to the property rights that individuals and firms possess within a given legal system. It is impossible, in other words, to say anything about how individuals and firms value a particular risky activity without first understanding the extent to which a particular risktaker holds a legal entitlement to the fruits of a risk that turns out well or the legal obligation to bear the costs of one that turns out poorly. Property rights are thus central. Equally important, though perhaps less appreciated, is the role of taxation, which by its very nature must effect some change in the set of property entitlements that would obtain in a world without taxes (or with different taxes). An analysis of the relation between taxation and risktaking occupies a central role in a venerable line of public finance literature and, more recently, has captured the

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Page 1: Mitchell A. Kanelawprofessorblogs.com/taxprof/linkdocs/Kane.pdftaxation is importantly different in open versus closed economies. In particular, I suggest that in the open economy

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* Associate Professor of Law, University of Virginia School of Law. 1 See, e.g., Evsey D. Domar & Richard A. Musgrave, Proportional Income Taxation and Risk-Taking, 58 Q.J.Econ. 388 (1944); James Tobin, Liquidity Preference as Behavior Toward Risk, 25 Rev. Econ. Stud. 65; Jan Mossin, Taxation and Risk-Taking: An Expected Utility Approach, 35 Economica 74 (1968); Joseph E. Stiglitz, The Effects of Income, Wealth, and Capital Gains Taxation on Risk-Taking, 83

Michigan Tax Policy Workshop – April 6, 2005[This is a preliminary draft. Please do not cite or distribute without the author’s permission.]

Risk and Redistribution in Closed and Open Economies

Mitchell A. Kane*

An economy in which the owners of physical and human capital undertake some

amount of financial risk is surely preferable to one in which they undertake none. But

what is the optimal amount of risktaking? Whatever answer we give to that question,

law will necessarily play a leading role in the story. The reason is that it is impossible to

divorce preferences regarding risktaking from some background legal regime. Most

obviously that will be the case with respect to the property rights that individuals and

firms possess within a given legal system. It is impossible, in other words, to say

anything about how individuals and firms value a particular risky activity without first

understanding the extent to which a particular risktaker holds a legal entitlement to the

fruits of a risk that turns out well or the legal obligation to bear the costs of one that

turns out poorly. Property rights are thus central. Equally important, though perhaps

less appreciated, is the role of taxation, which by its very nature must effect some

change in the set of property entitlements that would obtain in a world without taxes (or

with different taxes).

An analysis of the relation between taxation and risktaking occupies a central role

in a venerable line of public finance literature and, more recently, has captured the

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Q.J.Econ. 263; Jack M. Mintz, Some Additional Results on Investment, Risk Taking, and Full Loss Offset Corporate Taxation and Interest Deductibility, 96 Q.J.Econ. 631 1981); Jeremy I. Bulow and Lawrence H. Summers, The Taxation of Risky Assets, 92 J.Pol.Econ. 20 (1984); Roger H. Gordon, Taxation of Corporate Capital Income: Tax Revenues Versus Tax Distortions, 100 Q.J.Econ. 1 (1985); Louis Kaplow, Taxation and Risk Taking: A General Equilibrium Perspective, 47 Nat. Tax. J. 789 (1994); Joseph Bankman and Thomas Griffith, Is the Debate Between an Income Tax and a Consumption Tax a Debate About Risk? Does it Matter?, 47 Tax L. Rev. 377 (1992); Alvin C. Warren, Jr., How Much Capital Income Taxed Under an Income Tax is Exempt Under a Cash Flow Tax?, 52 Tax L. Rev. 1 (1996); Noel B. Cunningham, The Taxation of Capital Income and The Choice of Tax Base, 52 Tax L. Rev. 17 (1996); Deborah H. Schenk, Saving the Income Tax with a Wealth Tax, 53 Tax L. Rev. 423 (2000); David M. Schizer, Balance in the Taxation of Derivative Securities: An Agenda for Reform, 104 Col. Law. Rev. 1886 (2004); Terry Chorvat, Apologia for the Double Taxation of Corporate Income, 38 Wake For. L. Rev. 239 (2003); David Weisbach, The (Non) Taxation of Risk, U. Chicago Law & Economics, Olin Working Paper No. 203 (2004).2 The term “loss offset” refers generically to any case in which the government grants taxpayers some tax benefit in virtue of incurring a net loss on an investment. This may be the case where the taxpayer is permitted to deduct a loss against net income from profitable investments, as well as the case where the taxpayer has no net income against which to offset the loss but nonetheless receives a refund from the government.

attention of a number of tax scholars.1 The basic insight that motivates these literatures

is that under an income tax that provides loss offsets2 taxpayers and the government

are in a de facto partnership with respect to the return to risky investments. In the

extreme case of a single flat rate for both gains and losses and full refundability of

losses, the government shares a percentage of both upside and downside risk that

matches the tax rate.

The normative implications that follow from the existence of such a de facto

partnership are complex, and hotly disputed, but in general the conclusions one draws

will depend chiefly on two (interdependent) factors. First, from the perspective of the

taxpayer how does the existence of such a de facto partnership change incentives

regarding the amount of risk to undertake? Second, from the perspective of the

government what effect does the de facto partnership arrangement have on government

decisions about how much risk to bear and how to disperse risk across the citizenry.

These are difficult questions, about which I will have more to say later. At the outset,

though, it is useful to highlight some common ground. In particular, current analyses of

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3 To be accurate, this is the shared assumption if we assume further that the government is not diversifying idiosyncratic risk more effectively than private parties. This further assumption is itself controversial, and I discuss it in greater detail in Part IV below. Ultimately, though, my descriptive and normative claims do not depend on this further assumption.4 Again the assumption here is that there is no gain from diversifying idiosyncratic risk that was not already fully diversified. Cf. supra note ___.

these questions often share at least one common assumption: for a given level of

aggregate risk in the economy (i.e., privately held risk and publicly held risk) the

aggregate yield is not affected by the proportion in which the risk is held privately or

publicly.3

One can readily see that this follows directly from the partnership analogy.

Suppose a world with no taxes and a partnership of individuals or firms that holds a

portfolio of risky investments with aggregate expected yield of y. The nature of the

respective partnership interests should have no bearing on the aggregate yield. That is,

if one were to sum the individual expected yields enjoyed by each of the partners then

the aggregate expected yield should remain y.4 So too, one might imagine, where the

partnership now involves both private parties and the government, which takes an

equity stake through an income tax.

Although this description should characterize the state of affairs in a closed

economy, my central descriptive claim is that it does not generally characterize the state

of affairs in an open economy. Rather, the combined effect of domestic and

international tax instruments is to sever – across jurisdictions – some of the upside and

downside risk that would naturally be conjoined in the private capital markets. The

result is that the aggregate expected yield for the de facto public and private partnership

may be more or less than would be experienced in the closed economy – even holding

everything else constant (e.g., the nature of the investments and the level of

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diversification). In this paper I will refer to this systematic splitting of upside and

downside risk across sovereigns as divergence. Interestingly, where divergence occurs

it will generally not be possible (with current tax instruments) to reverse the effects

through governmental action. Rather, the effects will be reversible only through private

investment decisions. This gives rise to an allied phenomenon that I call retention.

Of course, it is trivially true that one can restore the initial assumption regarding

the preservation of aggregate expected yield by recasting the de facto partnership as

one between all private and public sectors across all relevant economies. Such a shift

in perspective, however, is normatively problematic. To state the point most bluntly,

what that shift in perspective reveals is that the phenomena of divergence and retention

produce distributional effects across nation states that are out of step with the generally

accepted taxing entitlements in the cross-border setting.

This paper has four parts. In Part I first provide an abstract description of the

phenomena of divergence and retention and then explain how these phenomena relate

to ongoing debates regarding tax and risktaking. In Part II I discuss the degree to which

actual international tax instruments manifest these phenomena. In Part III I show why

divergence and retention are normatively problematic and suggest that potential

remedies will best proceed through multilateral efforts to provide more generous loss

offsets. In Part IV I claim that to the extent the phenomena of divergence and retention

continue to manifest themselves they should be taken into account in other important

policy debates. In particular, I suggest that there are likely important ramifications for

the debate regarding the efficacy of governmental efforts to encourage innovation

through the tax system and the debate over whether it is better to relieve international

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5 Formally, the definition of y is :qipi

i=1

n

∑ where q represents an expected rate of return and p represents

the probability of return. Domar and Musgrave, supra note 1, at 395. 6 Id.7 Technically, Domar and Musgrave state the relation as y = g – r. This simply reflects the fact that they define r as the expected value of negative returns multiplied by (-1). This allows them to treat r as a positive number. As defined in the text I treat r as a negative number.

double taxation through a foreign tax credit or through an exemption of foreign source

income.

Divergence, Retention and the Effects on Private and Social Risk

Divergence and Retention – An Abstract Description

In this section I provide an initial abstract characterization of the descriptive

claims in the paper. These claims relate to the ways in which the interaction of risk and

taxation is importantly different in open versus closed economies. In particular, I

suggest that in the open economy context one sees two characteristics – what I will call

divergence and retention – that do not apply in the closed economy context.

To state the relevant abstractions I borrow from the basic framework adopted by

Domar and Musgrave to analyze the relationship between taxation and risktaking. They

provide the following definitions of the terms yield and risk. Yield (y) is defined as the

expected return, given a (known) probabilistic distribution of possible returns.5 Risk (r)

is defined as the negative component of that probabilistic distribution.6 Finally, they

define g as the positive component of the probabilistic distribution that determines y.

Thus it is necessarily the case that y = g+ r.7 I will generally follow these definitions of

risk and yield.

Because this conception of risk appears quite out of step with the advances of

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8 Domar and Musgrave, supra note 1, at ___. They do note, however, that considerations would be different in the case of a progressive income tax because variance would then impact the applicable tax bracket.9 Domar and Musgrave, supra note 1, at 397 (“A more elaborate analysis would allow for additional variables defining the shape of the probability distribution, for example, in terms of standard deviation . . . .”).10 See, e.g., Bulow and Summers, supra note 1, at 22 (noting and following the common adoption of a mean variance approach to risk).

modern portfolio theory, a few words of explanation on choice of definitions are in order

at the outset. Perhaps the most striking feature of this definition of risk is that it includes

no reference to the variance of the possible returns. Through the modern lens it is

difficult to imagine analyzing the relation between risk and yield within a framework that

excludes consideration of variance. Domar and Musgrave originally defended this

definition of risk over other possibilities (including possibilities that include analysis of

variance) on the ground that it is the cutoff between positive and negative returns –

between profits and losses – that is of crucial importance under a proportional income

tax.8 The adopted definition of risk thus fits hand in glove with their ultimate normative

claims, which relate to the optimal design of loss offsets in the tax system. Still, the

authors acknowledge that a fuller analysis of investor incentives would have to take

account of variance.9 And, not surprisingly, more modern public finance scholarship

has followed precisely that path.10

My reason for reaching back to this somewhat peculiar definition of risk is closely

linked to the utility that the definition yielded in the original Domar and Musgrave

analysis. Specifically, the definition provides a relatively simple means of exposing

precisely those features of international tax instruments that are relevant to the present

analysis. Conversely, analyses of risk best suited to portfolio optimization miss

something important under the present analysis. This contrast can be seen in the

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11 [Cites to literature on loss aversion.]12 Finally, it is worth noting that r, as defined here, is closely related to mean variance approaches to risk. For a normal distribution, as mean variance increases so too necessarily will r.

following way. To the rational investor it should seem somewhat odd to decompose

yield into its positive and negative components.11 At least absent special cases

(perhaps, for example, a loss raises a particular threat of insolvency or triggers a

covenant under a debt obligation), the line between a positive and negative return is

arbitrary. For example, the nominal cost arising from a drop in yield from 8% to 4% and

a drop from 2% to -2% is identical. But to the tax law – for reasons that have much

more to do with administrative convenience and politics than theoretical purity – the

arbitrary zero-point between profit and loss is often crucial.12 Because my descriptive

project relates to the way in which that distinction between profits and losses plays out,

it is exactly the decomposition of yield into its positive and negative components, as

defined above, that will expose the relevant features of the law. The project differs in

this way from many analyses in the literature, which analyze the effects on risky

investment assuming full loss offsets. By contrast, my initial descriptive task is to show

the distributional effects under the domestic and international tax instruments that are

actually in place, which do not provide full loss offsets.

