Source versus Residence Based Taxation with International Mergers and Acquisitions

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1 Soure versus Residene Based Taxation with International Mergers and Aquisitions Johannes Beker Clemens Fuest CESIFO WORKING PAPER NO CATEGORY 1: PUBLIC FINANCE NOVEMBER 2009 An eletroni version of the paper may be downloaded from the SSRN website: from the RePE website: from the CESifo website: Twww.CESifo-group.org/wpT

2 CESifo Working Paper No Soure versus Residene Based Taxation with International Mergers and Aquisitions Abstrat This paper analyses tax ompetition and tax oordination in a model where apital flows our in the form of mergers and aquisitions, rather than greenfield investment. In this framework, we show that differenes in residene based taxes do not neessarily distort international ownership patterns. Moreover, tax ompetition yields globally effiient levels of soure based orporate inome taxes if residene based taxes on apital inome are absent. In ontrast, in the presene of residene based taxes on dividends, soure based orporate inome taxes are ineffiiently high. The widespread view that tax oordination is less urgent if residene based taxes are available may therefore be misguided. JEL Code: H54, H25, F23. Keywords: orporate taxation, tax ompetition, mergers and aquisitions. Johannes Beker Max Plank Institute for Intelletual Property Competition and Tax Law Department of Publi Eonomis Marstallplatz 1 Germany Munih johannes.bekerip.mpg.de Clemens Fuest Centre for Business Taxation Said Business Shool University of Oxford Park End Street Oxford OX1 HP United Kingdom lemens.fuestsbs.ox.a.uk This version: 9 th November 2009 We thank partiipants at workshops and onferenes in Munih and Magdeburg for helpful omments. We gratefully aknowledge finanial support from the ESRC (Grant No RES ).

3 1 Introdution One of the most powerful theorems in the literature on international taxation and apital alloation is that residene based taxation is superior to soure based taxation. As a onsequene, models analysing optimal tax poliy strategies under soure based tax ompetition usually assume that residene based taxes are not available. However, most of these models are based on the impliit assumption that investment takes the form of green eld investment. This neglets that a large part of international apital ows takes the form of mergers and aquisitions (M&A). Sine reent ontributions laim that taking into aount M&A investment does lead to substantial hanges in the e ieny properties of taxation, see e.g. Desai & Hines (2004) and Beker & Fuest (2008, forthoming), it is important to investigate the role of residene based taxation in a model where investment takes the form of M&A. The purpose of this paper is to develop a simple model whih may serve as an equivalent to the standard framework for tax ompetition based on green eld investment, i.e. the realloation of real apital instead of ownership. We onsider a world with two ountries, where domesti investors may either aquire existing rms at home and abroad or buy bonds in the international redit market. M&A investment is driven by synergies. In this framework, we explore the impat of soure and residene based apital inome taxes. A rst important nding of our analysis is that international di erenes in residene based taxation do not neessarily distort ownership patterns. Seondly, we show that, if investment takes the form of M&A instead of green eld, the role of soure and residene based taxes for international tax ompetition and oordination is di erent. In the baseline version of our model, the equilibrium orporate tax levels emerging under tax ompetition are globally optimal if residene based taxes on dividends are zero. There is no role for welfare enhaning tax oordination. In ontrast, if residene based dividend taxes exist, tax ompetition yields ine iently high level of orporate tax rates. The reason is that orporate taxation a ets neighbouring ountries negatively through two di erent hannels. Corporate taxation of the host ountry redues the tax base for residene based dividend taxation, and orporate taxation of the residene ountry redues the prie the 1

4 aquirer is willing to pay for the target rm and, thus, dereases national inome of the host ountry. Residene based taxes on interest inome and dividends have omplex external e ets on the neighbouring ountries welfare levels as well. These e ets are often ambiguous in sign and di er substantially between the residene and the host ountry. To deal with omplexities arising due to the asymmetry of tax ompetition equilibria in our model, we onsider a spei type of oordination experiment, whih holds the relative tax burden on apital inome in the two ountries onstant. We show that, rstly, a oordinated inrease in residene based taxes on interest inome only redistributes inome aross jurisditions; welfare effets only emerge if the preferenes for publi goods di er. Seondly, dividend taxes an be shown to be ine iently low if asymmetries between ountries are small. Our results stand in sharp ontrast to the existing tax ompetition literature where tax ompetition with soure based taxes usually leads to ine ient equilibria, and international tax oordination is required to implement the globally optimal tax poliy. In these models, the need for tax oordination is weakened and may even vanish if residene based taxes are available. For purpose of presentational larity and omparison with the standard ase of green eld investment, we fous on the polar ase where investment onsists exlusively of mergers and aquisitions. This implies the assumption that the stok of real apital (the existing target rms in our model) is onstant and given. As we show in Beker & Fuest (2008), onsidering green eld investment and M&A simultaneously adds some omplexity and requires a number of assumptions whih themselves limit the analyti sope with regard to tax e ets on M&A. This is why we hoose to analyse the pure ase of M&A only in this paper. The assumption that there is no green eld investment drives the e ieny result for the tax ompetition equilibrium with soure based taxes only. Given this, in terms of poliy onlusions, it would be inappropriate to question the potential for welfare enhaning oordination of soure based taxes. But our ndings do hallenge the view that implementing residene based taxation may be a substitute for oordination. In the literature, the issues of apital mobility and tax ompetition have been studied intensively, see Fuest, Huber & Mintz (2005) for a reent survey. A broad and still growing empirial literature on the impat of taxes on investment and apital ows is surveyed by Devereux (2007). However, as noted above, these 2

