Optimal fiscal policy in an open economy with capital income shifting and consumer cross-border purchases

Agata Kocia,Janusz Kudła,Katarzyna Kopczewska,Konrad Walczyk,Robert Kruszewski

doi:10.12775/equil.2015.011

Abstract

The paper presents a fiscal policy model integrating tax avoidance, the complexity of tax systems and the fiscal solvency hypothesis within the traditional framework of tax competition. Furthermore, we take into account: taxation of consumption, possibility of capital income shifting and foreign goods purchases (untaxed in the destination country). We conclude that if fiscal policy is by no means unfettered the equilibrium can be allocation efficient, provided that the marginal rate of substitution between private and public goods is one. The changes in public debt affect tax rates in equilibrium differently: positively for the consumption tax rate and negatively for the labor tax rate. The change of the capital tax depends on the level of economic internalization. This approach is especially useful during a solvency crisis and can be applied to predict tax rates’ adjustment when the bonds issuance decreases or public debt accelerates.

Highlights

In order to increase production and employment and, household income, a government may set tax rates that attract production factors
Zodrow and Mieszkowski model has a number of simplifying assumptions, namely: − production capabilities of the economies involved in tax competition are symmetric; − each economy produces one private and one public good; − the markets are perfectly competitive; − consumer preferences are homogeneous and distribution of income is uniform; − the only variable and mobile factor of production is capital, and its rate of return is fixed; − government seeks to maximize social welfare measured by the total utility of all consumers (Kudła, 2013)
The paper raises the issue of optimal fiscal policy in an open economy when capital is mobile and, unlike labor, capital income can be shifted abroad and consumers may freely trade cross-border

Summary

Introduction

In order to increase production and employment and, household income, a government may set tax rates that attract production factors. Economists differently assess the effects of tax competition According to some, this will – assuming free international movement of capital and people – lead to alignment of relations in competing economies between what a taxpayer pays and what he receives in return. The traditional theory of tax competition between countries for the production factors or any of its extensions do not fully correspond to the actual conditions of taxation and give neither a satisfactory explanation of the problem of fiscal competition that would find confirmation in empirical data nor normative solutions for the shape of the optimal tax system. The subsequent section describes the impact of debt parameters on capital, labor and consumption tax adjustment for the unconstraint model with selected functional form It provides some interesting results on the fiscal response triggered by debt parameters and changes of other tax rates.

Basic Model

The Optimal Taxation

Properties of Binding Constraint Solutions

An Illustratory Explicit Solution

Findings

Conclusions