Optimal Taxation of Foreign Assets and Production Factors in a Small Open Economy∗

This paper studies the dynamic Ramsey taxation of foreign assets in a small open economy model with international mobility of capital. The benevolent government of the small open economy chooses taxes on factors of local production and net foreign assets to finance an exogenous stochastic stream of government expenditures. The government can fully commit to future policies and balanced budgets, and can observe net foreign assets at the aggregate level but not the resident household’s individual accounts. The paper finds that the optimal tax scheme replicates a flat tax rate on households total assets, no matter whether they are held at home or abroad. Furthermore, numerical simulations show that it is optimal to tax foreign assets and physical capital rents to insure against fiscal shocks, while the expected burden of fiscal expenditures is mostly borne by labor income. The welfare gains of introducing the tax on foreign assets according to the Ramsey policy are quantified between 2.3 percent and 0.4 percent of annual consumption. The results can be related to the bilateral withholding tax agreements that Austria and the United Kingdom signed with Switzerland in the ongoing European debt crises. ∗I wish to thank my advisor Fabrizio Zilibotti, Timo Boppart, Filippo Brutti, Gino Gancia, Michelle Rendall, Dominic Rohner, Kjetil Storesletten, Christoph Winter, Josef Zweimüller, as well as participants of the Zurich Workshop on Economics 2012 and the Doctoral Seminars at the University of Zurich for the great support at all stages of this work. †Email: [email protected].