International capital tax evasion and the foreign tax credit puzzle

This paper examines the role of international tax evasion for the choice of an optimal foreign tax credit by a capital exporting region. Since a foreign tax credit raises the opportunity cost of concealing foreign source income, it can be employed to discourage evasion activity. The existence of international tax evasion possibilities could thus help rationalize a choice of tax credit in excess of a deduction-equivalent credit level. Our analysis shows that, in general the optimal credit will be one that results in a mixed tax system and, under certain conditions, the presence of international tax evasion can indeed result in a higher optimal foreign tax credit for a capital exporting country.