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Economic integration and the optimal corporate tax structure with heterogeneous firms

Christian Bauer, University of Munich
Ronald B. Davies, University College Dublin
Andreas Haufler, University of Munich

IIIS Discussion Paper No. 373

We study the optimal combination of corporate tax rate and tax base in a model of a small open economy with heterogeneous firms. We show that it is optimal for the small country's government to effectively subsidize capital inputs by granting a tax allowance in excess of the true costs of capital. Economic integration reduces the optimal capital subsidy and drives low-productivity ¯rms from the small country's home market, replacing them with high-productivity exporters from abroad. This endogenous policy response creates a selection e®ect that increases the average productivity of home ¯rms when trade barriers fall, in addition to the well-known direct effects.

Keywords: corporate tax reform, trade liberalization, firm heterogeneity
JEL Classification: H25, H87, F15

Last updated 28 August 2014 by IIIS (Email).