Why countries differ in thin capitalization rules: The role of financial development

The purpose of thin capitalization rules is to limit multinational firms' possibilities of engaging in tax planning via debt shifting. This paper analyzes the optimal design of thin capitalization rules in the presence of financial frictions when a host country, in the first stage, chooses the type of thin capitalization rule and then, in the second stage, decides about the strictness. We show that welfare under a safe haven rule is higher than under an earnings stripping rule if firms are not able to manipulate the interest rate on internal loans. Welfare, however, can be higher under an earnings stripping rule if firms are able to manipulate the interest rate on internal loans. We also show that the optimal level of internal interest deductions decreases with the financial development of the host country. Our results are consistent with countries' actual policy choice.