5 ontributions usually assume that investment takes the form of green eld investment. The literature dealing with the impat of taxes on M&A is muh smaller. In an early ontribution, Devereux (1990) points out that tax distortions to ownership may be important if apital produtivity depends on ownership. Gordon & Bovenberg (1996) as well as Fuest & Huber (2004) analyse tax poliy strategies in models where rms may be sold to foreign investors. But they do not onsider tax ompetition or tax oordination. Desai & Hines (2004) argue that U.S. taxation of foreign soure inome is likely to distort ownership patterns and to put U.S. rms at a disadvantage when ompeting for foreign aquisitions. They propose to exempt foreign soure inome from domesti taxation. In Beker & Fuest (forthoming), we analyse this argument and show that exemption is an appropriate poliy hoie when ownership advantage is a publi good within the rm, but is dominated in welfare terms by a ross-border ash- ow tax system. In Beker and Fuest (2008), we analyse tax ompetition in a model where M&A and green eld investment are alternative modes of entry and show that the existene of M&A investment intensi es tax ompetition. However, this analysis does not inlude residene based taxes. Hau er & Shulte (2007) onsider tax inentives in a model where M&A an take plae within and aross borders. They show that ownership patterns are highly important for the welfare impliations of tax poliy hoies. From an empirial point of view, a number of ontributions use the U.S. tax reform in 1986 to explore the tax e ets on M&A ativity, see e.g. Auerbah & Slemrod (1997). 1 Swenson (1994) explores the idea that e etive tax inreases in the U.S. may indue investors loated in ountries with foreign tax redit regimes to take over U.S. rms beause the higher U.S. taxes may be redited against home ountry taxes, and nds robust evidene supporting the hypothesis. In a reent paper, Huizinga & Voget (forthoming) study the empirial impat of international taxation shemes on M&A ativity. Among other things, they nd that investors from tax redit ountries are less likely to take over foreign rms than investors from ountries where foreign pro ts are exempt from domesti taxation. The remainder of the paper is set up as follows. In setion 2, we present the model and derive the main results. In setion 3, we onsider some extensions. 1 See also Sholes & Wolfson (1990) and Collins, Kemsley & Shakelford (1995). Empirial evidene on non-tax aspets of m&a ativity is reported in Andrade, Mithell & Sta ord (2001). 3

6 Setion 4 disusses how the results relate to the literature and setion 5 onludes. 2 The model We onsider a world onsisting of two ountries, domesti and foreign. Eah ountry is inhabited by a large number of households. For notational onveniene, their number per ountry is normalized to unity. Households live for two periods. The utility of the representative domesti household is given by W = U(C 1 ; C 2 )+H(G) where C 1 and C 2 are onsumption in the rst and the seond period, U (C 1 ; C 2 ) is private utility and H(G) is utility from the provision of a publi onsumption good G in period 2. For private utility, we assume U (C 1 ; C 2 ) = u(c 1 ) + C 2, where the subutility funtion u(:) is stritly onave, with u 0 > 0, u 00 < 0. This utility funtion implies that inome e ets on rst period onsumption are zero, so that the interest elastiity of savings is stritly positive. 2 Aordingly, the utility funtion of the foreign representative household is denoted by W = u (C 1)+C 2 +H (G ). The asterisk denotes the foreign ountry. In period 1, the domesti and the foreign household have a given endowment of E and E units of a numeraire good, respetively. Households may borrow or lend in the international apital market at the interest rate r. 3 In addition, the domesti household owns m existing and immobile rms operating in the domesti ountry. Without a hange in ownership, the after tax pro t earned by eah domesti rm in period 2 is given by "(1 ), where is the domesti orporate inome tax. Aordingly, the foreign household owns m rms operating in the foreign ountry with an after-tax pro t of " (1 the foreign orporate inome tax. ), where is The domesti household onsiders aquisitions of rms in the domesti and in the foreign ountry. To keep the model as simple as possible, we assume that the representative household in the foreign household does not onsider aquisitions. 2 This assumption is not ritial but simpli es the exposition. 3 The seminal ontributions by Rihman (1963) and Feldstein & Hartman (1979) assume that domesti households only invest in the multinational rm s equity. A portfolio apital market is absent in these models. It is straightforward to show, however, that our results also hold if there is no portfolio apital market in our model. A formal derivation is available from the authors upon request. 4

7 This asymmetry simpli es the exposition but also implies some omplexities whih are disussed in setions 3.3 to 3.5. If an existing domesti target rm is aquired by the domesti household, the hange of ownership does not imply a reloation of real apital. But the ownership hange does have a real eonomi e et in the form of synergies. This synergy inreases the seond period ash ow of the domesti target rm by. Equivalently, if a foreign target rm is aquired, seond period ash ow inreases by. We assume that eah target rm is haraterized by a spei synergy. More preisely, we assume that eah potential target rm draws a synergy or from a uniform distribution with support [ ; + ] and [ ; + ], respetively. The distribution funtions are denoted by () and ( ) and density funtions are onstant and normalized to unity to ease notation. This synergy is the driving fore for hanges in ownership in our model. The intuition behind this assumption is that the target rm has some spei asset (like ustomer relations, patents, brand names) whih beomes more valuable in the hands of the aquirer. The value of these spei assets di ers aross target rms. Alternatively, one may think of adjustment osts whih arise after the aquisition of a target rm. The lower the adjustment ost, the higher the net synergy or. An important question whih arises in this ontext is whether the overall number of aquisitions is limited by e.g. managerial apaity. In the baseline version of our model, we assume that there is no limitation on the overall number of takeovers whih may take plae. In setion 3.6, we will onsider the ase where the number of feasible aquisitions is limited due to onstrained management apaities or onvex transation osts. 2.1 The market for M&A investment The market for aquisitions works as follows. In period 1, all domesti and foreign target rms draw a synergy or. Then, the domesti household bids for target rms. At this stage, the target rm spei synergy is ommon knowledge. If the aquisition takes plae, the aquirer has to pay the aquisition prie P to the vendor. In period 2, the aquirer reeives the ash ow generated by the target rm. 5

