Many subsidiaries can deduct interest payments on internal debt from their taxable income. By issuing internal debt from a tax haven, multinationals can shift income out of host countries through the interest rates they charge and the amount of internal debt they issue. We show that, from a welfare perspective, thin capitalization rules that restrict the amount of debt for which interest is tax deductible (safe harbor rules) are inferior to rules that limit the ratio of debt interest to pre-tax earnings (earnings stripping rules), even if a safe harbor rule is used in conjunction with an earnings stripping rule.
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