Taxation and Capital Market Liberalization: A Political-Economy Model

Abstract

This paper investigates the effects of financial liberalization on the welfare state from a politicaleconomy point of view. Most research on the subject does not treat financial liberalization as a political process, but take the changing economic environment as exogenously given. This is the essence of the tax competition literature, which reaches the conclusion that under full capital mobility countries compete over a fixed amount of international capital by undercutting each others’ tax rates, effectively engaging in a "race to the bottom" in tax rates. The present paper addresses these issues, but unlike the basic line of argument of the tax competition literature, it concentrates on the domestic political forces that could have contributed to the process of financial liberalization. Within an OLG political-economy framework, decisions regarding capital tax rates and the extent of capital market liberalization are made concurrently. The model's main result is that when the tax rate on capital income is established in the political process along with the restrictions on capital outflows, and when income of foreign origin cannot be taxed, there is a positive correlation between the two policy decisions. This positive correlation occurs because the tax rate is chosen in the political process so as to offset the effect of capital flight due to less restriction on capital outflows. In addition, the effect of a change in the distribution of income resulting from the aging process is tested. In a closed economy, an increase in the proportion of the population that derives its income from capital lowers the tax rate on capital income. The introduction of an additional policy target, the extent of capital mobility, creates additional forces that have offsetting effects. An increase in the proportion of the elderly generates political pressure for a more liberal capital controls policy. A less restrictive policy toward capital outflows, in turn, leads to heavier capital taxation in order to offset the depletion of the economy's capital-tax base.