We set up a model where two countries compete for internationally mobile firms through statutory tax rates and thin capitalization rules that limit the tax-deductibility of internal debt flows within multinational enterprises. Moreover, both multinational and domestic firms can respond to a higher domestic tax rate by increasing the level of external debt finance. For the case of identical countries we show that tax competition leads to inefficiently low tax rates and inefficiently lax thin capitalization rules. A coordinated tightening of thin capitalization rules will benefit both countries, even though it intensifies competition via statutory tax rates. If countries differ substantially in the number of domestic firms, however, then a coordination of thin capitalization rules may reduce welfare in the country with the larger domestic tax base.

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