Economic integration and the optimal corporate tax structure with heterogeneous firms

Published: Aug. 1, 2011, 11 a.m.

b"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 e\\xaeectively 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 firms from the small country's home market, replacing them with high-productivity exporters from abroad. This endogenous policy response creates a selection effect that increases\\nthe average productivity of home firms when trade barriers fall, in addition to the well-known direct effects."