Why Countries Differ in Thin Capitalization Rules: The Role of Financial Development

In the absence of financial frictions, the purpose of thin
capitalization rules is to limit multinational firms’ possibilities
of engaging in tax planning via debt shifting. This paper analyzes
the effects of thin capitalization rules in the case where firms
have limited access to external funding. First, we show that a host
country allows positive internal interest deductions if its
financial development is sufficiently low. This amount increases
when the financial development of the host country worsens. Then we
ask which of the two most common thin capitalization rules used in
practice is better suited to maximizing welfare of the host
country. We show that welfare under a safe haven rule is higher
than under an earnings stripping rule if firms are not able to
manipulate transfer prices. Welfare, however, can be higher under
an earnings stripping rule if firms are able to manipulate transfer
prices. The analysis provides an explanation for why countries
differ in the strictness and in the type of thin capitalization
rule.