Double tax discrimination to attract FDI and fight profit shifting: The role of CFC rules

Governments worldwide use targeted tax policies to trade off the gains from increased FDI against the cost of excessive profit shifting by multinational firms. We show that optimal tax systems generally incorporate both thin capitalization rules, which tax discriminate between purely national and multinational firms, and controlled-foreign-company (CFC) rules, which discriminate between home-based and foreign-based multinationals. Introducing CFC rules is optimal if investment elasticities of home-based and foreign-based multinationals differ due to transaction costs for FDI. We also analyze the effects of reduced transaction costs for FDI and reduced costs for debt shifting on the optimal policy mix. Our results correspond to the observed development of anti-avoidance rules in OECD countries.