Optimal tariffs, optimal taxes and economic development

Cross-section and time-series data suggest that nations substitute income taxes for tariffs as they develop. This paper confronts the data within the context of a two-country open-economy endogenous growth model in which public expenditure is financed by an optimal tariff and income tax. When the latter is subject to administrative costs, the model predicts that the government will optimally substitute the income tax for the tariff as output rises along the transition. The model is calibrated and a simulation yields time paths for the shares of total government revenue derived from the tariff and the income tax that are consistent with the data.