In addition to adopting these basic definitions of y, r, and g, it will be helpful to

introduce the following notation. I will denote the private portion of yield as yPRIV and the

public portion of the yield, collected through the income tax, as yPUB. Thus in a world

with no taxes y = yPRIV and in a world with income taxes y = yPRIV + yPUB. The relation

between the private portion of y and the public portion of y is of course a function of the

tax rate (t). That is, yPUB = (yPRIV)(t). It is useful, however, to be able to refer to the

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13 See Schizer, supra note 1, at ___.

positive and negative components of y separately as follows: y = gPRIV + rPRIV + gPUB +

rPUB. The relation between private and public r and g is again a function of tax but

because jurisdictions may well tax gains and losses differently, I will use the term t+ to

refer to the tax rate on profits and the term t- to refer to the tax rate on losses. Following

the useful terminology recently coined by David Schizer one can succinctly capture the

relationship between these two variables in terms of a “gain-loss ratio,” which under the

above notation is simply (t+/t-).13 Thus a gain-loss ratio of 1 represents a regime that

employs so-called full loss offsets. From the taxpayer’s perspective, a gain-loss ratio of

more than one represents the case where gains are taxed at a higher rate than losses

and a gain-loss ratio of less than one represents the case where gains are taxed at a

lower rate than losses. Whatever the gain-loss ratio, however, if one disaggregates the

positive and negative return, the relationship between private and public interests is as

follows: rPUB = (rPRIV)(t-) and gPUB = (gPRIV)(t+).

It is now possible to describe the phenomenon that I call divergence. In the

closed economy framework r and g in the aggregate are necessarily conjoined in a

single economy, regardless of the allocation of risk between the public and private

sector. In the open economy framework, however, it is a perhaps surprising result that

the effect of the typical international tax instruments (operating on top of typical

domestic tax instruments) is to produce a divergence between the jurisdiction that

enjoys the upside potential (g) and the jurisdiction that bears the downside cost (r).

More precisely, there is a split between gPUB on the one hand (which disproportionately

benefits the capital importing jurisdiction) and (rPRIV + rPUB) on the other (which is borne

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14 At this level of abstraction two clarifications may be useful. First, gPRIV does not appear in this formulation because it, by definition, is the expected positive return to the private sector in the capital exporting country. Thus to the extent that (rPRIV + rPUB) is borne by the capital exporting country, no split between upside and downside occurs. Second, as will become clear below, the importance of disaggregating r into rPRIV and rPUB in this exposition is to capture an important distinction between relief of double taxation through foreign tax credit versus exemption methods. Relative to exemption countries, in a credit country the ratio of rPUB to rPRIV will tend to be greater.15 [Cites]16 [Cites]

disproportionately by the capital exporting jurisdiction).14

The phenomenon that I call retention is closely related. As a benchmark first

consider the closed economy context. In a sense rPUB and gPUB are like placeholders.

As commentators have pointed out it is not as if the government can bear risk

indefinitely.15 Just as the private investor who bears risk faces the ex ante possibility of

a range of different possible returns, so too the government that bears risk faces the ex

ante possibility, other things equal, of different possible revenue streams from the

income tax. What are the government’s options when the revenue stream comes in at a

level higher or lower than expected? Essentially, there are three possibilities. The

government can adjust its tax policy (i.e., collect more or less revenue going forward to

account for the shortfall/windfall); adjust its spending policy; or adjust its borrowing

policy.16 Whichever option the government takes the risk is essentially returned to the

private sector in some fashion. In the closed economy setting the risk, of course, need

not be returned to the very same investor who initially bore the conjoined portion of

yPRIV. However, it is necessarily true that the risk must be returned to the private sector,

comprised of individuals and firms, in the relevant closed economy.

Contrast the situation of the open economy. Where the phenomenon of

divergence arises we see a split between (rPRIV + rPUB) and gPUB, with different sovereigns

expecting the costs and benefits. The phenomenon of retention tells us that the

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17 The normative assumption is that an increase in aggregate risktaking is a good thing. See Domar and Musgrave, supra note 1, at 391 (“There is no question that increased risktaking . . . is highly desirable (except during acute boom conditions) and that therefore a higher degree of loss deduction is of vital importance.”). That assumption may well have been unproblematic at the time they wrote. Although it has become commonplace to bemoan the astonishingly low levels of personal savings witnessed today in

ultimate effect of this when gains or losses are realized is that the jurisdiction that bears

the downside cannot pass the cost, through governmental action, to the private sector

of the other jurisdiction. Conversely, the jurisdiction that enjoys the upside could pass

the gains back to the other jurisdiction through foreign aid but generally will not. Thus

divergence is a split between ex ante expected returns. Retention relates to the inability

to reverse those effects ex post. As we will see the conjunction of these two points

produces important distributional consequences.

Incentive Effects on Private and Social Risk

Before turning to a discussion of the ways in which international tax instruments

reflect the properties of divergence and retention it will be useful to situate the analysis

within the context of the existing literature on the relation between taxation and

risktaking. Specifically, I suggest here that the descriptive claims in this paper hold to

some extent regardless of where one comes down on the key disputes that animate the

current literature.

In their classic paper on the relation between taxation and risktaking Domar and

Musgrave set out to answer a relatively specific question: What degree of loss offsets

ought the income tax to provide? The answer, they claimed, was that a proportional

income tax should provide full loss offsets because this is the approach that will best

encourage an increase in aggregate (i.e., public plus private) risktaking. The paper thus

countered the conventional wisdom that an income tax, by reducing the return to

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the United States, it was not always so. Towards the end of World War II, with the Great Depression still in recent memory, the country faced a rather different problem – the prospect of hoarding. In that context, some economists harbored the concern that upon war’s end individuals and firms might be unwilling to stake their capital on the types of risky ventures that would drive sufficient growth in the economy. [Cites.]18 See Domar and Musgrave, supra note 1, at 390.19 The assumption is that the taxpayer has additional funds available for investment, either cash or other liquid investments that can be moved into riskier investments or the ability to borrow. This assumption regarding liquidity and credit constraints plays a crucial role in current debates. [Cites – Schizer, Shuldiner]

riskbearing, would make riskbearing less desirable to investors.17

Domar and Musgrave cast their basic argument within the framework of the

definitions of yield and risk described above. In a system with full loss offsets, the effect

of the income tax is to decrease y (for each positive return the government claims a

portion of the return equal to tax rate t) but with an equal effect on r (for each possible

negative return the government bears a portion of the loss equal to tax rate t). Thus the

overall yield decreases but the yield per unit risk remains constant as y and r have been

reduced proportionately.18 Because the taxpayer has a reduced yield after the tax there

will be an incentive to recoup that reduction by undertaking additional risky investment.

That is, there is an income effect from the income tax that encourages additional

risktaking.19 On the other hand, because the yield per unit risk remains constant there

is no incentive to shift from riskier investments to less risky ones. That is, in a system

with full loss offsets, there is no substitution effect at all.

Importantly, for purposes of the current exposition, Domar and Musgrave did not

claim that the income effect will result in the taxpayer returning to the pre-tax level of

riskbearing; rather, the claim was simply that private risk-taking increases somewhat in

virtue of the income tax with full loss offsets. Since the risk that would be borne in the

absence of the tax is simply split between the private and public sectors under the

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20 By contrast the results in a system with either partial loss offsets or no loss offsets are theoretically indeterminate. One should still witness an income effect but there will be an offsetting substitution effect because the yield per unit risk necessarily decreases. Domar & Musgrave, supra note 1, at ___. Note that the case of no loss offsets and partial loss offsets are instances where the gain-loss ratio is greater than one and the case of full loss offsets involves a gain-loss ratio of exactly one. Technically there is another possibility – the case in which the government treats losses more favorably than gains, which involves a gain-loss ratio of less than one. Domar and Musgrave do not discuss this case in their paper but it does describe certain areas of taxation. See Schizer, supra note 1, at ___.21 See, e.g., Bulow & Summers, supra note 1, at ___; Kaplow, supra note 1, at 794-98; Gordon, supra note 1, at 5–6; James R. Hines, Uncertain Tax Revenue and Taxation of Risky Assets, John M. Olin Program for the Study of Economic Organization and Public Policy Disc. Paper No. 69 (1991); Michael P Devereux, Taxing Risky Investment, Centre for Economic Policy Research Disc. Paper No. 4053 (2003).

income tax, the effect of the increase in private risktaking, however small, must be to

increase aggregate private and public risktaking.20

A rich literature, both in public finance and tax , has followed on this classic

analysis of the topic. There are many twists and turns in these literatures but two points

of contention arise repeatedly. First, and related to the question that Domar and

Musgrave addressed directly, how do taxpayers adjust the riskiness of their investments

in the face of an income tax with a given structure? Second, how does the government

adjust its actions in the face of the riskiness inherent in its tax revenues?

Domar and Musgrave, who undertake a partial equilibrium analysis, essentially

collapse these two issues. That is, having shown an increase in private risk taking they

conclude that aggregate risk must increase. But the government’s actions are important

in a number of ways. First, the way in which the government disperses the risk inherent

in tax revenues may well have feedback effects on the decisions made in the private

sector. Second, the government could adjust its own portfolio to counteract the effects

of the riskiness in its tax revenues. Subsequent scholarship has addressed these

issues in general equilibrium models, with varying implications for the basic Domar and

Musgrave conclusion regarding the likely increase in aggregate risktaking.21

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In this paper I do not take a position on which of these models best captures the

likely effects under a particular tax system. Thus I remain agnostic about whether any

particular tax system increases, decreases, or leaves unaffected private risk or

aggregate risk. That is not to say these issues do not impact the force of the claims I

make here. Rather, it is only to say that where one comes down on the question of how

much private or aggregate risk we observe under various forms of an income tax

impacts the magnitude of the effects I describe here in a dynamic setting but will not be

determinative of their existence. For divergence and retention to exist it simply has to

be the case that jurisdictions in the open economy context tax, as they do, using

instruments similar to those described in Part II.

If one can fairly characterize the public finance scholarship in this area as

focused on the question of how much risktaking (private and social) follows given a

particular implementation of an income tax (particularly as one moves from partial to

general equilibrium framework), tax scholars have tended to focus on the inverse issue.

That is, what sort of tax system ought we to have given a particular reaction in

risktaking. As noted Domar and Musgrave did not conclude, even under their

somewhat restrictive assumptions, that taxpayers under a proportionate income tax with

full loss offsets would necessarily replicate the risk levels borne in a world with no taxes.

The question that has most occupied tax scholars, however, is what conclusions to

draw in cases where that level of risk is replicated. Thus, modern tax scholars often

characterize one of the essential implications of the Domar and Musgrave analysis as

showing that a taxpayer in a system with full loss offsets (and a single level tax rate) can

neutralize the effect of the tax on risk premium by “scaling up” the size of the

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22 See, e.g., Schizer, supra note 1, at ___; [Cites – Weisbach, Zelenak, Shuldiner.]23 [Cites.] If taxpayers can indeed scale-up the investment then in effect the cost of the income tax reduces to the cost on the riskless return to capital. Because that return has historically been low, this is thought to count as an argument for moving towards consumption taxation.24 David Weisbach has questioned the need to compare taxpayer preferences in worlds with and without taxes. He suggests, rather, that taxpayers need only take account of after-tax prices, as they surely do, in the world with taxes. Weisbach, supra note 1, at ___. This possibility, however, does not affect the argument in the text, which is simply that the descriptive claims in this paper depend at the core on the design of domestic and international tax instruments rather than on any specific claims about taxpayer behavior.

investment.22 That issue is of crucial importance to tax scholars because it bears

heavily on the decision between an income tax and a consumption tax.23 For the same

reasons discussed above, the question of whether taxpayers replicate pre-tax levels of

risk affects only the magnitude of the phenomena described in this paper. Regardless of

the degree of “scaling up” tax systems that use instruments similar to those described in

Part II will manifest the properties of divergence and retention.24

Divergence and retention, then, exist to some degree under an income tax

irrespective of the incentives the tax has for taxpayers undertaking risky investments

and governments facing risky tax revenue streams. This tells us something important

about the relevance of closed versus open economy analysis in the taxation and risk

context. Specifically, the reason to undertake an analytically distinct analysis of this

topic in the open economy context is largely distributional. This is not to say, of course,

that there will not be important efficiency effects in the open economy context. It is

simply to say, rather, that one would expect that efficiency considerations can be

captured under the same specifications that apply in the closed economy context. For

example, if the incentives of individual taxpayers depend upon features such as the

gain-loss ratio and the degree to which the government can absorb additional

idiosyncratic risk that was not diversified in the private capital markets, then it should not

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25 See infra ___ for details on how this would work.

matter to the taxpayer whether it is operating in the open or closed economy context.

The taxpayer’s incentives may well depend upon the actions of the sovereign, but why

should the taxpayer care about which sovereign is taking on some portion of the risk?

