Optimal Tax Policy when Firms are Internationally Mobile

tion technology F is well-behaved (F_κκ < 0 < F_κ). After-tax profits are:

π_i -(1 — u) ^f Çk {A_i, B_i)^, A_i, B_l^ — (1 — ua) K (A_i, B_i)         (1⁾

where u is the statutory tax rate and a the rate of tax depreciation allowances.⁸
Optimal investment implies

∂F{K(A_i,B_i) ,A_i,B_i} _ _{1 — uα}
∂K (Ai,Bi)      ^{- 1} — u

which implies the optimal choice of K. In the following, K without tilde
denotes the optimally chosen K. It is straightforward to show that K_u — ^K < 0
and K_a — ^K > 0. a — 1 implies undistorted investment.

Firm 1 is assumed to have a high firm-specific profitability Ai and a low
location-specific profitability B_i. Firm 2 has a low A₂ and a high B₂. Roughly
speaking, firm 1 is internationally mobile and firm 2 is not. Mobility means, that
firm 1 leaves the country if its after-tax profits π are smaller than the profits which
could be earned abroad π*.

The government maximizes the utility of the households according to the social
welfare function

W - U (c) + H (д')

where c is private consumption and д is a publicly supplied good. Consumption
c is the after-tax income of the two firms. д is financed by the tax revenues.

The government has the choice between two general strategies. The first is
to levy high taxes, accepting that firm 1 will leave the country. In this case,
the standard result of the taxation of locally fixed profits is valid: Investment is
undistorted and the tax rate can reach 100%.

The second is to choose the optimal tax policy subject to the constraint that
firm 1 stays in the home market. In the following we will focus on this case. The
maximization problem is:

W — U Ç( (Fi (1 — u) — (1 — au) K^ + H Çu ( ( (Fi — aKi)^     (4)

⁸Any other taxes than source taxes are ruled out.

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