A tax competition approach to resource taxation in developing countries

In this paper, we investigate the effect of cost misreporting of extractive firms on the optimal design of tax policies. We build a two-period, two-country model where governments aim to attract a foreign-owned multinational firm to raise tax revenues by levying a profit tax and a royalty. The firm overstates its production costs to reduce declared profits and it decides in which country to locate. We find that cost overstatement pushes royalties upward but remains detrimental for tax revenues as well as the capital invested by the firm. The mining country that attracts the extractive firm is often the country with the highest coefficient of overstatement. However, the firm may locate in the country with the lowest overstatement and lowest royalty if both countries have the same profit tax. Reinforcing expertise in mining sectors to reduce asymmetries of information between firms and tax authorities appears to be a priority in developing resource countries.