8 For the tax treatment of aquisitions, we make the following assumptions. The revenue from selling rms is untaxed and investors annot dedut aquisition osts from the orporate tax base. This may be interpreted as a highly stylised way of modelling aquisitions in the form of share deals, as opposed to asset deals. We thus abstrat from many omplexities assoiated with the tax onsequenes of mergers and aquisitions. These inlude e.g. apital gains taxes, the tax depreiation of goodwill, the transfer of reserves, the use of loss arryforwards after ownership hanges and other spei tax law provisions of the national tax systems, some of whih are surveyed in Huizinga & Voget (forthoming). We also abstrat from tax planning onsiderations like e.g. the naning of foreign aquisitions with debt issued in high tax jursiditions to bene t from interest dedutions. 4 The domesti household s willingness to pay for a domesti target rm j an be determined as follows. If she aquires the rm, she pays the aquisition prie P ( j ) in period 1. The payment of the aquisition prie is naned by a redution of the household s portfolio investment. The return on portfolio investment is (1+r)(1 t), where t is a residene based tax on inome from portfolio investment. In period 2, she reeives the after tax ash ow (" + ) (1 ) (1 ), where is a residene based tax on dividends. Given this, the highest aquisition prie aquirers are willing to pay is given by (1 + r)(1 t)p ( j ) = (" + j ) (1 ) (1 ) (1) Competition among aquirers will imply that the equilibrium prie of aquisitions will be given by P ( j ) as de ned by (1). Given this, under whih irumstanes will domesti vendors sell their rms? If they sell, they may invest the proeeds in the market for portfolio apital or use them for onsumption in period 1. Thus a domesti vendor will sell if the purhase prie is equal to or larger than the present value of the seond period inome in ase the rm is not sold: (1 + r)(1 t)p ( j ) " (1 ) (1 ) (2) Sine P ( j ), as de ned in (1), is inreasing in j, we may onlude that all 4 For a survey of evidene on international tax planning see Devereux (2007). 6

9 domesti target rms with will be aquired while rms whih o er lower synergies will remain in the hands of their original owners. It follows from (1) and (2) that the ut-o level is simply given by = 0. This re ets that the domesti tax system is neutral for domesti aquisitions in this model. In the ase of foreign target rms, the aquisition prie is given by (1 + r)(1 t)p ( j) = " + j (1 ) (1 ) (3) and the vendor is willing to sell if (1 + r)(1 t )P ( j) " (1 ) (1 ) (4) This yields the uto value 1 1 t = " 1 1 t 1 (5) whih implies = (t ; t; ; ), with > 0, < 0, t < 0 and t > 0. Note that the soure based orporate inome tax does not a et the number of aquisitions. The reason is that this tax is apitalized in the purhase prie - it always has to be paid, independent of who owns the rm. For residene based taxes, things are di erent. An inrease in t redues the number of border rossing aquisitions beause a lower return on portfolio investment inreases the value of target rms in the hands of the initial foreign owners. The reason is that these rms o er a return in period 2 whih is not subjet to the tax on portfolio inome. Put di erently, an inrease in this tax redues the disount rate of foreign owners. For the same reason, an inrease in t inreases border rossing aquisitions. A higher residene based tax on dividend inome in the foreign ountry leads to more aquisitions beause the aquirers are not subjet to this tax. Aordingly, a higher domesti dividend tax redues border rossing aquisitions. Equation (5) allows to de ne onditions for ownership neutrality of the international tax system. In the absene of taxes, (5) boils down to = 0. Ownership neutrality would require that this equation holds in the presene of taxes, too. Soure based taxes do not disturb ownership neutrality, as has been pointed out 7

10 in the literature (Devereux, 1990). But interestingly, residene based taxes do not neessarily distort ownership neutrality either. For instane, if eah ountry taxes dividends and interest inome at the same rate, ownership neutrality prevails even if the tax rates di er aross ountries. The view that taxes on foreign soure dividends may violate ownership neutrality is based on the idea that an investor from a ountry with high taxes will end up with a lower return on the aquisition of a given rm than an investor from a low tax ountry. But this neglets that the prie an investor is willing to pay will also depend on the tax burden on alternative investments. If the tax on intererest inome is also higher, this may neutralise the higher dividend tax, and no ownership distortions arise. We may state these results as Proposition 1 Ownership neutrality: i) International di erenes in soure based taxation do not distort ownership alloation. ii) Ownership neutrality is ompatible with international di erenes in residene based apital inome tax rates if 1 = 1 t. 1 1 t Proof. The proof diretly follows from equation (5). 2.2 The international redit market How do hanges in taxes and investment a et the international redit market? Consider rst the budget onstraint of the domesti household. In the rst period, the household s endowment E may be used for onsumption, redit market investment S or for the naning of aquisitions. Expenditures for naning domesti aquistions are R + P ()d, but these expenditures ow bak to the domesti household in the same period beause the domesti household owns these rms in the rst plae. However, expenditures on aquisitions of foreign target rms, given by P ( )d = " + j (1 ) (1 ) (1 + r)(1 t) d (6) do not ow bak to the domesti households and therefore have to be naned 8

