Capital Accumulation and Foreign Investment Taxation

Abstract

This paper presents a dynamic, choice-theoretic general equilibrium model of capital accumulation in an open economy. Equilibria with and without capital mobility are described and compared. It is shown that neither is necessarily Pareto optimal and that an equilibrium with free trade in capital does not Pareto-dominate an equilibrium with autarky. The effects of restricting capital flows by taxing foreign investment eamings are discussed. It is seen that there will be no agreement within a country as to what constitutes an optimal tax. of restricting capital mobility by foreign investment taxation is discussed. The model employed is a two-country, overlapping-generations model (OLG) with production. It is an international version of Diamond's (1965) closed economy model, which combines a one-sector Solow growth model with Samuelson's OLG model. Each period a given number of agents are born. The agents live two periods and then die. In their first period of life agents born in period t may trade only with agents born in t - 1 or t. In their second period of life they may trade only with agents born in t + 1 or t. The model begins at period one. At this time the young of generation one and the old of generation zero are alive. It will be seen that in the first period of life agents save, and in the second period of life agents consume the return on their savings. Thus, the abstraction of a two-period life captures the essential feature of a life-cycle model: the agents begin life by saving, but at some point start to dissave. The major results are that if two countries differ only in initial capital abundance, then in autarky the initially more capital-abundant country will always be more capital abundant and will always have higher wages and lower interest rates than the initially less capital-abundant country. However, the steady state is identical in each country, with or without trade. Neither an autarky nor a laissez-faire equilibrium is necessarily Pareto optimal. Autarky and laissez faire are shown to be Pareto non-comparable. In the relatively capital-abundant country, laissez faire is preferred by generation zero and autarky is preferred by later generations. The reverse is true in the relatively labour- abundant country. There will be no unanimity as to the optimal level of foreign investment taxation in either country. Generation zero in the relatively capital- (labour-) abundant country will prefer a smaller (larger) tax than that which would maximize current national