Working Paper: NBER ID: w3416
Authors: Roger H. Gordon
Abstract: Recent theoretical work has argued that a small open economy should use residence-based but not source-based taxes on capital income. Given the ease with which residents can evade domestic taxes on foreign earnings from capital, however, a residence-based tax may not be administratively feasible, leaving no taxes on capital income.\nThe objective of this paper is to explore possible reasons why capital income taxes have survived in the past, in spite of the above pressures. Any bilateral approach, such as sharing of information among governments or direct coordination of tax rates, suffers from the problem that the coalition of countries is itself a small open economy, so subject to the same pressures. Capital controls, preventing capital outflows, may well be a sensible policy response and were in fact used by a number of countries. Such controls have many drawbacks, however, and a number of countries are now abandoning them.\nThe final hypothesis explored is that the tax-crediting conventions, used to prevent the double taxation of international capital flows, served also to coordinate tax rates. The paper shows that while no Nash equilibrium in tax rates exists, given these tax-crediting conventions, a Stackelberg equilibrium does exist if there is either a dominant capital exporter or a dominant capital importer, in spite of the ease of tax evasion. While the U.S. , as the dominant capital exporter during much of the postwar period, may well have served as this Stackelberg leader, world capital markets are now more complicated. These tax-crediting conventions may no longer be sufficient to sustain capital-income taxation.
Keywords: capital income tax; open economy; tax coordination; capital controls
JEL Codes: H25; H32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital controls (F38) | mitigate tax evasion (H26) |
| ability to evade taxes on foreign investments (H26) | reliance on residence-based taxation (H26) |
| capital controls (F38) | stabilize capital income taxation (F38) |
| dominant capital exporter or importer (F21) | influence sustainability of capital income taxation (H23) |
| tax-crediting conventions (H20) | coordinate tax rates among countries (F38) |
| capital controls (F38) | erosion of tax base (H26) |