The paper begins with a discussion of tax neutrality in an open economy. The focus is on the distinction between taxation based on the ownership of capital and taxation based on the location of capital. Even at this conceptual stage, tax implications of moving from a closed economy to an open economy can be dramatic. The greater the mobility of financial capital among countries, the greater are the opportunities for international tax arbitrage. Efficiency considerations may require highly unrealistic constraints on the optimal tax rates such as uniform taxation, exemplifying the difficulty of international tax coordination.
The actual tax treatment of foreign source capital income is quite complex. There exist many other sources of distortion than can be described in a stylized theoretical framework. The efforts by countries to relieve double taxation of foreign source income are often incomplete and asymmetric across income types. The tax treatment of multinationals is extremely complicated, influencing both their real and financial behavior. The existence of alternative forms of international capital flows creates additional complications. Foreign direct investment faces a very different statutory tax treatment than foreign portfolio investment. The role of tax treaties and investment incentives in attracting foreign investment is not as clear as generally perceived. The rest of the paper addresses practical aspects of taxing international capital income.
The organization of the paper is as follows: Section 1 analyzes the basic principles of tax neutrality in the presence of international capital mobility. The most standard practices of taxing foreign source income are summarized in section 2. Section 3 discusses various tax effects on international investment and financial behavior, while their implications for Korean tax policy are presented in section 4.

Contents

1. Tax Neutrality In an Open Economy
A. Source-based Taxation and Capital Import Neutrality
B. Residence-based Taxation and Capital Export Neutrality
C. Implications for Optimal Tax Policy and Policy Coordination

2. The Taxation of Foreign Source Income

3. Tax Distortions to International Investment
A. The Effects of Foreign Tax Credits and Tax Deferrals on the Effective Tax Rate on Foreign Source Income
B. The Effectiveness of Investment Incentives
C. Tax Effects on Financing Decisions
D. Tax Effects on Multinational R&D Decisions
E. Relative Tax Advantage of a Portfolio vs. Direct Investment

4. Implications for Korean Tax Policy
A. Incentives in the Tax Laws
B. Tax Treaties
C. Tax Policy Concerning the Form of Foreign Investment
D. Summary of Policy Implications

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