Optimal capital and labor income taxation in small and developing countries

This paper argues that smaller and poorer countries have lower optimal tax rates on capital and labor income than their larger and richer counterparts. It further provides an alternative explanation for such empirically observed differences in tax rates. The model focuses on a closed economy, but is extended by introducing mobile capital. The difference in tax rates here is efficient and not due to tax competition. For the result, less than perfect competition is necessary. The intuition is that monopolistic markups distort markets in a similar way as taxes. Hence, optimal tax rates are inversely related to markups and I show theoretically that smaller and poorer countries have larger markups. Therefore, these countries have lower optimal tax rates. Since smaller and poorer countries face larger competition distortions, there is less space for tax distortions. Hence, a smaller tax rate itself is insufficient to conclude a country is engaging in tax competition. Empirical analysis of the banking industry also shows that smaller and poorer countries have larger markups.