International macroeconomic theory shows that domestic tax policy in a global economy affects foreign economic conditions via complex, dynamic interactions through relative prices, tax revenues, and wealth distribution. This paper proposes a tractable quantitative framework for assessing tax policies that is consistent with this theory. The significance of the international transmission channels of tax policy is evaluated in the context of a “workhorse” two-country dynamic general equilibrium model. The model is used to assess the potential effects of the European harmonization of capital income taxes. The results show that this policy, if enacted along the lines followed in harmonizing value-added taxes, yields large capital outflows and a significant erosion of tax revenue for Continental Europe while the opposite effects benefit the United Kingdom. Welfare in the United Kingdom rises as result, while Continental Europe may incur a substantial welfare cost.

Introduction

One of the main themes of Assaf Razin's extensive research program is the analysis of the policy implications of the dynamic macroeconomic theory of international taxation. In joint work with Jacob Frenkel, with Elhanan Helpman, and with Efraim Sadka, Razin produced seminal contributions that were among the first to formalize the microfoundations of the intertemporal analysis of tax policies in open economies. These studies were part of a growing literature that examined the international implications of tax policies within the context of dynamic general equilibrium models.