Optimal Fiscal Policy in an Open Economy with Capital Income Shifting and Consumer Cross-Border Purchases

The traditional theory of international tax competition for production factors or any of its expansions give neither a satisfactory explanation of the problem that would find confirmation in empirical data nor normative solutions for the shape of the optimal tax system. It seems that such a theory requires consideration of tax avoidance, the complexity of tax systems and fiscal solvency hypothesis. The paper presents a fiscal policy model integrating all the three concepts within the traditional framework of tax competition. Especially we take into account: taxation of consumption, possibility of capital income shifting and – untaxed in the destination country – foreign goods purchases. We conclude that if fiscal policy is by no means unfettered the equilibrium is allocation efficient, provided the marginal rate of substitution between private and public goods to be one. The tax on consumption is hence driven by the tax sensitivity of domestic and foreign purchases and the total volume of foreign purchases in the country and the tax on capital is determined by: the labour productivity effect, the capital income effect, the consumption effect and the tax burden exportation effect. One can show that this approach is especially useful during solvency crisis and can be applied to predict tax rates' adjustment when the bonds issuance decreases or public debt accelerates