That should matter only to the extent that different sovereigns impose different levels of

tax and provide different levels of relief for losses. Those effects, however, can be

captured by the same analyses that would apply to closed economy contexts where the

government treats gains and losses differently.

An example may be useful to show the point. Suppose that it were the case that

taxpayers in a closed economy undertake more risk as the gain-loss ratio decreases. It

is surely possible that the shift of capital from a domestic investment to a foreign

investment could similarly produce a decreasing gain-loss ratio.25 If that is right, then

there may be incentives in the open economy framework to undertake additional risk

that did not exist in the closed economy context. However, from the taxpayer’s

perspective such incentives should be explicable in the same terms as the effects

where the gain-loss ratio alters in the closed economy framework.

Manifestation of Divergence and Retention under Common Tax Instruments

In this part of the paper I undertake the chief descriptive task of showing how

divergence and retention exist under the basic international taxing instruments. My

approach will be as follows. First I provide a baseline case with strict assumptions to

demonstrate the phenomenon of divergence and then I relax these assumptions in

various ways to make the discussion more realistic. In the text I will keep the discussion

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26 [Cites.]

as general as possible, with the hope of demonstrating how the phenomenon can be

expected to arise in many jurisdictions. In the margin I will provide specific references

to the way that U.S. law would apply in such cases. Lastly, I discuss the manifestations

of retention under common tax instruments.

A Baseline Case

Suppose for the moment, contrary to fact, that there was a simple one-to-one

mapping between taxpayers and sovereigns and that this relationship grounded the

claim of the sovereign to impose a tax on the income of the taxpayer. We might call

that one-to-one relationship “residence,” and were this mapping to exist, each taxpayer

would clearly be a resident of one, and only one, sovereign jurisdiction. Suppose

further that each sovereign were to tax all income of its residents without regard to the

source of the income (i.e., without regard to the geographic location in which the income

was earned). In such a world there would be no divergence (and derivatively no

retention). Each sovereign, having made no concession to the taxing claims of sister

jurisdictions, would essentially have rejected the need for unique taxing instruments in

the open economy setting altogether. However, if sister jurisdictions were to tax income

on the grounds that it was earned within the borders of their sovereign territory – that is

taxation based on source – then cross-border investment would bear a higher tax

burden than wholly domestic investment. In order to prevent such multiple taxation from

deterring wealth enhancing cross-border trades, one sovereign would have to cede the

primary right to tax to another. That elimination of multiple taxation, of course, is one of

the central tasks of our international tax rules.26 It is the implementation of those rules,

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however, that also creates the phenomenon of divergence.

There are two basic ways in which jurisdictions eliminate double taxation in the

cross-border setting – either through exemption or foreign tax credit. In an exemption

system, the sovereign disclaims taxing jurisdiction over income with foreign source (i.e.,

income earned outside its sovereign borders). In a credit system, the sovereign

includes all income of residents in the tax base but provides a credit, under specified

circumstances, for foreign taxes paid. Because exemption systems only tax their

residents on domestic source income they are typically referred to as territorial systems.

By contrast, credit systems, because they include income in the tax base regardless of

source, are typically referred to as worldwide systems. There is a nearly century-long

debate over the relative superiority of these two systems, and I will have more to say

about how the claims in this paper bear on that debate in Part IV. For now, though, the

descriptive task is to show how worldwide and territorial systems manifest divergence,

as well as to show how they manifest the phenomenon in different ways.

To further the discussion it will be useful first to analyze the problem in an

extremely stylized fashion with restrictive assumptions, which I will relax presently. I will

assume a world containing two jurisdictions, J1 and J2, which have identical tax systems,

except for the fact that J1 relieves double taxation through a foreign tax credit and J2

applies an exemption system. J1 and J2 tax all income (corporate or individual) at a

single flat rate t and allow taxpayers the unlimited ability to offset losses against income

up to the point where net income is reduced to zero. There are no provisions for the

refundability, carryback, or carryover of net losses. J1 and J2 have also entered into an

income tax treaty that follows verbatim the OECD Model Tax Convention on Income

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27 I justify the restriction to corporate taxpayers on the ground that this is the way in which nearly all foreign direct investment is conducted. In my discussion of portfolio investment below, I expand the discussion to cover the case of individual taxpayers.28 OECD Model Tax Convention Art. 5, 7, 23A, 23B. Collectively, these articles provide that the source country may tax the business profits attributable to a permanent establishment therein and that the residence country must provide double tax relief through either a credit or an exemption.29 Under U.S. law the result follows from I.R.C. § 61.30 Under U.S. law TP1 would be able to credit taxes paid to a foreign government (here Pt) under I.R.C. § 901(a) and (b), subject to the limitations set forth under I.R.C. § 904. Assuming for simplicity that DSI and P represent net amounts (i.e., all deductions have already been allocated and apportioned) then the overall limitation of I.R.C. § 904 would permit a maximum credit here of (t)(DSI+ P)(P/DSI + P), or simply Pt. Because there is only one item of income in this example one can ignore the separate basket limitations under I.R.C. § 904(d).

and on Capital. I will consider two cases in turn involving risky foreign direct investment.

In the first case two resident corporate taxpayers of J1, TP1 and TP2, undertake a

direct investment opportunity in J2 (i.e., there is no distinct legal entity formed in J2).27

TP1 and TP2 each have a fixed amount of domestic source income, DSI, arising from

activities that they undertake in J1, and each taxpayer is entering J2’s market for the first

time. Finally, I assume that the two investment opportunities have the same expected

return and risk profiles. In the terminology introduced above, each investment

opportunity has the same expected value y, which can be decomposed into its positive

component g and its negative component r.

What happens in this case if TP1 in fact realizes a positive return, P, on its

investment opportunity while TP2 realizes a negative return, N? In general the source

country would exercise the primary taxing jurisdiction.28 This means that J2 will tax the

positive return of TP1 at tax rate t. Thus J2 will collect tax revenue equal to Pt. J1, which

applies a credit system, will require TP1 to bring P into income, thus giving rise to a

tentative tax liability Pt.29 However, assuming the requirements of the foreign tax credit

have been met, TP1 may claim exactly Pt in foreign tax credits, thereby reducing the

liability to J1 to zero.30 The treatment of TP2 is drastically different. Although the source

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31 Under U.S. law the loss would be permitted under I.R.C. § 165, which permits a deduction for losses generally, without any limitation for losses that arise from foreign investments. Where an overall foreign loss offsets domestic source income the loss may be “recaptured” through operation of the foreign tax credit limitation rules on overall foreign losses under I.R.C. § 904(f). In brief, under this provision the taxpayer must reduce the amount of foreign tax credits in subsequent years where there is overall net foreign source income. If the taxpayer never experiences net foreign source income, however, the loss is never recaptured. Note that although most credit countries follow the approach of allowing net foreign losses to offset domestic source income, this approach is not universal. See Hugh J. Ault and Brian J. Arnold, Comparative Income Taxation, A Structural Analysis ___ (noting that Australia does not permit foreign losses to offset domestic source income). Also, some credit countries that do permit such losses lack recapture rules. [Cites.]32 Note that if DSI < N this does not shift the burden of any portion of the loss to J2. Rather, it just shifts the burden of the loss back to the private sector of J1. As will be seen presently this is similar to the effect witnessed more generally where the residence country applies an exemption method.

jurisdiction exercises the primary taxing jurisdiction, on the assumption that there is no

refundability of net losses J2 will not bear any portion of this loss. J1, however, permits

the loss to be offset against TP2’s domestic source income.31 That is, J1’s tax revenue

decreases by Nt.

Under these assumptions the same results follow for any realized positive or

negative return. That is, on any positive return P, J2 collects Pt and J1 collects nothing,

and on any negative return J2 bears no cost and J1 bears the full cost of Nt (assuming

that DSI ≥ N).32 Thus on an ex ante basis for any given taxpayer undertaking a cross-

border investment it follows that the J1 fisc bears the full expected downside tax cost of

the negative component of the return rt and J2 enjoys the full expected upside of the tax

potential gt. This split of gt and rt across the fiscs of two sovereigns is the basic

phenomenon of divergence (in the foreign tax credit context) and is summarized in the

table below, with the subscripts PUB and PRIV denoting the public and private sectors

and the bolded entries representing the divergence.

Table IDivergence Where Residence Country Applies a Foreign Tax Credit

J1 = Residence Country and J2 = Source Country

Foreign Profit Foreign LossJ1-PUB 0 rt

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33 See supra note ___.34 [Cites.]

J1-PRIV g(1-t) r(1-t)J2-PUB gt 0J2-PRIV N/A N/A

Now consider a second case in which everything is the same as the first case,

except that J1 now relieves double taxation through an exemption method rather than a

foreign tax credit. As in the first case the source jurisdiction will exercise the primary

right to tax.33 The result with respect to the realized profit is thus identical to the above

case. J2 will capture revenue of Pt. The key difference between the two cases is the

fashion in which the realized loss is treated. Unlike the case of a jurisdiction applying a

foreign tax credit, a country applying an exemption system will not allow foreign source

losses to offset domestic gains.34 Thus in this case neither J1 nor J2 bears the cost Nt at

the governmental level. Rather, the full cost of the loss, N, is borne here by the

taxpayer who undertakes the investment.

Again, under the relevant assumptions these results follow for every positive

return P and every negative return N. Thus on an ex ante basis for a given taxpayer J2

enjoys the full expected upside gt and J1 does not bear any downside at the

governmental level. However, the private sector of J1, which is not permitted a

deduction for its loss bears the full downside r. These results can be summarized in the

following table, again with the bolded entries representing the divergence.

Table IIDivergence Where Residence Country Applies an Exemption Method

J1 = Residence Country and J2 = Source Country

Foreign Profit Foreign LossJ1-PUB 0 0

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35 Note that one might have supposed that a full specification of a two sovereign world, where each country can apply one of two types of systems (credit or exemption), would have yielded four possible cases, rather than two. That is not so, however, because the variable regarding whether to tax on a worldwide or a territorial basis exists only with respect to outbound investment. In the inbound case countries always tax on a territorial basis. Thus the ramifications of (i) a taxpayer resident in a credit country investing into a credit country or (ii) a taxpayer resident in an exemption country investing into a credit country are already captured by the two cases I discuss in the text.

J1-PRIV g(1-t) r = rt + r(1-t)J2-PUB gt 0J2-PRIV N/A N/A

I will have more to say later about the relevance of the distinction between credit

and exemption systems. At this point, though, I would emphasize that I treat both of

these cases as manifesting the phenomenon of divergence in this paper. That is

divergence is a phenomenon that relates to the severance of some portion of upside

and downside risk across sovereigns jurisdictions. For these purposes I include the

case where the divergence occurs as between two governmental sectors (as in the

case of the credit method described above) and as between the governmental sector of

one sovereign and the private sector of another sovereign (as in the case of the

exemption method described above).35

Relaxation of Assumptions

The analysis above demonstrates what I will refer to as the baseline case of

divergence. Under that baseline, where tax rates are the same in two jurisdictions, for a

given risky investment with expected return of g + r, the source jurisdiction anticipates

ex ante an expected return of gt and the residence jurisdiction anticipates ex ante an

expected (negative) return of rt. The assumptions producing that baseline above are

obviously quite stringent and do not accurately capture many essential elements of

international taxation in the real world. Accordingly in this section I examine the effect

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36 I mean to generalize here to cover the possibility of a progressive rate structure. Thus the terms tR and tS should be understood to represent whatever tax rate is applicable given the jurisdiction’s progressive rate structure. Because the important element that requires analysis here is the differential rate between the residence and source jurisdictions the feature of progressivity does not add anything to the analysis. That is, whether that differential arises in virtue of different flat rate structures or the application of different brackets (under either different or identical progressive structures) is irrelevant to the analysis in the text.37 The decision to hold the residence country rate fixed while varying the source country rate is arbitrary. One could just as well hold source country rates constant. It is necessary, though, to hold one jurisdiction’s rate constant or else it is impossible to make meaningful statements about how relative rates affect divergence. The reason is that absolute rates also affect the degree of divergence. In other words, having adopted the baseline case of divergence to involve a split of rt and gt across the residence and

of relaxing the key assumptions. There are many potential complications here, and

jurisdictions obviously take a multitude of different approaches to these issues. What I

hope to show here, however, is that through a conceptual analysis of the features

common to many tax systems, it is possible to identify those features of systems that

are likely to increase or decrease (from the baseline) the level of divergence. Moreover,

I show that even if divergence is less than under the baseline, it is still likely to exist

under more plausible assumptions to some extent.

