Optimal Origin-based Commodity Taxation in a Small Open Economy

This paper investigates whether the pursuit of redistributional objectives may provide a rationale for origin-based taxation in small open economies. The analysis is developed in a simple two-class economy where consumers are classified according to the type of labour they supply. As world prices are given for a small open economy, the full burden of origin-based commodity taxes falls on the two types of labour. When a non-linear tax is levied on labour income, origin-based taxes cannot directly improve income distribution as the two types of labour face different marginal tax rates. However, the government can exploit the differential incidence of these origin-based taxes and increase social welfare by relaxing the self-selection constraints that bind the non-linear tax. Rather surprisingly, the value judgements embedded in the social welfare functional do not affect the structure of optimal origin-based commodity taxation.The paper also shows that the optimal structure of origin-based commodity taxation does not change when the labour income tax schedule is constrained to be linear, and that a positive source-based tax on capital income may be optimal if it results in a differential burden on the two types of labour.