Perspectives on Tax Policy in Small and Open Economies

Abstract

The ongoing internationalization of many European and non-European economies has important implications for policies related to public finance. Economies relatively open to trade in financial assets, goods, services and factors of production are likely to respond to tax policy differently than relatively closed economies. The divergent impacts are related to both distributional aspects and allocative efficiency. This volume takes stock of some new insights from research on public finance in open economies. The focus is twofold. On the one hand, the degree of economic openness establishes further constraints on optimal tax policy. New sources of tax-induced inefficiency may be created by internationalization, and the costs of maintaining old policies may increase. This perspective is further discussed in the contribution by Christiansen, Hagen and Sandmo. On the other hand, institutional features typical of the open economies in Europe need to be better incorporated into the standard theory of public finance. Examples are labor unions, housing investment, cross-border shopping, monopolies, and pension saving. These extensions often involve market imperfections, which raise secondand third-best issues. Examples of market failures examined in this special issue are environmental externalities, knowledge spillovers, imperfect competition in commodity markets, and labor-market imperfections giving rise to involuntary unemployment. Higher mobility of financial capital, induced by lower transaction costs and deregulation of capital markets, has attracted considerable attention to the taxation of capital income. The standard normative model assumes perfect mobility of physical capital, while labor and residents are completely immobile. If a government can freely tax labor and country-specific rents, it should not adopt any source-based taxes on capital income. Intuitively, with perfect capital mobility, a source-based tax on capital is shifted to the immobile factor labor. It is better to tax labor directly rather than indirectly through a source-based tax on capital, since the explicit labor tax does not distort production.