The International Income Taxation of Portfolio Debt in the Presence of Bi-Directional Capital Flows

A country’s net flow of capital consists of simultaneously occurring imports and exports. Because a tax on the income from capital imports affects the quantity of capital exports and vice versa, tax policies toward inbound and outbound capital should be jointly formulated in order to avoid distorting these bi-directional flows and the local capital market more generally. For a small open economy, distortion-free local capital markets are shown to require, in the limited case of portfolio debt flows: (1) the taxation of income from capital imports by the importing country at the same rate as income of residents from locally invested capital; and (2) the exemption from net tax (that is, after any foreign tax credit) in the home country of the income of its residents from capital exports.