Policy commitment and the welfare gains from capital market liberalization

This paper evaluates the quantitative impact of capital liberalization on the taxation structure and welfare of the liberalizing countries when governments conduct fiscal policy optimally but without commitment (time-consistent policies). The transition from a regime of capital autarky to a regime of free mobility leads to a decrease in the long-term tax rate on capital of 13 percent and an increase in the tax rate on labor of 2 percent. As a consequence of this taxation shift, welfare increases by about 1 percent. The reduction in capital taxation induced by capital market liberalization is welfare improving because, in the absence of capital mobility, the time-consistent policies over-tax capital. ∗I would like to thank Hilary Appel, Thomas Cooley, Jason Cummins, Per Krusell, Jonathan Heathcote, Vı́ctor Ŕıos-Rull and Akos Valentinyi for helpful comments. Send correspondence to: Vincenzo Quadrini, Department of Finance and Business Economics, Marshall School of Business, 701 Exposition Boulevard, Los Angeles, CA 90089. e-mail: [email protected]