By Soojin Kim
Two key determinants of optimal tax policies in open economies are the mobility of factors of production, capital and labor; and strategic interaction between governments in setting their policies. This paper develops a two-country, open-economy model with labor mobility and a global financial market to study optimal taxation. Governments engage in tax competition in which they choose a labor income tax code and a capital income tax rate. A quantitative application of the model to the United Kingdom (UK) and Continental European countries (CE) shows that factor mobility and competition between governments are indeed crucial in the design of optimal policies. Incorporating labor mobility leads to a divergence in the optimal tax system: Unlike in an economy with only capital mobility, where both countries use similar capital income tax rates, the optimal capital income tax rate in the UK is lower than that in the CE when both capital and labor are mobile. This is due to the differences in productivity between the two countries. In the calibrated economy, the UK, whose productivity is higher than that of the CE, attracts more labor through migration. Thus, the welfare-maximizing level of capital in the relatively small CE is lower than that in the UK. Moreover, I find that capital income tax rates are higher with competition. With competition, both governments lower capital income tax rates, rendering the marginal benefit of a lower tax rate to decrease. The steady-state welfare gain from implementing the Nash equilibrium policies is about 11 percent of consumption of the status quo economy.
The optimal taxation literature largely assumes that the studied country lives in autarky. This is definitely not true, as tax competition is always on the mind of policy makers. The important message of this paper is that even with mobile factors and tax competition, there is room for tax rates to differ across countries, still giving each country some wiggle room to set its priorities.