Rate Differentials

Under my strict assumptions I assume that both jurisdictions tax at a single flat

rate. Obviously, in the real world jurisdictions apply different tax rates and may adopt

progressive rather than flat rates. These facts, though they may affect the degree of

divergence, are unlikely in general to eliminate the phenomenon. To examine the effect

of rate differentials I will denote the tax rate of the residence country as tR and the tax

rate of the source country as tS.36 Thus the baseline case discussed above is simply the

case where tR = tS. Here, I examine the effects on divergence if we hold tR constant but

allow tS to vary. That is, from the perspective of a residence country that applies a given

tax rate what magnitude of divergence will be observed with respect to capital export to

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source jurisdictions respectively, the degree of divergence will increase as t increases (even assuming the residence and source country apply the same rate). Thus holding tR constant allows one to isolate the effect of relative rate differentials.39 Under U.S. law the mechanical analysis is essentially the same as the one described above, with modification for the different tax rates. See supra note ___. Thus the taxpayer who realizes a positive return P would have tentative tax liability of PtR and would be able to credit taxes paid to a foreign government (here PtS) under I.R.C. § 901(a) and (b), subject to the limitations set forth under I.R.C. § 904. Here the overall limitation of I.R.C. § 904 would permit a maximum credit of (tR)(DSI+ P)(P/DSI + P), or simply PtR. Because PtR > PtS, the taxpayer will be able to claim the full amount of credit for taxes paid to the source country (and will have excess limitation that can soak up excess foreign tax credits carried back or over to the relevant year). 39 See supra note ___ for the relevant analysis under U.S. law.40 Note that the provision of tax sparing credits does not change the result. If the residence jurisdiction provides tax sparing credits and the source jurisdiction applies a zero tax rate then there is no divergence because the taxpayer enjoys 100% of the upside on a positive realized return.

source countries that apply higher or lower rates?37

Consider first the case where the residence country applies a foreign tax credit.

If the source jurisdiction applies a lower rate of tax than the residence country (tS < tR),

then the effect under a foreign tax credit in general will be to impose a residual

residence jurisdiction tax liability, with the effect that the taxpayer faces an overall rate

of tR. That is, where the taxpayer realizes a positive return P the credit should operate

to levy a tax in the residence country equal to PtR – PtS.39 Losses on a realized negative

return would still be borne entirely by the residence country (i.e., NtR).39 Thus the effect

will be to reduce divergence as compared to the baseline case because part of the

upside potential is shifted back to the residence country. However, except in the special

cases of a tax haven imposing a 0 rate of taxation or a developing country that imposes

a 0 rate under a tax holiday, the phenomenon of divergence will still exist.40 On an ex

ante basis the effects, as compared to the baseline can be summarized as follows.

Table IIIDivergence Where Residence Country Applies a Foreign Tax Credit

J1 = Residence Country and J2 = Source CountryTax Rate in Source Country < Tax Rate in Residence Country

Foreign Profit Foreign LossJ1-PUB g(tR-tS) rtR = r(tR-tS) + rtS

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41 The analysis under U.S. law in the case of a realized positive return is again similar. See supra note ___. Thus the taxpayer who realizes a positive return P would have tentative tax liability of PtR and would be able to credit taxes paid to a foreign government (here PtS) under I.R.C. § 901(a) and (b), subject to the limitations set forth under I.R.C. § 904. Here the overall limitation of I.R.C. § 904 would permit a maximum credit of (tR)(DSI+ P)(P/DSI + P), or simply PtR. Because PtR < PtS, the taxpayer will be able to claim the full amount of credit for taxes paid to the source country (and will have excess foreign tax credits that may be carried back or over under I.R.C. § 904(c)). Under the assumption of one foreign investment there is no possibility to cross-credit with respect to low taxed foreign source income in the given tax period. If one relaxes this assumption and allows for the possibility of multiple foreign investments then there may be effects on the division of profit in J1 as between the public and private sectors. In particular, assuming J1 applies a foreign tax credit and permits some cross-crediting as between high-taxed and low-taxed foreign source profits, then the effect will be to produce a public-private division of profit in J1 that lies somewhere between that seen in Table III and Table IV. In other words, the taxpayer is using excess foreign tax credits to reduce the government’s tax claim on low-taxed foreign profits to something below the amount that would be taxed in the single item case described in Table III. This result, however, does not impact the level of divergence. I discuss the affect of introducing multiple foreign investments further below. See infra ___.

J1-PRIV g(1-tR) r(1-tR)J2-PUB gtS 0J2-PRIV N/A N/A

Conversely, if the source jurisdiction imposes a more burdensome tax than the

residence country (tS > tR) then the effect will be to increase the level of divergence from

the baseline. As compared to the baseline the downside borne by the residence

country remains the same but the upside taken by the source country increases. That

is, the source country will collect PtS on a positive realized return and the residence

country will bear the cost of NtR on the negative return.41 On an ex ante basis the

results can be summarized as follows.

Table IVDivergence Where Residence Country Applies a Foreign Tax Credit

J1 = Residence Country and J2 = Source CountryTax Rate in Source Country > Tax Rate in Residence Country

Foreign Profit Foreign LossJ1-PUB 0 rtR

J1-PRIV g(1-tS) r(1-tR) = r(1-tS) + r(tS-tR)J2-PUB gtS = gtR + g(tS-tR) 0J2-PRIV N/A N/A

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The analysis in the case where the residence country applies an exemption is

more straightforward. Because the residence country neither seeks to tax any portion

of realized positive returns nor grants any benefit with respect to negative returns the

relative rate of host country and residence country taxation does not affect the level of

divergence. All that matters is the absolute rate of taxation in the host country. Thus if

the host country tax rate is higher than with respect to a realized positive return the host

country will be entitled to PtS and the full downside of a negative return must be borne

by the taxpayer. Similarly, if the source country rate is lower than the residence country

rate the source country will still be entitled to an amount equal to PtS on positive returns

and the taxpayer will bear the full amount of the loss. Note that as long as the source

country taxes at some positive rate the phenomenon of divergence continues to exist.

On an ex ante basis the results can be summarized as follows.

Table VDivergence Where Residence Country Applies an Exemption Method

J1 = Residence Country and J2 = Source CountryTax Rate in Source Country ≠ Tax Rate in Residence Country

Foreign Profit Foreign LossJ1-PUB 0 0J1-PRIV g(1-tS) r = rtS + r(1- tS)J2-PUB gtS 0J2-PRIV N/A N/A

These various effects can be summarized as follows. First, as the source

country rate decreases relative to the residence country rate divergence likewise

decreases under both a credit and an exemption system. However, so long as the

source country taxes at a positive rate divergence continues to exist. Second, as the

source country rate increases relative to the residence country rate, divergence

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increases under both a credit and an exemption system. These results should not be

surprising given that under the current assumptions the residence jurisdiction always

bears the entire burden of r. Thus the magnitude of divergence can be readily captured

by the rate of tax in the source country. Moreover, any positive tax rate in the source

country yields some degree of divergence. The above descriptive analyses do,

however, reveal various subtle distinctions between the ways in which credit and

exemption systems spread that burden across the public and private sectors. As noted,

I will return to the normative implications of these distinctions in Part IV.

The above-described effects are what might be thought of as direct effects on the

amount of divergence in the sense that these effects tell us how divergence changes,

as compared to the baseline discussed above, if we assume that taxpayer behavior is

held constant. Differential tax rates, however, will also affect taxpayer decisions about

where to locate investment. That can happen in the obvious way – where, for example,

an investor resident in an exemption country prefers a foreign investment over a similar

domestic one because the host country offers a more favorable tax rate. But it could

also happen in a less obvious way that is more directly connected to the discussion in

this paper. Such effects are best understood through the impact of the gain-loss ratio

on the taxpayer’s incentives. Although it is the topic of some dispute it is plausible that

alterations in the gain-loss ratio in the closed economy setting can have some impact on

the level of risktaking that taxpayers undertake as compared to the situation where

there is no income tax. In the wholly domestic setting, of course, the gain-loss ratio is

simply a function of how the government taxes gains and losses. But in the open

economy context differential tax rates across jurisdictions can also give rise to

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alterations in the gain-loss ratio.

One way to see the point vividly is to examine the interaction of two tax systems

which have different tax rates, but where each of the jurisdictions maintains a gain-loss

ratio of 1 (i.e., identical tax treatment of gains and losses). For example, suppose the

residence jurisdiction applies a credit method and the source jurisdiction applies a

higher tax rate than the residence jurisdiction. Although the gain-loss ratio would be 1

on a domestic investment, the gain-loss ratio on a foreign investment (tS/tR) would be

something greater than 1. To the extent that variations in gain-loss ratio in the wholly

domestic setting produce different incentives regarding risktaking, it is plausible to

expect that similar effects would be observed in the open economy scenario. The

difference is that in the open economy setting one would observe both shifts in the

amount of risk undertaken and locational effects. I do not propose to analyze the

magnitude (or even the direction) of such locational effects in this paper. I note,

however that to the extent they exist then clearly this will have an impact on the

absolute amounts of divergence that one will ultimately observe.

Base Differentials (Source and Nonsource)

Jurisdictions apply not only different rates from one another but also may define

the tax base in different ways. For purposes of determining how base variances affect

the level of divergence observed in the baseline case it will be useful to distinguish

between those base differences that relate to source determinations and those

differences that do not. I consider non-source determinations first because they are

relatively easy to dispense with. A nonsource base differential may arise where one

jurisdiction includes or excludes an item in the tax base but another does not. This type

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42 See supra note ___. 43 Under U.S. law the foreign tax credit limitation under I.R.C. § 904 would be (tR)(DSI+ P)(0/DSI + P), or 0. [Discussion of treatment of FTC limitation in other countries.]

of variation in base definitions, however, does not present any conceptual issues

distinct from those addressed above in connection with differential rates. That is, the

analysis above proceeded under the assumption of identity across tax systems, other

than with respect to rates. Thus there was no need to distinguish between statutory

rates and effective rates. The analysis, however, would apply in the same fashion to

either statutory rates or effective rates. Because this type of base differential can be

captured through an expression of effective tax rate, the rate analysis described above

captures any effects that arise through such base differentials.

Variations in source determinations across jurisdictions, by contrast, present

distinct issues because such variations generally portend a breakdown of agreed

positions regarding the primacy of taxing rights. At least as viewed from the perspective

of the law to be applied by the residence jurisdiction, the general effect of such source

variations will be to decrease the level of divergence. In the extreme case where two

jurisdictions both treat an entire realized positive return as domestic source income,

then from the perspective of the residence country any divergence would seem to

disappear. Consider first the case of a residence country that applies a foreign tax

credit. In the baseline case divergence exists insofar as the source country expects ex

ante to benefit by gt and the residence country expects to bear the cost of rt. However,

this analysis depends upon the credit country granting a foreign tax credit equal to Pt for

any realized return P.42 In fact, if the residence country treats the realized return P as

all domestic source income then no credit will be available.43 Thus the residence

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44 Specifically, the expected private return in the baseline case is g(1-t) but in the case of a completely inconsistent source determination the private return would drop to g(1-2t). Note that the drop will be less than this where the jurisdiction allows the taxpayer to deduct foreign taxes (even where there is no foreign source income). See, e.g., I.R.C. § 164.

country on an ex ante basis would expect to collect gt with respect to positive returns.

The result is similar where the residence country applies an exemption method. In that

case the residence country would not provide an exemption and thus would also seek to

collect Pt for any realized return P and would expect to collect gt on an ex ante basis.

Two factors, however, bear mention here. First, to the extent there are

conflicting source rules the elimination of divergence may well be illusory. Assuming

there is no reconciliation of the conflict (e.g., through competent authority proceedings)

the source jurisdiction will maintain a primary right to tax a positive realized return. If

that tax liability is in fact satisfied then the aggregate public and private return in the

residence jurisdiction remains the same as in the baseline case (i.e., g(1-t)). Thus it

may be true that the residence country fisc now expects to collect gt but this comes at

the cost of depleting the expected private return (as compared to the baseline case).44

Second, note that such discrepancies in source determinations are the exception rather

than the norm. As should be clear, the effect of conflicting source claims is to level

multiple levels of taxation on the same income stream (of a single taxpayer). The basic

structure of the international tax system, however, is designed to minimize precisely that

result.

In practice, then, the presence of base differentials across jurisdictions should

not cause significant departures from the baseline case of divergence (as modified to

take account of the possibility of rate differentials).

Loss Carrybacks and Loss Carryovers

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45 My assumption throughout the descriptive analysis in Part II is no refundability of losses. That is an accurate description of real world tax systems. A further assumption is that there is no de facto refundability through provisions that allow taxpayers to alienate their losses in the market. It is more difficult to generalize with respect to this issue but it is nonetheless true that many jurisdictions attempt to restrict the alienability of losses. [Cites.] 46 Note that if the residence jurisdiction taxes on a worldwide basis then there is a potential double benefit to the taxpayer insofar as the loss in period 1 has already been used to offset domestic source income.

