Optimal capital taxes for public good provision

Abstract

This paper constructs a general equilibrium trade model of a small open economy that produces many traded private goods and one non-traded public consumption good. Trade in goods is free, but the country taxes the internationally mobile capital to finance the provision of the public good. Within this framework, the paper identifies the conditions under which the optimal policy on the internationally mobile capital calls for a tax. Under the assumptions that (i) the welfare function is concave with respect to the tax rate, and (ii) the net revenue-maximizing capital tax rate is positive, it is shown that the marginal cost of the public good always understates its social marginal cost.