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Economic integration and the optimal corporate tax structure with heterogeneous firms

  • Christian Bauer

    ()

    (University of Munich)

  • Ronald B. Davies

    ()

    (University College Dublin; Institute for International Integration Studies, Trinity College Dublin)

  • Andreas Haufler

    (University of Munich)

We study the optimal combination of corporate tax rate and tax base in a model of a small open economy with heterogeneous firms. We show that it is optimal for the small country's government to effectively subsidize capital inputs by granting a tax allowance in excess of the true costs of capital. Economic integration reduces the optimal capital subsidy and drives low-productivity firms from the small country's home market, replacing them with high-productivity exporters from abroad. This endogenous policy response creates a selection effect that increases the average productivity of home firms when trade barriers fall, in addition to the well-known direct effects.

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Paper provided by IIIS in its series The Institute for International Integration Studies Discussion Paper Series with number iiisdp373.

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Length: 37 pages
Date of creation: Aug 2011
Handle: RePEc:iis:dispap:iiisdp373
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