Social Comparisons and Optimal Taxation in a Small Open Economy

Almost all previous studies on optimal taxation and status consumption are based on closed\nmodel-economies. This paper analyzes how international capital mobility – which may\nconstrain the use of capital income taxation – affects the optimal redistributive income tax\npolicy in a small open economy when consumers care about their relative consumption. If the\ngovernment can perfectly observe (and tax) returns on savings abroad, it is shown that the\npolicy rules for marginal labor and capital income taxation derived for a closed economy largely carry over to the small open economy analyzed here. However, if these returns are unobserved by the government, the marginal tax policy rules will be very different from those pertaining to closed model-economies. In this case, capital income taxes on domestic savings will be completely ineffective, since such taxes would induce the consumers to move their savings abroad. The labor income tax must then indirectly also reflect the corrective purpose\nthat the absent capital income tax would otherwise have had.