Corporate Tax Systems and Cross Country Profit Shifting.

The paper analyses optimal taxation of corporate profits when governments can choose both the rate and the base of the corporation tax, but are constrained to collect a given amount of corporate tax revenue. In a standard two-period model of investment and international mobility of portfolio capital only, the optimal tax system allows a full deduction for the costs of capital (cash-flow taxation). When foreign direct investment is permitted, however, and firms can shift profits between countries through transfer pricing, it will be optimal for easch government to distort investment decisions in order to reduce tax rates and limit the incentive for profit shifting. This result conforms with recent reforms of corporate tax systems, which have generally reduced tax rates while broadening tax bases.