The analysis in the baseline case assumes a single taxable period with no

prospect for the carryback or carryover of losses. The availability of loss carrybacks

and loss carryovers is only of value to the taxpayer to the extent that there is net

positive income against which to set the losses in other taxable periods.45 Thus in

relaxing the assumption regarding the availability of loss carrybacks and carryovers it

will be useful to distinguish two cases: (i) the case where there is net foreign source

income in other taxable periods and (ii) the case where there is net domestic source

income in other taxable periods. For purposes of this analysis I make the simplifying

assumption that jurisdictions apply the same sourcing rules.

The first case I consider is the effect of net foreign source income in other

taxable periods. This captures the case where it is the source jurisdiction that is

applying the carryback or carryover. Under the strict assumptions of the baseline case

we saw that the host jurisdiction enjoys the full benefit Pt on a realized profit and bears

none of the cost Nt on a realized loss. If the host jurisdiction permits carryovers and

carrybacks, however, this will tend to decrease the level of divergence observed under

the baseline case because with respect to a realized loss the host jurisdiction now will

bear a portion of Nt, at least to the extent that there is net positive income against which

to set the loss. In the limiting case, if there is positive income equal in magnitude to N in

years within the carryback-carryforward window then the full burden of Nt will be shifted

to the source jurisdiction.46

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The United States seeks to recapture this benefit under I.R.C. § 904(f). See supra note ___. Not all credit countries, however, have such recapture rules. Id. The possibility of such a double benefit does not arise where the residence country taxes on a territorial basis because in that case the residence jurisdiction would not have permitted the foreign source loss to offset domestic source income in the first instance. In any event, I do not take the absence or presence of such a double benefit to affect the degree of divergence, as defined here. Once the source jurisdiction bears a portion of a loss that is equal to its revenue take on a profit, the divergence is removed. Further effects that arise from the residence jurisdiction treatment of overall foreign losses impact only the division of gains and losses as between the public and private sectors in the residence jurisdiction.47 Again, I assume no refundability.

Thus the effect of carrybacks and carryovers can be to eliminate the

phenomenon of divergence but it is useful to make three observations. First,

divergence will necessarily continue to exist to some extent where a given taxpayer has

net foreign source losses over the life of the taxpayer.47 Second, divergence will

continue to exist where the taxpayer has net profit over the life of the taxpayer but

experiences foreign source losses in a given taxable period which expire because not

usable within the allowed carryback-carryover window. Finally, even if the taxpayer is

able to fully carryback or carryover any experienced losses divergence persists to some

extent so long as carryovers are not adjusted by an appropriate rate of interest. For

example, suppose a resident of an exemption country bears a foreign source loss that

will ultimately be carried forward to offset income in a period five years later. Assuming

there is no interest adjustment, the loss is effectively borne by the residence jurisdiction

during this five year window.

The second case I consider is the case of net domestic source income in other

taxable periods. This captures the case where it is the residence jurisdiction that is

applying the carryback or carryover. The availability of carryovers and carrybacks in

this situation does not affect the level of divergence. The result follows readily in the

case where the residence country taxes on a territorial basis because then foreign

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losses are never available to offset domestic source income. Thus carrybacks and

carryovers have no effect. Where the residence jurisdiction taxes on a worldwide basis,

the provision of carrybacks or carryovers likewise does not impact the level of

divergence. In the restrictive assumptions of the baseline case, of course, the

provision of carrybacks or carryovers has no effect at all because it was assumed that

there was always sufficient domestic source income to absorb any foreign loss in the

taxable period. But even if one relaxes that assumption, the provision of carrybacks or

carryovers does not affect the level of divergence but rather simply determines how a

loss is split between the private and public sectors of the residence jurisdiction.

In sum, the provision of carrybacks and carryforwards by the source jurisdiction

will tend to reduce the level of divergence. It is unlikely, however to eliminate the

phenomenon. The provision of carrybacks and carryforwards by the residence

jurisdiction will not affect the level of divergence but will further accentuate the

differences between the way credit and exemption systems distribute losses between

the public and private sectors.

Multiple Foreign Investments

In the discussion of the baseline case I assume that there is only a single risky

foreign investment. The relaxation of this assumption yields a similar analysis to that

just undertaken in connection with the provision of loss carrybacks and carryforwards by

the source jurisdiction. The only difference is that introducing other investments

produces the possibility that there will be net foreign source income against which to

offset foreign losses for purposes of source country taxation in that tax period in which

the loss arises. To the extent this is the case there will be a reduction in the level of

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divergence because the source jurisdiction will be absorbing a portion of the downside

on realized losses. In the extreme case where aggregate profits on all foreign

investments are at least equal to aggregate losses on foreign investments then there is

no divergence. This is just to say that divergence is a phenomenon that arises in the

case where there is an overall foreign loss across all investments of a taxpayer in a

given tax period.

Controlled Foreign Corporations versus Branches

In the baseline case I consider the example of a taxpayer investing abroad

through a branch. Cross-border investments more typically occur, however, through

local corporations, so it is necessary to consider how the conclusions of the baseline

case are likely to play out under such a structure. Interestingly, the descriptive analysis

is largely the same.

As should be apparent at this point, departures from the level of divergence

described in the baseline case are driven by the tax instruments of the jurisdiction of

source, not the jurisdiction of residence. The latter instruments may have important,

and subtle, effects on the sharing of risk as between the public and private sectors of

the residence jurisdiction but do not affect the level of divergence (in a static analysis).

It is appropriate, therefore, to begin the analysis of how the introduction of a local

corporate entity affects the analysis from the perspective of the source jurisdiction.

Interestingly, the analysis remains largely the same. The chief reason is that source

jurisdictions generally tax the operations of a branch and a local corporation under

similar tax regimes. In the treaty context, at least, the source jurisdiction is generally

precluded from applying more onerous tax treatment to the branch under

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48 OECD Model Tax Convention Art. 24. The source jurisdiction could seek to provide more favorable treatment to foreign taxpayers in an attempt to attract foreign capital, while not granting the benefit to domestic interests in order to preserve revenue. [Cites.] In such cases of “ring-fencing,” however, it would be odd for the source jurisdiction to distinguish between branches of foreign corporations and local subsidiaries of foreign corporations. I thus ignore the possibility in the current analysis. 49 In the case where the source jurisdiction does apply a branch profits tax then there will likely be no difference between the branch and subsidiary case in virtue of differential rates between the branch profits tax and a dividends withholding tax because such disparities are generally eliminated by treaty.

nondiscrimination principles.48

Two special issues, however, do bear mention. First, in the case where the

source jurisdiction imposes a withholding tax on dividends paid by a subsidiary to a

foreign parent but imposes no branch profits tax, then there would potentially be a

greater degree of divergence in the case of foreign investment through a subsidiary as

compared to a branch. The reason is that the source jurisdiction would capture a

greater portion of the upside on a profitable investment. In the terms discussed above,

tS would be relatively higher in the subsidiary case, and this tends to increase the level

of divergence. This effect, however, may be eliminated by treaty.49 Second, if the

subsidiary is permitted to consolidate with other local entities then this creates the

possibility that losses of the subsidiary could be offset against the income of entities in

consolidation, even though no such offset would be permitted in the branch case.

Where such a phenomenon arises, this would tend to decrease the level of divergence.

This is simply a specialized instance, however, of the general point offered above that

divergence is a phenomenon that arises in connection with overall foreign losses.

Turning to the residence jurisdiction the chief differences between undertaking a

foreign investment through a foreign subsidiary as opposed to a foreign branch relate to

questions of timing and the mechanics of double tax relief. Timing differences arise with

respect to profits realized through a foreign subsidiary because the residence

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50 My initial focus on direct, rather than portfolio, investment may appear out of step with much of the tax and risk literature, which often expressly limits analysis to the case of portfolio investment. [Cites.] That limitation, however, has a specific genesis, which does not bear upon the descriptive analysis undertaken here. In particular, the primary reason to limit discussion to portfolio investment is that it is assumed that the taxpayer can more readily enter into the market and procure additional portfolio investments of the same character (i.e., either identical investments or investments with the same risk profile). The availability of additional investment opportunities will be a central concern if one’s analysis depends on how much the taxpayer increases, or scales up, the level of riskbearing under the income tax. The descriptive and normative claims I make here, however, do not depend for their validity on any particular taxpayer response or adjustment to investment holdings.51 See OECD Model Tax Convention Art. 10 (capping source country right to tax dividends on portfolio investment at 15% for individuals and 5% for controlling corporate shareholders); Art 11 (capping source country right to tax interest at 10%). Rates under many treaties, or unilaterally under domestic law, may be even lower. From the standpoint of the residence country double tax relief will decline in virtue of the reduced source country tax. That will be the case for credit countries because there will be less tax to credit. It will also generally be the case for exemption countries. See OECD Model Tax Convention Art. 23A (requiring exemption country to give only a deduction for the amount of tax levied by the source country under Article 10 or Article 11).

jurisdiction may well not tax the profit until the time of an actual distribution or

disposition of shares. Conversely, losses realized through a foreign subsidiary will not

be available to offset domestic source income until there is a disposition of shares. The

mechanics of double tax relief, at least in a credit system, likewise must be adjusted so

as to match the timing of the availability of foreign tax credits and the inclusion of the

associated foreign source income. In all of these instances, however, the stakes relate

simply to the division of profit and loss between the private and public sectors of the

residence jurisdiction.

Portfolio Investment versus Direct Investment

I have up to this point considered only the case of a domestic corporation

undertaking foreign direct investment. I consider here the case of portfolio investment

(undertaken either by a resident domestic corporation or individual).50

Source jurisdictions generally cede substantial taxing jurisdiction over returns to

portfolio investment.51 Insofar as the analysis in the baseline case depends on the

source jurisdiction capturing upside potential under its superior claim to tax profits, one

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52 See OECD Model Tax Convention Art. 10 (capping source country taxation of dividends from direct investment to 5% and from portfolio investment to 15%).

might expect that portfolio investment would produce relatively less divergence than

direct investment. More specifically, as compared to the baseline case where the

source jurisdiction captures Pt on a realized positive return, it would seem that in the

case of the portfolio investor the source jurisdiction captures a lesser amount equal to

Pw, where w is equal to the maximum permissible withholding tax under a treaty (or, if

lower, the withholding tax granted unilaterally under domestic law). Such an analysis,

however, offers only a partial, and skewed, picture of what is going on because the tax

imposed on the portfolio investor is a shareholder level tax. A complete analysis must

also consider any underlying corporate tax.

Consider the case of a portfolio investor in a source country corporation.

Assume, consistent with the baseline case, that the source jurisdiction taxes resident

corporations at rate tS. Considering corporate and shareholder taxes in the aggregate,

the real difference between portfolio and direct investment is in the different level of

withholding taxes that may be collected on each.52 With respect to a realized profit P

the effect of such a difference in withholding rates can be fully captured by the analysis

of rate differentials offered above. In particular, because the withholding rate on

portfolio investment is generally higher than that on direct investment, as compared to

the baseline case the source country will tend to capture a greater portion of a realized

profit P where it is structured as a portfolio investment. Conversely, absent refundability

(and subject to the caveats introduced above) the same source jurisdiction bears no

part of the realized loss N. Thus, other things equal, the level of divergence should be

greater for portfolio investment as compared to direct investment.

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53 One interesting and distinguishing feature of the terminal disposition is that in an attempt to prevent loss trafficking jurisdictions may limit the ability to use pre-acquisition losses against post-acquisition income. See, e.g., I.R.C. § 382. Where a source jurisdiction imposes such limitations, the effect can be to increase divergence because it dampens the impact of the loss carryforward window that would otherwise be available. See supra ___. This is but a specific instance of the more general proposition that as one moves toward full refundability (or alienability) of losses then divergence decreases, and as one moves away from full refundability (or alienability) the effect is just the opposite.54 See supra ___.55 The analysis becomes complicated where there are multiple foreign investments. In particular, if there are other investments that produce foreign source profits, an exemption country will generally exempt such foreign source income no matter what but the amount of double tax relief in a credit country may depend on how the loss is sourced for foreign tax credit limitation purposes. Depending on the applicable sourcing rules this could, but need not, have the effect of bringing a credit system closer to an exemption system in terms of how losses are split between the private and public sectors. A numerical example

Gain or Loss Realization from Disposition

One final modification to the baseline case I consider is the situation where a

profit or loss is realized for tax purposes from the disposition of an investment, as

opposed to the ongoing operation of such investment. Consistent with much of the

preceding discussion, on the assumption of no refundability, this relaxation of

assumptions generally does not impact the level of divergence because the relevant

differences relate to tax consequences in the jurisdiction of residence.

