Optimal Taxation of Capital Income in Models with Endogenous Fertility

3 Small open economy

3.1 The model

This section investigates the implications of endogenous fertility choices on
the efficient capital income taxation in an international context. Let us ex-
tend the previous analysis to a small open economy that produces a single
tradable good, perfectly substitutable with the foreign produced good, and
that operates in a perfectly globalized capital market. Perfect capital mo-
bility implies that the relevant domestic interest rate is determined by the
exogenous world interest rate, denoted by r*.¹5 Moreover, we assume that
no international migration of workers occurs.

Financial wealth per capita, a, consists of physical capital and net foreign
assets per capita, which are denoted by b; that is, a = k + b. While b may
be either positive or negative, a is considered to be strictly positive.

There are two systems of taxing income from capital in an open economy:
the residence-based (often called worldwide) system and the source-based
(also known as territorial) system.

Under the residence-based system of capital taxation, incomes from do-
mestic and foreign wealth are taxed uniformly. Therefore, perfect capital
mobility requires that the before-tax rates of return on each asset are equal-
ized; that is, r — δ = r*. The households’ flow budget constraint is given
by
..

k + b= [(1 — τ a)r* — n](k + b) + (1 — τ ι)wl + q — c,        (12)

where τ a represents a proportional tax rate on income from financial wealth
inspired by the residence-based principle of taxation.

The maximization of (1) subject to (3) and (12) yields

Y= = (1 — τ ι)wT ' + k + b,                  (13a)

U_c

¹⁵ It is assumed that saving is not taxed abroad.

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