An Economic Analysis of Extraterritorial Taxation

Abstract:

This paper proposes an economic analysis of extraterritorial tax policy. We consider a country imposing top-up taxes to the foreign profits of multinational firms to ensure a minimum effective corporate tax rate. We analyze the incidence of this tax, its domestic and global welfare effects, and derive conditions for optimal unilateral policy in a flexible multinational monopoly model. We obtain four main results. First, extraterritorial taxation generates additional tax revenues but leads to domestic price increases. When foreign profits are not taxed, the tax revenue gains dominate consumer welfare losses even for small countries. Second, when the foreign tax rate is positive, welfare effects are ambiguous. The optimal extraterritorial rate rises with domestic market shares and falls with foreign tax rates. A large enough country (or coalition of countries) can top-up foreign taxes, but a small country alone cannot overtax firms that are already heavily taxed abroad. Third, taxing the undertaxed profits of foreign multinationals has generally better welfare effects than tariffs. Last, revenue gains from extraterritorial profit taxation increase quadratically with country size. Extraterritorial tax collection turns the logic of tax competition on its head: large destination market countries (for which revenue gains typically swamp price increases) have incentives to tax the undertaxed profits of multinational firms, which can lead to a race-to-the-top with corporate income tax rates.