Where the disposition of an investment results in a realized loss N the analysis of

divergence is only slightly different from the case where such loss is realized prior to

disposition. Under the constant assumption of nonrefundability, the full loss N is

necessarily borne by the aggregate of the public and private sectors in the residence

country.53 Credit and exemption countries, however, may distribute that loss in a

different fashion. If the residence country taxes on a worldwide basis and applies a

foreign tax credit, then in general any loss will be available to offset domestic source

income.54 If the residence country taxes on a territorial basis, however, the use of that

loss (i.e., the ability to shift the loss from the private to the public sector) will depend on

whether the loss is treated as domestic or foreign source.55

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may assist in demonstrating this point. Suppose a corporate investor resident in J1 has $10 million of domestic source income; realizes a $2 million loss on the disposition of shares in a wholly-owned J2 subsidiary; and realizes $2 million of dividend income from a wholly-owned J3 subsidiary. For simplicity, assume there is no other income; there is no controlled foreign corporation legislation; there are no dividend withholding taxes; and all countries tax corporate income at a flat 30% rate. If J1 is an exemption country then $2 million of dividend income from the J3 subsidiary will generally be exempt from tax and the $2 million loss would not, if it is treated as foreign source, be available to offset domestic source income. Thus the taxpayer bears residence country tax of $3 million. The private sector, as is typical in an exemption country, bears the full amount of the (foreign) loss from the disposition of the J2 subsidiary. If J1 is a credit country, by contrast, the $2 million loss will generally be available to set off against the $12 million of worldwide income, yielding $10 million of taxable income, or $3 million in tentative tax liability. Whether the taxpayer can claim a foreign tax credit with respect to the $2 million dividend will depend on how the residence jurisdiction sources the loss for purposes of applying any foreign tax credit limitations. For example, if the residence jurisdictions sources the loss 100% foreign then there would be no net foreign source income and likely no ability to take a foreign tax credit. In such a case the way in which the loss is split between the public and private sectors matches the result in an exemption country. If the loss is sourced 100% domestic, however, then the foreign tax credit limitation is unlikely to preclude the taking of a credit. In the United States, for example, such a loss would be treated as U.S. source and thus would not limit the taking of a foreign tax credit that was otherwise available. See International Multifoods Corporation and Affiliated Companies, 108 T.C. 579; [Treasury Regulations]. In that case, the greater shifting of losses to the public sector, typical in credit systems, remains intact.56 See OECD Model Tax Convention Art. 13(2).57 The mechanics of the double tax relief are the same as already discussed. See supra ___.58 See OECD Model Tax Convention Art. 13(4).

Where the disposition of an investment results in a realized profit P one needs to

distinguish between asset and stock dispositions. Consider first the case of a domestic

corporation with a foreign branch that realizes a gain upon disposition of all branch

assets. This is the case that most closely tracks that of the case in which the taxpayer

is realizing income on an ongoing basis. In particular, the source jurisdiction retains the

primary right to tax this gain.56 Thus on a realized positive gain of P, the source

jurisdiction captures Pt, and the residence jurisdiction is required to provide relief from

double taxation (notwithstanding the fact that, as we just saw, in the inverse case the

loss would be borne by the residence jurisdiction).57 The case of a stock disposition

(either direct or portfolio investment) gives precisely the opposite result. That is, the

source jurisdiction does not have the jurisdiction to tax the gain realized on a stock

disposition.58 Thus it is the residence country here that captures the full amount Pt. At

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59 If there has been previously taxed corporate level gain at the source country level note that the possibility for double taxation arises. Residence countries may provide relief in this circumstance even though generally applicable rules would attribute domestic source to the gain from the sale of stock. For example, the United States generally recharacterizes the gain on stock in CFCs, to the extent previously realized, as foreign source dividend income. Section 1248. The significance of that recharacterization is that it permits the U.S. corporate seller to claim an indirect foreign tax credit. Section 902. [Compare results in exemption country.]

first blush this may appear to suggest that there is no divergence where the foreign

investments are conducted in subsidiary form and gains are deferred until the time of

disposition. This is incorrect, however, because any gain on a stock disposition should

simply represent gain at the underlying corporate level. Such gain may have already

been realized (and taxed by the source country) at the corporate level but not yet

distributed or may be unrealized at the corporate level but continue as a latent source

country tax inherent in low basis corporate assets.59 This source country tax, whether

already imposed or latent, preserves the divergence in these cases.

Retention

The phenomenon that I call retention is derivative upon the phenomenon of

divergence. As I develop in detail below, divergence is, in the first instance, a

distributional phenomenon across jurisdictions. The jurisdiction that disproportionately

enjoys upside potential (the source country or capital importer) enjoys a revenue

increase (as compared to the baseline where the investment is made with capital

originating within the sovereign) and the jurisdiction that disproportionately bears the

downside (the residence country or capital exporter) suffers a revenue decrease (as

compared to the baseline where the investment is made locally rather than abroad).

What I call retention arises because these distributional effects cannot be

reversed at the governmental level. Typically, they may only be reversed, rather, to the

extent that there are shifts in the level and direction of private investment activity (e.g.,

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60 The exception to this general point would be the case where the government itself takes portfolio positions in risky foreign investments. I do not reject the possibility but note rather that as a practical matter there are substantial political constraints on such activity becoming a widespread practice. 61 See OECD Model Tax Convention Art. 24.62 The possible exception is a country that captures a disproportionate share of its tax base through taxes on imported capital. Such countries, however, are the ones least likely to be bearing net downside in light of divergence.

the capital exporter becomes a capital importer).60 The point is easy to see both from

the perspective of the jurisdiction enjoying the upside or from the perspective of the

jurisdiction bearing the downside.

From the perspective of the country bearing the downside the options available

at the governmental level for absorbing the cost of losses are to increase taxes,

increase borrowing, print money, or decrease spending. These options need not

exclusively effect the domestic economy but they will affect the domestic sphere

disproportionately. For example, it generally will not be possible to increase taxes on

foreign residents because of treaty nondiscrimination restrictions.61 Any tax increases

will have to be neutral as between taxpayers and thus are likely to affect the home

country economy disproportionately.62 Similarly, spending cuts and the costs of

increased borrowing are likely disproportionately to affect the domestic economy.

From the perspective of the country bearing the upside there is likely no domestic

political pressure to spread these benefits back to another jurisdiction. And, for the

same reasons as those canvassed above, if an increase in revenues were to spur

neutral adjustments to fiscal or monetary policy, these can be expected to have a

disproportionate positive impact on the domestic economy.

The Distributive Case for Reducing Divergence

I turn now to normative considerations. In this Part III I consider first the

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63 One possible response here is that there is no normative justification and that the current state of affairs simply represents the effects of the relative bargaining power of sovereigns. We expect partners acting at arm’s length in the market to bargain so that upside and downside risk are in alignment. If one were to witness a partnership arrangement in which one partner took a substantial portion of the upside potential without bearing any downside risk one would conclude that something was awry. Why do we see just that state of affairs as between sovereignties, which bargain over their international taxing jurisdiction, in connection with the phenomenon of divergence? Divergence is a zero sum distributional phenomenon, in which the winner is the capital importer and the loser is the capital exporter. Thus we might expect the observed system to be an artifact of undue strength exercised by capital importers in the design of the instruments used to divide the international tax base. Although, it would be necessary to consider these effects with respect to the persistence of the phenomenon and the likely response of jurisdictions encountering attempts to alter the status quo, I would reject an uneven bargaining power

normative ramifications of the phenomenon of divergence in isolation. The basic

argument is that international tax policy has paid insufficient attention to the

phenomenon of divergence and that divergence ought to be reduced on distributive

grounds.

Questioning the Distributional Effects

Much of the normative debate in the area of international taxation focuses in

some way upon the question of how jurisdictions ought to divide the right to tax the

positive return to economic activity that spans national borders. Why has there been so

little attention paid, one might wonder, to the seemingly analogous question of how

jurisdictions ought to divide the losses from cross-border economic activity? Perhaps

the answer to that question is that you do not need a separate theory to deal with

losses. That is, it is certainly possible that whatever theory one adduces to address the

question of the division of the rights across jurisdictions to tax net income is also

sufficient to address the issue of losses. The descriptive analysis offered above,

however, suggests that this facile response is inadequate. There is something peculiar

about the phenomenon of divergence, at least insofar as it departs from our common

understandings of how upside and downside risk are generally conjoined in the market.

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explanation of how the phenomenon came to arise in the first instance for the simple reason that the nations that were the architects of the international tax system that largely persists today were likely to have been the countries that were net capital exporters.64 I distinguish here between the duplication of net losses and the duplication of deductions, as might occur where taxpayers engage in so-called international tax arbitrage transactions. A number of commentators have addressed the issue of international tax arbitrage in recent work. [Cites.] As long as the taxpayer engaging in arbitrage has net income in the relevant jurisdictions, however, the duplication of deductions can be analyzed within the typical framework of division of the rights to tax income. The only difference is the question becomes one of international double non-taxation as opposed to international double taxation. The issue I address here is quite different, as it involves the case of a real economic loss and the question of how that loss is to be spread across jurisdictions.

If divergence is normatively justified, it cries out for independent theoretical

explanation.63

One plausible explanation for the almost total absence of attention paid to the

question of loss division is that unlike the case of gains there is generally no prospect of

loss duplication.64 In other words, accepting that the central problem of international

taxation arises out of overlapping entitlements and the accompanying possibility of

double taxation, the possibility of duplication with respect to losses generally does not

arise. The reason, of course, is that jurisdictions do not provide for the refundability of

losses. At most, then, a taxpayer may benefit once from a net loss to the extent that the

residence jurisdiction permits the loss to be used to offset domestic source income.

Viewing the issue through the general international framework of ameliorating the

detrimental effects of overlapping taxing jurisdiction, it is not surprising that it would

appear as if there is simply no issue to address. The basic normative claim I develop in

this part of the paper calls that approach into question.

Divergence and retention clearly produce distributional effects across

jurisdictions. That fact, standing alone, carries no normative weight, however. To the

contrary, distributional effects across jurisdictions are commonplace and widely

accepted as normatively unproblematic in the area of international taxation. This

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65 This claim should be distinguished from the very different claim that relative priority of overlapping source and residence entitlements should be determined with respect to the distributive consequences. See, e.g., Reuven Avi-Yonah, Globalization, Tax Competition, and the Fiscal Crisis of the Welfare State, 113 Harv. L. Rev. 1573, 1649-50 (2000). [Cites -- Musgraves.]66 [Cites.]

follows from the conjunction of factor movements across borders and the generally

accepted right of jurisdictions to tax on a territorial or source basis. Put simply, where a

resident of one jurisdiction deploys capital abroad and the host country applies its

source-based taxing jurisdiction, distributional effects necessarily follow.

It is important, though, not to let these pervasive distributional effects obscure a

rather different point. Specifically, transnational redistributive consequences of

international tax instruments other than what follows simply from the conjunction of

factor movements and the exercise of the entitlement of source-based taxation stand in

need of some affirmative justification.65 At least in democratic societies, that claim is a

matter of political legitimacy. Of course, some may reject the claim that any state ever

has the power to exercise coercive redistributive policies. Bracketing such claims and

accepting the legitimacy of some redistribution, though, the argument from political

legitimacy is simply that a redistributive tax system should function either at the level of

the nation state or at the level of subnational units, so long as these are the relevant

political units that have responsive democratic law-making institutions. Redistribution

across nations may or may not be morally desirable from the standpoint of universal

distributive justice, but pending the establishment of democratically responsive

supranational institutions such redistribution should be considered an illegitimate act of

state coercion.66

Source basis taxation, by definition, is not premised upon some political

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67 Taxation on the basis of residence, by contrast, is generally premised at least in part upon some political connection between the taxpayer and the state. See Peggy Musgrave, Consumption Tax Proposals in an International Setting, 54 Tax L. Rev. 77 (2000); Peggy Musgrave, Interjurisdictional Coordination of Taxes on Capital Income, in Tax Coordination in the European Community 197 (Sijbren Cnossen ed., 1987). That connection is tenuous in the case of corporate taxpayers with widely dispersed ownership of capital stock and residence-based taxation must be defended on some other basis.68 [Cites.]69 A fanciful example will help to illustrate the point. Suppose that the United Kingdom took the position that all modern English language literature owes some debt to Shakespeare and that on this basis it would assert “source” basis jurisdiction to tax any royalties on English language publications in the United States. Putting aside administrative concerns, this would be an illegitimate extension of source basis jurisdiction that would lack political legitimacy. 70 For a comprehensive discussion of the normative basis of the source entitlement see Nancy H. Kaufman, Fairness and the Taxation of International Income, 29 Law & Pol’y Int’l Bus. 145, ___ (1998).

connection between the state and the owner of capital deployed within the host

country.67 Rather, it must be justified on other grounds, which I discuss in a minute. In

terms of justifying the legitimacy of the taxing claim in the absence of any political ties,

one could rely on the fact that the taxpayer will generally have chosen voluntarily to

deploy capital within the source jurisdiction.68 In any event, though, arguments from

state legitimacy place intense pressure on source basis taxation because the actual

exercise of such jurisdiction, which in fact exceeds the proper bounds of the source

entitlement, will lead to illegitimate redistributive effects.69 The question that I address

here is whether the phenomena of divergence and retention implicate just such a

problem of an illegitimate exercise of source basis taxation.

