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account deficits, no capital import restrictions with current account surpluses.
(3) Maintaining the domestic tax structure (tax base and tax rates)
3(a) Capital controls prevent tax arbitrage
Taxation affects the pattern of international capital flows -- by directing savings and financial transactions
to countries with a favourable fiscal regime. Differences in the taxation of the returns on capital (withholding
taxes on interests, profits and dividends) across countries may lead to capital flight from high to low tax
countries to such an extent that nations may be deprived of their tax bases and, as a consequence, of their
welfare systems. Differences in the tax structure are created by different tax rates, differences in the bases
that are taxed and by different possibilities of avoidance and evasion. The importance of differences in
tax structure in explaining closed nominal interest rate differentials is likely to increase with more integrated
financial markets.
In addition, countries with inefficient tax systems may be more likely to impose capital controls. Because
they erode the tax base, capital outflows may greatly reduce the efficacy of the inflation tax on domestic
money holdings. The use of inflation tax is more attractive in the presence of a large tax base, i.e. when
the demand for base money is high. This is more likely in countries where a large amount of transactions
take place with the use of cash, and where banks have large amounts of reserves (Alesina, Grilli and Milesi-
Ferretti, 1994, p. 304). Capital controls, by isolating domestic financial intermediaries from foreign
competition, allow the imposition of high bank reserve requirements. This maintains a high demand for
monetary base and thus assures a large tax base for the inflation tax. The inflation tax provides the government
an alternative source of revenue as opposed to conventional forms of distorting taxation such as income
taxation (Phelps, 1973, Cukierman, Edwards and Tabellini, 1992)).22
Of course, this argument is closely related to the previous argument on the maintenance of internal balance.
Relevant indicators are the inflation tax (INF TAX, the inflation rate times base money as percentage of
GDP, active instrument i.e.the growth of seigniorage as a consequence of inflation) and seigniorage (SEIGN,
the growth rate of nominal GDP times base money as percentage of GDP, active and passive instrument
i.e. the growth of seigniorage as a consequence of inflation and real income). We conjecture that with higher
inflation tax and seigniorage revenue, the intensity of capital export controls will be higher.
(3b) Capital controls redistribute income
Left-wing governments are hypothesized to favour the taxation of capital income over that of labour income,
and to be tempted to introduce capital controls to prevent capital export and thus maintain a large domestic
tax base for capital levies (Alesina, Masciandaro and Tabellini, 1994).23 We introduce the dummy variable
LEFT, taking the value 1 when a left-wing government is in place and the value 0 otherwise (see Appendix
B). Furthermore, we expect political unstable countries to have more capital export restrictions. We proxy
the political instability of countries with the frequency of significant government changes (SIGGOV)
constructed by De Haan and Van ’tHag (1994).24 This brings us to the final argument for capital controls.
22 Note, however, the inflation tax may not be a choice variable for the government if monetary policy conduct is delegated to
an independent central bank.
23 Underlying the capital levy explanation of capital controls is the assumption that the government has sufficiently wide support
to introduce capital controls.
24 The Grilli, Masciandaro and Tabellini (1991) index of significant government changes gives similar results. However, this index
is not available for Finland and Sweden.