11 in addition. The budget onstraint in period 1 is thus given by C 1 = E S P ( )d (7) In the seond period, the household reeives inome from investment in the international redit market and pro t distributions from domesti and international M&A investment. The budget onstraint in the seond period an be written as C 2 = S(1 + r)(1 t) + m d! + (" + ) (1 ) (1 )d + " (1 ) (1 ) (8) (" + ) (1 ) (1 )d Optimal hoie of S implies u 0 (C 1 ) = (1 + r)(1 the following budget onstraints t). The foreign household has C1 = E S + P ( )d (9) Z! + C2 = S (1 + r) (1 t ) + m d " (1 ) (1 ) (10) Optimal saving by the foreign household implies u 0 (C 1) = (1 + r)(1 t ). Equilibrium in the portfolio apital market requires that net lending equals net borrowing whih implies that net savings have to equal zero, S + S = 0. The two rst order onditions for optimal savings and the redit market equilibrium ondition determine the equilibrium values of S, S and r, for given taxes and a given pattern of domesti and foreign aquisitions. How do taxes a et the apital market equilibrium? Consider rst the e et of tax hanges on the interest rate r. Lemma The equilibrium interest rate r is inreasing in t and t. Changes in the number or the pries of foreign aquisitions do not a et the interest rate r. Proof. Totally di erentiating u 0 = (1 + r)(1 t) and u 0 = (1 + r)(1 t ) yields ds = " Z # + d P ( )d 9 1 [dr(1 t) dt(1 + r)] (11) u00

12 and " Z # + ds = d P ( )d 1 u 00 [dr(1 t ) dt (1 + r)] (12) Using ds + ds = 0 and adding up yields dr = r u 00 dt r dt u 00 (13) with = 0. (1 t) + (1 t ) u 00 u 00 < 0. This implies dr dt > 0; dr dt h R i + > 0; dr=d P ( )d = The nding that a hange in the expenditure of the domesti household on foreign aquisitions does not a et the interest rate an be explained as follows. Consider an inrease in the number of foreign aquisitions. This implies that the revenue from selling rms aruing to the foreign household in the rst period inreases. The foreign household invests this additional ash ow in the international redit market beause, at a given interest rate, it is optimal to hold rst period onsumption onstant. The domesti household, in ontrast, needs additional ash to nane the aquisition and therefore redues redit market investment by the same amount. As a result, the interest rate remains onstant. E etively, the domesti households borrow from the foreign households in order to buy assets previously owned by these households. Lemma 1 also implies that the interest rate would not be a eted by hanges in domesti or foreign orporate or dividend tax rates. 3 Tax poliy Our main interest is to investigate the role of residene and soure based taxes in the ase of unoordinated tax poliies and the sope for welfare enhaning tax oordination. In our model, governments levy taxes mainly to nane the provision of publi onsumption goods. But taxes also a et investment behaviour and, therefore, aquisition pries and the interest rate. Countries may be interested to hange these pries in order to inrease national inome or to maximize welfare. 10

13 Publi expenditure of the domesti ountry is given by G = S(1+r)t+( + (1 )) " m" + d # + (" + ) (1 ) d : (14) The rst term on the right hand side of (14) is revenue from the residene based tax on interest inome, the seond term stands for revenue from taxing domesti rms and the third term is revenue raised by the residene based tax on foreign dividends. The publi setor budget onstraint of the foreign ountry is given by Z! + G = S (1 + r) t + m d " [ + (1 )]+ (" + ) d : (15) The budget onstraint of the foreign government di ers from that of the domesti government in that there is no revenue from taxing dividends from rms loated in the domesti ountry and that the orporate tax partly falls on rms owned by residents of the domesti ountry. However, as will be disussed further below, taxing these rms at soure will redue the pries at whih these rms are aquired, so that the tax burden will ultimately be borne by residents of the foreign ountry. In the following, we start by onsidering the optimal poliy hoies with respet to the soure based orporate inome tax and then turn to residene based taxes. The objetive of the analysis is to analyse the role of the di erent taxes under tax ompetition and to investigate the sope for welfare enhaning tax oordination. Under tax ompetition, the domesti government sets its tax instruments to maximise the welfare of the domesti household, W = u(c 1 ) + C 2 + H(G), and the foreign government maximizes the foreign household s welfare, W = u (C 1) + C 2 + H (G ). Eah ountry s government takes as given the tax poliy of the other ountry. Tax oordination will be disussed further below. 11

14 3.1 Soure based taxes We start by onsidering the soure based orporate inome tax. The rst order ondition for the optimal domesti orporate tax rate an be written as " Z # W + = (H0 1)(1 ) m" + d = 0 (16) whih implies that the marginal utility of publi onsumption equals the marginal utility of private onsumption (H 0 = 1). The reason is that the domesti tax a ets neither savings nor M&A investment. The fators driving the orporate tax poliy of the foreign ountry are slightly more omplex. The rst order ondition is given by W = (H 0 1) m +H 0 d! (" + ) d u 0 " (1 ) (17) (1 + r)(1 t) (" + ) (1 ) d = 0 The rst term on the right hand side of (17) represents the redistribution of funds from foreign rms ( rst term) owned by foreign households to the foreign government. The seond term stands for the welfare e et of taxing rms owned by the domesti household. The third term re ets that a higher orporate tax redues the aquisition pries reeived by foreign households who sell their rms in period 1. Whether or not H 0 struture of residene based taxes. 5 1 > 0 holds is ambiguous and depends on the 3.2 Residene based taxes Governments may levy residene based taxes on the two types of investment inome in our model: dividends from rm ownership and interest inome from redit market investment. The rst order ondition for the optimal domesti tax on 5 It is straightforward to show that a neessary and su ient ondition for H 0 1 > 0 to hold is that the sum of the seond and third term of (17) is negative. Using u 0 = (1 + r) (1 t ), this is given if t + (1 t ) < t. 12

