Knowledge Spillovers and The Optimal Taxation of Multinational Firms

This paper examines a key policy question for many developing countries: Should they allow and even subsidize the entry and operation of multinational firms? I consider a model in which spillovers drive the formation of productive knowledge, the typical rationale for attracting multinational firms. I depart from most work on the gains of openness and instead of using simple counterfactual policies (i.e. compare complete openness or complete closedness with each other or with actual policies) I characterize the gains attainable under a Ramsey program, when taxes are set to maximize the welfare of the recipient country subject to the equilibrium behavior of national and foreign agents. I find that contrary to laissez-faire, openness under optimal taxation always leads developing countries to catch up with developed countries and improves their welfare. However, in stark contrast with some observed practice, I find that a developing country should only subsidize the entry of foreign firms if the domestic accumulation of know-how is also subsidized.