Answering that question requires an examination of the underlying justifications

for source basis taxation. The source entitlement premises jurisdiction to tax upon a

notion of territoriality. In short, a jurisdiction is presumed to have the jurisdiction to tax

income that is earned within its borders, notwithstanding the fact that the owner of such

income has no additional ties to the jurisdiction (either physical or political). Although

there is some dispute over the theoretical justification for the source entitlement, it is

typically grounded either upon a theory of benefits or economic rents.70 Under a

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71 Musgrave, supra note ___, at 79.72 Commentators generally ignore the question of losses altogether when discussing international tax jurisdictional entitlements. In the one instance where I have found specific mention of the issue, the author states without qualification that losses are not relevant. See Kaufman, supra note 70, at ___ n. 236.

benefits theory the host country’s claim to tax a portion of the foreign person’s income

arises in virtue of the provision of local benefits or services to the taxpayer. Under an

economic rents theory the taxing claim is grounded on the view that the taxpayer enjoys

pure economic profits due in part at least to the fact that the source country possesses

certain attributes (like natural resources or proximity to markets).71 It is not difficult to

see how these explanations of the jurisdictional entitlement come to bear with respect to

the profitable economic activity of a foreign person. In other words, the profitable

enterprise can be viewed as realizing a positive private return in part because a portion

of its factor inputs have been funded by the host jurisdiction (benefits theory) or

because it captures some component that represents a return to attributes of the host

country (economic rents theory).

By contrast, these theories of the source entitlement have not been taken as

relevant to the case of the foreign taxpayer who enter a local jurisdiction and fails to

make a profit.72 In other words, the universally accepted position is that the source

entitlement relates to the ability to tax positive returns but surely does not create any

obligation to reimburse taxpayers for negative ones. That is, the features that ground

the entitlement to tax under either a benefits or rents rationale can be understood as

contributing to the private return which is subject to source country tax, but it is not as if

those very same features could typically be seen as causing a portion of a taxpayer’s

losses where the taxpayer fails to make a profit. Nobody, therefore, suggests that a

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host jurisdiction incurs some type of obligation to compensate a foreign person through

its tax system because the jurisdiction failed to provide greater benefits, or possess

more valuable resources, than it in fact did.

The distributive consequences of divergence and retention, however, call this

conventional wisdom into question. As just noted, it is surely true that nobody within

the current framework of international taxation suggests that source jurisdictions have

an obligation to reimburse foreign taxpayers a portion of negative returns realized within

their territory. The interesting question, though, is whether this commitment is grounded

in some aspect of the source entitlement, or, alternatively, whether it is simply an artifact

of the pervasive commitment wholly within the domestic context not to refund losses

through the tax system. My claim here is that it is the latter explanation rather than the

former.

A simple thought experiment demonstrates the point. Suppose that all

jurisdictions in the world did in fact impose an income tax with full refundability of losses.

If that were the state of affairs there would doubtless be a perceived need to address

the “problem” of double loss refundability. Many of the standard problems of

international double taxation would replicate themselves, though in inverse form. For

example, if a taxpayer could double losses on a foreign investment, as compared to a

domestic investment, then there would be a distortion towards undertaking economically

identical (and risky) foreign investments. Arguably economic efficiency requires that the

taxpayer be allowed to claim only the refundable loss available under domestic rules.

This, of course, is the twin of capital export neutrality, as applied to refundable losses.

Similarly, one might argue that economic efficiency requires that the taxpayer be able to

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claim only the refundable loss in the source jurisdiction – the twin of capital import

neutrality, as applied to refundable losses. It would be surprising, though, if anybody

seriously argued that taxpayers should get to claim duplicate refundable losses.

Regardless of the level of loss that should be refundable from an efficiency perspective,

there would be a need to address the question of which jurisdiction bears the cost of the

loss. It seems highly likely that the answer provided would be that with respect to a

risky investment the same jurisdiction that stood to gain from taxing the upside on a

profitable investment should bear the cost of the refundable loss on the downside. That

is, in a world with universal full refundability of losses, the likely understanding of the

international tax jurisdictional entitlements would be to eliminate the phenomenon of

divergence.

If my proposed analysis of this thought experiment is correct, then this tells us

something important not just about a hypothetical world with full refundability of losses

but also about the world we actually inhabit. Specifically, it is the source entitlement

itself – as currently interpreted – that can be understood as the normative principle that

would drive the requirement of the host country to bear the cost of refundable losses.

For reasons discussed above, this might seem odd at first blush. That is, it seems

strange to think that tax consequences arise in connection with benefits or economic

rents where the taxpayer is in fact not profitable. But this is only odd if one thinks about

the situation ex post. If we analyze the source entitlement with respect to a risky

investment ex ante then it becomes apparent that the expected return y is dependent in

part on features such as the provision of benefits and resources that may, but need not,

produce economic rents. From this perspective there is nothing in the source

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entitlement that dictates treating gains differently from losses. Quite to the contrary,

other things equal, a proper understanding of the source entitlement should treat gains

and losses symmetrically. The host jurisdiction should bear the downside risk that

accompanies the upside potential. It is simply the (greater) commitment to

nonrefundability in the domestic sphere that prevents the implementation of that norm.

Returning to the ex post perspective, consider three host jurisdictions that

provide varying degrees of governmental services (High, Medium, and Low) that

plausibly ground the right to tax based upon source. Suppose further that in part

because of these varying degrees of services a foreign investor realizes a large profit in

High, a modest profit in Medium, and a loss in Low. If we countenance a distinction

between High and Medium under a benefits rationale (by, for example, concluding that

High can tax the larger amount of locally earned income while Medium is limited to

taxing the modest profit) then why should the source entitlement not institute a similar

differential between Medium and Low, by requiring Low to compensate the foreign

investor? The answer has nothing to do with the source entitlement and everything to

do with commitments under domestic law regarding refundability.

This hypothetical case of High, Medium, and Low has a familiar analog in

arguments about refundability in the wholly domestic context. If, for example, a

domestic tax system premises differential tax treatment of two taxpayers upon

differential ability to pay, it appears wholly arbitrary to draw a sharp line between those

taxpayers with positive net income and those with losses. Arbitrary, that is, strictly from

the ability to pay perspective. There may be good reasons to draw such a line but the

relative well being of taxpayers is not one of them. Thus the standard approach in

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73 As we have already seen matters get complicated because the effects are somewhat different with respect to credit and exemption countries. Where the country of source does not provide refundability and thus keeps the loss out of the public sector this may move the loss to the private sector of the residence country or to the public sector of the residence country, depending on factors such as whether the residence country applies a credit method and whether there is residual domestic source income to suck up the loss. In any event, however, it is the decision of the source country not to provide refundability that necessarily results in the loss being borne either in the private or public sector of the

domestic taxation that draws a sharp line between profits and losses (thus precluding

refundability) may well be justified on political or pragmatic grounds.

The manifestation of the commitment to nonrefundability in the international

context through the phenomenon of divergence is more troubling, however. The reason

is that the necessary result is the assertion of source country taxing jurisdiction that is

beyond what should be permitted under a proper and full interpretation of the source

entitlement. As noted above, the assertion of such jurisdiction raises problems of

political legitimacy. This is not to say that we necessarily should have full refundability

in either the domestic or the international setting. Other factors might trump any such

move. Even so, too little attention has been paid to what is arguably a fundamental

conflict between two sensible policy commitments. The first such commitment is that

net losses ought to be borne by the private sector rather than the public sector. This

commitment derives its appeal without any need to reference the open economy setting

and is embodied in the universal decision to reject refundability of losses. The second

such commitment is that where there are factor movements across borders involving

risky returns, the upside and downside risk should be conjoined in a single economy.

Under the current patchwork of domestic and international taxing instruments these two

commitments cannot simultaneously be satisfied because the decision not to refund net

losses necessarily shifts, in the open economy context, the loss back to the residence

jurisdiction.73 The resulting state of affairs – divergence – tells us that the second

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residence country.74 For a discussion of arguments in favor of full refundability, see Mark Campisano and Roberta Romano, Recouping Losses: The Case for Full Offsets, 76 N.W.U.L.Rev. 709 (1981); Bravenec & Fraser, A Net Operating Loss Refundable Credit, 70 Proc. Nat’l Tax A.-Tax Inst. Am. 360 (1977); Tarleau, Difficulties Faced by Taxpayer Trying to Take Advantage of a Loss Carryover, 4 J. Tax. 91 (1956). For a discussion of the contrary view see Robert H. Scarborough, Risk, Diversification and the Design of Loss Limitations Under a Realization-Based Income Tax, 48 Tax L. Rev. 677 (1993); Daniel L. Simmons, Net Operating

commitment must give way. I turn now to a discussion of the ramifications and potential

responses.

Potential Responses

Full and Partial Refundability

The first point to observe regarding possible reductions in the level of divergence

is that unilateral limitations by the residence country with respect to losses do not

reduce divergence. For example, a credit country that allows net foreign losses to offset

domestic source income might contemplate enacting stricter recapture rules. Or, a

credit country could remove the possibility of using a net foreign loss to offset domestic

source income at all (in effect behaving like an exemption country in this respect). Note

that such adjustments do not impact the level of divergence because they do not shift

the burden of loss bearing onto the source country. Rather, such adjustments simply

relate to how the loss will be split across the private and public sectors of the residence

country in the first instance.

The only way to guaranty the elimination of divergence is for the source country

to offer full refundability of losses. One of the important normative implications of this

paper, then, is that it suggests a previously undiscussed reason to favor full refundability

of losses. Although a number of commentators have advanced arguments for full

refundability, these suggestions have met with scholarly resistance and have never

gained much political traction.74 These debates, however, have not taken account of

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Losses and Section 382: Searching for a Limitation on Loss Carryovers, 63 Tul. L. Rev. 1045 (1989); Richard L. Bacon and Nicholas A.Tomasulo, Net Operating Loss and Credit Carryovers: The Search for Corporate Identity, 20 Tax Notes 835 (1983).75 I have found only one source that even considers the international ramifications with respect to the decision to have refundable losses. See A Report of the Technical Committee on Business Taxation (Ottawa: Department of Finance, December 1997). Interestingly, this report takes international factors to weigh against refundability insofar as the concern would arise that multinationals would use debt financing to segregate interest expense in a jurisdiction providing refundability. While I acknowledge the potential concern, this problem is not insoluble. For example, if there were uniform asset-based apportionment of interest expense taxpayers would not have the ability to channel losses into particular jurisdictions in the manner feared.76 Political considerations aside, there would be a number of technical problems implicated by full refundability in a world of disparate tax systems. These are not insoluble but further complicate any such move towards full refundability. For example, assuming jurisdictions are applying progressive income taxes, at what rate would the host country offer refundability? Also, what mechanisms would be required to prevent taxpayers from siphoning deductions off to particular jurisdictions so as to manufacture isolated losses, even though an enterprise is profitable on an aggregate basis. See supra ___ regarding interest allocation.

the perverse distributive consequences in the open economy setting that follow from the

decision not to have refundability.75

I should be clear that I do not claim that divergence necessarily shows that full

refundability is the best policy. I claim here only that divergence is normatively

problematic on distributive grounds and that its elimination requires full refundability.

