Corporate tax systems and cross country profit shifting

The paper analyses optimal taxation of corporate profits when governments can choose both the rate and the base of the corporation tax, but are constrained to collect a given amount of corporate tax revenue. In a standard two-period model of investment and international mobility of portfolio capital only, the optimal tax system allows a full deduction for the costs of capital. When foreign direct investment is permitted, however, and firms can shift profits between countries through transfer pricing, it will be optimal for each government to distort investment decisions in order to reduce tax rates and limit the incentive for profit shifting.