Tax competition and tax coordination in an optimum income tax model

Abstract

The paper uses the self-selection approach of Stiglitz (1982) to study tax competition and tax coordination in a many country–optimum income tax model. In the model, the government can impose a non-linear tax schedule on wage income and a (source-based) tax on mobile capital. In an uncoordinated equilibrium, it turns out that countries can use the capital tax instrument to weaken the self-selection constraint. The paper presents examples where positive and negative capital taxes are optimal from a single country perspective. If the production function is weakly separable between labor and capital, it can be shown that the optimal capital tax is zero. The paper also shows that, contrary to the standard tax competition model, the uncoordinated equilibrium can be efficient. If the wealth distribution (the endowments with capital among individuals), is egalitarian, a coordination of capital taxes does not affect welfare. For non-egalitarian wealth distributions, a coordinated increase in capital taxes can raise or lower welfare depending on the redistributive impact of a higher capital tax.