Dhammika Dharmapala (Illinois), Competitive Neutrality Among Debt-Financed Multi-national Firms (with Mihir A. Desai (Harvard)) at NYU today as part of its Colloquium Series on Tax Policy and Public Finance convened by Daniel Shaviro (NYU) and William Gale (Tax Policy Center; visiting at NYU):

Debt plays an important role in the financing of multinational corporations (MNCs). Interest
expenses are typically tax-deductible in most corporate income tax systems, and there has been a
growth of interest in recent years in the tax treatment of debt and its consequences. This paper
discusses the optimal form that interest deductibility and associated restrictions should take in a
multi-jurisdictional setting. We straightforwardly extend existing neutrality norms in
international taxation to serve as a benchmark. Our simple notion of competitive neutrality (CN)
entails that all multinational firms competing for the same investment face the same after-tax
cost of debt, regardless of their country of residence. We first show using a simple three-country
framework that when MNC investments are debt-financed, the potentially differential
deductibility of debt entailed by various tax law provisions leads in general to violations of CN.
We also show that a multilateral formula apportionment system would not generally satisfy CN,
unless all MNCs’ assets are distributed across countries in the same proportions. Moreover, we
also show that MNCs’ ability to establish “multiple-dip” financing structures (in which the same
third-party debt is deducted in multiple countries) generally exacerbates these violations of CN. 

We suggest – more as a thought experiment than as a serious policy proposal – a regime that
satisfies CN under a general set of conditions. This involves countries imposing a worldwide
debt cap that restricts a multinational affiliate’s deductible interest to (some arbitrary fraction of)
the total worldwide third-party interest payments of its multinational group. We argue that if all
countries adopt this rule, and do not impose any other restrictions on interest deductibility for
multinational affiliates, then CN will be satisfied if firms earn sufficient income in each country.
This regime relies on harnessing rather than restricting MNCs’ “multiple-dip” financing
structures. We also review various proposed explanations for why interest is tax-deductible, and
conclude by revisiting the arguments for the tax deductibility of debt in a multi-jurisdictional
setting.