Tax Evasion and the Optimal Tax Treatment of Foreign-Source Income

This paper models a capital-exporting country that encounters difficulties in taxing foreign-source income, due to tax evasion problems. The paper compares the country's optimal effective tax rates on the income from capital invested at home and abroad (including penalties levied on detected tax evaders). It is found that tax evasion abroad does not provide a justification for a relatively low effective rate on foreign-source income. Under a variety of circumstances, foreign-source income should actually be taxed at a relatively high effective rate, regardless of the severity of tax evasion problems abroad. However, tax evasion abroad does tend to reduce the optimal taxation of capital income both at home and abroad. Thus the paper demonstrates how capital mobility effectively makes the optimal tax on capital income at home dependent on tax evasion problems abroad. The paper also investigates the role of constraints on capital exports as a substitute for high effective tax rates on foreign-source income.