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Optimal taxation, internationally

In a global economy, designing an international tax system is a “pressing concern”

March 30, 2021

Author

Douglas Clement Managing Editor
Decorative key image
Jake MacDonald/Minneapolis Fed

Article Highlights

  • A dynamic international trade model helps analyze intergovernment cooperation on fiscal and trade policy
  • Coordinated fiscal policy can promote efficiency with unrestricted trade and full capital mobility
  • The model is relevant to policy among states or provinces, as well as among nations
Optimal taxation, internationally

To most, taxes are a necessary evil. Necessary for the public goods they finance and redistribution they effect; evil because, well, few enjoy the sacrifice of income.

Economists have a different take. Taxes aren’t fundamentally evil because they’re necessary, but they do distort economic behavior, and the distortions should be minimized. Taxing capital discourages investment, for instance. Taxing wages discourages labor. By altering incentives, taxes hinder efficient allocation of productive resources. The challenge, then, is to design a tax system that raises the revenue needed with the least possible distortion: optimal taxation.

They use a model of dynamic trade to understand the interplay among nations that trade, but set tax policy nationally. In what ways should nations coordinate policies?

The effort has intrigued and challenged some of the field’s finest minds, from Frank Ramsey, a brilliant young scholar at Cambridge University whose vital insights in two short articles have guided economists for the past century, to James Mirrlees, another British economist, who won a Nobel Prize in 1996 for his exploration of how nations can raise enough tax revenue to provide adequate social insurance without discouraging work effort.

Understanding the elements of an optimal tax system is precisely the goal of Minneapolis Fed economists V. V. Chari and Juan Pablo Nicolini, with their colleague Pedro Teles, and they’re explicit in acknowledging their debt to previous scholars—“we use both the Ramsey and the Mirrlees approaches to optimal taxation.” But their analysis goes well beyond, extending globally. And they use a model of dynamic trade to understand the interplay among nations that exchange goods and services, but set tax policy at the national level. In what ways should nations coordinate their tax and trade policies?

To achieve Pareto-efficient optimal taxation within a fiscal union, trade and capital mobility should be unrestricted, and trade agreements should be combined with fiscal policy agreements.

Chari, Nicolini, and Teles seek answers to what they refer to elsewhere as “classic policy questions.” Should tax rates be uniform among nations? Should international trade be unrestricted by tariffs and subsidies? What level of capital mobility is best? Should taxes be based on where goods are produced or where they’re consumed? Should tax adjustments be made at national borders to compensate for tariffs?

The economists examine taxation at many levels, focusing particularly on what should be taxed, where those taxes should be levied, and what adjustments should be made. And underlying the entire examination is the restriction of “Pareto efficiency”—that a tax system is efficient if altering its elements would entail a loss for someone covered by it. The 80-page paper is a complex piece of work—purely theoretical, highly technical—and this brief summary touches only the surface.

Among the key findings:

To achieve optimal taxation that is Pareto efficient within a fiscal union,

  • Trade and capital mobility should be unrestricted.
  • Trade agreements should be combined with agreements on fiscal policy; without coordination, the latter can undo benefits of the former.
  • Taxation should be based on where products are consumed rather than where they’re produced.
  • Household asset income should be taxed at a uniform national rate, and corporate income should not be taxed.
  • If used, value-added taxes should be subjected to border adjustments.

A benchmark, explored and extended

The economists begin with a benchmark trade model that includes taxes on just three things: consumption, labor income, and international trade. This benchmark shows that optimal allocations are production efficient. To oversimplify, that means that there is no less expensive way to produce any given set of goods and services internationally. To achieve this, import tariffs must exactly offset export subsidies.

Once these trade taxes are set, labor income and consumption tax rates can be determined. The model also demonstrates that because nations differ in productivity rates and preferences about savings versus consumption, tax harmonization—all nations having identical tax rates—is not necessarily optimal.

The economists then tweak the model, altering features to explore various types of taxes and related policies, from corporate income taxes to transfers between governments to value-added taxes. The result is a rich portrait of optimal taxes in a global context.

The model shows, for example, that if governments agree to lump-sum transfers among themselves—to compensate for varying levels of economic development, perhaps, or to facilitate negotiations on another front, like immigration or the environment—they can set trade taxes to zero. That demonstrates that such trade taxes are simply a means of intercountry redistribution. Adding corporate income and household asset taxes does little to change these outcomes.

Taxes, added and subtracted

The economists also find that altering the benchmark to eliminate consumption and trade taxes, but allowing intergovernment transfers and taxes on labor income, corporate income, and household asset income can be Pareto efficient if corporate income taxes are set to zero and then taxes on labor income and household asset income are set accordingly. In that context, setting corporate income taxes at any rate other than zero restricts capital mobility, demonstrating the need to coordinate trade agreements with fiscal policy.

It is optimal to tax household asset income of all sorts—interest, dividends, and capital gains— at a uniform rate. And residence-based tax systems are preferable.

It is optimal as well, they find, to tax household asset income of all sorts—interest, dividends, and capital gains—at a uniform rate. And because taxation on household asset income is necessarily based on residence and corporate income is source-based, that implies that residence-based tax systems are preferable. If source-based taxes are preferred for administrative reasons, they can be efficient if adjusted; source-based taxes on corporate income, for instance, should be constant and exclude investment expenses.

The economists also consider value-added taxes—a common tax internationally, though not in the United States—and study the disagreement among economists about the advisability of border adjustments. Border adjustments are essentially taxes levied on imports but not exports (similar to residence-based taxation rather than source-based). The economists’ analysis favors supplementing value-added taxes with border adjustments, paralleling their recommendation of residence-based taxation. “Destination-based systems,” they write, “have advantages over origin-based systems.”

Generalizing the model

Chari, Nicolini, and Teles point out that their model is not applicable solely to international settings. States or provinces of individual nations also trade with one another and set tax policy within their jurisdictions. Public goods financed by a national government can be reinterpreted as local public goods. The model’s findings are equally relevant in this context.

Their results extend to environments in which tax rates vary for different individuals, and governments lack knowledge of people’s productive potential or work effort.

And they further generalize, arguing that their results apply to international trade models other than the specific mathematical formulation they use and can extend to environments in which, à la Mirrlees, tax rates vary for different individuals and governments lack knowledge of people’s productive potential or work effort. In these contexts, too, they find, trade and capital mobility should be unrestricted.

In addition, their results, derived for a setting without economic shocks, apply equally to models in which the economy is subject to aggregate fluctuations—that is, when shocks cause economic downturns and upswings.

The paper, in sum, is comprehensive—extending to multiple settings, assumptions, and models—and flexible in its capacity for evaluating different elements of taxation. As such, it stands as a foundation on which future analysis of international tax systems will likely be based. Even in the age of Brexit, designing such systems remains a “pressing concern,” write the economists, as the European Union discusses tax harmonization and the potential of forming a fiscal union. Tax reform in the United States may also benefit from its findings on border adjustment taxation.

Douglas Clement
Managing Editor

Douglas Clement is a managing editor at the Minneapolis Fed, where he writes about research conducted by economists and other scholars associated with the Minneapolis Fed and interviews prominent economists.