15 interest inome an be written as W t = (1 + r) P ( ) d +H 0 (1 + r)t S (" + ) (1 t ) + W r t r t = 0 (18) where we use H 0 = 1 derived from equation (16), P ( ) t = P ( ) 1 t and t = 0. The rst term on the right hand side is negative and re ets that a higher tax on redit market investment inreases the willingness of domesti investors to pay for the aquisition of foreign rms. This redistributes inome from the domesti eonomy to the foreign eonomy. The seond term (in square brakets) represents the impat of the portfolio adjustments triggered by the tax hange on the government budget. The inrease in t will indue households to inrease aquisitions and redue redit market investment (or inrease borrowing). Finally, the last term on the right hand side aptures the e et of an inreasing interest rate (as r t > 0, as shown above) on welfare with W r = S + (1 + r)ts r + (1 t) P ( )d (19) where we use P ( ) r = P ( ) 1+r. Whether or not the domesti eonomy bene- ts from an inrease in the interest rate depends, among other things, on whether it imports or exports apital. How does the foreign ountry set its tax on interest inome? The rst order ondition for t is given by W = (H 0 1) S (1 + r) (20) t +H 0 (1 + r)t S t + (" (1 ) ) + W r t r t = 0 where we use P ( ) = 0. The rst term on the right hand side of (20) stands t for the welfare e et of shifting funds from the private to the publi setor (as long as H 0 > 1). The seond term desribes the impat of tax indued portfolio restruturing on the government budget. Essentially, fewer rms will be sold to 13

16 investors from the domesti ountry whih implies that redit market investment delines, so that revenue from the residene based tax on interest inome dereases, too. 6 Dereasing foreign aquisitions are assoiated with an inreased foreign revenue from taxing dividends as more rms remain in foreign ownership and with a deline in orporate tax revenue as long as the the marginal aquisition yields a positive synergy, i.e. > 0. The e et of an inrease in interest rates on foreign welfare is given by W r = S (1 + (H 0 1) t ) + H 0 (1 + r)t S r (1 t ) P ( )d (21) Consider next the tax on dividends. The rst order ondition for the optimal domesti dividend tax an be written as W = (1 t) (1 + r) 1 P ( ) d +H 0 (1 + r)t S (" + ) (1 The rst term on the right hand side of (22) is positive and re ets that the dividend tax redues the willingness of domesti investors to pay for foreign rms whih redues their prie. The seond term re ets the impat of the hange in the household s portfolio struture on the government budget onstraint. It turns out that, at least for t 0, the optimal domesti dividend tax is unambiguously positive, despite of H 0 = 1. The reason is that the government wants to strategially redue aquisition pries and, if t > 0, gains from an inrease in redit market investment. The foreign ountry s optimal dividend tax poliy is implied by " W = (H 0 1) Z! # + m d " (1 ) +H 0 (1 + r)t S + (" (1 ) ) = 0 (23) The foreign government annot use its dividend tax to strategially manipulate 6 It annot be exluded that the optimal tax t is negative. In this ase, a deline in S would of ourse inrease tax revenue net of subsidies. ) = 0 (22) 14

17 aquisition pries beause aquisition pries are determined by the willingness to pay of domesti investors and therefore do not depend on, see equation (3). Thus, the optimal foreign dividend tax will depend on the sarity of publi relative to private funds (H 0 1) and the impat of the portfolio restruturings aused by a hange in this tax on the government budget. 3.3 Coordination of soure based taxes Are tax poliies emerging under tax ompetition optimal for the eonomy as a whole? Or is there sope for welfare enhaning tax oordination? At a more general level, is the need for tax oordination related to soure or residene based taxation? To answer these questions, we start by onsidering oordination of the soure based orporate inome tax holding all other poliy variables onstant. As the literature shows (see e.g. Buovetsky, 1991), oordination experiments in an asymmetri setting is a omplex issue. Fortunately, these omplexities an be dealt with in our framework with regard to soure based taxation. Here, our main result is the following Proposition 2 i) In the absene of residene based taxes on dividends ( = 0), there is no sope for welfare enhaning oordination of the soure based orporate inome tax. Tax ompetition leads to nationally and globally optimal tax levels. ii) If dividend taxes are positive ( > 0), a oordinated inrease in soure based orporate inome taxes, departing from the equilibrium without oordination, dereases welfare. Proof. We onsider a oordinated marginal hange in the domesti and the foreign orporate tax rates, departing from the equilibrium under tax ompetition and holding all other poliy instruments (t, t, and ) onstant. The hange in domesti welfare is dw = W W d + d. Sine the equilibrium under tax ompetition implies W = 0, the welfare e et an be expressed as dw = W d = H 0 (" + ) d (24) 15

