Optimal Dynamic Taxation with Respect to Firms

Abstract

In this paper we develop a framework for determining optimal profit taxation in a market economy with value-maximising firms, which face costs of adjustment for investment. The government chooses this tax rate in such a way that the utility of the consumer, which depends on public and private consumption will be maximised. The private consumption is financed by wage income and dividend. while public consumption is financed by tax revenues. We show that there is a dynamic trade-off between public consumption now and in the future. Two possible solutions are derived. The first solution, which is the formal outcome of an open-loop Stackelberg equilibrium of a game between government and firms, is time-inconsistent and is only credible, if there is commitment or if there are reputational forces. The second solution, which corresponds to a feedback Stackelberg equilibrium. is time-consistent, but yields a lower value of steady-state utility.