Thus divergence, and the distributional consequences that accompany it, should play a

part in the debate over refundability. Having said that, I consider the likelihood that

considerations of divergence could tip the balance towards full refundability to be

remote. Even in the wholly domestic setting calls for full refundability will have difficulty

gaining political traction because of the likely, if incorrect, view of the public that it is

simply wrong for the government ever to subsidize losses with a refund check. That

political complication, of course, becomes all the worse in the open economy context

where the government becomes obligated to refund a portion of a loss to a foreign

taxpayer. The mere possibility of such refunds would likely doom any proposals for full

refundability, even if reciprocal benefits were granted through multilateral discourse.76

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Given the practical unlikelihood of a shift towards full refundability of losses, the

natural question that arises is what practical instruments are available to reduce

divergence. Not surprisingly, the basic instruments that are available here are the same

as those discussed in the wholly domestic setting for the provision of more generous

loss offsets, short of full refundability. In particular, the provision of more generous

carryback/carryover windows; the allowance of an interest adjustment for loss

carryovers; and provisions allowing greater alienability of losses would all facilitate the

reduction of divergence. The normative weight of the divergence phenomenon here is

similar to the case of full refundability. That is, divergence (and the normatively

unattractive distributive consequences that accompany it) does not necessarily demand

any particular degree of loss offset because there are other considerations at play that

may drown out the impacts from divergence. Again, however, divergence should be

taken into account and should operate as a thumb on the scale in favor of more

generous loss offsets. One complicating feature of the dynamic, however, is the

appropriate degree of multilateralism, to which I turn next.

Multilateralism

A subtle, but important, aspect of a state’s policy towards loss offsets is the

impact of unilateral modifications in such policy. Domestic interests often lobby,

particularly during economic downswings, for more favorable treatment of losses. Note,

however, that one (likely unintended) consequence of unilateral adjustments in the

direction of more generous loss offsets (e.g., extending the carryforward window) is a

detrimental increase in the level of divergence, from that jurisdiction’s perspective. The

reason is that under treaty nondiscrimination rules, the jurisdiction generally cannot

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restrict the benefit of more generous loss offset provisions to local interests. Rather, the

provisions must be available to benefit imported capital as well. This increases the

downside that the jurisdiction absorbs on risky cross-border investment, without any

offsetting concessions from the jurisdictions in which the capital originates. Regardless

of the ultimate effect of divergence on the adopted policy for loss offsets, then, an

important normative implication of this analysis is that jurisdictions should consider

greater coordination of policies regarding loss offsets through multilateral channels.

Normative Considerations in a World With Divergence

In Part III I suggested that the features of divergence and retention are

normatively unappealing as stand alone phenomena and that the most practical means

of addressing this is through multilateral attempts to grant more favorable treatment of

net losses. As long as the phenomena continue to exist, though, they have potentially

important normative implications for broader debates about the relation between

taxation and risk, which often take place within a closed economy framework, and about

international tax policy generally. I consider here the two issues of risk subsidization

and risk dispersion. Both issues have important implications for the perpetual debate

over the relative superiority of credit and exemption systems.

Risk Subsidization

I began this paper with a rhetorical question about the optimal degree of

risktaking in an economy. One possible answer to the question about what degree of

aggregate risktaking is optimal would simply refer to individual preferences regarding

risk. Arguably, we maximize welfare just in case each taxpayer bears that level of risk

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77 [Cites – Kaplow, Shuldiner, Arrow, others.]78 [Cite.]

that is in accord with the taxpayer’s preferences. The role of the income tax, to the

extent it transfers risk from the private to the public sector, could then be analyzed in

two ways. First, if we assume that individuals hold their optimal degree of risk in the no-

tax world then the effect of the income tax will depend on the way in which the risk is

passed back to the private sector. If the risk can be returned to individuals in exactly

the fashion they would have held in a world with no taxes, then the role of the income

tax in shifting risk to the government will not be welfare reducing. Although possible in

theory it is unlikely that risk would be returned to the private sector in such a fashion.77

In any event, though, it would not be welfare enhancing. Second, if we assume that

individuals do not hold their optimal degree of risk in the no tax world then there may be

some opportunity to increase welfare by shifting risk to the government through the

income tax. For example, to the extent that individuals are unable to adequately

diversify their idiosyncratic risk because of the non-existence of various insurance

markets the income tax could provide welfare enhancing pooling of risk.78

Under this analysis the ability of the income tax to increase welfare by shifting

risk depends on whether we are at an optimal state before the income tax is imposed.

Note that what each of these analyses has in common, though, is that aggregate (social

plus private) risk is held constant and the question is whether one can enhance welfare

by shifting that risk among parties. I return to this possibility below, where I discuss risk

dispersion.

I want to focus first, however, on a different possibility, which is the case where

the government might seek to increase welfare not simply by shifting or pooling a given

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level of risk but rather by augmenting the level of aggregate risktaking. In one sense

this approach is inherently problematic because it departs from the supposition that the

optimal degree of risktaking is simply a function of individual preferences regarding risk.

That is, the assumption would be that individual preferences, even if with complete

diversification through the market, do not produce an optimum result. Once we depart

from that assumption we are left stranded without a beacon to tell us how much risk is

the right amount. Still, I would offer several observations here.

First, it is at least theoretically coherent for the government to seek to increase

welfare by augmenting aggregate risktaking over and above the level indicated by

private preferences. The argument here is the same as the standard argument for any

subsidy implemented in order to capture a positive externality (or the use of a Pigovian

tax to eliminate a negative one). That is, because the full social benefit of welfare

enhancing allocations cannot be internalized under any plausible private property

regime, the subsidy provides the private investor with the incentive to make the welfare

enhancing allocation. Distributional concerns, at least in theory, can be dealt with

separately.

Second, the government does purport to use tax policy in just this way. Familiar

examples include research and development credits, investment tax credits, and

accelerated depreciation.

Finally, I want to highlight the possibility that the provision of loss offsets under

an income tax could operate to subsidize risktaking generally in the way that the more

tailored subsidies mentioned above operate in narrower sectors of the economy. This

idea, of course, goes all the way back to the original proposal forwarded by Domar and

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79 See, e.g., United States v. Foster Lumber Co. 429 U.S. 32, 42 (1976) (“Congress also sought through allowance of loss carryovers to stimulate enterprise and investment, particularly in new businesses or risky ventures where early losses can be carried forward to future more prosperous years.”)

Musgrave that loss offsets ought to be made more generous in order to augment

aggregate risktaking. One obvious complication is that we do not currently inhabit the

somewhat unique historical station from which Domar and Musgrave wrote. That is, it

may well have been noncontroversial at the time to claim that normatively aggregate

risktaking should be higher than individual preferences would dictate. That is a much

harder case to make today, particularly on the tail end of a bubble economy. A second

complication is that there is no consensus on whether the government can in fact

augment aggregate risktaking through the structuring of the loss offset provisions of the

income tax.

For present purposes I propose to bracket these complications in order to

demonstrate how the analysis plays out differently in the open economy context, if we

assume that the government in fact is using loss policy to increase aggregate

risktaking.79 Generally, a welfare enhancing allocation of assets towards greater

riskiness would be one in which the cost of the subsidy is less than the value of the

positive externality that is captured under the resulting allocation. The interesting

feature in the open economy context is the way in which this calculus may break down.

There are two elements at play. First, what the phenomena of divergence and retention

tell us is that the “cost” of subsidizing risktaking is borne disproportionately by the

residence jurisdiction. Second, and notwithstanding the first point, it would be surprising

if the relevant positive externality did not have some geographical component, such that

the source country in effect captures a portion of the positive externality. For example,

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80 I.R.C. § 168(g)(1)(A).81 I.R.C. § 41(d)(4)(F).82 There is an underlying question about whether the loss offsets actually would have locational effects. For a model showing that an increase in the rate of tax on foreign source income, with full loss offsets, does increase the amount of U.S.-owned capital that is deployed abroad, see David G. Hartman, Foreign Investment With Risk, 93 Q.J.E. 213-32 (1979). For a model considering the effects with a variety of different loss offset limitations, see Rainer Niemann, Asymmetric Taxation and Cross-Border Investment Decisions, CESifo Working Paper No. 1219 (2004).

one can imagine that the subsidization of risky research and development creates

substantial local positive externalities in connection with the benefits of attracting or

fostering the educated workforce necessary to carry out the research. To put the point

most provocatively, to the extent the that government does seek to subsidize risktaking

through the provision of loss offsets under the income tax, the possible effect is the

subsidization of externalities that are realized in part, perhaps significantly so, by

another sovereign.

Interestingly, this basic idea is implicit in the implementation of various subsidy

policies. For example, the United States strips away the benefit of accelerated

depreciation where the property is used predominantly outside the United States.80

Similarly, the R&D credit is specifically disallowed for activities that occur outside the

United States.81 One way to understand these limitations is that the government is

unwilling to bear the cost of the subsidy where the potential upside, in terms of tax

revenue and positive externalities, may be captured by another jurisdiction. A similar

point applies here, to the extent that the government uses loss offsets to subsidize

risktaking, with the difference that there is no simple solution available to remove the

benefit of the subsidy for foreign investments.82

Note that the way in which the distinction between credit and exemption systems

affect the analysis is complicated. Throughout this paper I have taken the position that

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83 [Cite – Ault.]84 Note that the imposition of recapture rules, such as those in I.R.C. § 904(f), will never provide a full solution. The reason is that the recapture rules have no effect to the extent there is never positive foreign source income in the future. On an ex ante basis the taxpayer should discount the possible cost of recapture by the probability there is never positive foreign source income. In this way, the taxpayer may still experience some subsidy, even where there is recapture of overall foreign losses.

divergence arises where the residence jurisdiction in the public or private sector bears a

portion of the downside risk without the corresponding upside. Clearly, if it is the case

that it is borne by the private sector then the possibility of government subsidization of

increased risktaking does not even arise. Thus in the first instance it would appear that

the issue discussed in the text has greater relevance under credit systems (where there

may be some possibility of offsetting net foreign losses against domestic source

income) than under exemption systems, where that is not generally the case. In

practice, however, that distinction between credit and exemption systems overstates the

case because of the slipperiness in rules for allocating deductions, particularly interest.

Even where the residence country applies an exemption method to the extent the

investor is able to allocate interest expense on what is essentially debt-financed foreign

investment, the same affect will arise. Although exemption jurisdictions may well apply

a tracing approach to curtail this possibility, few jurisdictions (the U.S. being the key

exception) have detailed rules on the issue of allocation at all.83

Note that there are two quite different ways in which a credit system might

approach this problem. First, it can place greater restrictions on the use of foreign

losses or, to like effect, impose stricter recapture rules under a foreign tax credit

limitation.84 Second, it could restrict the generosity of its loss offsets generally. The

tradeoffs between these two choices may well be complicated. The first option

necessarily moves the credit system closer to an exemption system. To the extent the

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jurisdiction prefers the efficiency consequences that accompany a credit system this

may be undesirable. The second option increases the beneficial effects of divergence

when the jurisdiction functions as a capital importer but may have offsetting detrimental

effects in terms of the desired local effects of the chosen policy towards loss offsets.

Risk Dispersion

In the discussion above regarding risk subsidization I focused on the case where

the government seeks to use tax policy to augment aggregate levels of risktaking in the

economy. Here I take up briefly the question of dispersion of risk in the case where the

total level of risk is held constant.

As just noted, where the aggregate level of risk is constant the normative

implications of the risk bearing by the government through the income tax essentially

come down to the question whether the government can pool risk more effectively than

the private insurance markets. Once again I bracket here the question whether the

government can in fact enhance welfare and address the separate question of how any

analysis on the subject should be broadened to take account of the open economy

implications.

The key point to highlight in this respect is the different ways in which credit and

exemption systems impact the analysis. Generally the modern debate over whether to

relieve double taxation through a credit or exemption system has focused largely on the

different efficiency norms that the two systems implement. Thus proponents of credit

systems tend to focus on the consistency with capital export neutrality and proponents

of exemption systems tend to focus on the consistency with capital import neutrality.

The analysis in this paper suggests that the choice between credit and exemption

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systems has other potential implications that have been ignored to date.

The key difference between credit and exemption systems from the perspective

of taxation and risk is the way in which the credit system is more likely to shift downside

back to the public sector of the residence country and the exemption system is more

likely to shift downside back to the private sector. From the standpoint of distributional

effects across jurisdictions (the concern in Part III above) it does not matter (ignoring

dynamic effects) whether a positive or negative return is borne by the private or public

sector of a given economy. However, from the standpoint of the welfare effects of risk

dispersion it could make quite a crucial difference. In particular, to the extent that the

government does serve a welfare enhancing function through risk dispersion then this

offers an additional reason to favor credit systems. Conversely, if siphoning risk off to

the government yields welfare reductions then this offers an additional reason to favor

exemption systems. It is difficult to reach any firm conclusions without greater

consensus on the role of government as risk pooler. And, the independent reasons to

favor a credit system versus an exemption system may well dwarf these effects.

Nonetheless, these are potentially important welfare effects that should be included in

the overall debate regarding the ideal form of double tax relief.