18 whih equals zero for = 0. Likewise, we an derive the e et on the welfare of the foreign ountry as dw = W d = 0. The result in proposition 2 may be explained as follows. Given that there is only M&A investment and redit market investment in our model, international apital ows do not involve a reloation of real apital from one ountry to another. Moreover, the domesti household is not limited in the number of aquisitions. As a onsequene, the marginal synergy is zero, tax payments under the original owner and the aquirer are equal and orporate tax rate hanges have no impat on M&A investment. If > 0, orporate taxes are ine iently high under tax ompetition, i.e. a tax rate ut gives rise to positive sal externalities. This happens beause a ut in the foreign orporate tax rate inrease the dividends after foreign taxes. As a result, domesti tax revenue inreases. It is interesting to ontrast the sal externalities arising in our model to the sal externalities arising in models of tax ompetition with green eld investment. In the ase of green eld investment, a orporate tax rate ut in one ountry inreases apital demand in that ountry. Savings available for the reation of new prodution failities beome sarer, so that the interest rate inreases. As a result of this, green eld investment in other jurisditions delines, and savings from these jurisditions ow to the jurisdition whih has redued its tax rate. If these jurisditions levy a soure based tax on the marginal green eld investment, they lose tax revenue. Therefore tax rate uts give rise to negative sal externalities. However, if they also levy a residene based tax on savings, the inrease of the interest rate aused by the tax ut in the other jurisdition raises revenue from the residene based tax on savings. This mitigates the negative sal externality of orporate tax rate uts. In so far, residene based taxes on apital inome tend to redue the need for tax oordination. 3.4 Coordination of residene based taxes In the previous setion, we have shown that tax ompetition in soure based orporate taxes may e etively lead to e ient outomes. We did so by showing that a small inrease in and holding all other poliy instruments onstant has no welfare e et if = 0 and has negative welfare e ets if > 0. In the following, 16

19 we analyse an equivalent experiment for t and t. To start, onsider a small inrease in the foreign tax rate t on domesti welfare. W t = H0 (" + ) (1 ) + W t r r t (25) where we used = 0 and P ( ) = 0. An inrease in t redues the foreign t t household s inentive to save and inreases the present value of future inome from rm pro ts and, thus, the minimum selling prie for the marginal target rm. As a onsequene, aquisitions are redued whih dereases dividend tax revenue ( rst term). Moreover, the interest rate is inreased whih a ets the domesti household s welfare aording to equation (19). If S < 0, then W=r has an ambiguous sign. W t Similarly, an inrease in t a ets foreign welfare by 1 t = (1 + r) 1 t P ( )d +H 0 (" (1 ) ) t +W r r t (26) where we have used P ( ) t = P ( ) 1 t. The rst term aptures the inrease in intramarginal aquisition pries in response to rising domesti inome taxes. The reason for this e et is that an inrease in t makes saving less attrative than aquiring rms. This inreases demand for target rms. The seond term seizes the hange in tax revenue due to an inrease in foreign aquisitions, =t < 0. Dividend tax revenue is redued and orporate tax revenue is inreased as long as the marginal synergy is positive. Finally, inreasing interest rates (see Lemma) a et welfare aording to equation (21), whih has an ambiguous sign. Both externalities are ambiguous in sign. As mentioned above, tax oordination in an asymmetri setting raises some omplexities, as has been previously noted in the tax ompetition literature, see e.g. Buovetsky (1991). The main omplexity arising in our model is that a symmetri inrease in tax rates, starting from an asymmetri equilibrium, leads to a hange in the relative tax pries of aquisitions, see equation (5). For instane, inreasing t and t by the same amount redues the ut-o level (inreases foreign aquisitions) if t > t and vie versa. This e et on the relative tax prie makes the oordination e ets dependent on the 17

20 (relative) size of the tax rates in the initial equilibrium. In general, oordination e ets then beome ambiguous. There are two ways of dealing with this issue. Firstly, we ould add a seond setor in whih foreign households aquire target rms to have a symmetri model with idential equilibrium tax rates. It is straightforward to show that our key results remain robust, but the notation beomes muh more umbersome. Seondly, we may onsider asymmetri tax oordination experiments, i.e. oordinated tax inreases whih leave the relative tax pries una eted. In the following, we will pursue this seond strategy, mainly to keep the exposition simple. Therefore, let both ountries inrease their tax rates suh that the relative tax prie 1 t stays onstant whih requires dt = 1 t dt. As a onsequene, the 1 t 1 t alloation of ownership (i.e. the number of aquisitions in eah ountry) remains una eted. How do savings and the interest rate reat to suh a tax reform? It follows from S + S = 0 that S r dr + S t S S dt + dr + dt = 0. With S = 1 t, S = 1 t, r t r u 00 r u 00. Domesti 1 t S = 1+r S, = 1+r and dt = 1 t dt = dt, it follows dr = 1+r t u 00 t u 00 1 t dt saving is a eted by ds dt to show that ds W t + W t = S + S t r dr = 1+r 1 t 1+r = 0. It is straightforward dt u 00 u 00 1 t = 0 as well. The overall e et is then given by d (W + W ) = dt d t + W + W 1 t d t or t t 1 t We summarize this in d (W + W ) dt 1 + r = (H 0 H 0 ) S 1 t (27) Proposition 3 Departing from the unoordinated equilibrium, a oordinated inrease in t and t whih leaves the number of aquisitions in eah ountry unaffeted, i.e. dt = 1 t dt, inreases welfare if H 0 H 0 > 0 and S = S > 0. 1 t This proposition shows that a oordinated inrease in t and t mainly redistributes funds among the two jurisditions. 3.5 Tax oordination in taxes on dividends How do hanges in dividend taxes a et the neighbour ountries? Again, we start with onsidering the e et of a small inrease in the foreign poliy parameter on 18

