Switching from Safe Haven to Earnings Stripping Rules: Welfare Enhancing or Not?

Internal debt financing can be used by multinational firms to shift profits from high-tax to low-tax countries. Governments apply thin capitalization rules (TCRs), which limit the deductibility of interest expenses, to restrict this behavior. TCRs fall in two main categories: safe haven rules (SHR) and earnings stripping rules (ESR). We derive the locally and the socially optimal type of TCR in a general equilibrium two country model. A unilateral switch from SHR to ESR is welfare improving, because it allows governments to tax at different effective rates the economic rents of domestic and multinational firms. Thus, we provide an explanation for the recently observed trend to replace SHR with ESR. If multinational enterprises manipulate transfer prices in order to shift profits to tax havens, earnings stripping is also socially optimal. However, if profit shifting takes place among the subsidiaries located in high-tax jurisdictions, safe haven rules may be jointly welfare maximizing. Thus, a prisoner dilemma may emerge.