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Taxation of Investment and Savings in a World Economy: The Certainty Case

  • Roger H. Gordon

This paper explores the characteristics of individual portfolio holdings in a world economy with a unified securities market where there are many countries, each with its own tax rates and inflation rate. When nominal interest is taxable but income to equity owners is tax exempt in all countries, I show that the highest tax bracket investors specialize in equity and, among the remaining investors, those with lower tax rates buy bonds of countries with higher inflation rates. Because of the tax system, countries with a higher inflation rate must pay a higher real interest rate on their debt. This is necessary in equilibrium to compensate those who purchase the debt for their higher taxable income. This diversity of real rates of return in the world securities market has a variety of effects on the optimal tax policy of a small open economy. I also explore a model where there is a unified world market in bonds, but no international trade in equity. Here, I find a strong tax incentive for firms owned by investors in countries with high personal tax rates to become multinationals and invest abroad. If domestic investors do end up purchasing both bonds and domestic equity, then the optimal corporate tax rate on real corporate income in a small open economy would be quite high relative to the personal tax rate on nominal interest income, in order not to distort the portfolio composition of domestic investors.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1723.

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Date of creation: Oct 1985
Date of revision:
Publication status: published as Gordon Roger H. "Taxation of Investment and Savings in a WOrld Economy," American Economic Review, Vol. 76, No. 5, (December 1986), pp. 1086-1102.
Handle: RePEc:nbr:nberwo:1723
Note: PE
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  1. Daniel J. Frisch, 1981. "Issues in the Taxation of Foreign Source Income," NBER Working Papers 0798, National Bureau of Economic Research, Inc.
  2. Feldstein, Martin S, 1978. "The Welfare Cost of Capital Income Taxation," Journal of Political Economy, University of Chicago Press, vol. 86(2), pages S29-51, April.
  3. King, Mervyn A. & Fullerton, Don, 2010. "The Taxation of Income from Capital," National Bureau of Economic Research Books, University of Chicago Press, edition 0, number 9780226436319, March.
  4. Harvey Galper & Eric Toder, 1984. "Transfer Elements in the Taxation of Income from Capital," NBER Chapters, in: Economic Transfers in the United States, pages 87-138 National Bureau of Economic Research, Inc.
  5. Daniel Frisch, 1983. "Issues in the Taxation of Foreign Source Income," NBER Chapters, in: Behavioral Simulation Methods in Tax Policy Analysis, pages 289-332 National Bureau of Economic Research, Inc.
  6. John H. Makin, 1984. "Exchange Rates and Taxes," NBER Working Papers 1350, National Bureau of Economic Research, Inc.
  7. Wilson, John Douglas, 1987. "Trade, Capital Mobility, and Tax Competition," Journal of Political Economy, University of Chicago Press, vol. 95(4), pages 835-56, August.
  8. Joseph E. Stiglitz, 1983. "Some Aspects of the Taxation of Capital Gains," NBER Working Papers 1094, National Bureau of Economic Research, Inc.
  9. Peter A. Diamond & J. A. Mirrlees, 1968. "Optimal Taxation and Public Production," Working papers 22, Massachusetts Institute of Technology (MIT), Department of Economics.
  10. Robin Boadway & Neil Bruce & Jack Mintz, 1984. "Taxation, Inflation, and the Effective Marginal Tax Rate on Capital in Canada," Canadian Journal of Economics, Canadian Economics Association, vol. 17(1), pages 62-79, February.
  11. Alan J. Auerbach, 1980. "Wealth Maximization and the Cost of Capital," NBER Working Papers 0254, National Bureau of Economic Research, Inc.
  12. David G. Hartman, 1985. "On the Optimal Taxation of Capital Income in the Open Economy," NBER Working Papers 1550, National Bureau of Economic Research, Inc.
  13. Charles L. Ballard & Don Fullerton & John B. Shoven & John Whalley, 1985. "General Equilibrium Analysis of Tax Policies," NBER Chapters, in: A General Equilibrium Model for Tax Policy Evaluation, pages 6-24 National Bureau of Economic Research, Inc.
  14. Atkinson, Anthony B & Stern, N H, 1974. "Pigou, Taxation and Public Goods," Review of Economic Studies, Wiley Blackwell, vol. 41(1), pages 119-28, January.
  15. Feldstein, Martin & Hartman, David, 1979. "The Optimal Taxation of Foreign," The Quarterly Journal of Economics, MIT Press, vol. 93(4), pages 613-29, November.
  16. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
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