The real exchange rate under various systems of international capital taxation.

• Author: Hatzipanayotou, Panos

1. Introduction

   International organizations, such as the Organization for Economic Co-Operation and Development (OECD) and the European Community (EC), have promoted, to varying degrees, the liberalization of capital movements among their member countries.(1) The "Code of Liberalization of Capital Movements," an agreement drawn in 1982 by the OECD, sets different degrees of capital liberalization among its member countries, depending on the nature of capital transactions (e.g., direct or portfolio investment). The Treaty of Rome (1957) recommended, among other things, the liberalization of capital movements among the EC countries (Chapter IV, articles 67-72). By and large, capital movements in the EC have been liberalized since 1990. The remaining restrictions in the capital markets of some member countries, such as Greece, Ireland, Portugal, and Spain, were to be eliminated by the end of 1992.(2) These developments in the world capital markets have prompted a renewed interest among trade theorists regarding the response of key economic variables (e.g., national income, employment and welfare) to the liberalization of capital movements.

   With capital becoming more mobile internationally, capital flows in a country depend, among other things, on the domestic and the foreign capital tax rate, and on the prevailing system of taxing net repatriated capital earnings in the capital-exporting countries. Frequently, capital-exporting countries tax the net repatriated capital earnings according to a system (i) of tax credits, under which tax payments by foreign capital invested in a capital-importing country are credited toward its tax liability to the source capital-exporting country,(3) (ii) of tax deductions, under which payments by foreign capital invested in a capital-importing country are deducted as a cost in calculating its tax liability to the source capital-exporting country, and (iii) of untaxed repatriated net capital earnings by the capital-exporting country. Recently, Bond and Samuelson |4~ using a game theoretic approach in a one-commodity two-country model, examine the welfare effects of capital taxes under a system of capital tax credits and of capital tax deductions. Slemrod |17~ using aggregate data from seven countries (i.e., Canada, France, Italy, Japan, the Netherlands, the U.K., and the U.S.) examines how the U.S. tax system in conjunction with the tax system of a capital-exporting country affects the FDI in the U.S. Slemrod's results support a negative relationship between effective U.S. capital tax rates and FDI into the U.S. Disaggregating the data by capital-exporting country, he does not find systematic differences in the responsiveness of FDI, with respect to changes in U.S. tax rates, from capital-exporting countries with a tax credit system (i.e., Italy, Japan, and the U.K.), and the remaining capital-exporting countries with a system of untaxed repatriated capital earnings.(4) Hatzipanayotou and Michael |11~ in a model of a small capital-importing and a small capital-exporting country, assuming free trade and variable labor supply due to endogenous supply adjustments examine, among other things, the employment and welfare effects of capital taxes under a system of capital tax credits, tax deductions, and untaxed repatriated net capital earnings.

   The response of another key variable, the real exchange rate, to the liberalization of capital movements is yet to be examined in a trade theoretic context, despite its important analytical and policy implications. Trade theoretic studies of the real exchange rate, ignoring international capital mobility, have primarily examined its response to trade restrictions (e.g., a higher tariff), and to exogenous shocks (e.g., income transfers, and an improvement in the terms of trade). In the context of a small open economy, it has been concluded that a higher tariff or an improvement in the terms of trade leads to a real exchange rate appreciation |2; 6; 7; 13~.(5) Recent studies, however, have shown that these conventional results may not necessarily hold in more general models, such as the three-good (exported, imported and nontraded goods) two-factor Heckscher-Ohlin model, or the three-good specific factor model |5; 8~.(6) In such general models (e.g., the three-good specific factor model), the higher tariff exerts two effects, which work in opposite directions, on the real exchange rate. A substitution effect, due to the induced production and consumption distortions, and an income effect whenever the initial tariff is non-zero. As a result, whether a higher tariff leads to a real exchange rate appreciation or depreciation depends, among other things, on the relative size of these two effects.

   This paper examines the real exchange rate effect of liberalizing capital movements, through reduced capital taxes under the three alternative systems of taxing repatriated capital earnings, for a small capital-importing and a small capital-exporting country. Two results emerge from the present analysis. First, whether liberalization of capital movements affects the real exchange rate depends on whether the country is a net capital-exporter or a net capital-importer, and on the prevailing capital tax system. Second, when changes in capital taxes affect the real exchange rate, it is, as in the case of a higher tariff, via a substitution and an income effect. But, contrary to the case of a higher tariff, the substitution effect is only due to a production distortion, while the income effect is due to changes in capital tax revenue that is distributed to households as a lump-sum. The analysis also stresses under which tax systems the real exchange rate effect of a higher capital tax depends, among other things, on the foreign capital tax rate.

   Section II examines the real exchange rate effect of liberalizing capital movements under the three alternative tax systems for a small capital-importing country, and section III for a small capital-exporting country. The last section offers some concluding remarks.

2. A Model of a Small Capital-importing Country

   Consider a small capital-importing country that produces many traded and nontraded goods, using an internationally mobile factor of production, capital, and some nontraded factors. The country's endowment of capital and of the nontraded factors are fixed. Commodity trade is free and the domestic prices of the traded goods, which equal the world prices, are given by the vector p. The relative prices of the nontraded goods, given by the vector q, are endogenously determined in order to equate domestic demand and supply of the nontraded goods.

   Let r and r* denote the domestic and world rate of return to capital. Similarly, positive (negative) values for |Rho~ and |Rho~* denote the capital tax (subsidy) by the home capital-importing and the foreign capital-exporting country. Three alternative systems of taxing the repatriated earnings of the internationally mobile capital are considered.

   First, a system of capital tax credits under which the capital-exporting country offers capital tax credits that reduce the domestic tax liability of its capital invested abroad by the amount of tax payments made in the capital-importing country. That is, a unit of capital invested in the capital-importing country pays an amount r|Rho~ in taxes in the host country, and an amount max((|Rho~* - |Rho~)r, 0) to the foreign capital-exporting country. Thus, a unit of capital earns a net rate of return equal to r(l - max(|Rho~*,|Rho~)), when invested in the home capital-importing country, and equal to r*(1 - |Rho~*), when invested in the foreign capital-exporting country. Equilibrium in the world capital market requires that

   r(1 -...