Optimal Tax Policy when Firms are Internationally Mobile

of the economy, as does Bond (2000), the term in square brackets as well as the
whole RHS of equation (10) becomes negative. A reduction in the tax allowance
a, i.e. a broadening of the tax base, leads to a rise in welfare.

How can a distortion of investment lead to increasing welfare? By broadening
the tax base and lowering the tax rate the government redistributes tax liabilit-
ies from the high profits firm to the low profits firm. The government can thus
increase overall tax revenues without losing the mobile firm. In other words, the
government equalizes the marginal loss resulting from the investment distortion
and the marginal gain resulting from additional tax revenues.

The opposite case is possible, too. Assume that the immobile firm is more
profitable than the mobile firm. In this case, the government wants to redistribute
tax liabilities from the less profitable firm to the more profitable one. It can do so
by lowering the tax base and increasing the tax rate, i.e. by subsidizing investment.
Such a tax system hits the profitable firms harder than the non-profitable ones.

The two firm model can be questioned concerning two aspects. First, under
more realistic assumptions, it will probably not be optimal for the government to
keep all firms in the home market. It will rather accept some exits and weigh the
resulting losses in tax revenue against the gains of the remaining firms due to a less
distorting tax system. Second, by distorting the tax system the government might
drive out firms which are immobile and just break even under an undistorted tax
system.

We therefore consider a more general model with a continuum of firms.

3 A more general model

3.1 Firms

Consider an economy with a continuum of mobile profit-maximizing firms, which
differ in profitability. A and B are now independently distributed parameters with
A C {A ,A¹} and B C {B^-,B⁺}, where A and B^- can be negative.

The firm decides not to produce if

π (A,B) < 0                             (11)

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