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Privatization, public investment, and capital income taxation

  • Huizinga, Harry
  • Nielsen, Soren Bo

The authors investigate the optimal boundary between the public and private production sectors. They use a model in which government and private production coexist -in which a range of production activities can be carried out by either the government or the private sector. In effect, the government determines which activities to maintain within the public sector and which to privatize. In choosing the sectoral boundary, the government trades off the relative inefficiency of marginal government production against the private investment distortion created by tax policy. In an open economy, the private investment decision, is distorted by a source-based income tax. In a closed economy, the private investment decision is distorted by either a private investment tax or a savings tax. Either tax produces a wedge between the gross return on investment and the net-of-tax return received by savers. Because of this tax wedge, the private cost of capital exceeds the shadow cost of public capital. Optimally, the government sector is shown to be"too large"in the sense that the government carries out some activities in which it has an efficiency disadvantage and the private sector has an efficiency advantage. And it invests more in those activities than the private sector would. Generally the size of the government sector is related positively to the investment tax wedge. The level of investment taxes -and thus the size of the state production sector- may be affected by tax competition in the international economy. As international capital becomes more mobile, there seems to be more scope for international (investment) tax competition. As a result of tax competition, perhaps, corporate income tax rates have been on a downward trend in European countries. In Europe, the general lowering of corporate income taxes has coincided with a trend toward privatizing government activities. The authors focus on the relationship between capital income taxes and the size of the government production sector. Analogously, one could consider the relationship between labor income taxes and the size of the state sector. In that instance, the model predicts that a formerly state-owned enterprise, after privatization, reduces its payroll. Privatization also seems to lead to reduced employment levels. These results hold in both open economy and closed economy versions of the model.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1741.

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Date of creation: 31 Mar 1997
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Handle: RePEc:wbk:wbrwps:1741
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  1. Harry Huizinga & Soeren Bo Nielsen, . "Capital Income and Profits Taxation with Foreign Ownerwhip of Firms," EPRU Working Paper Series 95-09, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
  2. Schmidt, Klaus M., 1996. "Incomplete contracts and privatization," European Economic Review, Elsevier, vol. 40(3-5), pages 569-579, April.
  3. Diamond, Peter A & Mirrlees, James A, 1971. "Optimal Taxation and Public Production: I--Production Efficiency," American Economic Review, American Economic Association, vol. 61(1), pages 8-27, March.
  4. 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.
  5. Peter A. Diamond & J. A. Mirrlees, 1968. "Optimal Taxation and Public Production," Working papers 22, Massachusetts Institute of Technology (MIT), Department of Economics.
  6. Diamond, Peter A & Mirrlees, James A, 1971. "Optimal Taxation and Public Production II: Tax Rules," American Economic Review, American Economic Association, vol. 61(3), pages 261-78, June.
  7. Oliver Hart & Andrei Shleifer & Robert Vishny, 1996. "The Proper Scope of Government: Theory and an Application to Prisons," Harvard Institute of Economic Research Working Papers 1778, Harvard - Institute of Economic Research.
  8. Dasgupta, Partha & Stiglitz, Joseph E, 1972. "On Optimal Taxation and Public Production," Review of Economic Studies, Wiley Blackwell, vol. 39(1), pages 87-103, January.
  9. Shapiro, C. & Willing, D.R., 1990. "Economic Rationales For The Scope Of Privatization," Papers 41, Princeton, Woodrow Wilson School - Discussion Paper.
  10. Jean-Jacques Laffont & Jean Tirole, 1991. "Privatization and Incentives," Working papers 572, Massachusetts Institute of Technology (MIT), Department of Economics.
  11. SANDMO, Agnar & DREZE, Jacques H., . "Discount rates for public investment in closed and open economies," CORE Discussion Papers RP -98, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  12. Abe, Kenzo, 1992. "Tariff Reform in a Small Open Economy with Public Production," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 33(1), pages 209-22, February.
  13. Boardman, Anthony E & Vining, Aidan R, 1989. "Ownership and Performance in Competitive Environments: A Comparison of the Performance of Private, Mixed, and State-Owned Enterprises," Journal of Law and Economics, University of Chicago Press, vol. 32(1), pages 1-33, April.
  14. Laban, Raul & Wolf, Holger C, 1993. "Large-Scale Privatization in Transition Economies," American Economic Review, American Economic Association, vol. 83(5), pages 1199-1210, December.
  15. Bos, Dieter & Peters, Wolfgang, 1988. "Privatization, internal control, and internal regulation," Journal of Public Economics, Elsevier, vol. 36(2), pages 231-258, July.
  16. Bhaskar, V & Khan, Mushtaq, 1995. "Privatization and Employment: A Study of the Jute Industry in Bangladesh," American Economic Review, American Economic Association, vol. 85(1), pages 267-73, March.
  17. Hagen, Kare P., 1988. "Optimal shadow prices for public production," Journal of Public Economics, Elsevier, vol. 35(1), pages 119-127, February.
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