Capital Markets: The Size of Government and Tax Coordination

International capital market integration has become the subject of major theoretical and practical interest in recent times. Policymakers are becoming more and more aware of the potential benefits accruing from such integration, which allows more efficient allocations of investment and saving between the domestic and the foreign market. In particular, with the prospective comprehensive integration of capital markets in Europe in 1992, some key policy issues arise. The financial, monetary, and exchange rate management policy implica-tions of capital market integration have been widely discussed in the context of the European Monetary System (EMS) (see, e.g., the survey in Micossi 1988). However, capital market integration also has profound effects on the fiscal branch of each country separately and on the scope of tax coordination among them. These issues have not been dealt with extensively so far. The present paper attempts to contribute to the economic analysis in this area. The opening up of an economy to international capital movements affects, as expected, the size and the structure of the fiscal branch of its government. Capital flows influence both the optimal structure of taxes, on domestic and foreign-source income, and the welfare cost of taxation. As a result, the optimal size of government (the optimal provision of public goods) and the magnitude of its redistribution (transfer) policies are affected as well. In this context, the paper analyzes the effects of relaxing restrictions on the international flow of capital on the fiscal branch of government