Public Infrastructure Provision in the Presence of Terms-of-Trade Effects and Tax Competition

This paper analyses and compares the performance of carbon taxes and capital taxes in financing public goods with positive effects on private firm productivity. It is motivated by Franks et al. (2017), who ask whether using carbon taxes could be motivated on fiscal grounds rather than by environmental ones, arguing that the advantage of the carbon tax consists in its potential to reap foreign resource rents. I employ an analytical general equilibrium framework of n identical countries, where local firms use internationally mobile capital and imported fossil fuel and in production as well as local public infrastructure. The latter is financed solely by either taxing the input of fossil fuels (carbon tax) or capital. The choice of the policy instrument is exogenous to policy makers and symmetric across countries. I find that the effect of policy on the fossil fuel price (terms-of-trade effect) leads to higher public good provision under carbon taxation. However, tax-competition could cause either policy instrument to yield higher provision depending on how strongly either tax base reacts to changes in the tax rate. And finally, I conclude that the ranking of the two policy scenarios is ambiguous when considering tax competition and the terms-of-trade effect simultaneously. A numerical exercise shows cases for higher provision of either policy.