21 domesti welfare, holding all other poliy parameters onstant. W = H0 (1 + r)t S (" + ) (1 ) (28) with = " 1 1 t 1 1 t < 0. Inreasing redues the minimum selling prie of the foreign owners and, thus, inreases the number of foreign aquisitions. This redues domesti savings (or inreases domesti borrowing) and thus dereases revenue from interest inome taxation. In addition, if there is a positive tax rate on dividends, tax revenue from this soure is inreased. Note that has no impat on the interest rate r. 7 Now, onsider the e et of a small inrease in on foreign welfare. W = (1 + r) (1 t ) P ( )d 1 +H 0 (1 + r)t S + (" (1 ) ) (29) Inreasing redues the prie the domesti investor is willing to pay for the target rm. As a onsequene, all purhase pries are redued. In addition, rising dividend taxes redue the demand for foreign aquisitions and, thus, the need for foreign savings. This redues revenue from interest inome taxation. Finally, the derease in foreign aquisitions inreases foreign dividend tax revenue but redues orporate tax revenue if the marginal synergy is positive. Again, both externalities have ambiguous signs. We therefore onsider an experiment equivalent to the one in the previous setion. Let both ountries inrease their dividend tax rates suh that the relative dividend tax prie 1 stays onstant whih requires d = 1 d = d. Consequently, the number of foreign 1 1 aquisitions remains una eted. The e et on global welfare is given by d (W + W ) d = (H 0 1) (t t) (1 + r) 1 " Z! # + m d " (1 ) P ( ) d (30) 7 It is straightforward to show that the externality on domesti welfare is positive if t <. 19

22 We summarize this in Proposition 4 Departing from the unoordinated equilibrium, a simultaneous inrease of and suh that the number of foreign aquisitions remains onstant, i.e. d = 1 d, inreases welfare if H 0 1 > 0 and t t 0 and, otherwise, 1 if the tax di erene t t is su iently small. The above three propositions 2 to 4 suggest that, if investment takes the form of M&A and the number of aquisitions is unlimited, soure based taxes are inef- iently high and residene based taxes are - under mild symmetry requirements - ine iently low. In the following, we onsider the ase in whih the number of aquisitions is limited. 3.6 Extension: Limited number of aquisitions A ruial assumption for the above analysis is that the number of M&A transations is not limited. As a onsequene, investors aquire target rms until the marginal after-tax surplus is zero. In the following, we will assume that the number of aquisitions is onstrained to a ertain number N. Possible reasons are sare management apaities, boundaries to rm size et. In any way, it aptures the idea that the marginal aquisition yields a positive surplus. At the margin, investors make a disrete investment hoie between the domesti and the foreign loation, whih has an equivalent in the analysis of green eld investment hoies, see Devereux & Gri th (2003). The above model is modi ed by adding the additional assumption of R + d+ R + d = N from whih follows d = d. Investment is pro t-maximizing if 1 (1 t)(1 = + " ) 1 (31) 1 (1 t )(1 ) from whih follows that soure based taxes are no longer neutral. Domesti orporate taxes inrease the number of foreign aquisitions d d d = = d 2 and foreign taxes do the opposite, d = 1 d of taxes on interest inome and dividends are equivalent to those derived in the model above. 1 2 = d d. The e ets 20

23 W Optimal orporate tax poliy of the domesti ountry is given W = 0 and = 0, see the appendix. What are the externalities of orporate taxation in this setting? Consider rst a small inrease in the foreign tax rate and its e et on domesti welfare: W = H 0 (1 + r)t S H 0 H 0 (" + ) (1 (" + ) d (32) ) + ( + (1 )) An inrease in dereases the number of foreign aquisitions and, thus, dereases the need for external nane, as S= = P ( ) > 0, whih inreases the revenue from taxes on interest inome. The seond term aptures the negative e et of an inrease in on the domesti dividend tax base. Furthermore, the foreign orporate tax rate dereases rm inome in period 2. However, it also redues aquisition pries in period 1 whih fully ompensates for the inome loss in period 2. The third e et aptures the hange in tax revenue due to the realloation of international aquisitions. The overall e et is ambiguous. Now, onsider the e et of a small inrease of on foreign welfare: W = H 0 (1 + r) t S +H 0 ((1 )" ) [u 0 P ( ) " (1 ) (1 )] (33) (34) An inrease in inreases the number of foreign aquisitions whih inreases the domesti need for foreign nanial funds, as S = = P ( ) < 0. This inreases revenue from taxing interest inome ( rst term). Furthermore, it dereases inome from selling rms in period 1 and redues rm inome in period 2. The net e et an be shown to be stritly positive. 8 Finally, the inrease in foreign aquisition redues foreign dividend tax revenue and inreases revenue from taxing the marginal synergy. Sine the externalities are di erent for both ountries, the question arises whether a oordinated inrease of and inreases welfare or redues it. Due to 8 It an be shown that u 0 P ( ) " (1 ) (1 ) = (1 t ) (1 t) (1 ) (1 ) > 0. 21

24 the asymmetry of ountries, we onsider a oordination experiment similar to those analysed above. Let both ountries inrease their orporate tax rate suh that the alloation of ownership remains una eted, i.e. d = 1 1 d = d, whih implies that,, S and S remain onstant. Then, world welfare W + W hanges as follows: d (W + W ) d = (H 0 1)(1 ) m" + + (H 0 1) " d! Z! + m d " (1 ) + (1 ) (" + ) d Z + (H 0 H 0 ) + t t + (1 ) (" + ) d (35) 1 t whih is positive as long as asymmetries, measured by t t and H 0 H 0, do not beome too severe. Thus, if the number of aquisitions is limited for some reason, the e et of oordination is similar to the one in the ase of green eld investment. # 3.7 Extension: Capital gains taxes and tax depreiation of goodwill So far, we have assumed that the proeeds from selling the rm are exempt from tax and that the aquirer annot write o the purhase prie. Assume now that there is a apital gains tax denoted by, and further that the aquirer gets a orporate tax dedution of the purhase prie in period 1. 9 In this ase, the maximum aquisition prie for foreign aquisition would be given by (1 + r)(1 t)p ( j)(1 ) = " + j (1 ) (1 ) (36) whih is the equivalent to equation (3). between selling and not selling if The vendor would be indi erent (1 + r)(1 t )P ( j)(1 ) " (1 ) (1 ) (37) 9 All other assumptions are as in the base version of the model. 22

