Consumption and Cash-Flow Taxes in an International Setting

Abstract

We model the effects of consumption-type taxes which differ according to the base and location of the tax. Our model incorporates a monopolist producing and selling in two countries with three sources of rent, each in a different location: a fixed factor (located with production), mobile managerial skill, and a monopoly mark-up (located with consumption). In the general case, we show that for national governments, there are tradeoffs in choosing between alternative taxes. In particular, a cash-flow tax on a source basis creates welfare-impairing distortions to production and consumption, but is incident on the owners of domestic production who may be non-resident. By contrast, a destination-based cash-flow tax does not distort behavior, but is incident only on domestic residents. In the alternative case of perfect competition, with the returns to the fixed factor accruing to domestic residents, the only distortion from the source-based tax is through the allocation of the mobile managerial skill. In this case, the sourcebased tax is also incident only on domestic residents, and is dominated by an equivalent tax on a destination basis, or by a sales tax.