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The Status of Capital Income Taxation in the Open Economy

The paper addresses the issue of the low taxation of capital income for a small open economy which is completely integrated into the world capital markets. First, the closed- economy optimum tax proposition is extended to the open economy, by appealing to the efficiency of a residence-based taxation, with a zero tax rate at the steady state. Second, the paper proves that if containing capital flight is not feasible, it is efficient to tax exempt capital income from domestic sources along the transition path, as well, Third, even though it is efficient to let capital flow freely when taxation of foreign-source income is possible, capital controls are second-best efficient when such tax policy is infeasible.