Cross-border loss offset can fuel tax competition

•Following the Marks and Spencer ruling, cross-border loss offset is an important policy issue.•We analyze coordinated cross-border loss compensation in a tax competition model.•The loss offset scheme favored by policymakers is likely to intensify tax competition.•An alternative loss offset scheme is shown to have more favorable properties. Following recent court rulings, cross-border loss compensation for multinational firms has become a major policy issue in Europe. This paper analyzes the effects of introducing a coordinated cross-border tax relief in a setting where multinational firms choose the size of a risky investment and host countries non-cooperatively choose tax rates. We show that coordinated cross-border loss compensation may intensify tax competition when, following current international practice, the parent firm's home country bases the tax rebate for a loss-making subsidiary on its own tax rate. In equilibrium, tax revenue losses may thus be even higher than is implied by the direct effect of the reform. In contrast, tax competition is mitigated when the home country bases its loss relief on the tax rate in the subsidiary's host country.