25 This yields the uto value = " (1 )(1 t)(1 ) (1 )(1 t )(1 ) 1 (38) If the apital gains tax is equal to the orporate inome tax rate and the purhase prie is fully dedutible, i.e. (1 )=(1 ) = 1, the results derived in the preeding setion would be preserved. If there are asymmetries, i.e. if (1 )=(1 ) 6= 1, aquisitions are distorted. However, it is straightforward to show that our results onerning the need for orporate tax oordination also hold in this ase. 4 Disussion of the results How are the results derived in the two preeding setions related to the literature on tax ompetition and tax oordination? In standard models of tax ompetition with green eld investment, an inrease in soure based apital inome taxes indues a apital ow to other jurisditions. If these jurisditions tax the marginal green eld investment, they bene t from this apital in ow, i.e. a positive sal externality arises. Things are di erent if residene and soure based taxes oexist. In most models of green eld investment with residene based apital inome taxes, the welfare gains from a oordination of soure based taxes are small or even disappear, see Buovetsky and Wilson (1991). In the baseline version of our model, quite the opposite is true. In the absene of residene based taxes, there is no need for orporate tax oordination, but as soon as residene based taxes exist, a ase for tax oordination an be made. The fat that the bulk of foreign diret investment is atually M&A suggests that residene based taxes should reeive more attention in international tax oordination initiatives. As disussed above, a ruial assumption of our results onerns limitations in the number of aquisitions. As our purpose is to build a model whih serves as an equivalent to the standard model of green eld investment, the question arises if and how the number of investment projets is limited in the standard model. In an open eonomy, the number of green eld investment projets may have three kinds of limits, rstly the available amount of saving, seondly the dereasing returns to 23

26 apital in a given loation and, thirdly, a limitation in the number of investment projets per rm. The latter is similar to the one assumed in setion 3.6. The seond limit has an equivalent in our model in the dereasing synergy (, ) of target rms. At the margin, a green eld projet s return net of the ost of apital is zero as is an aquisition s after-tax synergy. A ruial di erene ours at the rst limit whih does not hold for aquisitions. Whereas green eld investment absorbs savings, aquisitions just redistribute savings. Capital invested in a green eld projet annot be used elsewhere whereas the proeeds from selling the rm may be invested at the world apital market. In the light of these arguments, we would like to propose that the baseline version of our model may be onsidered as an equivalent to the standard model of green eld investment where the marginal return just overs the ost of apital, whereas the model analysed in setion 3.6 may serve as an equivalent to the green eld model of disrete investment hoies, as in Devereux and Gri th (2003). It is also interesting to disuss our results in the light of the view developed in Desai and Hines (2004) who argue that, sine M&A investment abroad does not redue the domesti apital stok, a tax poliy whih is based on this assumption is neessarily misguided. As a onsequene, governments should exempt foreign inome from tax beause an additional tax upon repatriation distorts ownership deision and leads to e ieny losses. Our analysis on rms that taking into aount M&A investment hanges the impliations for tax poliy substantially. However, we also show that di erenes in residene based do not need to distort ownership deisions, see equation (3). Our results are also related to the literature on the apitalization of taxes in land pries (see Mieszkowski, 1972, or Hamilton, 1976). Soure based taxes are neutral for the number of aquisitions beause any tax hange will be fully apitalized in aquisition pries. This happens beause target rms are immobile by assumption and therefore annot esape taxation by reloating abroad. The omparison with the literature on land pries also points to a limitation of our analysis: We do not disuss the initial investment deisions that reated the target rms. Adding this deision would introdue elements of green eld investment into the model. The key tax e ets related to mergers and aquisitions derived in our model would remain, but they would ome out muh less learly. 24

27 5 Conlusions This paper develops a framework designed to analyse the role of soure and residene based taxes for tax ompetition and tax oordination in a world where investment takes the form of M&A investment rather than green eld investment. In the base version of our model, domesti entrepreneurs aquire domesti and foreign rms to exploit synergies. An aquisition does not imply a hange in the stok of a rm s real apital, just a hange in ownership. The governments levy soure based taxes on orporate pro ts and residene based taxes on dividends and interest inome. If the number of potential aquisitions is unlimited, soure based taxes do not a et M&A investment. One reason is that M&A investment does not absorb savings, in ontrast to green eld investment. We nd that, if governments an only levy soure based taxes, the tax levels they hoose under tax ompetition are also e ient for the eonomy as a whole, whih implies that there is no room for welfare enhaning tax oordination. The reason is that a hange in the soure based tax in one ountry does not a et M&A investment in other ountries, i.e. no sal externalities arise. In ontrast, if there are residene based taxes, ompetition in soure based taxes gives rise to negative sal externalities whih imply ine iently high tax rates in equilibrium. These results ontrast with ndings for tax ompetition for green eld investment, where soure based taxes are usually seen as the major soure of sal externalities. The availability of residene based taxes makes the demand for tax oordination less pressing or even implies that no oordination of soure based taxes is neessary any more (Buovetsky and Wilson, 1991). If the number of aquisitions is limited for some reason, the impliations for tax poliy are similar to the ase of green eld investment. Higher soure based taxes will give rise to positive sal externalities and ine iently low tax levels are likely to prevail under tax ompetition. In terms of poliy impliations, our results imply that the prevailing view, aording to whih tax ompetition leads to ine iently low levels of soure based taxes, has to be quali ed. More attention may have to be devoted to the interation between soure and residene based taxes and the impat of taxes on M&A investment. 25

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