Capital Tax Competition and Dynamic Optimal Taxation

By Till Gross

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 fight, 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.

This paper highlights an important point that can explain much of the divide in the public debate about capital income taxation. Those who want higher taxes consider capital to be largely exogenous and thus rent. Those who want lower taxes see capital as mostly endogenous and thus subject to distortions. What this paper does not address, though, is how progressive taxation can address the issue of equity and redistribution. In the context of tax competition, this is important as it adds a new layer of trade-offs: raising taxes reduces inequality, but is also more likely to reduce tax income when tax competition is possible. This paper is a good start to think about this, one step at a time.

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