Part 1 - AL-Tax

Chapter 3candidate will win and set tax rates to maximize his or her own welfare. Themodel’s stages are: (1) Elections occur in both countries; (2) Elected citizencandidatesset their respective countries’ tax rates; (3) All private economic decisionsare made. In this case, the candidate who enters and wins will be the onewith endowment e p such that s/he desires to implement the following ModifiedRamsey Rule:pkS( τ ) eS( τ )ppp L( τl) ep⎡[ 1ετ( )]Sp1L( τl)⎣⎢p l kkτpkp*2 τ kpτ( τk)( τ ) F*( τ , ττ )Spkk⎤⎦⎥ .(3.5)Equation (3.5) gives the optimal capital-tax-rate policy for the domestic policymakerto choose, which, as one can see, is a function of the capital tax-rate chosenabroad. The game is symmetric, so the optimal capital tax-rate for the foreignpolicymaker to choose looks identical from his or her point of view and, importantly,depends on the capital tax-rate chosen domestically. That is, equation(3.5) gives best-response functions τ k T(e p , τ * k) and τ * k T * (e p , τ k ) for the foreignand domestic policymaker respectively. In words, the domestic (foreign)capital-tax rate depends on the domestic (foreign) policymaker’s labor-capitalendowment and the foreign (domestic) capital tax rate – i.e. capital taxes arestrategically interdependent. The slope of these functions, ∂T/∂τ * k and ∂T*/∂τ k ,can be either positive or negative. An increase in foreign tax rates induces capitalflow into the domestic economy, but the domestic policymaker may use theincreased tax base to lower tax rates or to raise them (the latter to seize the greaterrevenue opportunities created by the decreased elasticity of this base). Figure 3.1plots these reaction functions assuming that both slope positively. The illustratedcomparative static shows an increase in the domestic policymaker’s labor-capitalendowment. This change shifts the function T outward, raising the equilibriumcapital-tax rate in both countries.Although formal tax-competition models, like Persson and Tabellini’s (or Hays’or Basinger and Hallerberg’s), clearly demonstrate the strategic (‘spatial’ 5 ) interdependenceof capital taxes, as any of the alternative arguments reviewed abovewould also imply, very few scholars have empirically modeled that interdependencedirectly. Not all tax/welfare-state retrenchment arguments, however, necessarilyinvolve tax competition. Iversen and Cusack (2000), for example, arguethat structural change in the labor force, specifically deindustrialization, is theprimary force pushing welfare/tax-state retrenchment. Pierson (2001) concurs inpart, but also emphasizes path dependence (technically, state dependence),namely the accumulation and entrenchment of interests (or their absence) behind51