Capital Tax Competition and Dynamic Optimal Taxation

In: https://ir.library.carleton.ca/pub/410

Abstract

I analyze international tax competition in a framework of dynamic optimal taxation for strategically competing governments. The global capital stock is determined endogenously as in a neo-classical growth model. With perfect commitment and a complete tax system (where all factors of production can be taxed), governments set their capital taxes so that the net return is equal to the social marginal product of capital. Capital accumulation thus follows the modified golden rule. This is independent of relative country size, capital taxes in other countries, and the degree of capital mobility. In contrast, with an exogenous capital stock returns on capital are pure rents and a government's ability to capture them is limited through capital flight, triggering a race to the bottom. With an endogenous capital stock, capital is an intermediate good and taxes on it are not used to raise revenues, but to implement the optimal capital stock. Even in a non-cooperative game it is thus not individually rational for governments to engage in tax competition. I provide a general proof that if the modified golden rule holds in a closed economy, then it also does in an open economy.