Dynamic Capital Tax Competition

We re-examine the view that capital taxes are too low when capital is mobile across tax jurisdictions. We do so by emphasising two previously neglected implications of non-cooperative capital tax setting in a fully dynamic environment. First, in a truly-dynamic environment, the returns to the non-capital factors of production and thereby disposable income and savings depend on predetermined capital stock. Thus, capital-market clearing interest rates depend also on past rates and taxes. Hence, taxes affect future interest rates, and thereby future consumption levels, capital stocks and tax revenues abroad. Second, in an overlapping generations economy, the effect of capital taxes on the current income of different generations is not the same across generations. The reason is that for old generations capital taxes affect the returns to their savings, while for younger generations capital taxes affect their non-capital income. This implies that capital taxes may produce an externality through affecting current consumption levels abroad. These two horizontal externalities may lead, ceteris paribus, to too high national capital taxes, and may more than offset the usual effects of tax competition. In this case, and contrary to conventional wisdom, national capital taxes will be too high