Relativity, mobility, and optimal nonlinear income taxation in an open economy

Abstract

Recent evidence suggests that globalization has reduced the barriers to international labor mobility and induced more cross-country social comparisons. In an open economy with tax-driven migration and consumption externalities (relativity), we derive an optimal tax formula that subsumes existing ones obtained under a maximin social objective and additively separable utility and sign the second-best (Mirrleesian) marginal tax rates for all skill levels. We establish the thresholds of the elasticity and level of migration to determine when relativity and inequality act as complements or substitutes in shaping the optimal top tax rate. Under both Nash and Stackelberg tax competition if the migration probability of top-income workers is approximately 50%, numerical calculation using parameter estimates from empirical studies shows that the country with labor inflow (outflow) implements over 10% lower (higher) marginal tax rates than suggested by the autarky equilibrium of Kanbur and Tuomala (2013).