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DP2348 | Is Tax Policy Coordination Necessary?

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The answer to this question is "yes". We re-examine noncooperative and cooperative equilibria under perfect capital mobility. To this end, we develop a two-country optimal growth model with endogenous national fiscal policies. The channel for interdependence is distortionary income taxes. We study both the Residence and Source principle of international taxation. National governments play Stackelberg vis-à-vis private agents, while they can play either Nash or cooperate vis-à-vis each other. We solve for Markov-perfect (time consistent) equilibria. We show that the pertinent Nash equilibria are degenerate. Thus, under both the Residence and Source principle, only cooperative equilibria can exist. The driving force is perfect capital mobility. This is a new result that provides a strong argument for world tax coordination. When we solve for cooperative equilibria, we show that it is optimal to set a common tax rate across countries, irrespective of the principle of international taxation (Residence or Source) and differences across countries. A cooperative solution under the Source principle may be more difficult to implement than under the Residence principle.