Local taxation of global corporations: a simple solution

The explosion of globalization has increased firms incentives to exploit international tax differentials to their benefit. In this paper we consider a simple world with two countries with different market sizes and two multinationals with a division in each country. Both countries use a source-based profit tax on multinationals, who compete a la Cournot in each local market and use profit shifting based on the tax differential. We assess policies aimed to mitigate inefficient tax choices and show that tax harmonization cannot benefit the small country which adopts a lower tax rate to channel a tax revenue from the large country. We propose a simple revenue sharing mechanism in which countries share equal proportion of their own revenue with each other. It is shown that revenue sharing increases equilibrium tax rates in each country, reduces the tax differential, and benefits both countries despite of reallocation of resources from the high tax to the low tax country.