International Capital Tax Evasion and the Foreign Tax Credit Puzzle

This paper examines the role of international tax evasion for the choice of an optimal foreign tax credit by a capital exporting region. Since a foreign tax credit raises the opportunity cost of concealing foreign source income, it can be employed to discourage evasion activity. The existence of international tax evasion possibilities could thus help rationalize a choice of tax credit in excess of a deduction-equivalent credit level. Our analysis shows that, under certain conditions, the presence of international tax evasion can indeed result in a higher optimal tax credit for a capital exporting country, but the conditions for this result to hold are quite restrictive. We find that : (i) although an increase in the foreign tax credit unambiguously reduces evasion activity per unit of exported capital, it also encourages exports, and may thus result in higher evasion costs ; (ii) the presence of evasion reduces the "compounding" effect of the double taxation of foreign source income, thereby reducing the need for a foreign tax credit ; (iii) by making residence based taxes distortionary, the presence of international tax evasion raises the marginal cost of the public funds that are obtained through domestic taxes, and hence raises the social cost of a foreign credit.