OH BELLA INGRATA!

For the capital income tax, we can proceed by noting that a strict interpretation of the tax rate Tko as the total tax rate on capital imposed only by the OECD country is not

necessary. Every country imposes some taxes on capital (with perhaps a few resource rich countries being exceptions), and very few countries tax all capital at the same constant average rate. In practice, average and marginal rates for many taxes vary substantially due to exemptions, allowances etc. It is more intuitive to think of Tko as a

differential tax rate. This represents, for a country that taxes capital at a higher rate than other countries, its excess tax rate on capital income. Tax competition implies that the OECD country might seek to reduce or eliminate this differential. This differential tax could simply be the difference between the average tax rate on the income from capital in all sectors in the OECD country and the average tax rate on capital income in the rest of the world.

There are several different ways of looking at this differential tax rate on capital income. First, we can note that Corporate Income Tax rates (combined federal and local) vary widely between even the OECD countries. For 2009, the combined rate for the U.S. at 39.1% was the second-highest within the OECD, exceeded only marginally by Japan in 2008. The OECD average for the same year was 26.3% (Source: The Tax Foundation website; available at: http://www.taxfoundation.org/research/show/23473.html ).

Further, the combined U.S. average rate for tax on dividends that combines the effects of the Corporate Tax and Income Tax is 49.6%, and only two countries, Denmark and France had a rate above 50%. (Source: OECD website; available at:

http://www.oecd.org/document/60/0,3343,en_2649_34533_1942460_1_1_1_37427,00.ht ml#cc)

Secondly, there is an even more interesting way of looking at this issue. Auerbach (2008) has pointed out that taxation of capital is not uniform. In addition to the well- known issue of double taxation of dividend income and the existence of the non- corporate sector, exemptions, thresholds, tax shelters and differential treatment of different forms of capital income ensure that the effective tax rate after including the excess burden of distortions due to non-uniform tax treatments is higher than the average tax rate assuming uniform taxation. Auerbach (1989) calculates that this differential could be of the order of 9% of capital income in the U.S.

Therefore, a reduction in the effective tax rate could take the form of a

rationalization of the tax structure to remove distortions, and this could mean a reduction in the effective tax rate on capital income. Perhaps this rate is of the order of 5%, even if the complete distortion is not removable, tax reform could seek to rationalize capital

income taxation in a way to make it uniform and reduce distortions, and have the same effect in practice as reducing the tax rate on an imaginary uniform rate applied to all capital. Note that it does not apply to a specific tax on one form of capital, such as the corporate income tax, but rather to taxes on income from capital. This includes income taxes on capital income (dividends, profits and interest), property taxes on that part of assessable property value not accounted for by land and tax on capital gains. A government may seek to eliminate all the differential tax.

Since we have abstracted away from risk differentials and other distortions including transport costs, the only difference between prices in OECD and ROW is the tax wedge. This need not be interpreted literally as saying that one country has a tax and the other has none, it is perfectly reasonable to say that it represents only the difference in the average tax rate between the two countries. Since there are no exemptions, the

average rate also equals the marginal rate.

In the capital income tax model, we have made the assumption that the difference between OECD and ROW is the differential tax on capital income. There is no difference in the rates of taxation of labor income. Let us proceed with the assumption that this difference is Tko = 5%. We can treat this not as the actual difference, but as one that is

hypothesized. If we are willing to assume that the policymaker is interested in removing half this differential, we can further assume that dTko = - 2.5%. This policy combination

could also accommodate any other ratio of the total differential.

In practice, the differential may be greater or less than 5% (as discussed above), and the change aimed at may also be greater or less than the differential assumed. The

equations have been derived in general form and any combination of numbers can be used. Any combination is possible, although changes in the average tax rate of an order greater than 5% will be extremely rare for a large country. This also implies that in the case where the country tries to get rid of the entire estimated differential in the average tax rate at one go, Tko = - dTko.

This set of assumptions and data are enough to derive several key variables in our analysis, given our assumption that all prices were equal to 1 to begin with (without taxes).