Dynamic Optimal Taxation in Open Economies

This paper analyzes optimal capital taxation in open economies with strategic interaction in a neo-classical growth model. With a territorial or source-based tax system, I show that optimal capital taxes in steady state are zero for a large open economy, thereby generalizing the result previously established only for the special cases of a closed and a small open economy. If the steady-state assumption is relaxed, optimal capital taxes are still zero when marginal utilities of private and public consumption are bounded, or when the utility function is quasi- linear in consumption. Moreover, in the latter case the solution is also time-consistent. For the residential or world-wide tax principle, however, countries are not able to tax all factors of production, so capital income taxes are generally non-zero except in the limiting cases of a closed or small open economy. Allowing for both residential and territorial taxes restores zero capital taxes.