Optimal Taxation, Capital Mobility and Tax Evasion

Abstract

The problem of capital flight and tax evasion is of paramount concern to many countries. The fear is that capital mobility may lead to capital flight from high to low tax countries in such large amounts that it deprives a nation of its tax base and, as a consequence, its welfare system. Today's international climate, where bank secrecy laws protect foreign investors' anonymity in addition to substantial differences in national tax rates, makes this fear a reality. Capital flight and tax evasion are also of concern from an equity as well as an efficiency point of view. To the extent that labor cannot evade taxation as easily as capital, labor is subject to higher effective tax rates than capital. The presence of capital flight therefore imposes a higher tax burden on immobile factors and creates inequality. Giovannini (1989) and Razin and Sadka (1991) have recently studied the welfare effects of capital flight. Both studies are undertaken from the extreme assumption that foreign savings cannot be taxed and hence, that tax evasion is undetectable and costless. Although evidence suggests that governments have difficulties taxing foreign source income, governments derive positive tax revenue from foreign source income. This paper thus adopts a different perspective. Capital flight and tax evasion are viewed as problems of tax enforcement. The purpose of the paper is to analyze the intertemporal savings decision of an individual who can allocate consumption between two periods by borrowing and lending abroad and domestically. It is assumed that foreign savings can evade taxation with a certain probability depending on the amount of money the government allocates to tax enforcement. Within this setting, we investigate how taxes on foreign and domestic savings should be set optimally, and how much money if any the government should allocate to tax enforcement.